Reading time (mins): was going to be only 2 or 3 when I started, but yet again it’s just a little bit longer
Sophistication level (1 (idiot) – 10 (expert)): 7
Entertainment value (1 (turgid) – 10 (side-splitting)): 6
When someone buys a company they want reassurance that they are getting what they are paying for. They will have justified the price to themselves based on various assumptions. These could be a combination of assumptions about the net value of the assets of the company less the liabilities of the company; and assumptions about the profits of the company (its sales less the direct costs incurred in making those sales and less all the other overheads involved in running the company).
Before buying the company the buyer will have made all the enquiries (‘due diligence’) it thinks necessary to get a grip on all these things. It will then get its lawyers to put together a lengthy share purchase agreement setting out loads of different statements of fact which it has assumed to be accurate, which it wants the seller to warrant. If a statement later proves to have been inaccurate the buyer can then ask for some of its money back.
In working out how much of its money it can ask to get back a buyer (and a court if it comes to it) will have to work out how much less the buyer would have agreed to pay for the company if it had known in advance that the statement was inaccurate. The way the share purchase agreement works is that if a seller knows a warranted statement is untrue in any way it can explain this in a ‘disclosure letter’, which effectively forms part of the share purchase agreement. If something has been disclosed then the buyer can’t later make a claim about it. If the buyer doesn’t like the disclosure it can try to change the purchase price, or ask for a specific indemnity relating to the known risk which has been disclosed (eg a disclosure, against a warranty that there is no potential litigation, that so-and-so has threatened to sue for such-and-such); or if the seller won’t agree to reduce the price or to give an indemnity the buyer can just pull out of the deal if it doesn’t want to take the risk.
On top of the disclosure process, the seller will want to add further provisions in the share purchase agreement which exclude or limit its liability under the warranties. For example it will want to set various ‘de minimus’ threshold amounts below which the buyer should not be able to make claims; and it will want to set time deadlines after which the buyer can no longer make a claim. It might also look to exclude certain types of consequential losses which the buyer might otherwise look to recover as part of its claim.
Much of the legal work in dealing with share purchases is spent in drafting and negotiating the warranties and disclosures and the limitation and exclusion clauses.
I have covered some of the above in detail in previous legal briefings,eg Why you have warranties in business and share sales
In this recent case Primus International Holdings Company (‘Primus’) had sold a group of two aerospace manufacturing companies (one in the UK, one on Thailand) to Triumph Controls UK Limited (‘Triumph’) for about US$76 million. The sale agreement included a warranty that the disclosed financial forecasts for the target group had been ‘honestly and carefully prepared’. These predicted that the target group would be profitable in the future (although at the time of sale it was making a loss).
Triumph later discovered various operational and business problems in the target group (broadly relating to planned transfers of production lines from the UK company to the Thai company). As a result the group failed to reach anywhere near its forecasted earnings, and indeed Triumph had to pump a further US$85 million into it to keep it afloat. Triumph claimed that these problems had not been honestly and carefully taken into account in the financial forecasts. The trial judge agreed with Triumph, and agreed that Triumph wouldn’t have paid as much for the group if the forecasts had been carefully prepared, in which case they would have predicted far lower future profitability.
The share purchase agreement contained a somewhat unusual exclusion clause saying that Primus could not be liable for breach of any warranty ‘to the extent that …the matter to which the claim relates…is in respect of lost goodwill’. Primus argued that this clause meant that Triumph couldn’t claim anything, because the only loss it had suffered was in relation to a loss of goodwill.
The case therefore came down to what the agreement meant by the expression ‘loss of goodwill’:
- Primus argued that ‘goodwill’ has a widely accepted meaning in accounting terms, being broadly the difference between the price paid for the shares less the net book value of the group’s assets less its liabilities. This is what accountants or corporate financiers would tell you it means. (They might add something along the lines that this price difference factors in the capitalised value of a business as a going concern, based on the expected free future cash flows of the business discounted to a present value at an appropriate after tax weighted average cost of funds…).
- Triumph argued that goodwill has its traditional legal meaning, being its good name, reputation and business connections.
What did the trial judge say?
She said that the starting point in this case was to work out what loss Triumph would normally be able to recover as a result of the breach of warranty. This should basically be the difference between what Triumph paid for the shares and what it would have agreed to pay if the financial forecasts had been honestly and carefully prepared. Here, the loss should be calculated by reference to the reduced projected profitability of the group, caused by lower revenues and greater costs, that should all have been forecast if the financial projections had been honestly and carefully prepared.
The next step was to work out what effect the exclusion clause had in excluding that loss. The judge effectively said that ‘the plain and natural meaning of goodwill in a commercial contract is business reputation’ (shorthand for good name, reputation, and business connections), and this was nothing to do with the basis on which Triumph’s loss should be calculated. So she said the exclusion clause did not apply at all.
She ruled that if the financial forecasts had been honestly and carefully prepared Triumph would have wanted to pay about US$5.7 million less than it did pay. So this was the amount of damages she would award. The actual amount awarded was then reduced by US$1.5 million because there was an overall $US 1.5 million ‘de minimus’ threshold in the share purchase agreement.
Primus appealed to the Court of Appeal.
What did the Court of Appeal say?
The Court of Appeal completely agreed with the trial judge.
- It seems somewhat amazing that on a deal of this size (or any size) this exclusion clause wording was used, particularly if Primus had really wanted it to have the meaning it said it thought it had.
- As with many cases I report on, we can happily rely on our courts to spin all the legal precedents and arguments and rules of interpretation in a way which applies commercial common sense. As the Court of Appeal said in this case, if Triumph’s arguments had prevailed, Triumph would have deprived itself of most of the force and protection of the warranties in the SPA, without any clear words to that effect.
- in particular may be scratching their heads at all this. The Court of Appeal acknowledged ‘the tension between the commercial approach to goodwill, and the way it is treated by accountants’, but said that was just the way it was and the way it had to be.
- If you are buying or selling a company it can help to make clear in the agreement itself or in the course of discussions the basis on which the buyer has worked out what it is prepared to pay for it. This can be useful when courts are trying to work out later how much a buyer can claim in damages if there is a breach of warranty.
- If you are buying or selling a company it helps if all the clauses in the purchase agreement are as clear as possible. If you are in doubt about what a word used in the agreement means, it can help to add a clause defining it (ie saying what it is meant to mean for the purposes of the agreement).
- If you are selling a company try hard to avoid making any promises about what might happen in the future.