Corporate Law Update

• The High Court considers how to calculate damages for breach of warranty and apply limitations on liability where a company is sold at a discount
• ICSA is consulting on potential changes to improve the quality of independent evaluations of listed company boards
• The European Commission publishes final technical specifications for the new single electronic reporting format for listed company annual reports
• The Financial Conduct Authority has published changes to its Handbook to implement the Second EU Shareholder Rights Directive
• A few other items of interest

Court finds damages for warranty breach exceeded purchase price

Last week we reported on the case of 116 Cardamon Limited v MacAlister, which raised interesting questions on when a matter that contradicts the warranties will be considered effectively disclosed to a buyer.

A second interesting point arising from this case is how the court calculated damages for breach of warranty, given that the business had been sold for a bargain.

What happened?

As a reminder, the case concerned the sale of shares in an insurance company. The sellers had initially proposed to sell the shares for £5m. The buyer made a significantly lower counter-offer of £2.3m, based on its analysis of the company’s projected profit stream.

The sellers accepted the buyer’s offer, which they regarded as involving a “significant discount”, on the basis that the buyer would not conduct due diligence (so as not to inform the local management team of the proposed sale) and that the sellers would be giving warranties “blind”.

As is customary, the share sale agreement (SPA) contained various warranties by the sellers about the state of the business. These included warranties about the target company’s accounts.

The SPA also limited the sellers’ liability for breach of warranty to the amount of the purchase price (the “cap”) and it stated that the first £500,000 of any warranty claim was irrecoverable (the “de minimis”). The judgment does not set out the precise wording of the de minimis, but the judge recited the following comment by the sellers’ representative (to which the buyer agreed):

“The de minimis is £500k (no minimum amount for a claim) and if it exceeds £500k [the sellers] will be liable for over £500k.”

The buyer brought claims for breach of warranty in relation to three matters, two of which we covered last week.

The third matter concerned claims for which the company might potentially need to pay out under a before-the-event legal expenses insurance business it operated. The buyer said that the company had significantly underprovided for these potential claims in its statutory accounts, and that the sellers had therefore breached a warranty that the accounts gave a true and fair view of the company’s affairs.

Importantly, the alleged underprovision was so dramatic that the buyer claimed the entire amount up to the cap in the SPA: around £2.3m.

The buyer also said that the combination of the size of the underprovision and the bargain price at which it bought the company meant the loss it had suffered, and so the true value of its claim, actually exceeded the purchase price and, therefore, the cap. As a result, although it could claim only up to the cap, it said it was entitled to claim the whole amount, with no reduction under the de minimis.

What did the court say?

The court agreed that the accounts had underprovided for potential claims and that the sellers had therefore breached the warranties. That being so, the court had to award damages to the buyer.

The general approach to a breach of warranty on a private share sale is that the loss is the difference between the value of the shares taking the breach into account, and the value they would have had if the warranty had been true (the “as-warranted value”).

Quantifying the loss in this case should have been simple. In broad terms, the court would simply need to identify the underprovision in the warranted accounts and award that amount to the buyer.

However, it turned out that the previous year’s accounts had also underprovided for potential claims. This meant that not only was there already an underprovision in the warranted accounts, but the starting point from which they had been prepared was wrong, exacerbating the loss. This made it much more difficult to calculate the damages payable to the buyer.

The judge was not satisfied with the expert evidence she had been provided on the calculation of the loss, and so she had to ask herself whether she should order a separate determination of loss or conduct the exercise herself. She decided to undertake the calculation herself.

The sellers had argued that the as-warranted value of the company’s shares was the purchase price. However, the judge said it was wrong to take the purchase price as an indication of the value of the shares, particularly where, as here, the company was sold at a discount.

Ultimately, the judge didn’t reach a precise figure for the as-warranted value, but she did conclude that it was at least £500,000 more than the purchase price. This had two principal consequences:

• The loss suffered by the buyer exceeded the purchase price, and so the buyer was able to claim up to the cap in the SPA.
• Because the claim exceeded the purchase price by more than £500,000, there was no need to reduce it by £500,000 under the de minimis. The judge’s reasoning seems to be that, if the true value of the shares had been reduced by the de minimis, the value of the claim would still exceed the cap and so the buyer would have been entitled to claim the full amount up to £2.3m.

What does this mean for me?

The judgment throws two points into sharp relief:

• It’s not always straightforward to predict how a court will calculate damages. On any breach of warranty claim, there will always be disagreements over valuing the shares. Should the calculation operate on the basis of the company’s equity value or enterprise value? Should the valuer work from the market value of the shares or their equitable (previously “fair”) value? Should any assessment focus principally on net asset value or on revenue streams (such as EBITDA)?
  
  However, there may also be hidden issues which can have an impact. In this case, the court had to look beyond the faulty accounts and examine discrepancies in a previous year’s financials that had not even been warranted.
  
  For sellers, this illustrates the risk of focussing narrowly on the “here and now” or on the recent past when giving warranties. Rather, a seller should take the time to investigate matters going back for a reasonable period of time, as these may well have an impact on the warranties.
• Draft your limitations carefully. It is very common for an SPA to include a cap on the seller’s liability for breaches of warranty, and a hurdle which the buyer has to clear before it can bring a claim. That hurdle or “basket” will also normally “tip”, meaning that the buyer will be able to claim its whole loss, and not merely the amount that exceeds the hurdle.
  
  However, often the basket will not tip, meaning the buyer must absorb the first chunk of any loss (similar to most insurance policies). It is tempting to assume that the maximum amount a buyer will therefore only ever be able to claim is the cap in the SPA, less the hurdle. That is based on the notion that the purchase price reflects the true value of the shares being sold.
  
  This is not so. Depending on how the SPA is worded, the fact that a buyer may be required to absorb the first chunk of its own loss will not necessarily reduce the seller’s overall liability for warranty claims. A seller should review any proposed limitations on its liability very carefully with its advisers to ensure that they knit together properly, particularly where the sale of the shares or business in question is being made at a discount.

ICSA consults on independent board evaluation

ICSA: The Governance Institute has published a consultation as part of a review it is conducting on independent board evaluations of UK listed companies. The purpose of the review (which is being carried out at the Government’s request) is to assess the quality of evaluations and explore how that quality might be improved.

In particular, ICSA is seeking views on the following:

• Is the purpose of independent board evaluation to help boards to continually improve their performance, or does it serve some other purpose?
• Are recent changes to the UK Corporate Governance Code likely to improve the standard of reporting on board evaluations? (The 2018 Code requires companies to set out the outcomes of evaluations, the actions arising from them and their impact on board composition.) Is there any need for guidance on how listed companies can report against the Code on this point?
• Is there any value in introducing a code for board evaluators and accompanying disclosure guidance for listed companies? ICSA has produced a draft code and principles and has invited comment on them.
• Should there be minimum standards of independence and integrity for a proposed board evaluator?
• Should shareholders have more influence in appointing the independent board evaluator?
• Should evaluators be subject to oversight or accreditation by a formal body?
• Is there any other action that could be taken to improve independent board evaluation?

ICSA has asked for responses by Friday, 5 July 2019.

EU adopts single electronic reporting format

The European Commission has published a new regulation formally introducing the new single electronic reporting format (SERF) for financial reporting.

The SERF will apply to all annual financial reports (i.e. annual accounts) published by issuers whose securities are admitted to trading on a European Union (EU) regulated market. This includes issuers whose shares are admitted to the London Stock Exchange Main Market, Special Fund Segment or High Growth Segment, or to the NEX Exchange Main Board. These issuers will need to follow the new SERF reporting requirements when preparing and publishing their annual accounts.

As it stands, the Regulation will not apply to AIM, Professional Securities Market (PSM) or NEX Exchange Growth Market companies.

The Regulation requires an issuer’s entire annual report to be prepared in extensible hypertext mark-up language (XHTML). On top of this, if the report contains consolidated financial statements prepared under International Financial Reporting Standards (IFRS), the issuer will need to mark the statements up in extensible business reporting language (XBRL) using a strict taxonomy set out in the Regulation. Finally, XBRL information will need to be embedded within the XHTML format using Inline XBRL specifications set out in the Regulation.

EU issuers will be able to mark the rest of the annual report up in XBRL as well using a taxonomy provided by their home country. Non-EU issuers must not mark up any part of their annual report other than their IFRS consolidated financial statements.

The Regulation comes into force on 18 June 2019 and will form part of UK law immediately. It will also continue to form part of UK law should the UK leave the EU without any form of transitional arrangement, although it will then be susceptible to amendment under UK law.

Issuers must use the new format for financial years beginning on or after 1 January 2020. We can therefore expect to see the first reports adopting the SERF no later than the end of April 2021.

FCA publishes changes to implement SRD II

The Financial Conduct Authority (FCA) has published a policy statement (PS19/13) setting out changes to its Handbook to implement the Second EU Shareholder Rights Directive (SRD II). The FCA consulted on the proposed changes earlier this year (see our previous Corporate Law Update).

For equity issuers, the key change is a new requirement to seek independent board approval for material related party transactions (RPTs) and announce details of the transaction. The requirement will sit in a new Rule 7.3 of the FCA’s Disclosure Guidance and Transparency Rules (DTR).

For this purpose, a transaction will be “material” if its size exceeds 5% of the issuer’s profits, assets, market capitalisation or gross capital. Transactions with the same related party over a 12-month period will need to be aggregated.

The new obligation will apply to all issuers with a premium or standard listing of shares, and to issuers whose securities are not listed but are admitted to a regulated market (such as the High Growth Segment (HGS) or Specialist Fund Segment).

Issuers incorporated in the European Economic Area (EEA) will be exempt from the new rules if they are subject to equivalent rules in their home EEA state. Issuers incorporated outside the UK or the EEA will be subject to slightly relaxed requirements: they will not need to seek board approval, and they may be able to apply definitions of “related party” under their own local accounting standards.

The new rules should not impose much (if any) additional burden on many issuers. Premium-listed issuers are already required by the FCA’s Listing Rules to announce RPTs and, if the value exceeds 5% using the tests above, obtain independent shareholder approval. HGS issuers are already required to announce RPTs whose value exceeds 5% under the tests above.

However, the definition of “related party” under the new rules is wider than the corresponding definition in the Listing Rules and the HGS Rulebook. Premium-listed and HGS issuers should therefore bear in mind that the new rules may capture some RPTs that currently do not need to be announced.

For many standard-listed issuers, however, the changes will impose new announcement obligations.

Separately, new provisions in the FCA’s SYSC and COBS sourcebooks will require FCA-regulated asset managers and life insurers to disclose details of their stewardship and engagement policies.

The new rules come into effect on 10 June 2019.

Other items

• FCA publishes near-final changes to Prospectus Rules. The Financial Conduct Authority (FCA) has published Policy Statement PS19/12 setting out changes to the Prospectus Rules to accommodate the new Prospectus Regulation, which comes into force in the UK on 21 July 2019. The changes broadly reflect the proposals on which the FCA consulted in January this year. For more information, see our Corporate Law Update for the week ending 1 February 2019.
• QCA publishes report on contribution of small and mid-caps. The Quoted Companies Alliance (QCA) has co-published a report with investment research firm Hardman & Co. on the contribution of small and mid-cap quoted companies in the UK. The report notes that small and mid-cap companies account for 93% of UK quoted companies (Main Market and AIM) but only 20% of aggregate market capitalisation, employ 3m people (about 11% of total UK private sector employment) and contribute £26bn in tax (about 5% of total UK tax revenue).
• QCA polls members on Market Abuse Regulation compliance. The QCA and Thomson Reuters Practical Law have co-published a survey of QCA Members to find out how small and mid-size companies have found the Market Abuse Regulation (MAR) in practice. Among other things, the poll shows that 14% have been asked by the Financial Conduct Authority (FCA) for a copy of their insider list, 57% of members have delayed the disclosure of inside information, and one member was asked by the FCA for a written explanation for delaying disclosure. 79% of members have adopted the ICSA/GC100/QCA model code as their securities dealing code, whilst 21% have adopted a bespoke code. The survey contains other interesting statistics.