United States: Court Of Appeal Sets Out Correct Approach To Material Adverse Change In Respect Of Prospects Warranties

In an update to our May 2023 blog on the case, the Court of Appeal has held in Decision Inc Holdings Proprietary Ltd & Another v. Stephen Garbett & Another¹ that the High Court erred both in its interpretation of and approach to a material adverse change in prospects warranty in a share purchase agreement.

The court also determined that a notice provision requiring Decision to summarise the nature of a claim and the amount claimed required it to give an amount claimed in respect of each of the alleged breaches.

Background

In October 2018, Decision Inc. purchased the entire shareholding in Copperman Consulting from the defendants, Stephen Garbett and Anis El-Mariesh.

The share purchase agreement (SPA) contained a warranty that there had been no material adverse change in the prospects of the company since the account's date – namely, 31 December 2017.

Between May and July 2018, the defendants provided Decision with an earnings forecast and various documents setting out the expected pipeline of future work.

Before the sale (but unbeknownst to Decision), the company had performed significantly worse than the forecast, with turnover for August at £270,000 (as opposed to the £630,000 forecast), and for September at £283,000 (as opposed to the £627,000 forecast). After the sale, the company continued to perform badly, with earnings before interest, taxes, depreciation and amortization (EBITDA) for the whole of 2018 at £314,000 (as opposed to the £1.6 million forecast).

Decision issued a claim for breach of three warranties including breach of the warranty that there had been no material adverse change in the company's prospects.²

The High Court's decision on the prospects warranty

The judge started by setting out the three-stage process to determine if a material adverse change warranty had been breached:

• What is the baseline figure?
• What is the actual figure?
• What is the difference between those figures, and is it so large that it is material?

Analysing the prospects warranty, the judge acknowledged that the term 'prospects' could well extend beyond future profitability, but was of the view that – in this case – future profitability was the primary concern of the parties. He focused his analysis on the company's projected and actual EBITDA accordingly.

The judge considered the baseline figure to be 'the expected or forecast level of the relevant factor at the time of the contract', which would be 'the level which reasonable buyers and sellers ... would have agreed to be the most likely estimate of the factor concerned over the period concerned'. In determining the baseline figure for the prospects warranty, the judge considered that the best guide to the expectations of the parties was to be derived from the agreed pricing structure of the SPA. This resulted in a baseline figure of £1 million.

The actual figure the judge compared this baseline figure to was a combination of the actual performance of the company in August and September 2018 and an analysis of what a reasonable seller would conclude the company's likely profitability would be (which was a matter of expert evidence). This resulted in a figure of £326,000.

The judge concluded that the £674,000 difference between the baseline and actual figures was a material difference, and that the defendants had therefore breached the material adverse change warranty as to prospects.

The defendants appealed.

The Court of Appeal's decision on the prospects warranty

Lord Justice Newey, who gave the sole substantive judgment, noted the following problems with the High Court judge's analysis of the prospects warranty:

• The warranty given was that there had been no material adverse change since the accounts date (i.e., 31 December 2017). It was therefore necessary to analyse what the prospects were as of that date and compare them to the prospects at the effective date of the SPA. Instead, the judge had used the expectations of the parties at the time of the contract and had used the pricing structure of the SPA to determine those expectations.
• The comparison undertaken must be between the same things (i.e., the prospects) on different dates. Instead, the judge had used 'the expectations that a reasonable buyer would have had' as to the prospects of the baseline, rather than the prospects themselves.
• The word 'prospects' looks to the future. Accordingly, any analysis of prospects must be concerned with what might happen after the relevant date. However, in establishing the actual figure, the judge had focused heavily on EBITDA for 2018. He was therefore assessing what had already happened by the effective date, not what the company's prospects were after the effective date.
• Finally, had the parties had EBITDA in mind in respect of this warranty, they could have been expected to use that term. The word 'prospects' – naturally read – connotes 'chances or opportunities for success' in a more general way. The judge was therefore wrong to equate prospects with EBITDA alone.

The notice provision

The SPA contained the following notice provision:

'The Sellers shall not be liable for a Claim unless notice in writing summarising the nature of the Claim (in so far as it is known to the Buyer) and, as far as is reasonably practicable, the amount claimed, has been given by or on behalf of the Buyer to the Sellers'.

The defendants submitted that Decision's notice was inadequate, because it failed to give the amount claimed for the breach of the prospects warranty.

The High Court had rejected this defence on the grounds it would not have been possible for the claimants to allocate different values to the different breaches.

The Court of Appeal held that the language of the notice provision – particularly, the phrase 'a Claim' – required Decision to set out the amount claimed in respect of each claim (rather than a total figure for all claimed breaches) and concluded that it was not reasonably open to the judge to find that it was not reasonably practicable to do so. Although any damages sought in respect of the breach of the prospects warranty may have overlapped with the damages claimed in respect of the breach of the other warranties, that did not prevent Decision from assessing what the damages would be if no other breach of warranty were alleged or made out.

The failure of Decision to include the amount claimed in respect of the breach of the prospects warranty meant that the defendants could not be held liable for any such breach.

On that basis, the appeal was allowed, and the claim was dismissed.

Takeaways

The errors the High Court judge at first instance fell into in his analysis of the prospects warranty are an excellent demonstration of just how difficult these clauses can be to interpret – and how easy it can be to get it wrong. The more clarity that can be brought to bear at the drafting stage, the more certain buyers can be as to their possible recourse.

Buyers and their representatives must take heed of the swelling body of case law on failure to comply with notice provisions. This, again, starts with drafting these provisions clearly, so there can be no doubt as to the level of information that is to be provided.

Footnotes

1. [2023] EWHC 588 (Ch)

2. Decision's claims in respect of the other alleged breaches of warranty failed and were not the subject of the appeal – and so are irrelevant to this blog.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.