Some of these claims arise from deals completed in a hurry, or where the commercial desire to seal a deal has overridden the need to properly secure both parties’ positions through the transaction documentation. Claims for breach of warranty can also be initiated by more cynical purchasers as a matter of policy in all the acquisitions they carry out; or they may also be used as a means to avoid or delay tranches of deferred consideration.
Whatever the background, purchasers who choose to claim breach of warranty can come across a number of stumbling blocks to a successful claim. Some of these are considered below.
Damages
The measure of damages in a breach of warranty case is the difference between the value of the business sold as warranted and its actual value.
It is often assumed that the value of a business sold as warranted is equivalent to the consideration paid. However, sometimes the warranted information only supports a proportion of the consideration paid. The purchaser may have paid more for a number of reasons, such as their own projections of what the company could achieve in the future, which may be based on comparable businesses rather than warranted information on the business acquired.
Understanding the valuation that the warranted information supported should be the starting point to assess the damages a purchaser could credibly recover.
Bases of valuation
Arguments over how a business was valued when it was acquired can become central to quantifying potential damages. This was highlighted in Senate Electrical Wholesalers v Alcatel Submarine Networks [1999].
In this case the claimant pursued damages in excess of £26m based on an alleged breach of warranty relating to historic trading figures, but based on a valuation that was at odds with the split of the consideration specified in the sale and purchase agreement. At first instance, the court took an approach which assumed that had the purchaser been aware of the overstated trading figures it would have negotiated a reduction in the consideration estimated at £5m. But the Court of Appeal awarded no damages, even though the court found for a material breach of warranty following an overstatement of the profits reported in warranted management accounts. The Court of Appeal judgment said: “In our view it is quite clear that if this is how the original price is calculated, it is the obvious way to calculate the damages by applying the same multiplier to the shortfall in maintainable earnings/profits…”
The Court of Appeal’s decision in this case underlines the link between the basis of valuation to arrive at the original consideration and the basis of damages for a subsequent finding of breach of warranty.
This decision therefore demonstrates that the eventual outcome of a breach of warranty case may be a finding of a breach, but no loss. Clearly, this is an unattractive prospect for a claimant, considering the time and expense involved in bringing such an action.
The claimant’s own accounts — having it both ways?
When one company purchases another, the directors of the acquiring company might perceive, after the event, that what they bought is worth less than they paid. But how should they disclose this impairment of the asset acquired in its own accounts?
Accounting standards dictate that the identified impairment of the value of the business acquired should be recognised in the acquiring company’s audited financial statements. But this suggests to their audience, including the company’s investors and the financial markets, that the directors made an error of judgement and bought an overpriced company.
The directors can only be vindicated in their decision to acquire the business if they pursue a claim for breach of warranty successfully and secure damages to compensate for their perceived overpayment.
This tension can lead claimants to try and have it both ways: they claim for the acquired business being worth less than as warranted, but do not reflect this impairment in their accounts. The particulars of claim in a breach of warranty case can therefore be completely at odds with the treatment of the transaction in the claimant’s own audited financial statements.
This arose in Senate, where the claimant made what was described as a “massive” claim by the Court of Appeal, but the audited financial statements of the claimant indicated only a “modest” loss. The Court of Appeal commented: “…it hardly lies in the mouths of the directors or auditors of Senate to say that the accounts were wrong having regard to their statutory duties…”
One of the first courses of action for a defendant in a breach of warranty case should be to examine the financial statements of the acquiring company to see if they can identify such an obvious conflict with the particulars of claim.
The directors of the claimant company have limited room for manoeuvre to avoid this tension between what they report in the financial statements and the basis of its claim for breach of warranty. One practical solution might be to settle the case before the perceived impairment to the value of the business acquired has to be disclosed to the outside world. This could influence the tactics in the case.
Warranties over accounts
A variety of warranties may have been given on the results reported in the audited financial statements and management accounts of the company being sold. However, a number of these may turn out to be problematic for the vendor if a claim under the warranties is brought against them.
For example, giving a warranty that includes the word ‘accurate’ in relation to accounts is likely to leave the vendor exposed. This term is fundamentally incompatible with the basis on which accounts are prepared, which involve judgement rather than the absolute precision that the word ‘accurate’ implies.
Any warranties given over management accounts can be dangerous for vendors, unless the management accounts in question are really of the standard that the warranty implies. In our experience management accounts do not measure up to the warranties given over them, which, with hindsight, could have been identified at the time of transaction.
As this article highlights, claims for breach of warranty may not be as cut and dried as some claimants think.
Doug Hall is head of forensic services at Smith & Williamson.
LitigationJuly2008
