W&I insurers and their corporate insureds may be interested in the decision in Cardamon v MacAlister, which clarifies the court’s approach to quantum in breach of warranty claims.
In our article of 15 November 2018, we considered the English law position in respect of the measure of damages for breach of warranty, and the implications for W&I insurers. This article considers the recent decision in Cardamon v MacAlister, which gives further guidance on this issue, in particular as to the approach where the buyer has made a good bargain.
Measure of damages for breach of warranty
It is well-established that the measure of damages for breach of warranty should compensate the claimant such that it is put in the position it would have been in had the information warranted been true (Karim v Wemyss). These damages should be calculated by reference to the difference between the value of the company at the time of completion of the acquisition (the value of the company “as warranted”) and the value of the company given the actual state of affairs as a result of the breach (the value of the company “as is”).
The value of the company on the completion date is often taken to be the purchase price of the company on the basis that it represents the market value of the company at that date. However, this may not be appropriate where the buyer has made a good or a bad bargain (ie the buyer has paid less or more for the company than it was worth).
Cardamon v MacAlister
Cardamon involved the quick sale of a small company. The purchase price represented a significant discount from the value of the target company, as warranted,at the time of the acquisition (ie Cardamon made a good bargain). Post-acquisition, it transpired that the accounts did not accurately reflect the true financial position of the company and Cardamon claimed against the sellers for breach of the accounts warranties in the Share Purchase Agreement (SPA).
Two issues arose in relation to quantum. The first was whether there was sufficient evidence for the court to be able to quantify one aspect of the breach of warranty claim. The second was what measure of damages should be applied. We consider each in turn below.
Quantification of loss
One aspect of Cardamon’s breach of warranty claim concerned the material undervalue of the target’s insurance claim liabilities. Having concluded that there was a breach of warranty in respect of this aspect, the court was satisfied that a “substantial loss” had been suffered. The experts’ approaches to quantification were rejected as “unreliable”, but this lack of evidence did not preclude the court from assessing the damages as best it could in the circumstances. A full assessment of the damages, which would have involved a manual review of all outstanding insurance claims, was not considered proportionate (Tai Hing Cotton Mill Ltd v Kamsing Knitting Factory considered). Damages were therefore quantified on the balance of probabilities.
Measure of damages - good bargain
In circumstances where Cardamon had made a good bargain, the court concluded that it would be wrong to take the purchase price as indicative of the target’s value without considering the expert evidence in full. The court recognised that there were plainly reasons why the company might have been sold at an undervalue and these could not be ignored when quantifying Cardamon’s loss. The experts agreed, by reference to its enterprise value and equity value, that the target’s value “as warranted” was more than £500,000 over the purchase price. The figure of £500,000 was significant in this instance since the SPA contained a damages cap; this limited damages to the purchase price, in respect of which the first £500,000 was irrecoverable by Cardamon. It was only, therefore, necessary for the court to consider whether the value of the target “as warranted” was £500,000 over the purchase price in order for Cardamon to recover the full amount of its claim (being the purchase price of £2.386m). However, the court’s findings suggest that, had the damages cap not existed, the court may have awarded a figure significantly higher than the purchase price, to account for the good bargain.
The case raises an interesting question, which is best illustrated by a hypothetical example. Imagine that a target company’s value, as warranted, is £10m. However, the Buyer manages to negotiate a significant discount, and the sale price is agreed at £2m. In fact, there is a breach of warranty, and the target’s true value (as is) is £5m. The Buyer, thinking the "as warranted" price (£10m) is correct, believes it has negotiated an £8m discount. As it is, the discount is only £3m. On discovery of the breach, can the Buyer sue the Seller for any damages, and if so, how much?
To speak of the Buyer having suffered a "loss" in these circumstances feels, at first blush, counter-intuitive: the Buyer has received a company actually worth £5m for only £2m - that’s still a £3m gain, isn’t it? But the logical consequence of the Cardamon decision appears to be that the Buyer could sue the Seller for £5m, that being the difference between the value as warranted (£10m) and the value as is (£5m), and the fact that the purchase price (£2m) means that the Buyer is not in real terms out of pocket is neither here nor there.
The rationale can, perhaps, be explained in this way. The law seeks to give the Buyer the "benefit of its bargain". If the Buyer was able to negotiate a deal whereby, had the Seller’s warranty been true, the Buyer had obtained an £8m discount, why should the Seller be entitled to say that the Buyer should not be entitled to compensation to the diminution in the discount to which it was contractually entitled?
In practice, this interesting point may arise rarely, given that in most cases the purchase price will reflect the value of the company as warranted, or at least any discounts will not be so significant that the purchase price remains below the value as where there has been a serious breach of warranty. The time may come when the courts have to grapple with an example along the above lines, however.
What this means for M&A parties and W&I insurers
Sellers, Buyers and W&I Insurers should be aware of the potential impact that the applicable measure of damages can have on their exposure under a W&I policy. The measure of damages may be affected depending on whether the buyer has made a good or a bad bargain and all parties should be mindful of this when assessing the risk. In the case of a good bargain, as in Cardamon, this could produce surprising results, in that a claimant may be awarded damages in an amount significantly higher than the purchase price. Moreover, the claimant may recover damages notwithstanding that the true value of the company purchased, even considering the breach of warranty, is greater than the purchase price. Equally, the quantum of damages may be reduced in the event that the buyer has made a bad bargain.
W&I Insurers should also pay particular attention to any losses that are excluded under the SPA, and they may wish specifically to stipulate in the policy that an indemnity will (or will not) be provided on the basis of a particular measure of damages, or to exclude particular types of loss, for example, consequential or indirect losses which may include loss of profits.
Whilst it is not the subject of this article, the Cardamon case also considered declinature for late notification (see our article here) and the meaning of fair disclosure.
This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.