Seller opportunism or buyer remorse?

Introduction

In recent months, the English courts have considered a steady flow of disputes arising out of M&A transactions. While straightforward indemnity and breach of warranty claims are well represented among these cases, less common battlegrounds have also been traversed. In many instances, the issues have centred on the drafting of particular provisions in sale and purchase agreements (SPAs) and other transaction documentation. However, difficult questions of principle have also come up which will be of real interest to deal team advisers and disputes lawyers who operate in this area.

In this article, we examine some of the major M&A cases to have come before the courts in the past two years. The case for undertaking such a review now is particularly justified because the incidence of such cases appears to be on the rise. This increase may well be attributable to the recent growth in M&A activity in most business jurisdictions. However, it may also be that buyers are perceiving postcompletion claims as a real opportunity to unlock further value from deals or, viewed less cynically, as an acceptable route to recovering losses for which the seller has accepted liability.

Disputes as to price

In any deal, the appropriate pricing mechanism will be an important consideration. In some cases, a “locked box“ structure will be preferred, whereby the equity price is fixed based on a historic set of accounts, leaving limited scope for post-acquisition adjustment. In other transactions, a “completion accounts“ or “price adjustment“ mechanism may be adopted, whereby the buyer pays an agreed enterprise value at completion which can then be adjusted after completion accounts have been produced. Another commonly used structure is an “earn-out“ mechanism whereby additional consideration becomes payable if the company meets certain financial targets postacquisition, as in Treatt Plc v Barratt & Others [2015] EWCA Civ 116, or the company is sold on by the buyer for a price exceeding an agreed threshold, as in Starbev GP Limited v Interbrew Central European Holdings BV [2014] EWHC 1311 (Comm).

used, its operation may be contingent on compliance with some procedural requirements, such as service of a notice. That was the position in the Treatt case, where the SPA provided for the buyer to serve a notice specifying the amount of the earn-out within a certain period, failing which the amount would be determined by an independent accountant. If a valid notice was properly served, the sellers would then have a limited period in which to invoke the SPA’s dispute resolution provisions, failing which the notice would be binding. The seller having omitted to invoke the dispute resolution provisions, the issue was whether the buyer’s notice was valid – a point which, though technical, was capable of binding the seller to the buyer’s valuation. Construing the relevant clause in the SPA, the Court of Appeal found that it was necessary for the notice to be based on audited accounts, which the buyer’s purported notice was not, thereby rendering it invalid. The decision reinforces the importance of observing the procedural steps which are prescribed.

On a more substantive note, an important question in the Starbev case was whether the buyer had fallen foul of “anti-avoidance provisions“ within the SPA by structuring the on-sale of the company with the purpose of reducing payments due to the seller under the earn-out mechanism. The dispute turned on whether the contractual provisions were wide enough to capture the proceeds of a Convertible Note that were payable to the buyer, and whether the “purpose“ of the Note was to reduce the sums payable to the seller – an objective test which, in the court’s view, required ascertaining the dominant purpose of the transaction. On both counts, the court was satisfied that the antiavoidance provisions applied. This conclusion was reached with the benefit of important factual evidence showing that the Note was given by the on-purchaser at the buyer’s insistence and that the upside for the buyer was, in fact, very limited.

As for the completion accounts or price adjustment approach, it is common for SPAs to provide for post-completion adjustment of the price based on the company’s net debt at closing. One such provision was the source of considerable argument in Bikam OOD & Anor v Adria Cable SARL [2013] EWHC 1985 (Comm), where the seller rejected the net debt figure arrived at by the independent accountant. That dispute was settled under a so-called Net Debt Agreement. However, in the proceedings before the Commercial Court the seller attempted to re-open the issue. On the seller’s case, this was said to be appropriate on the grounds of various misrepresentations made by the buyer which had induced the seller to enter into the Net Debt Agreement. However, none of these alleged misrepresentations were made out on the evidence. The court also gave short shrift to a further argument that the buyer was in breach of a clause in the SPA requiring the buyer to give full access to all accounting information and documents on which the net debt review was based.

A completion accounts regime was also at the heart of the dispute in Shafi v Rutherford [2014] EWCA Civ 1186. Unusually, the issue was whether the expert accountant instructed by the parties to resolve a dispute relating to the draft completion accounts had misdirected himself when deciding that the SPA obliged him to carry forward an error made in the company’s previous audited accounts. Though a question of construction, the Court of Appeal’s view that the expert was not so required was informed by the commercial argument that the parties cannot have expected the expert to ignore the correct implementation of accounting policies. The Shafi case demonstrates how even apparently uncontentious SPA provisions are also being tested before the courts.

Indemnity claims

For buyers, one of the principal means by which they may protect themselves against known financial liabilities of the company is to require the seller to give indemnities. If indemnities are necessary, it is clearly preferable from the seller’s point of view that they are capped at an agreed value. However, even if liability is open-ended, sellers may draw some comfort from the well-known approach that indemnity contracts are to be construed in favour of the indemnifier. That said, the courts will not go out of their way to assist sellers faced with indemnity claims, as shown by various cases in 2014.

In the first of these cases, Heritage Oil and Gas Ltd & Anor v Tullow Uganda Ltd [2014] EWCA Civ 1048, the seller had sold its interest in two petroleum exploration areas to the buyer. Amongst other detailed provisions relating to tax claims, the buyer was required to give notice to the seller of any tax claim within 20 business days. Following completion, the Ugandan revenue authority decided that the seller was liable to pay tax of approximately US$313 million in respect of the profit it had made on the disposal of its interests. When the Ugandan government refused to recognise the transfer of the seller’s interests until the tax liability was paid, the buyer paid the outstanding amount and claimed under the indemnity. However, the seller contended that it was discharged from any liability to indemnify the buyer as a result of the buyer’s failure to comply with the notice provisions which, according to the seller, operated as a condition precedent to its liability. Noting the absence of any wording to show that this was the intention of the parties and the presence of express conditions precedent elsewhere in the agreement – two features of the SPA which strongly militated against the notice provision being a condition precedent – the Court of Appeal rejected the seller’s argument.

In the second case, Wood v Sureterm Direct Limited & Anor [2014] EWHC 3240 (Comm), the narrow preliminary issue before the court was whether an indemnity ‘against all actions, proceedings, losses, claims, damages, costs, charges, expenses and liabilities suffered or incurred, and all fines, compensation or remedial action or payments imposed on or required to be made by the Company following and arising out of claims or complaints registered with the FSA …’ [emphasis added] was to be construed so that the italicised words applied to the whole of the clause, or so that they only applied to the words ‘all fines, compensation or remedial action or payments imposed on or required to be made by the Company’. This issue was important because, if the former construction was correct, the sellers would be relieved from any liability to indemnify the buyer against a potentially large number of motor insurance misselling claims which were not causally connected with an FSA investigation. That commercially unattractive consequence was one of the matters taken into account by the court when finding against the sellers.

Warranty claims

The law affords buyers very limited protection against the risk of the assets changing hands being worth less than the buyer believed at the time of purchase. This risk is generally mitigated via the due diligence process but it can also be addressed by way of warranties. Warranties in SPAs and other transaction documents therefore serve an important purpose, in that they provide the buyer with a remedy if statements made about the company prove to be incorrect.

Share sale agreements often impose restrictions on bringing a claim for breach of warranty (in the same way as for other forms of post-completion relief), for example, a shortened contractual limitation period or provisions specifying the content and timing of an initial notice of claim. In T&L Sugars Limited v Tate & Lyle Industries Limited [2014] EWHC 1066 (Comm), the agreement required the buyer’s warranty claims to be ‘issued and served’ within a certain period, failing which they would be deemed to be irrevocably withdrawn. Notwithstanding the existence of other recent authority to the contrary (Ageas UK Limited v Kwik-Fit (GB) Limited [2013] EWHC 3261 (QB)), the court concluded that the phrase ‘issued and served’ connoted service in accordance with the Civil Procedural Rules and that service in accordance with the agreement’s general notice provisions was insufficient. Nonetheless, the warranty claims were found to have been served in time.

Even if the necessary procedural steps are complied with, there will often be a substantial evidential dispute as to whether the warranties in question have been breached. That was certainly the position in the Bikam OOD case, where the key warranty specified the number of subscribers who had signed up to the target company’s digital television service at completion (a separate matter to the price adjustment issue discussed above). It was also the case in Sycamore Bidco Limited v Breslin & Anor [2012] EWHC 3443 (Ch), where a number of familiar warranties given by the seller (e.g. as to the accuracy of the company’s accounts and the absence of any material breach of contract) were said to have been breached.

Perhaps most interestingly, the Sycamore Bidco case also addressed the typically knotty issue of how the buyer’s losses fell to be valued. In this regard, it is well-established that where a warranty in a share sale agreement has been breached, the measure of loss is the difference between the value of the shares as warranted and their true value. However, this counterfactual exercise of determining what a willing purchaser would have paid to a willing seller in the absence of a market can be fraught with difficulty. For example, it may turn on what the buyer would have done had the true position been known – an inquiry which raises questions as to the factors relevant to the buyer’s approach and potentially requires expert evidence.

The buyer in the Sycamore Bidco case argued that the warranties given in the SPA were also representations in an attempt to side-step the possibility that the quantum of the claim would be reduced by a valuation exercise. If the judge had accepted that the warranties had this dual quality, the effect on the measure of damages would have been significant – enabling the buyer to recover a sum equal to or in excess of the consideration paid, as opposed to the far lower sums available for breach of warranty. However, the argument was firmly rejected and the position now must surely be that clear words are needed for this improbable outcome to arise.

Valuation was also at the centre of the dispute in Ageas (UK) Limited v Kwik- Fit (GB) Limited & Anor [2014] EWHC 2178 (QB), where the underlying point of principle was whether hindsight and subsequent events could be relied on in order to value a company at the date of the breach. Without the benefit of any clear authority, the judge concluded that it was permissible, but that such an approach can only be justified if the overriding compensatory principle requires it, and if the parties have not agreed that the risk of the contingency arising should fall on one party or the other. On this occasion, it could not be shown that the buyer would obtain a windfall and it was implicit in the parties’ bargain (as the deal was structured on a locked-box basis) that any post-locked-box date change of position should inure to the buyer’s benefit. The argument put by the seller in tandem with the buyer’s insurers that the quantum of the buyer’s warranty claim should be reduced was thus rejected.

Warranty and indemnity insurance

The Ageas case involved the buyer’s insurers under a policy of warranty and indemnity (W&I) insurance taken out to protect the buyer against losses resulting from breach of warranty. While there was no issue in the Ageas case as to the scope of cover given under the buyer’s policy, it is worth noting as a brief post-script that W&I insurance is increasingly being used in M&A transactions, where it provides additional coverage for breach of warranty claims above that which the seller is willing or able to offer. A common feature of such policies where they are taken out by buyers (as in the Ageas case) is that they enable the buyer to proceed directly against the insurer, without having to pursue the seller first in order to establish liability. This feature of “buy-side” policies may be particularly attractive, where the seller includes members of the target company’s management team who will continue to be involved with the target company and whose goodwill the buyer therefore wishes to retain. However, in practice, it also means that a significant proportion of breach of warranty claims are likely to be resolved as part of the insurance claim – a trend that is likely to increase as the appetite for this type of insurance continues to grow.

Comment

Drawing the threads together, it would seem very likely given present market conditions, coupled with the current incidence and content of M&A disputes, that the frequency of such cases will remain high. Because provisions in SPAs relating to post-completion relief are generally subject to stringent procedural requirements, procedural points will almost certainly continue be taken where the opportunity presents itself and where the financial and reputational stakes for those involved are high. While the ink is drying on the SPA, the lesson taught by all these cases is that the possibility of post-completion issues arising should not be overlooked.