Alan MacAlister and his wife (Sellers) were co-owners of a UK limited company, Motorplus Limited (Target) which carried on an insurance business. The Sellers weren't involved with the business day-to-day which was operated by a management team.
The Sellers negotiated the sale of their shares in the Target to Cardamon Limited (Buyer) for what they considered a heavily discounted price of ~ £2.3m on the basis that (a) the sale be completed on an expedited basis of two weeks; (b) the Buyer wouldn't carry out due diligence on the Target, and (c) the Sellers would be giving the warranties "blind" as they weren't involved with the running of the business.
The terms of the sale by the Sellers to the Buyer of the Target were documented by a share purchase agreement (SPA). The SPA contained standard warranties given by the Sellers to the Buyer in relation to the Target's 2013 statutory accounts (2013 Accounts), namely that:
- They had not been affected by unusual or non-recurring items
- They did not understate and liabilities
- They did not overstate the value of any assets.
Under the SPA the warranties were qualified by any matters that were fairly disclosed by the Sellers to the Buyer.
Limitations were also included in the SPA providing that:
- The first £500,000 of any claim wouldn't be recoverable
- The Sellers' liability under the warranties be capped at the purchase price
- The Buyer be required to notify the Sellers of non-tax related warranty claims in writing, summarising the nature of the claim, on or before the second anniversary of completion
- The Sellers wouldn't be liable for a claim if it was attributed to changes after completion of the accounting policies applied in preparing the accounts of the Target.
Immediately after completion of the sale, the business faced cash flow issues and the Buyer was required to provide significant cash injections.
The Buyer instructed its auditors to carry out an audit and it was revealed that the Target's 2013 statutory accounts (2013 Accounts) contained material inaccuracies and it was recommended that re-stated accounts be prepared. The re-stated accounts prepared by the Buyer's auditors had to be re-adjusted as follows:
- An increased provision of £2,159,403 in respect of the Target's liability to pay claims under a book of before-the-event legal expenses insurance business (FamilyPlus Scheme)
- A reduction from £570,673 to NIL of the carrying value of a debt owed to the Target by an associated company, Boomerang-Tag Limited (Associated Company).
On 19 May 2016, the Buyer formally notified the Sellers of its intention to bring claims for breach of the warranties discussed above, specifically:
- An underprovision in respect of the Target's liability under the FamilyPlus Scheme (Underprovision Claim)
- The debt owed by the Associated Company to the Target was overstated and should have been written off in full (Overstatement Claim)
- A failure by the Sellers to disclose that mid-way through FY 2013 the Target had changed the way by which it paid insurance brokers which the Buyer argued was "an unusual or non-recurring item" (Unusual Item Claim).
The Buyer brought proceedings for breach of warranty for the full amount of the purchase price.
The High Court upheld the Underprovision Claim but dismissed the Overstatement Claim and Unusual Item Claim.
The judge found that the provision in the 2013 Accounts was a very significant underprovision meaning the Sellers were in breach of the warranty. In addition, it was also found that the Target's statutory accounts for 2012 also contain underprovisions, which made the opening position of the 2013 accounts unreliable.
The Sellers had tried to rely on a limitation in the SPA arguing that the Underprovision Claim had arisen because the Buyer had adopted a different method post-Completion for valuing the FamilyPlus liabilities and, thus, in providing for them. This argument was dismissed.
Whilst the judge accepted that the debt should have been written off in full, the claim was dismissed as the position regarding the debt had been fairly disclosed by the Sellers to the Buyer.
In the Seller's disclosure letter a specific disclosure was made by the Sellers that the provision for the debt in the 2013 accounts represented only one half of the amount outstanding and said that this didn't mean the other half was considered recoverable.
In the disclosure letter it was also stated that all communications between the Sellers and the Buyer were to be treated as generally disclosed. Therefore, the Judge coupled the specific disclosure with email correspondence between the parties and their advisers during the transaction. In these emails the Target's financial controller had said the remaining balance of the debt will likely be written off and the Buyer had acknowledged this.
The Judge held that the position had been sufficiently disclosed as the email correspondence was clear and subsequently echoed by the specific disclosures under the disclosure letter.
Unusual Item Claim
The judge accepted the Buyer's argument that the change was an unusual and non-recurring item and had temporarily uplifted the figures in the Target's accounts.
The Sellers tried to argue that this change was fairly disclosed as it should have been apparent from reviewing the 2013 Accounts. The Judge disagreed on the basis that the uplift could have been caused by various factors and therefore the change should have been specifically mentioned by the Sellers in order for it to have been fairly disclosed.
However, ultimately this claim was dismissed by the judge due to the limitations in the SPA. The Buyer had failed to summarise the claim properly when the Buyer originally notified the Sellers of the claim and by the time the Buyer had done so, the cut-off date for notifying non-tax warranty claims had passed.
Assessment of Damages
The Buyer was entitled to compensation to put it in the position it would have been in, had the information warranted in relation to the Underprovision Claim been true.
The starting point was to calculate the difference between the value of the shares purchased (in effect the value of the Target "as warranted") and the value of the shares given the actual state of affairs ("as is").
The Judge rejected the Sellers’ argument that the Target's "as warranted" value was the price paid. In doing so, the Judge noted the circumstances of the sale had resulted in a discount, and the fact that Target’s earlier accounts contained underprovisions which made them inaccurate.
The Buyer and the Sellers both submitted expert valuation evidence and the Judge decided that it was not actually necessary to arrive at a precise figure, because it was at least £500,000 more that the purchase price. This meant that the Buyer was able to claim up to the cap in the SPA (i.e. the purchase price). It also meant that there was no basis for applying the limitation in the SPA which prevented the first £500,000 of any claim from being recoverable.
The Buyer was therefore awarded damages in the sum of £2,386,247.50.
If you are thinking about selling your business
For prospective sellers, the key take-away from this case is that it is incredibly risky to give warranties "blind" relying only on your managers or advisers.
In this case, in order to get the deal done quickly, the Sellers had given accounts warranties in reliance on their managers and auditors without carrying out their own assessment. These warranties ultimately turned out to be untrue and as a result, they lost the entire proceeds of the sale.
Just because a warranty is 'standard', it doesn't mean proper thought and care shouldn’t be given as to whether a seller can give the warranty or not. As this case demonstrates, just one small error in the accounts can lead to a loss of the entire purchase price.
This case also highlights the importance of the disclosure process. The Sellers were fortunate that their communications with the Buyer during the transaction were 'generally disclosed' under the disclosure letter. This 'general disclosure' is rarely accepted by buyers during negotiations. If that had not been the case, it is unlikely the specific disclosure would have been an effective disclosure on its own.
To be an effective disclosure it must contain sufficient details about the scope and nature of the matter being disclosed. In this case, just an uplift in the figures in the 2013 Accounts wasn't sufficient information to enable the Buyer to realise there had been a change in accounting policies.
Ultimately, the most full-proof way to make a disclosure is to set out any circumstances that might lead to a breach of warranty in detail as a specific disclosure under the disclosure letter rather than assuming the buyer should understand the issue themselves.
Our guide on selling a business may be helpful in this situation: How to sell a business.
If you are thinking about buying a business
Buyers who don't undertake proper due diligence of the target company are also taking a huge risk. Whilst the Buyer, in this case, was able to claim damages up to the purchase price threshold, its losses were said to extend way above the cap and the Buyer will be stuck with these losses.
We also have a great guide on the steps to take when buying a business, here: How to buy a business.
If you are thinking about bringing a breach of warranty claim
When things go wrong, and the buyer needs to notify a warranty claim, it is crucial that the notice complies with the relevant contractual requirements, including any applicable time limits and service requirements. A failure to do so will prevent a buyer from being able to pursue a claim for compensation, even if it is justified on the merits.