Breach of warranty claims: what’s it worth?

Tuesday 24th September, 2019

Upon the sale of a company, the seller is usually expected to give certain warranties in the sale and purchase agreement as to the finances and other aspects of the business being sold.  If one or more of those warranties turn out to have been wrong, the buyer may have a claim against the seller for breach of warranty.

But how is the value of such a claim to be quantified?

The starting point for quantifying damages in a breach of contract claim is to place the claimant in the position it would have been in if that breach had not occurred.  For a breach of warranty claim, that means putting the buyer in the position it would have been in if the warranty had in fact been true.

Those damages are calculated as follows:

  • the market value of the shares had the warranties been true;

less

  • the true value of the shares.

This calculation is usually assessed as at the date of completion.

Market value

As regards the top line of the equation above, often it is the case that the price that the buyer paid for the shares was the market value had the warranties been true and this is the usual starting assumption.  However, it is open to the buyer to put forward valuation evidence to seek to demonstrate that the market value of the shares was higher than the price paid and similarly it is open to the seller to seek to prove that the market value was lower than the price paid.

True value 

As regards the bottom line of the equation, when calculating the true value of the shares as at the date of completion, the Court may be willing to accept the same valuation methodology as was in fact used to value the shares for the purposes of working out the purchase price.

Taking a hypothetical example, let’s assume the purchase price for the entire issued share capital of the company was calculated based on 5 x EBITDA.  EBITDA (based on warranted financial information) was £5 million. Therefore the purchase price was £25 million (i.e. 5 x £5 million).

If following completion it is discovered that certain warranties were inaccurate meaning that the true EBITDA of the company as at completion was in fact only £1 million then the true value of the shares as at completion was in fact £5 million (5 x £1 million).

If this valuation methodology were accepted by the Court then the measure of loss on a breach of warranty claim would be (assuming that the price paid was equivalent to the market value) £20 million which equates to the difference between £25 million (the paid for the shares) and £5 million (the true value of the shares).

It may, however, be disputed between the parties what methodology was used to calculate the purchase price and each party may in fact have used a different methodology.  In any event, the court may conclude based on valuation evidence that another valuation methodology would be more appropriate.

Ultimately the damages to be awarded will be a matter for the court to decide based on valuation evidence.  However, for the purposes of an initial calculation of quantum for the purposes of a notice of claim to the seller and for any negotiations, the previous methodology used for calculating the price may be a good starting point.

It is worth noting that the increased availability of warranty and indemnity insurance for both buyers and sellers on corporate transactions means that, whilst these issues do not go away, the ultimate liability on a warranty claim may end up resting with the insurers – a welcome outcome for sellers, and for buyers where the option of bringing a claim against an incumbent management team is unattractive.

 

This article is current as of the date of its publication. The information and any commentary contained in this article is for general information purposes only and does not constitute legal or any other type of professional advice.  Marriott Harrison LLP does not accept and, to the extent permitted by law, excludes liability to any person for any loss which may arise from relying upon or otherwise using the information contained in this article.