In its judgment in Decision Inc Holdings Proprietary Limited v. Garbett and El-Mariesh, the High Court of England and Wales provided guidance on the interpretation of two types of warranties commonly found in sale and purchase agreements (SPAs): warranties as to the accuracy of a company’s records and warranties as to no material adverse change in respect of turnover and/or prospects.
The claimant in the case was ultimately successful. However, buyers should take note that, despite being provided with misleading information about the company’s financial performance, the claimant was not able to make out its claims for breach of warranty as to the accuracy of the company’s records or as to no material adverse change in respect of turnover. The sometimes surprisingly narrow interpretation of the scope of warranties must be appreciated, so that buyers can ensure they actually have the recourse they think they will.
In October 2018, Decision bought the entire shareholding in Copperman Consulting from the defendants.
Copperman is an IT consultancy specialising in the design of enterprise performance management software. The nature of the business is that it will have a small number of large projects ongoing, with relatively little flow work. Accordingly, the continual winning of large contracts is essential. Inevitably, therefore, the negotiation between Decision and the defendants focused heavily on the future business that Copperman might be expected to win.
In May 2018, the defendants provided Decision with a forecast containing the following predictions:
- Earnings before interest, taxes, depreciation and amortization (EBITDA) for the whole of 2018 would be £1.6 million.
- Turnover for August 2018 would be £630,000.
- Turnover for September 2018 would be £627,000.
This forecast was not updated prior to the effective date.
In support of the forecast, the defendants provided Decision with documents in May and July 2018 setting out the expected ‘pipeline’ of future business. These documents also were not updated prior to the effective date.
In respect of Copperman’s actual performance leading up to the sale, the defendants provided Decision with the following (surprisingly scant) information:
- Management accounts up to the end of July 2018, which showed monthly turnover for January to July 2018 as fluctuating between £315,000 – £515,000.
- A schedule of invoices for August, showing revenue for the month of £581,000.
- Despite the paucity of information regarding Copperman’s actual performance and doubt that the projected profits would be achieved, Decision went ahead with the purchase on 8 October 2018.
In fact, before the sale, Copperman had been performing significantly worse than the forecast indicated, with turnover for August of £270,000 (as opposed to the £630,000 forecast) and for September of £283,000 (as opposed to the £627,000 forecast).
After the sale, Copperman continued to perform badly, with EBITDA for the whole of 2018 at £314,000 (as opposed to the £1.6 million forecast).
In early 2019, Decision sought to restrike the deal. When the defendants rejected its proposal, Decision issued a claim for breach of:
- The warranty as to the accuracy of all of Copperman’s ‘financial and other records’.
- The warranty that there had been no material adverse change in Copperman’s turnover or prospects.
The SPA excluded liability for misrepresentation, which is why no claim was brought on this basis.
The High Court’s decision
The records warranty
The judge made the following findings regarding the financial information provided by the defendants:
- The projections set out in the May 2018 forecast and pipeline documents were ‘implausible’. However, the judge found no evidence that these documents did not accurately record the defendants’ beliefs as to the likely course of the financial year at the time the documents were produced. Nonetheless, the judge concluded that the defendants would have been aware that the forecast was not achievable by the time of the sale, as the company was approximately £0.5 million adrift by that time with no realistic prospect of making up the deficit.
- The August 2018 schedule of invoices purported to show revenue collected in August of £581,000. However, the schedule was prepared by aggregating all the invoices that covered the month of August and calculating their gross amount (e.g., a 12-month service contract with an annual value of £30,000 was included in the schedule as revenue of £30,000, rather than the £2,500 actually attributable to the month of August). The judge concluded that this document was prepared with the aim of heading off any further investigation into the financial state of Copperman.
Despite these findings, the question of whether the warranty as to the accuracy of the financial and other records of the company had been breached depended on whether these documents were in fact records of the company.
The judge acknowledged the observations of Mr. Justice Smith in Macquarie Internationale Investments Ltdthat the books and records of a company are ‘the records of everyday transactions which form the bedrock of that company’s account and management systems’, and that the term does not cover management accounts ‘which are more naturally regarded as a product of the books and records of a business than the books and records themselves’. However, the judge concluded that, since the warranty was explicitly extended from ‘records’ to ‘financial and other records’, ‘this term is clearly intended to include the accounts of the company as well as the underlying records from which they are prepared’.
The judge went on to state that it was clear that by no means all documents produced by a company in respect of its business are ‘records’ (as contended by Decision), and, importantly, that the term itself implies a retrospective element, so it could not cover any statement about a future transaction. On that basis, the judge concluded that the forecast and the pipeline documents were not records.
With regard to the schedule of August invoices, the judge concluded that it also was not a record but had been created from the records. It is not clear why he concluded that the term ‘records’ could extend to accounts but not to this schedule. However, he concluded in any event that even if the schedule was used in a way that was calculated to mislead, it was not in itself incorrect or misleading, since it was an accurate statement of the position of the books of the company.
No material adverse change warranty
The judge started by setting out the three-stage process to determine if a material adverse change warranty had been breached.
- What was the baseline figure? This is an objective test and is the level at which reasonable buyers and sellers – had they been asked to do so – would have agreed to be the most likely estimate of the factor concerned over the period concerned.
- What was the actual figure? The ease of establishing this depends on the factor: For turnover, the actual level of turnover as of the effective date can be established by simple inspection of the books. However, for a warranty as to future prospects, analysis may be necessary to determine what the actual prospects were (often this is a matter for expert evidence).
- What is the difference between those figures, and is it so large that it is material? Again, this is an objective test. The question to be determined by the court is whether a reasonable person who had entered into the contract with the aims of the buyer would have sought to withdraw from or renegotiate the transaction had they known of the change. The judge noted that this cannot be reduced to a mathematical expression – ‘everything depends on the circumstances’.
As Decision was in receipt of the company’s accounts up to 31 July 2018, the analysis of whether there had been a material adverse change focused on August and September.
The actual figures were clear: £270,000 turnover in August and £283,000 turnover in September. However, the position was less clear in respect of the baseline figure to be used. The judge, somewhat confusingly, referenced both the historic year to date figures (which fluctuated between £315,000 – £515,000) and the amounts the defendants had forecast (£630,000 and £627,000, respectively), stating that there was ‘prima facie a very significant change, whether the baseline for comparison is taken to be the historic average run-rate or the forecast level’. This suggests that either figure might be the correct baseline, which is odd. While not explicit, the judge subsequently appeared to favour the historic average run-rate – correctly, in our view.
As to determining whether the difference was material, the judge professed some difficulty. While he acknowledged that there was ‘a significant drop’ in the figures, he was not convinced that it was large enough for a reasonable seller to conclude that there had been a fundamental change in the nature of the revenue flows into the company. This indicates the height of the hurdle a buyer is required to overcome to succeed in a claim of this nature.
The judge acknowledged that the term ‘prospects’ could well extend beyond simply a company’s future profitability, but he was of the view that, in this case, future profitability was the primary concern of the parties. He focused his analysis on the company’s projected EBITDA accordingly.
In seeking to determine the proper baseline, the judge rejected the defendants’ forecast of £1.6 million EBITDA on the basis that Decision itself (and therefore, presumably, a reasonable buyer in Decision’s position) did not regard that figure as certain, or even probable. He instead used the pricing structure in the SPA as a guide. This resulted in a baseline figure of £1 million.
The actual figure was a combination of the actual performance of the company in August and September and an analysis of what a reasonable seller would conclude the company’s likely profitability would be (which was a matter of expert evidence). This resulted in a figure of £326,000.
Unsurprisingly, the judge had no doubt that the difference between the baseline and actual figures constituted a material adverse change.
This judgment highlights two potential pitfalls that buyers must keep in mind:
- Be aware of the limited scope of the term ‘records’: If you want ‘records’ to encompass accounts, or other documents purporting to represent a company’s performance, define the term accordingly.
- Do not assume that representations made by a seller regarding turnover and/or future prospects will form the baseline of a claim for breach of warranties in respect of those factors. The court will determine what a reasonable buyer would have understood the turnover and future prospects to be.
  EWHC 588 (Ch).
 Macquarie Internationale Investments Ltd v. Glencore UK Ltd  EWHC 2267.