Warranty claims and post transaction disputes – a cautionary tale

Rob Eldon and James Nightingale recently acted for the seller of a company “S” in defence of a warranty claim pursued by the buyer “B”. In having sought early advice S was properly protected and able to negotiate a very favourable resolution to the dispute, including a complete withdrawal of the threatened claim.

Background

Warranties are contractual protection as to certain matters, facts and circumstances relating to the business assets being sold, whether shares or the business itself. They are used to protect the value of a company and isolate the buyer from any inherent risk as to the nature and extent of the assets and liabilities of its acquisition. This is because, as a starting point on a share sale, the buyer of a company is liable for any historic liabilities. Consequently, unless a seller makes proper disclosure against any relevant warranties, if any such warranties prove to be untrue, the buyer may have a claim against the seller for breach of warranty.

Warranties are often given at the point of sale in relation to things such as the (i) the accuracy of previous accounts; and (ii) the existence of legal proceedings, ongoing or potential, against the seller or company. If a warranty subsequently turns out to be untrue at the point it is given, and that breach gives rise to a loss (in this context, being a diminution in value of the shares in the company being purchased), then the buyer can pursue the seller to recover that loss.

The purported claim

B had acquired a company from S last year. The share purchase agreement (SPA) provided for an element of deferred consideration, namely two further six-figure sums to be paid on the first and second anniversaries of the share purchase. The SPA also contained a number of warranties against which S had made disclosures.

B contacted S last year in relation to a customer complaint which, in B’s view, it had inherited upon the purchase of the company. In B’s view the complaint was likely to turn into a potential significant claim. B indicated to S that it was making a payment to the customer to settle the dispute with the customer. B stated that this would give rise to a warranty claim and a right to make a deduction from the next payment of deferred consideration in the amount of the sum being paid to the customer (by way of set off, which was permitted in accordance with the SPA).

Having originally acted for S on the transaction, Ward Hadaway were contacted by S to provide assistance in determining S’s exposure to a warranty claim.  Ward Hadaway identified a number of issues with B’s claim notification and responded to B on behalf of S querying the basis for the purported claim, as well as raising issues regarding the purported notice of claim. B ignored the letter, seemingly without having sought advice, and proceeded to make a deduction from the next payment of deferred consideration. This was a serious error of judgement.

What went wrong

Whilst the SPA provided that B was entitled to withhold payment from S where a valid warranty claim had been made, it also contained an accelerated payment clause, i.e. a provision which stated that the full balance of deferred consideration would fall due and payable in the event that any sums were not paid in accordance with the SPA.

The warranty claim itself was misconceived, although it would still have been open to B (after having originally notified S of the claim) to shore up its position had it sought early advice. However, the steps taken by B were ill-advised and prevented this. In having aggressively pursued the purported warranty claim, B had shot itself in the foot.

1. The original notice of claim was defective in a number of respects. Warranties often include specific notice requirements which, if they are not met, will invalidate what might otherwise be a bona fide claim.
2. The loss suffered by B did not appear to have resulted in a claimable loss. As above, a warranty claim will only arise if a particular warranty turns out to be untrue and which causes a reduction in the value of the relevant shareholding. Here, it was not clear (and not suggested by B) that the customer issue would actually have negatively impacted the value of company. B had simply asserted that it had suffered a loss equal to the sum it was having to pay to its customer.
3. As such, S was able to assert, with force, that a warranty claim had not been properly notified.
4. This allowed S to serve notice to demand payment of the full balance of deferred consideration, including the further six-figure sum which would not otherwise have fallen due until the following year, plus default interest in relation to the sums withheld. The full amount now falling due was significantly higher than the value of the sum which had been improperly withheld.
5. B had no good answer to the demand. It was left seeking to reassert the threatened warranty claim. However, the existence of a potential warranty claim was irrelevant as to the question of whether the full amount of deferred consideration had now become payable following B’s default and S’s demand for payment.

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Take Me There

The resolution

Having belatedly sought advice, B was forced to accept that it had not been entitled to withhold payment of the deferred consideration. This enabled Ward Hadaway on behalf of S to negotiate a settlement which included:

1. The withdrawal of the threatened warranty claim;
2. Payment of the withheld sum of deferred consideration;
3. The SPA being amended so that the warranty claims period was deemed to have expired (12 months earlier than it would otherwise have expired), which gave S comfort that no further claims, valid or otherwise, would be forthcoming from B; and
4. Payment of S’s legal costs in full.

In consideration for the above, S agreed to allow B to make payment of the further tranche of deferred consideration when it fell due in accordance with the SPA (i.e. with no accelerated payment).

Lessons learned

In tough economic times buyers will often actively look to pursue warranty claims to limit the sums which might become payable to sellers, or to recover sums already paid. Last year’s Court of Appeal decision in Drax v Scottish Power has given some comfort to buyers in confirming that notice of claim clauses should not become a “technical minefield to be navigated, divorced from the underlying merits of a buyer’s claim”. In other words, the Courts will seek to uphold notices of claim where possible, to avoid genuine warranty claims being frustrated on a mere technicality.

However, express contractual requirements do still need to be strictly complied with when notifying warranty claims. Moreover, pursuing unparticularised or obviously poor claims is always a bad idea, and will often lead to a weakening of that parties’ position. As above, getting this wrong can be costly and seeking early advice is key.

Ward Hadaway’s Commercial Litigation and Corporate teams are hugely experienced in dealing with warranty claims on behalf of both buyers and sellers, including negotiating specific provisions in SPAs, as well as pursuing and defending claims made in the period following sale.