The use of hindsight in share sale breach of warranty claims
On a share sale breach of warranty claim, will the court allow matters post-sale to influence quantum?
The question has recently been considered by the Court of Appeal whose decision has itself been the subject of further consideration by the Commercial Court. Those decisions provide a fertile ground for further litigation.
Recap on calculation of quantum
Before turning to consider the cases, a brief recap on quantum in this field:
The usual measure of loss in a share sale dispute is the difference between: (i) the value of the target company on the basis that the warranties are true (usually, but not always, taken as the purchase price); and (ii) the value of the company on the basis that the warranties are false.
Each such value is calculated on the basis of the price that would have been agreed between a hypothetical, willing, reasonable and knowledgeable seller and buyer acting at arm’s length.
Damages are assessed at the date the warranties are given, usually the date of sale, as that is the date of breach.
To take an example, if the warranty breached is that all material liabilities have been disclosed the task for the Court is to: (a) calculate the hypothetically negotiated price on the basis that all such liabilities had been disclosed; and (b) deduct from such price that which would have been agreed based upon the actual state of material liabilities. The difference between these warranty-true and warranty-false prices represents the loss usually recoverable.
It is important to note that the key loss here is that to the buyer, not merely the loss (which likely will be different) that the target company itself could suffer. Claims are often struck out due to failure to comply with claim notification provisions requiring details of quantum because the notices have only referred to the losses to the target, not the correct measure calculated as above (see most recently, for example, Drax v Scottish Power  EWCHC 412 (Comm) (currently subject to appeal)).
Competing arguments as to admissibility of hindsight in relation to contingencies
The share price the parties are prepared to agree for a company invariably depends upon assumptions as to the outcome of contingencies which the company faces: Will a particular material existing contract be terminated? Will a claim subsequently be made against the target company?
The existence (or extent) of such a contingency is frequently matter which has not been properly disclosed and led to the breach of warranty claim.
By the date that damages come to be assessed, the outcome of such a contingency may well be known. If the outcome has been positive for the target company, then that company may well have suffered no harm e.g., because no claim has ultimately been brought.
In such a scenario, a seller may argue that it would be unfair to reduce the notional warranty-false sale price – and hence increase the seller’s liability – on the basis of a contingency. Otherwise, it is said, the buyer is being compensated for a loss that never arose.
On the other side, a buyer may contend that it would be inappropriate to take into account hindsight in this way. The buyer would have paid less for the shares at the date of sale if it had actually known the truth. Taking into account the outcome on the contingency, in effect, would be to value an aspect of the shares at a date other than the date of sale. The allocation of risk in share sale agreement also means that, from the date of sale, the buyer has the risk of the company performing well or poorly. It would unfairly disrupt the allocation of risk, and not adequately compensate the buyer, if the later outcome was taken into account.
These arguments have been considered at first instance in several cases in this field.
Until last year, with the decision in MDW v Norvil  4 WLR 33;  EWCA Civ 883 they had not, however, been considered in detail in the share sale context by the Court of Appeal.
MDW v Norvil
The case involved a waste disposal company. The company had a permit to dispose of a limited amount of waste in the public sewers. In breach of that licence, it over-dumped excess waste, including through a sewage inspection chambers which was known internally within the company as the “magic hole”.
These actions enabled the company to avoid the costs it should have been paying to an external operator to take the waste. They placed the company in breach of its environmental permit, giving rise to a serious risk of a claim by the Environment Agency and ensuring reputational harm to the business.
The company was sold but the sellers did not reveal the breaches.
Upon their later discovery of the breaches, the buyers ensured the business operated lawfully. No claim was ever brought by the Environment Agency. No reputational harm ensued.
On the breach of warranty claim, given the lack of any claim or reputational harm, the sellers argued that there be no reduction in the notional warranty-false purchase price.
The trial judge and Court of Appeal rejected that argument. They accepted the buyer-side arguments set out in the preceding section above. They held that, save perhaps in an exceptional case, hindsight cannot be used to reduce quantum in this way.
The Court of Appeal did not completely shut the door to the use of post-SPA material, however, even in a non-exceptional case.
In MDW, it was unclear from the company’s records how much waste has been illegally dumped pre-sale. The extent of such over-disposal was material to quantum. The buyers could point to evidence of the extent to which excess waste arose post-sale. The buyers wished to use such evidence to shed light on how much had likely been illegally disposed pre-sale. The Court of Appeal permitted such evidence to be adduced. In doing so the Court held that that it was legitimate to use evidence of post-sale matters to shed light on events which had already taken place by the date of sale.
MDW has subsequently been considered in several cases.
An interesting example is Arani v Cordic  EWHC 95 (Comm), decided earlier this year, in which Adam Solomon KC and I acted for the sellers. We were instructed by Richard Marshall, Oliver Cooke and Lauren Cormac at Penningtons.
Arani v Cordic
In Arani, the target company had created an app for use by taxi companies and drivers.
For facilities such as pick up and drop off, the app relied upon the Royal Mail address database.
If a licence for the address database had been duly purchased by the company for every taxi company and taxi driver who used the app it would have cost in the order of £2m per year.
Instead, however, the company purchased a single user licence at c.£200 per year. They then extracted the address data from the database and supplied it as part of their app to their many taxi company customers and drivers.
Such conduct placed the company in breach of its licence for use of the address data.
When the target company was sold the breach of licence was not revealed, in breach of the SPA warranties.
In the event no claim was brought by Royal Mail. This was, however, plainly irrelevant to the calculation of damages given the Court of Appeal’s decision in MDW.
In terms of damages based on the ongoing licence costs to the company, the buyers argued that a reasonable purchaser would envisage the company continuing to use Royal Mail data but on a properly licenced basis, and so at c£2m p.a. With a springle of the usual expert accountant’s alchemic dust, this was translated to potential diminution of share value claim of £32m.
The sellers, however, pressed for and were able to obtain disclosure of what the buyers had in fact done post-sale upon discovering the licence breach. The disclosure showed that under the buyer’s direction, the target company had not proceeded with Royal Mail but rather had adopted an alternative solution with Bing Maps at a cost of only c£100k per year.
The sellers argued that this evidence was admissible as it provided relevant evidence as to how a hypothetical purchaser might have approached matters on a warranty false basis if the breach of licence had been revealed pre-SPA.
In particular, such evidence indicated that a hypothetical purchaser would have investigated the issue and also decided that it would be appropriate to proceed with Bing Maps. Such a hypothetical purchaser would have been prepared to agree the (warranty false) purchase price on this basis. The sellers’ expert said that this translated to a reduced hypothetical warranty-false purchase price – and hence loss – of only £600k on this aspect.
The Commercial Court (Bright J) agreed with the sellers’ arguments, awarding £600k on this aspect rather than the £32m losses the buyer had claimed to suffer.
The future and practical guidance
The above decisions indicate fertile ground for further litigation about which post-sale matters, on the particular facts, are properly admissible and material.
Where the buyer has taken steps post-sale which have alleviated the undisclosed warranted issues, sellers will seek to argue that a reasonable hypothetical buyer would also have envisaged such steps being taken pre-sale if aware of the particular issues.
In addition to the potential to challenge such arguments factually, there will doubtless be cases where it will be arguable that the materials which the sellers seek to introduce fall within the hindsight territory on which MDW tells parties they may not trespass.
In order to advance the factual arguments, the seller will need to obtain appropriate disclosure. They should look to provide a hook for demanding such disclosure in their defence to the warranty claim. If claims are pursued, the seller will also need to press for such matters to be an issue for disclosure within the Disclosure Review Document to ensure that the seller has the material necessary to advance their arguments with full force.
David Lascelles is a barrister specializing in commercial and company law at Littleton Chambers. He brings a wealth of experience successfully to resolve commercial and corporate disputes.
David is recommended by Chambers & Partners and Legal 500 as a leading junior in both commercial and company law and was nominated for Legal 500 commercial junior of the year in 2022. Chambers Global 2023 describes him as having “strategic brilliance beyond his years”.
David’s particular expertise is in high-value share sale and shareholder disputes He heads Littleton’s company law team. He is also highly experienced in litigation arising from commercial contracts and civil fraud more generally.