What’s the damage? How to measure damages for warranty claims
We take a closer look at warranty claims in relation to share purchase agreements.
When negotiating a share purchase agreement (“SPA”), a seller will be required to make certain statements about the status, both financial and operational, of the company being targeted by the purchaser. Such statements will be contained within the SPA and are set out as warranties.
For example, a seller may warrant that the company accounts “show a true and fair view of the state of affairs of the Company as at the Accounts Date, and of its profit or loss and total comprehensive income for the accounting period ended on the Accounts Date”.
A warranty is a contractual assurance that a statement made is true. Accordingly, if such a statement made in the context of a SPA by a seller to a purchaser proves to be untrue, this will constitute a breach of warranty and the purchaser may bring a claim against the seller for breach of contract. The usual remedy available to a purchaser for such a breach will be a recovery of damages.
Contractual measure of damages
Ignoring for present purposes limitations on claims set out in the SPA, how are damages for breach of warranty to be assessed?
It is well established that damages in a claim for breach of warranty should compensate the claimant party to put it in the position it would have been in had the information as warranted by the defendant party been true.
Such damages should be calculated by assessing the difference between the value of the company at the time of completion i.e. the “as warranted” value, and the value of the company as a result of the breach i.e. the “as is” value.
Generally, but not in all situations, the value of the company at the time of completion is considered as the purchase price paid for the company, as this is taken to represent the market value for the company at that time.
Tortious measure of damages
A potential purchaser will usually attempt to confirm statements made by a seller as both a representation and a warranty. The main reason for this is that if a warranty is also considered as a representation, it may allow a purchaser to establish liability for misrepresentation, which gives rise to a non-contractual tortious measure of damages, which may be different from contractual damages.
Whether a claim is advanced for breach of contract or misrepresentation can result in a significant difference in the level of potentially recoverable damages available to an aggrieved purchaser. However, it should be noted that in most cases sellers will successfully negotiate that the warranties they provide are purely contractual warranties and not also as representations.
However, in the unusual situation where a seller has provided representations, the key differences between the two types of claim – contractual for breach of warranty vs tortious for misrepresentation - affect how damages in such claims are measured.
These distinctions were placed under the microscope in the case of Sycamore Bidco Ltd v Breslin & Anor . Here the purchaser attempted (albeit unsuccessfully) to establish that warranties contained in a SPA were also representations. In his judgment Mann J helpfully set out the important distinction between warranties and representations and how establishing a statement made in a SPA as a warranty or representation can significantly impact the assessment of damages, he stated:
“The point has a real significance in terms of the measure of damages (and also the date at which damages should or can be assessed), so it is necessary to deal with it. If the claimants are right about it, and can otherwise put their claim successfully in misrepresentation, then they may be entitled to recover damages which would not be available under a contractual claim. At their highest, the misrepresentation claim damages are equivalent to or exceed the consideration paid [approximately £16 million]. At its highest the warranty damages claim is about £6 million. Hence the point’s importance.”
Contractual and tortious assessment of damages
As noted above, contractual damages relate to the loss of bargain whereas tortious damages are intended to put the innocent party in the position it would have been in had the breach not occurred. Whilst it is usually considered by advisors to a seller to be more likely than not that tortious damages may create a higher level of damages (and so they limit warranty claims in a SPA to contractual damages claims), whether or not in all cases contractual damages would be lower than tortious damages will, of course, depend on the specific facts of each individual case.
With regards to tortious damages, these should compensate the claimant party by putting it in the position it would have been had the breach not occurred - essentially this means the position that the purchaser would have been in had they not purchased the company. Such damages should be calculated by assessing the difference between the actual price paid for the company and the value of the company as a result of the breach.
The distinction between the assessment of damages on a contractual basis compared with the assessment of damages on a tortious basis can be best demonstrated by reference to the comments of Lewison LJ in his judgment in the case of Wemyss v Karim :
“Suppose that A owns a painting that he tells B was painted by a famous artist. If it had been, it would be worth £10,000. B pays £8,000 for it. It was not in fact painted by the famous artist and was only worth £100. If B can establish that what A said was a contractual warranty, then he is entitled to £10,000 - £100 = £9,900. But if he can only establish that the statement was an actionable misrepresentation (i.e. a tortious claim), then he is entitled to £8,000 - £100 = £7,900.”
What about a buyer who makes a good or bad bargain?
The assessment of damages in both a breach of contract and misrepresentation scenario may result in the court assessing the quantum of such damages as the same, as it may take the approach that the as warranted value of the company is equal to the actual price paid. However, if the purchaser made a ‘good’ or ‘bad’ bargain in respect of the purchase, the assessment of damages can vary quite considerably.
For example, a purchaser would have made a good bargain if they paid £20 million for a company where the company was worth £25 million “as warranted”. The purchaser later finds however that as a result of the breach of warranty, the “as is” value of the company is actually £15 million. In this scenario the assessment of damages on a contractual basis would be £10 million (i.e. the difference between the “as warranted” value and the “as is” value), whereas the assessment of damages on a tortious basis would be £5 million (i.e. the difference between the physical price paid and the value of the company as a result of the breach).
Using the example above in the context of a bad bargain (i.e. where a purchaser has paid £30 million for a company with an “as warranted” value of £25 million) contractual damages would remain at £10 million. However, in this scenario tortious damages would be assessed at £15 million.
It is important that both potential sellers and purchasers in a SPA remain cautious during the drafting and negotiation of the same in respect of which statements constitute warranties, representations or both, as even small alterations to the contract could have a big impact on the assessment of damages where a dispute later arises. Whilst care should be taken at the negotiation and drafting stage, we reiterate that it is highly unusual for a seller to agree that the warranties provided are also representations and in most circumstances a seller will usually state that warranties are provided purely on a contractual basis.
Accounting for a good bargain
The assessment of damages can alter quite significantly depending on whether a purchaser has made a good or bad bargain, but what is the position where a purchaser has secured a significant discount on an “as warranted” purchase price (a substantial good bargain) such that where a breach of warranty occurs it would not be judicious for the purchase price paid for the company to be considered as the “as warranted” value?
This was considered in the recent case of 116 Cardamon Ltd v MacAlister , in which Weightmans acted successfully on behalf of the claimant. This claim involved a quick sale of a company where the claimant secured a significant discount in the purchase price compared with the “as warranted” value of the company. Following completion, the claimant became aware that the company accounts did not reflect the correct financial position of the company and accordingly, the purchaser claimed against the seller for breach of the warranties contained in the SPA.
The Court acknowledged that there were reasons as to why the company had been sold at a discount and that these should be taken into account when assessing the claimant’s loss. Accordingly, the Court considered that it would be wrong in such circumstances to take the purchase price as the correct figure to represent the company’s value.
In addition to a de minimis limit contained in the SPA of £500,000 which was irrecoverable by the claimant, the SPA contained a cap on the liability of the seller for a breach of warranty (equal to the purchase price of £2.386 million). As such, the Court had to consider whether the “as warranted” value of the company was £500,000 more than the purchase price in order for the claimant to recover the full amount of its claim.
The Court made such a finding and the claimant was awarded the full purchase price in damages.
This case demonstrates that whilst the Court will take the purchase price as a starting point for valuing the warranted value of shares, it will not take that price as conclusive. In addition, the Court’s findings suggest that had the cap on damages not been in place, damages significantly higher than the purchase price may have been awarded by the Court to account for the good bargain made by the claimant.
Can buyers claim indemnity damages even if the SPA provides for contractual damages?
The “hypothetical indemnity” principle presents the argument that damages in a claim for breach of warranty should be assessed on the basis that had the correct and true position been known, the purchaser would have obtained an indemnity which at the time of entering into the SPA it did not actually negotiate.
This point was considered in the recent case of Oversea-Chinese Banking Corp Ltd v ING Bank NV . Here the warranty in question stipulated that the accounts gave a true and fair view of the state of the company. The claimant argued that this warranty was breached as the accounts failed to disclose the full extent of the target company’s liability to a third party by some US$6 million (the liability in the accounts had been stated as US$8.5 million whereas the actual liability was settled upon payment of US$14.5 million).
Interestingly the claimant did not bring its claim on the basis that there had been a diminution in value of the shares (i.e. the difference between the “as warranted” value and the “as is” value) but on the basis that had the third party liability been correctly stated in the accounts, thus meeting the warranty, the claimants would have sought an indemnity in relation to the liability which would have been triggered upon settlement with the third party. The claimant argued that the general rule for calculating damages (the diminution in value approach) could be departed from in appropriate circumstances and that in such circumstances damages could be assessed by reference to the hypothetical indemnity, and the amount which could have been claimed under such an indemnity. Accordingly, the claimant quantified its loss at US$14.5 million.
In its decision, the Court considered, inter alia, whether the claimant could measure damages on the basis of the hypothetical indemnity and divert from the general rule. The Court held that this was not the case and reaffirmed that the only way in which the claimant could recover damages was on the diminution of value basis. As the claimant had not sought damages on this basis the claim failed.
Damages in a breach of warranty claim will usually be measured in order to compensate the claimant and put it in the position it would have been in had the information, as warranted by the defendant party, been true.
The general position is that damages will be calculated by assessing the difference between the value of the company at the time of completion and the value of the company as a result of the breach. Generally, but not in all situations (as referenced in 116 Cardamon Ltd v MacAlister ), the value of the company at the time of completion is considered as the purchase price paid for the company by a willing purchaser to a willing seller, as this is taken to represent the true market value for the company at the time in question.
Parties to a SPA should ensure that they fully understand the warranties being provided and take necessary steps in order to protect their respective positions as much as possible. For sellers this may include the careful use of various methods of limiting liability, whereas purchasers should ensure that where possible, thorough due diligence is carried out and reliance is not placed solely on warranties provided by a seller as a suitable alternative to this.
Buyers wanting the best of both worlds should seek to ensure that warranties are also given as representations and if possible seek an indemnity damages basis as the measure of damages. Sellers will want to limit the measure of damages to the contractual basis and avoid any indemnity measure of damages (save in areas such as tax where it is the market norm to concede indemnity damages).
Sellers will of course also protect themselves against warranty claims risk by disclosure and through the full range of warranty claims thresholds and other limitations which it’s typical to include in the SPA. If faced with a claim, they need to ensure that they challenge the damages measure being asserted and not assume too readily that the face value “cost” of a breach of warranty is necessarily the same value as their damages liability exposure.