A known unknown: Court of Appeal clarifies calculation for breach of warranty damages

09 August 2022

In the recent judgment of MDW Holdings Ltd v Norvill, the Court of Appeal clarified the law on when it is permissible to take account of a contingency that has not in fact materialised when calculating damages for a successful breach of warranty claim. It confirmed that damages can account for the fact that the breach in question represented a risk to the business (which therefore negatively impacted its value), even if it was later established that that risk never materialised into any actual harm.

The case concerned the share sale of a waste disposal company G. D. Environmental Services Limited (GDE) to MDW Holdings Limited (MDW).  Post completion of the transaction, MDW discovered that the previous managers of GDE had breached various environmental regulations. This was contrary to the warranties that the sellers (the Norvill family) had given as part of the transaction, including warranting that the business had been conducted in accordance with all applicable laws and regulations. MDW therefore sued the Norvills for breach of warranty and deceit. In the first instance hearing, liability was established and MDW was awarded damages for the sellers’ fraudulent breach of warranty. The sellers appealed the way in which those damages had been calculated, arguing that the judge had been wrong to take into account a contingent risk of reputational damage to GDE that was now known not to have materialised.

Calculation of damages for breach of warranty

It is well established that the starting point for an assessment of damages for a breach of warranty claim is to compare (i) what the business would have been worth if the warranty were true (the “Warranty True” scenario), with (ii) the actual value of the business given that the relevant warranty was false (the “Warranty False” scenario). This effectively compares the value of the business that the claimant was expecting to buy with what they actually ended up purchasing, the shortfall being the amount they are owed as damages to compensate them for the amount by which the false warranty incorrectly inflated the value of the business.  

To calculate the Warranty True and Warranty False values of the business, the judge adopted a standard methodology used by professional business valuers, having the benefit of expert evidence from forensic accountants. The calculation involves three steps:

  1. assess the EBITDA of the business;
  2. apply a multiple (which is determined based on the specifics of the business case of the transaction) to account for capitalised earnings; and
  3. subtract the net debt of the business to give an estimate of the business’ overall value.

This process is followed for each of the Warranty True and Warranty False scenarios, and then the difference between the two values is calculated to arrive at the damages due.

In the first instance judgment, the judge decided to reduce the value of the multiple applied in the Warranty False calculation to take account of the fact that the breach of warranty had risked reputational damage to GDE. This adjustment had the effect of increasing the damages awarded to MDW. In the event, however, there was no loss to the company’s reputation or goodwill because of the breach of warranty. This point formed the basis of the seller’s appeal: they argued that the judge was wrong to account economically for something that might have happened (but ultimately did not) in the assessment of damages. The question before the Court of Appeal was therefore whether the judge was right to account for this potential (but in the event, non-existent) loss in his calculations.

Dismissing the appeal, the Court of Appeal found that the first instance judge had been “fully justified in lowering the multiplier”. The court helpfully distilled the principles found in case law on this subject, concluding that although events subsequent to an anticipatory breach of contract can sometimes be taken into account, that principle has no application to cases of actual breach. This seems justified because, as the court commented, if a party has been induced by deceit to make a purchase, the deceitful seller cannot reduce its liability by showing that a contingency that made the product worth less at the time of assessment never eventuated.

Applying this to a sale of shares, the point becomes clear. At the time of entry into the share purchase agreement, the existence of a risk to the firm’s goodwill would have materially impacted the value of the business, even if that risk was contingent at the time of the sale and, in the event, it was now known that the firm’s goodwill was not in fact damaged. Thought about another way: if the purchasers had known about the breach of warranty at the time of the sale (and the risk to the business it carried) then they would have factored this into their appraisal of the value of the business and “[a]s a matter of common sense, a willing purchaser would not have been likely to pay as much for the company”.  Whether the risk of reputational damage later occurred or not was irrelevant because it did “not mean that the value of the company was not reduced in the way the Judge found as at the date of the SPA.”

It is worth noting that the Court of Appeal placed some weight on the indication in the authorities that contractual allocation of risk should be borne in mind in making such an assessment. The permissibility of taking account of subsequent events in anticipatory breach cases is in part driven by the policy consideration of avoiding awarding an unjustified windfall to a claimant in such circumstances. In contrast, in a case such as this, a share purchase agreement represents a contractual allocation of risk between buyer and seller, and at the time it is entered into the buyer is taking risks of which it is permitted to take the upside. It is not a windfall if the buyer has chosen to purchase a business at a particular price and take on certain risks, the non-eventuation of which causes the value to rise. In this case, had the buyer known the truth, it would have priced in an impairment to goodwill to take account of the risk to the target’s reputation. If that risk does not then eventuate, that is a benefit to which the purchaser is entitled (indeed, the non-eventuation may be down to the purchaser’s efforts as the new owner of the company).

Contractual vs. tortious basis of assessment  

The buyers also cross-appealed the calculation of damages. While MDW supported the judge’s reduction in the multiplier, it argued that the judge should have assessed damages on the tortious basis, which would have used the actual purchase price paid for the company as the Warranty True value.  This would have increased the damages awarded to them, because the judge had found that the Warranty True value of the business was £242,948 less than the price the purchasers actually paid. 

The buyers argued that their case had always been premised on both contractual and tortious causes of action and, because they had been successful in showing fraud and deceit, the correct measure of damages was the tortious rather than contractual calculation.  A tortious assessment of damages seeks to put the claimant back into the position it would have been in had the wrong in question never occurred (as opposed to the contractual basis of assessment which seeks to but the claimant into the position they would be in had the contract been performed correctly). 

The Court of Appeal allowed the cross-appeal, finding that it was open to the buyers to say that the tortious basis should have been used. However, the question of what damages should be paid then had to be remitted back to the trial judge because it involved a question of fact. It would need to be established whether, had the buyer known the truth, it would still have purchased GDE and if so for what price.

We previously reported on this case (in respect of different topics) when it appeared in the High Court in our corporate law updates on 21 May 2021 and 28 May 2021.