What is covered by an indemnity for "liabilities"?

This blog examines the recent Court of Appeal decision relating to the acquisition of Nottingham Forest FC and asks what type of liabilities is a seller liable for under a liabilities indemnity?

Case Reference: Al-Hasawi v Nottingham Forest Football Club Ltd [2019] EWCA Civ 2242

Background: this case related to the purchase of Nottingham Forest Football Club (the Club) by Mr Evangelos Marinakis from Mr Fawaz Al-Hasawi in May 2017. Although the sale price for the shares in the Club was only £1, the transaction was structured so that the seller's existing loans of £6 million would be repaid by the buyer following completion and the Club would be purchased free of other financial debt.

This was a relatively unusual transaction in that due to the short period leading up to the signing of the share sale agreement (SPA) the buyer was not able to carry out the usual full due diligence exercise in respect of the Club, and had, to a large extent, to rely on information about liabilities disclosed by the Club. A key document produced by the Club's accounting department in that respect was a trial balance produced in January 2017 from a set of management accounts for the year ending December 2016 that showed the Club's financial position as at that time and specifically showed an overall liabilities balance of £6.6 million.  

The trial balance was produced in accordance with FRS 102 which requires a company to book liabilities on an accruals basis, ie in the accounting period in which they are incurred, not when they are actually discharged. (Unlike accounts which are prepared on a cash basis which simply record outgoings when they are paid. Accounts prepared on an accruals basis must recognise and report liabilities during the financial period in which the obligation or liability is incurred - an example of a specific accrual relating to a liability of the Club concerned the Club's medical officer Dr Peirce, who invoiced the Club in November 2016 for services to be rendered in the period up to June 2017).

Discussion around that trial balance resulted in the negotiation and agreement of a specific indemnity in the SPA at clause 7.1 whereby the seller was to indemnify the buyer for any losses suffered if following completion the buyer was able to establish that the actual liabilities position as at 31 December 2016 was more than £6.6 million.  

Definition of Liabilities: The SPA defined "Liabilities" in specific detail, including (i) a general description of liabilities: "the aggregate amount of all liabilities in respect of any fact, matter or circumstance on or prior to 31 December 2016 (and only to the extent that such liabilities relate to such period); and whether or not due for payment at 31 December 2016; and (ii) some specific examples of items that fell within that definition, (although this also excluded some specific items which were contained in the trial balance, so we can presume that the definition reflected ongoing negotiation between the parties).   

Completion occurred in May 2017, but in October 2017 the buyer brought a claim against the seller under the indemnity, claiming that there were additional accrued liabilities of approximately £604,000.

The issue between the buyer and the seller – what did "Liabilities" mean?: The buyer argued that Liabilities was to be calculated in accordance with how they were calculated in the trial balance – ie FRS 102 on an accruals basis. The seller agreed that the definition of Liabilities included liabilities calculated on an accruals basis BUT the words in brackets "(and only to the extent that such liabilities relate to such period)" were specifically included to limit the amount of those liabilities by excluding any costs which are attributable to services provided or events which occur after 31 December 2016. In effect, it would mean that any accrued liabilities would need to be analysed and apportioned so that the seller was responsible only for the actual costs relating to services or events up to 31 December 2016 and the buyer would be responsible thereafter. 

High Court decision: The High Court gave judgment in favour of the seller. The Judge concentrated in particular on the definition of Liabilities and the specific wording in brackets: "… (and only to the extent that such liabilities relate to such period)…" The Judge concluded that the proper construction of the indemnity was to protect the seller from having to pay for goods and services etc which benefitted the Club in the period after 31 December 2016 and the specific effect of the bracketed words was to exclude liabilities relating to that subsequent period. 

Court of Appeal decision: The Court of Appeal disagreed with the High Court decision and gave judgment in favour of the buyer.  It held that the purpose of the indemnity was to protect the buyer from undisclosed liabilities and the defined term Liabilities needed to be calculated in accordance with FRS 102 as otherwise it would not be possible to compare the liabilities in the trial balance with the actual liabilities as at 31 December 2016 ie it would not be possible to compare "like with like". A key point for the Court of Appeal was that if the High Court Judge's construction of the definition of Liabilities was adopted and applied to the trial balance then it is very likely that the total of those liabilities would not have even reached the figure of £6.6 million contained in the trial balance. As for the wording in brackets, the Court of Appeal's view was that the bracketed words actually confirmed that the liabilities referred to were accruals relating to the relevant period. To apply the High Court's interpretation of the bracketed words would alter the whole accounting basis of the indemnity provision.

Conclusion

Three things to learn from this case:

1. Legal drafting needs to be clear and concise - be wary of drafting (or accepting the other's side's drafting) where that drafting can create uncertainty.  A single phrase or sentence can often have a totally different meaning to different parties.

2. Context is important - when drafting an indemnity, make the commercial rationale for its inclusion clear. This will help a third party reading the indemnity to better understand why it has been included. In the new world of modern contractual construction, having signposts in a contract are a useful aid to contractual interpretation because the unitary exercise of contractual interpretation includes considering both the written text and the context.

3. Was an indemnity the right approach here? A financial adjustment mechanism would have provided the buyer with the certainty of being able to achieve a pound for pound adjustment and would have included much more detail on how Liabilities were to be calculated including by reference to specific accounting provisions.  

Finally, I have heard that some people consider this to be a harsh (or a cruel) decision. In one respect they are right – it is after all, "accrual decision"…