Partner Tom Snelling and barrister at Brick Court Chambers, Sophie Shaw, examine how litigation relating to warranty claims may surge due to the combined pressures of COVID-19 and Brexit, in Law360.
Tom and Sophie’s article was published in Law360, 31 July 2020, and can be found here.
With the twin pressures of Covid-19 and Brexit placing businesses from all sectors under acute financial stress, recent business buyers may look closely at their purchase agreements to see if there is scope to recover any losses from the seller or to escape from transactions which have not yet completed. It is therefore anticipated that a wave of breach of warranty and fraud claims will be both threatened and commenced in the near future. This article discusses some of the key questions that are likely to be raised by such claims, and which recent buyers and sellers (and those advising them) should bear in mind.
The unprecedented circumstances under which businesses are now operating seems likely to bring a number of warranties that would often have fallen under the radar to centre stage. Will “material adverse effect” clauses operating between signing and completion allow a (remorseful) buyer to renege on a transaction before completion if Covid-19 has caused a significant change to the financial position of the target? Cineworld certainly thinks so, and has relied on such a clause in pulling out of its acquisition of Cineplex. The first major case that looks set to test this question in England and Wales is the Travelport v Wex Inc litigation concerning a US$1.7 billion deal to buy a pair of travel-payments businesses. An expedited trial is due to take place in September this year and Cockerill J ruled on 5 July 2020 that seven more shareholders could be added to the litigation increasing to over a hundred the number of individual and institutional investor claimants.
Similarly, both buyers and sellers will be interested in the construction of warranties concerning “the ordinary course of business” in relation to the manner in which target firms have responded to Covid-19. Buyers who are yet to complete may look to such clauses for an escape route or to renegotiate the price, as Sycamore Partners has done in relation to its acquisition of a majority stake in Victoria’s Secret in the US. Sellers who are facing reduced or no earn-out payments as a result of poor financial results may also point to the way in which recent acquirers have managed the business to seek further sums despite the fact that relevant financial metrics have not been satisfied. Brexit is likely to generate similar questions and challenges when businesses, particularly those in retail and consumer products sectors, are forced to respond swiftly to the changed and changing trading environment.
The more commonly raised warranties should not be overlooked either. Whether the accounts present a “true and fair view” or are “not misleading” will raise questions as to whether sellers have complied with the relevant accounting standards in recognising and making provision for the effects of Covid-19 and the expected impact of Brexit on the business. What those accounting standards in fact require in such unusual circumstances may be hotly contested with complex, competing expert evidence.
An equally contentious area is the extent to which adverse Covid-19 and/or Brexit impacts will have been disclosed sufficiently to preclude claims for breach. English law leaves the parties to agree the form and extent of any disclosure that will be deemed to be adequate against the warranty, but a thorny issue that often arises is the extent to which a state of affairs has been “fairly disclosed”, exonerating the seller, and how far a seller has to go in bringing specifics to the attention of a buyer. The English Courts do not require buyers to don a deerstalker for Sherlock levels of detective work: “… fair disclosure requires some positive statement of the true position and not just a fortuitous omission from which the buyer may be expected to infer matters of significance.”[i] The fact that the adequacy of disclosure must always be measured against the requirements of the agreement[ii] and is therefore a case specific enquiry is likely to be particularly important given the uncertainties generated by Covid-19 and Brexit. Unsurprisingly, buyers currently in negotiations will be seeking heightened disclosure. Such buyers should also strengthen their contractual position, as a minimum, by refusing general disclosure of materials supplied to it or its reporting accountants but instead insisting on disclosures specific to each individual warranty.
A further consequence of Covid-19 is that buyers may be incentivised to scrutinise transactions and acquired businesses even more closely in order to uncover a fraud. The key attraction of a fraud claim in the current circumstances is the more generous measure of loss. Damages for breach of warranty are usually assessed at the date of breach, reflecting the difference in value between the business had the warranty been true and the actual value of the business received. Post-acquisition losses caused by Covid-19 will not, therefore, be recoverable. In a fraud claim, however, the claimant can recover all the damage directly flowing from the transaction, and the loss is generally assessed at a date after the fraud was discovered.[iii] Bringing a fraud claim will also often be the only way to circumvent contractual restrictions on claims such as exclusion, liability caps and limitation clauses.
Pleading fraud remains, however, a step so serious that “a party risks the loss of its fund of goodwill and confidence on the part of the court if it makes an allegation of fraud which the court regards as unjustified”.[iv] A robust fraud claim undoubtedly raises the temperature, and increases litigation pressure, especially where fraud is alleged against senior management. While a fraud claim can, therefore, increase pre-trial settlement prospects due to the prospect of serious allegations being aired in court, it can equally stymie constructive dialogue between the parties.
A further point worth flagging to potential breach of warranty claimants is the stringent approach to notification clauses that is taken by the courts. Failure to comply with the requirements of such clauses will result in the buyer’s claim failing, regardless of the substantive merits.[v] Potential claimants must ensure they provide a sufficient degree of detail in their notification letter to satisfy the requirements of the clause. They must also not overlook requirements that notification be provided “as soon as possible” or “promptly” as such phrases are not ignored by the courts simply because a long stop date is also given.[vi] Now more than ever, with the ever changing restrictions resulting from Covid-19 presenting further logistical challenges, claimants should not leave service of a notice to the last minute. While would-be claimants may seek to pray in aid the recent Cabinet Office guidance encouraging “reasonable and fair behaviour” in relation to contracts,[vii] there is no reason to think that the courts will look any more sympathetically than usual on a party who has failed to act swiftly and then struggles to effect service at the very last minute. The courts give great weight to the value of the certainty provided by notification requirements to sellers,[viii] and it would be dangerous to operate on the basis that any lower standard will be applied.
Buyers currently negotiating SPAs should also bear the importance of notification clauses in mind and ensure that they will have enough time to uncover any breaches while also managing the business through a challenging period. Sellers, on the other hand, must be wary of buyers seeking particularly “loose” or “low bar” notification requirements, which might enable a buyer to do the bare minimum by way of notifying a claim, overcoming the time bars, and then gradually to finesse its claim over time. Allowing this minimises the certainty as to the scope and quantum of any claim which is of great value to sellers.
Other areas where Covid-19 and Brexit are likely to result in efforts by both buyers and sellers to enhance contractual protection, to shift conventional risk allocation and minimise the follow-on risk of litigation, include:
- Sellers seeking to retain an ability to access the pre-sale documents (including audit reports) and information (potentially as well as employees) of disposed businesses so as not to be reliant on waiting for litigation disclosure and/or Redfern Schedules to defend any breach of warranty claims. For example, if the seller is to assess whether the true cause of any loss claimed by a (remorseful) buyer is actually a new management team’s approach to the challenges posed by current near-unique circumstances and to defend a claim on that basis, it will need to be able to understand and explain in detail the pre-sale approach of the target business;
- Buyers ensuring sufficient specificity in terms of warranties sought and the disclosure given against each of them (especially in respect of targets less likely to be able to achieve pre-pandemic levels of profitability); and
- An increased focus by buyers on repetition of warranties at closing, materiality thresholds for claims and qualifications on seller awareness. The importance of each is heightened in the current uncertain times in which the accurate financial estimation and valuation of many businesses has been made more complex. The importance is heightened yet further for both buyers and sellers where a purchase price is calculated by reference to a multiple derived from the target’s financial statements (such as a multiple of EBITDA). The multiple can play a key role in increasing a subsequent damages award for breach of warranty when quantifying the difference between valuations on a “warranty true” and “warranty false” basis significantly beyond the estimated EBITDA change at the present time.[ix]
Creditworthy buyers able to complete more swiftly than peers or with fewer anti-trust issues (especially given the delays caused by the lockdown in obtaining government approvals) are in a position to push most strongly for more protection as they can help relieve capital and cash flow constraints for sellers under extreme liquidity pressure. For example, they may insist upon specific indemnities in respect of adverse Covid-19/Brexit consequences and greater escrow retentions in respect of the purchase price to secure such potential indemnity and/or warranty payments by the seller.
There is no easy means to predict all of the ways in which Covid-19 and Brexit will impact on deal structuring; let alone the nature and extent of subsequent warranty claim disputes before the courts and arbitral tribunals. The potential impacts of both are labyrinthine in their own right, even before they are looked at together and deal-specific confounding factors are considered. It is against this backdrop that the questions posed above need to be analysed. Potential claimants would be well-advised to seek sophisticated litigation advice to stress test the viability of claims in light of the contractual deal struck, the available evidence-base and the external dynamics discussed in this article.
[i] Daniel Reeds Ltd v EM ESS Chemists Ltd  CLC 1405.
[ii] Infiniteland Ltd v Artisan Contracting Ltd  EWCA Civ 758, as relied on in the more recent judgment in Triumph Controls – UK Ltd v Primus International Holding Company  EWHC 565 (TCC).
[iii] Smith New Court v Scrimgeour Vickers  AC 254 and MAN v Freightlinger  EWHC 2347 (Comm).
[iv] Playboy Club London Ltd v Banca Nazionale Del Lavoro Spa  EWCA Civ 2025.
[v] See for example, Zayo Group v Ainger  EWHC 2542.
[vi] See for example Towergate Financial (Group) Limited v Hopkinson  EWHC 984 (Comm).
[vii] Guidance on responsible contractual behaviour in the performance and enforcement of contracts impacted by the Covid-19 emergency, Cabinet Office 7 May 2020.
[viii] See for example Senate Electrical Wholesalers Limited v Alcatel Submarine Networks Limited  2 Lloyd’s Rep 423.
[ix] See for example The Hut Group Ltd v Nobahar-Cookson  EWHC 3842 (QB).