What's the damage?

On every share sale, the sellers will provide warranties – statements of fact relating to the company being sold – to the buyer. If these warranties are not true, the buyer will be entitled to damages to reflect the reduction in value of the shares acquired. But how is this calculated?

Background

In the recent case of MDW Holdings Limited v Norvill, the Court of Appeal considered the damages that would be awarded to a buyer where the warranties provided by the sellers were not correct.

MDW Holdings Limited (MDW) had acquired the entire issued share capital of G.D. Environmental Services Limited (the Company) from the Norvill family, two parents and their son, for approximately £3.6 million. The Company's business involved the collection, processing and disposal of waste.

The share purchase agreement included various warranties, including that the business had been conducted in accordance with applicable laws, that the Company had all required consents and was not in breach of the terms of those consents, and that there were no circumstances likely to lead to proceedings against the Company.

It is fair to say that these warranties were not true – indeed, the judge at first instance found that there were repeated and persistent breaches of one of the Company's environmental permits; and that there had been "a culture of lying to the regulators when it was convenient to do so", notwithstanding that it was a criminal offence to mislead the Company's two regulators.

What's the damage?

As there had been a clear breach of certain of the warranties, it was left to the court to decide how damages should be calculated. It was not in dispute between the parties that damages should be calculated by looking at the difference between the value of the Company on the basis that the warranties were true (Warranty True) and the value of the Company on the basis that the warranties were false (Warranty False).

Here, the value was to be determined by reference to a typical valuation mechanism – applying a multiple to the Company's EBITDA.

While one might expect that the value of the Company – assuming the warranties were true – is the purchase price that has been agreed between the sellers and the buyer, the judge at first instance decided that the Warranty True value was, in fact, less than the purchase price. This decision was reached after hearing expert evidence – from an expert appointed by MWD and from an expert appointed by the Norvills – that the multiple applied to the Company's EBITDA to calculate the purchase price was "on the high side".

The judge then considered the Warranty False value, looking at the impact on EBITDA of the warranties being untrue – in particular, the additional costs that would have been incurred had the Company been operated lawfully. This has the obvious consequence of reducing the Company's EBITDA for the purposes of calculating the Warranty False value.

In addition, the judge also decided that the multiple applied to EBITDA should be reduced to reflect reputational damage that the breaches could cause the Company and the potential damage to the business of the Company – for example, that the Company could have been prosecuted or lost the licences required to operate the business.

The Norvills appealed to the Court of Appeal on the basis that there should have been no reduction in the multiple applied to EBITDA, because the potential damage to the business of the Company did not actually materialise – in other words, the Company was not prosecuted and did not lose its licences. While it was accepted that damages were to be calculated as at the date of the share purchase agreement, the Norvills argued that the judge should have had regard to how matters turned out.

The Court of Appeal dismissed the Norvills' appeal. It was held that events that occur after a purchase cannot affect the value at the time of the transaction which is, as mentioned above, the relevant date for assessing damages. The judge at first instance was justified in reducing the EBITDA – taking into account the extra costs that the Company would have incurred had it lawfully disposed of waste – and in reducing the multiple applied to EBITDA – on the basis that purchasers knowing the misconduct occurring within the Company would be prepared to pay less for the Company.

Conclusion

While parties to a share purchase agreement spend much time negotiating the warranties and associated limitations of liability, the case highlights the uncertainty as to what damages would be paid if one or more of the warranties turn out not to be true. 

The value of a company on the basis that the warranties are true may not be the same as the purchase price – this will be a matter for a judge to determine, based on expert evidence presented to the court. Further, while it is clear that a court will take into account the impact on EBITDA of a breach of warranty, it is also open to the court to adjust the multiple applied, particularly where the breach of warranty has the potential to cause reputational damage or affect the company's goodwill.

The simplest way to avoid a warranty claim is, of course, to ensure that a thorough disclosure exercise is carried out so that warranties are qualified by matters clearly set out in the disclosure letter. In this case – given that (as the High Court found) the Company had been misleading its regulators – it is perhaps not surprising that the warranties were not true and that appropriate disclosures had not been made.