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This recent case is a useful illustration of how the law works when you buy shares in a company and later have a warranty claim.
Sorry, quite a lot of background here (in fact there are three of them) but all possibly useful stuff to know particularly if you ever want to buy or sell a business…
Background (1) – Differences between a share sale and an asset sale
When a buyer wants to buy a business which is owned by a company, it can either buy the business assets of the company as a going concern (an ‘asset sale’) or it can buy the shares in the company (a ‘share sale’). In each case the price will ultimately be what the seller is prepared to accept and what the buyer is prepared to pay.
In an asset sale the buyer buys selected assets which are owned by the selling company, such as premises, plant and equipment, stock, benefit of ongoing contracts, work-in-progress, debtors and IPR. The value of these assets is usually worked out from the accounts of the business or from separate agreed valuations. The buyer then also buys the ‘goodwill’, which effectively represents what the buyer is prepared to pay for the business assets it is buying over and above their aggregate individual values. The buyer may choose not to buy selected assets, for example cash or certain contracts it does not want to take over, which the selling company will then retain. For tax and accounting reasons the sale agreement will generally set out the agreed price for each of the assets being bought, including the goodwill. The buyer may agree to take on certain liabilities, such as those relating to ongoing contracts it is taking over. And whether it wants to or not it will automatically take on certain employee liabilities under TUPE. All other liabilities will remain with the selling company.
In a share sale the buyer is buying the shares which represent the ownership of the company. The buyer is not buying selected assets owned by the company. By buying the shares in it the buyer effectively gets the company warts and all, with all its assets and liabilities (including tax).
Background (2) –how are shares valued?
As with an asset sale, the price of the shares will be whatever the parties manage to agree.
There are many different ways to value the shares in a company. The approach taken in any particular case may depend on the company’s business sector and the types of ‘assets’ it comprises. For example, ‘people’ businesses will generally be valued on a very different basis from property or plant and equipment-heavy businesses. The main differences are between:
- ‘Future earnings’-based valuations (I want to know what return I’ll make each year from my investment). Examples include:
- Market multiple: taking a key financial indicator, such as EBITDA (earnings before interest, tax, depreciation and amortisation) and multiplying it by an agreed number
- Discounted cash flows: effectively converting the sum of the future cash benefits of ownership into a single present day value.
- Balance sheet-based valuations (I want to know what the assets I have invested in are currently worth). For example, a straightforward net asset valuation: all the company’s current assets less all its current liabilities
If you are paying for a company mainly based on what returns it can earn you each year in the future, you may be annoyed if it ends up earning less each year because a warranty you were given was untrue. But so long as there is no negative impact on its future earnings you might be less bothered if one of its assets proves to be worth less than you were promised or if it ends up having a one-off liability you were not told about (for example, a debt or a tax bill).
Background (3): how does the way shares have been valued affect any warranty or indemnity claim a buyer may have?
What is a warranty?
A warranty in a contract is a contractual promise that a statement is true. If the statement proves not to be true this is called a breach of the warranty, which amounts to a breach of contract. The basic principle in contract law is that if there is a breach of contract a claimant is entitled to be put into the position it would have been in if the contract had never been broken. (If you are interested, I went into this in some detail in my previous legal briefings I overpaid because you lied to me and This is how badly you lied to me, which also explained the differences between contractual warranties and tortious misrepresentations.)
Unlike with an asset sale, many share sale agreements do not go into detail as to how the price was reached. It can be helpful if they do, because if it comes to the buyer making a claim against the seller under the warranties set out in the sale agreement the amount of damages the buyer can claim depends on what effect the breach of warranties has on the value of the asset being bought, ie the value of the shares in the company. If it is unclear how the value was worked out it can be hard to say what damages a buyer can claim for any particular breach of warranty.
In a breach of warranty damages claim we are most interested in the purchaser’s point of view as the damages should be based on its loss of bargain, ie what it paid for the shares as against what it would have paid if it had known about the breach of warranty. It is up to the buyer to prove what loss it suffered.
One of the reasons to have warranties is to drag out the existence of problems. A seller can disclose in a disclosure letter certain facts which make a warranty incorrect (eg: warranty: ‘the company has no bad debts’; disclosure: ‘Blah Ltd owes £x but doesn’t look like paying it’). The disclosure letter forms part of the share sale contract (which explains why drafting and negotiating warranties and disclosures and related provisions takes up such a large part of the legals in any share sale).
Once something is disclosed the buyer won’t be able to make a warranty claim based on the disclosed facts. So the buyer effectively accepts the risk. But the buyer might not like this and may try to renegotiate the price or insist on the seller giving an indemnity. When negotiating share sales it is common for a seller to be asked to give indemnities against certain known liabilities and other problems.
It would be technically possible for the parties to agree that something which the buyer knows about should be treated as not having been disclosed for the purposes of the warranties. But this generally doesn’t happen, as the buyer usually just asks for a specific indemnity to cover it.
What is an indemnity?
An indemnity is effectively designed to put the target company (ie not the buyer) into the position it would have been. In the old days these indemnities were often given directly to the target company itself, but for various tax reasons you don’t want to know about they are now worded as obligations to pay the buyer itself, rather than the target company. So for example if it is known that a major debtor is in financial trouble, the buyer may try to persuade the seller to agree to pay the buyer on a £ for £ basis any ultimate shortfall in that debt (ie effectively an amount which would have put the target company in the position it would have been if the doubtful debt had been paid in full).
If a buyer doesn’t know that there is a particular problem it might not ask for an indemnity. Buyers often try to get round this by adding a clause to the warranty provisions which says that if there is any breach of warranty the buyer can choose to make a claim against the seller calculated on an indemnity basis rather than the normal contract law basis. The seller will try to resist this. This is all part of the fun and games of negotiating a share sale agreement.
We are finally getting to the point of the recent case which I was just planning to give you a quick update report on…!
If the seller has given a warranty and hasn’t disclosed a problem and the buyer therefore doesn’t know about it and hasn’t asked for an indemnity to cover it, but says it would have asked for an indemnity if it had known about that kind of problem if it had known about it, can it argue that the amount of damages it can claim for the breach of warranty should be calculated on the basis of the indemnity that it would have asked for if it had known about the problem?
In this case Oversea-Chinese Banking Corporation (‘OCBC’) bought shares in a banking company (‘the company’) from ING. The agreement had a warranty that the 2008 accounts gave a true and fair picture. But in fact the company was owed money by Lehman Brothers which had filed for bankruptcy. The company ended up with $14.5m less than Lehman Brothers owed. Because of the way the price for the company had been worked out, this one-off loss didn’t actually make much difference to the value of the shares and therefore the price that would have been paid for them.
OCBC went to court arguing that if the true position with Lehman had been disclosed it would have insisted on an indemnity to cover the eventual liability not paid by Lehman Brothers, and that therefore ING should pay the $14.5m as damages for the breach of warranty.
What did the court decide?
Well, if you managed to read my rather lengthy background, you can probably guess. The court threw out OCBC’s claim. The judge confirmed the basic law that ‘the basic principle in contract is that the claimant is entitled to be put into the position he would have been if the contract had never been broken’. Here, the buyer was buying shares. The contract was broken because the warranty about the accounts proved to be untrue. So the damages amount should be the loss in value of the shares caused by the warranty being untrue. Which was minimal, based on the way in which the shares had been valued when coming up with a price for them.
Comments and tips
If the shares had instead been valued on a net asset value basis, or at least a clearly understood combination of net asset basis and future earnings basis, then of course the damages calculated on the loss of bargain basis would have been higher. But they hadn’t, so they weren’t. Instead, OCBC were trying to argue that a different type of damages calculation often described as ‘negotiating damages’ or ‘Wrotham Park’ damages which courts sometimes allow, for example in some cases involving breaches of restrictive covenants, should be applied here, which would have been a major change in approach so the court rightly knocked it on the head.
If the buyer had thought about things properly and was really concerned it could have covered its concerns in the contract. It had had the opportunity for example to ask for a specific indemnity against any potential liabilities of a certain type, or indeed it could have asked for a blanket provision giving it the right to make any warranty claims on an indemnity basis of calculation. But it hadn’t, so they couldn’t.
If you are a seller, and know of a potential disclosure you could make against a warranty, you might think about not making the disclosure because then the buyer might ask for an indemnity to cover that known risk (or might pull out of the deal or try to negotiate the price down) and you might figure that this might be worse than the potential hit you might take under a warranty claim. You will obviously need to be careful about the laws relating to misrepresentation, and particularly fraudulent misrepresentation, but I feel I have gone on long enough…
Case: Oversea-Chinese Banking Corporation Limited v ING Bank NV  EWHC 676 (Comm)