Post-M&A Disputes Series: Damages

In this final Part 4, we consider the issue of damages (and in particular the quantification of damages).

The background facts of the case are set out in Part 1.  In short, the Buyer purchased the Company, an education business, for some £16.813 million.  Within a year of completion, the Company had to repay £783,325 (the “Clawback”) in funding that had been claimed incorrectly under the applicable funding rules before the sale.

The Buyer demanded the value of the Clawback under an indemnity in the SPA (the “Funding Indemnity Claim”).  The Seller did not contest and paid the value of the Clawback to the Buyer.

The Buyer also brought claims for breaches of warranties, claiming that the Company was worth some £10.1m less than it would have been if the warranties had been correct (the “Warranties Claim”).

The key learning points on damages include the following:

• Warranties and indemnities should always be considered on their particular terms.  This case illustrates that in a post-M&A context they generally target losses of different natures.  Indemnities will provide effective compensation for specific losses and have substantial advantages over warranties  including £-for-£ recovery.  Warranties, when breached, can provide effective compensation to a buyer in respect of an asset (i.e. shares in a company) that is fundamentally less valuable due to a warranty falsehood than it would have been had the warranty given been true.  This case illustrates that damages for breach of warranty can substantially leverage a specific loss.
• The valuation of damages in post-M&A warranty claims is complex and requires expert input (and a buyer should consider expert input before a claim notice is submitted – see Part 1 of this series).  Particularly given the multiples basis of valuation, two experts can quite properly hold divergent views on subjective issues that drive substantially different damage calculations.  The court has the unenviable task of seeking to draw conclusions on how the reasonable hypothetical buyer and seller would have approached the value of the company in its true condition.
• Common provisions in an SPA will materially impact the assessment of damages and available recovery, for example, liability baskets and caps and exclusions (including exclusions of consequential losses and double recovery), as well as clauses regulating mitigation and the conduct of claims. Such clauses can have significant impacts on the outcome of a warranty claim and should be carefully considered and rightly receive substantial attention during the negotiation of any sale.

Quantification of warranty claims: General principles

The compensatory principle for contractual damages seeks to put the innocent party in the position it would have been in had the contract been properly performed.  In a breach of warranty claim under an SPA, this principle looks to the value of the shares that are the subject of the sale.  Damages for breach of warranty will usually be calculated as the difference between the market value of the shares being acquired under the SPA in the condition they were warranted to be in (i.e.: “Warranty True”) and the value of the shares in their actual condition and factoring in the breach (i.e.: “Warranty False”).  This assessment is generally based on the facts and expectations at the date the warranties were given (usually the date of the SPA or, if warranties are repeated at completion, the date of completion).

While the findings in Learning Curve do not change existing common law principles, they offer a useful insight into how those principles play out in practice when applied by a court tasked with tackling these difficult issues.

The court’s findings on quantum

The calculation of the market value of the shares of a target on both a “Warranty True” and “Warranty False” basis inevitably involves subjective judgments as to the agreement that might be reached between hypothetical reasonable buyers and sellers in uncertain counterfactual scenarios.

A very common method of investment banking is to take an enterprise value (“EV”) derived with reference to the earnings of a company, multiplied by an appropriate multiple.  How this multiple is arrived at can be determined by discounted cash flow analysis, comparable transactions or comparable companies (if public), and will be further informed by sector specific factors and iterated by due diligence. As parties negotiate a purchase price, both the earnings and the applicable multiple are subject to significant negotiation. The purchase price may then be adjusted to reflect the net cash or debt position of the business.

In the case of the Company, the purchase price paid by the Buyer was based on a maintainable EBITDA (“MEBITDA”) of some £2.571 million, multiplied by 5.5, plus net cash of some £2.663 million, giving a total purchase price of some £16.813 million.

The court’s approach to the “Warranty True” valuation

The “Warranty True” valuation is usually taken to be the price that the parties agreed.  Absent compelling evidence to the contrary, the agreed price is a good indicator of the value that two willing parties were prepared to accept.  Interestingly, in Learning Curve the parties had hardwired this calculation directly into the transaction documentation by recording the MEBITDA of £2,571,000 multiplied by 5.5 in a Schedule to the SPA.

Recording this calculation in the SPA reduces the scope for argument as to the “Warranty True” valuation.  In particular, the Seller’s arguments that the Buyer had achieved a ‘good deal’ (in the sense that the purchase price was below the true market value of the Company) were largely irrelevant given the parties' agreement on the “Warranty True” valuation.  It may also be beneficial to record an agreed valuation where this is not otherwise apparent from the price payable under the SPA.

The court’s approach to the “Warranty False” valuation

The Buyer claimed that the “Warranty False” valuation was some £10.1 million less than the “Warranty True” valuation, on the basis that the MEBITDA should be adjusted to £1,323,320 (down from £2,571,000) and the multiplier should be 3 (reduced from 5.5).

The Seller claimed that damages should be no more than the value of the Clawback (£783,325) and that leveraging that loss by applying a multiple would overcompensate the Buyer.

The court considered both elements of the calculation:

• MEBITDA calculation - The court approached this as a quantitative assessment of the earnings of the Company and found that the MEBITDA should be reduced by the value of the Clawback.  The Judge found, as a matter of evidence, that if the amount of the Clawback had been known to the parties at the time of the negotiation, it would have fed directly into the MEBITDA calculation.  Accordingly the MEBITDA value for the “Warranty False” calculation was £1,787,675.
• Multiplier – The court considered this to be a qualitative exercise and acknowledged that adjustments to the multiplier involves the evaluation of imponderables through the eyes of negotiating parties. In reality, the multiple adopted by the parties will also have been influenced by their relative bargaining positions at the time. The court heard factual and expert evidence from business valuation experts as to this subjective exercise, including multiples used for M&A transactions that were said to be comparable. The court also had regard to the particular risks to which the Company was exposed as a result of the breach of funding rules, including the risk of more extensive funding audits. Ultimately, making his perception on the quality of the shares of the Company, the Judge found that “it was a matter of common sense that the hypothetical reasonable purchaser would not have been likely to pay as much for the Company in light of the risks thrown up by its breaches of the Funding Regulations”. The Judge’s assessment was that the negotiations between the parties would have led to an agreement that the multiple should be 5 rather than 5.5.

The application of these adjustments resulted in the court’s assessment that the shares in the Company were worth some £5.2 million less than they had been warranted to be worth.

Having taken this approach towards the calculation of the EV, the Judge made clear that he would then “conduct a sense-check” on the implications of the adjustments made to the EV calculation.  The court was satisfied that a price reduction of some £5.2 million reflected a proper assessment of the damages suffered by the Buyer.

A number of additional points of interest arose in the case in relation to damages claims in a post-M&A context:

The Buyer mitigated its losses

SPA provisions often bolster the duty to mitigate with a clause that not only requires a buyer (i.e.: the claimant) to mitigate its losses but also requires the buyer to procure that the target takes steps to mitigate a liability that may give rise to a warranty claim. In Learning Curve, the Sellers challenged the negotiation by the Company of the Clawback amount, with one of the Sellers stating that he did not regard it as “the deal of the century”. The court rejected this criticism, finding that the Buyer had procured that the Company had taken reasonable steps to seek to reduce the liability to pay the Clawback as much as possible.

The use of hindsight

It is well-established that damages should be assessed at the date of breach of the contract, and hindsight should generally not be relied upon when assessing a Warranty False valuation. However, that is not to say that events occurring after the date of breach always have no bearing on a Warranty False valuation.  For example, post-completion events that were known or reasonably foreseeable at signing may be relevant to assessing the value of future contingencies, and/or subsequent events/conduct may assist in assessing how a hypothetical buyer would have viewed the risks or validate the consistency of the claimed loss, as at the transaction date.

In Learning Curve, the Sellers argued that the strong performance of the Company post-completion meant that the Buyer had not actually suffered any substantial loss, and as such would obtain a windfall if damages were to be awarded in the Warranties Claim.  The court rejected these arguments, finding that “a post-SPA rise in value which is referable to steps taken by LCG certainly cannot be regarded as a windfall to be offset against the damages assessed as at the date of the SPA”.

Conclusion

In Learning Curve, the Buyer was compensated for the specific loss suffered by the target company under the Funding Indemnity. However, that recovery did not compensate it for the fact that it had purchased shares in a company that were fundamentally less valuable than they were warranted to be in the SPA.  The Buyer was successful in this claim and secured judgment against the Sellers for some £5.2 million.

The case also illustrates the practical challenges for a buyer in prosecuting a warranty claim.  As considered throughout this series, the Seller contested almost every issue that could be challenged in such a claim, with the court largely dismissing each of the challenges. Nevertheless, having overcome all of those challenges and fought the proceedings for some two years (at no doubt considerable expense and business distraction), the Buyer was awarded damages around half of the £10+ million it had claimed.

The case stands for the proposition that – while warranties rightly provide ‘fall-back’ protection to buyers for risks that cannot be anticipated – in most cases buyers will be well served by robust due diligence during the transaction process to ensure that the risks to which a target business is exposed are well understood and  reflected in the purchase price. In this case, the regulatory non-compliance, if uncovered prior to signing, would have signalled elevated operational risk that a reasonable buyer would price not only through reduced EBITDA assumptions (i.e.: this government revenue stream is now far from certain to be maintained) but also multiple compression (i.e.: is such a multiple defensible given the now increased audit risk, potential funding restrictions and management credibility concerns).

Contributor: Tim Browning, Laura Heeley, Barry Cahill and Dan Jones