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M&A Diligence: a case study on Warranty Claims
The recent case of The Hut Group Ltd v Nobahar-Cookson & another  All ED (D) 215 Nov considered three key issues related to making a warranty claim:
- notification of a claim;
- the attribution of the acts of a party’s employees to that party; and
- the quantum of damages available to the claimant.
By way of background, the Buyer had acquired the entire issued share capital of the Target (a sports nutrition business) from the Sellers, the consideration for such acquisition being paid partly in cash, and partly in shares in the Buyer. The Buyer brought a claim against the Sellers for breach of an accounts warranty, and the Sellers brought a counterclaim for breach of one of the Buyer’s warranties (relating to the financial state of the Buyer, given as the Sellers were receiving shares in that entity).
In relation to the Buyer’s claim, the main point of interest was whether the Buyer had complied with the notice provisions set out in the share purchase agreement (SPA). The SPA stated that the Sellers would not be liable for a Claim unless the Buyer served notice on the Sellers “(specifying in reasonable detail the nature of the Claim and, so far as practicable, the amount claimed in respect of it) as soon as reasonably practicable and in any event within 20 Business Days after becoming aware of the matter”.
The Seller raised two arguments in relation to this provision: first, that the Buyer had not served notice within the agreed timeframe, and second, that the notice provided by the Buyer did not contain the required detail.
In relation to the former, Blair J held that “becoming aware of the matter” meant “becoming aware of the claim”, and that therefore the Buyer had actually served notice in time. He held that this construction was in accordance with common commercial sense, as without knowing that a claim had a proper basis the Buyer would not expect to have to notify the Sellers of it. The Buyer only knew that it had a claim after it had obtained advice from its accountants, and did indeed notify the Sellers of that claim within 20 Business Days of receiving that advice. However, the judge did also note in passing that courts should not be predisposed to interpreting tight timeframes in a way that is effectively “pro-notifier” - parties should be free to agree short timeframes for notification, as it is generally accepted that breach of warranty claims can be costly.
In relation to the latter, the judge held that “in reasonable detail the nature of the claim” meant that “not much was contractually required”. The judge referred to ROK plc v S Harrison Group Ltd  EWHC 270 (Comm) where it was held that this wording set a relatively low bar as to the amount of information that had to be provided. If the parties had intended more detail to be required, they should have specified such requirements in the contract. Therefore, in The Hut Group, the Buyer had provided sufficient information in accordance with the SPA.
The Sellers’ counterclaim arose due to large scale accounting fraud which had been committed by (inter alia) the financial controller of the Buyer, prior to completion. This fraud led to the Buyer being in breach of its warranties to the Sellers.
The main point of interest in relation to this counterclaim related to whether the fraud of the financial controller (not a named person in the SPA) could be attributed to the Buyer, such that the cap on the Buyer’s liability fell away. The judge, citing Man Nutzfahrzeuge AG v Freightliner Ltd  EWHC 2347 (Comm), held that this attribution of action was not a matter of vicarious liability, or a question of whether the financial controller’s knowledge should be attributed to the Buyer, but as whether the financial controller should be regarded as representing the Buyer.
Blair J held that, on the evidence, the fraud of the financial controller could be attributed to the Buyer itself, and the judge stated his reasons for this conclusion as follows:
- the financial controller was heavily involved in the transaction as he had provided the Buyer’s financial information which was essential for the deal to reach completion. It did not matter that the financial controller was not a “front facing” part of the deal team;
- this was not an isolated incident of one person acting alone, as one other member of the finance department was dismissed and three others were disciplined; and
- the context of the financial controller’s actions should be taken into account. There was evidence that he was under pressure from senior management to produce results and forecasts showing the Buyer in a favourable light, and the financial director (though himself not accused of fraud) played a part in creating an atmosphere where fraud was allowed to flourish.
The judgement set out a useful summary of the general approach to be applied to the quantification of claims for breach of warranty:
- The measure of loss for a breach of warranty in an SPA is the difference between the value of the shares as warranted and the true value of the shares. Blair J described this approach as “warranty true” versus “warranty false”, a measure which will not necessarily allow the claimant to recover all the costs of rectifying the problem created due to the breach of warranty. If the Buyer (the typical claimant) wants to be able to recover these additional heads of loss, it will need to include an indemnity in that regard in the SPA. Giving warranties on an indemnity basis is still not market practice within the UK, but is obviously more justifiable where an issue is known to the Buyer.
- Damages will usually be assessed at the date of the SPA, as that is the date when the breach of warranty occurs. Blair J rejected the Buyer’s contention that post-completion trading should be taken into account when assessing the quantum of the breach. Therefore, improvements in the state of the Buyer (and therefore the Sellers’ shares in the Buyer) were not relevant.
- In relation to the specific facts of this case, Blair J held that the correct quantification of damages would involve comparing the EBITDA of the Target on a “warranty true” versus “warranty false” basis, using the same multiple across both valuations. He disallowed on the facts the Buyer’s assertion that a lower multiple in the warranty false scenario should be used in relation to the Buyer’s claim for breach of the Sellers’ warranties, finding that a reasonable buyer and seller would not have revisited the multiple as well as the EBITDA.
For more information, please contact Gayatri Sehdev, Corporate Senior Associate