Corporate Law Update

In this week's update: Forward looking projections and damages calculations under an SPA, Variation (or not) of a partnership agreement and changes to directors' remuneration reporting.

Court considers multiple warranty claims under share purchase agreement 

Over the past two weeks we have looked at the recent case of Triumph Controls v Primus International, in which the High Court considered multiple warranty claims under a share purchase agreement (SPA). In particular, we looked at whether the buyer (Triumph) had validly notified the seller (Primus) of warranty claims, and at two warranty claims, each of which failed on different grounds.

This week, we look in detail at a third, successful warranty claim, as well as how the court calculated the damages owed to Triumph.

What happened?

To recap, Triumph acquired the shares in three subsidiaries from Primus. Those subsidiaries together comprised Primus’ composites manufacturing division in the UK and Thailand.

The SPA contained standard provisions, including numerous warranties about the state of the subsidiaries and their business.

After the transaction completed, the subsidiaries’ financial and operating position deteriorated rapidly. In particular, according to Triumph, numerous issues caused the financial performance of the business to be significantly worse than forecast.

According to Triumph, the value in the shares in the subsidiaries was completely wiped out, rendering them “worthless”.

Triumph brought claims against Primus for breaches of eight different warranties. The court grouped those claims into three categories. We discussed two of these categories last week. We now explore the last category – claims in relation to forward-looking projections – below.

The forward-looking projection claims

Primus warranted in the SPA that, as far as it was aware, forward-looking projections (FLPs) prepared in relation to the three subsidiaries had been prepared “honestly and carefully”. The claim centred on a pivotal document forming part of the FLPs, known as the long-range plan (LRP).

Triumph claimed that the FLPs had not been “carefully prepared”. The SPA did not set a specific standard of care, so the judge decided to give the words what she called their natural meaning: that the FLPs had been prepared “with care by those who had the required skills and knowledge”.

Importantly, the judge noted that Primus had not warranted that the FLPs were accurate. Essentially, therefore, the question was whether the FLPs were “credible and reliable” by reference to “evidence-based assumptions”, not that they turned out to be correct.

For this purpose, the parties’ experts jointly agreed the steps that a party would need to take in order to “carefully prepare” projections. These steps were not argued before the court and so do not form part of the judge’s reasoning, but they may be useful indicators of the kind of behaviour a court might expect when deciding on a similar matter in the future. The steps were:

  • To consider the latest available financial and operational information.
  • To consult with relevant members of management with appropriate knowledge.
  • To reflect forecasting practice in the business and industry in question.
  • To document the basis of any assumptions.
  • To subject the assumptions to independent review and challenge.

In the event, the court found that the FLPs had not been carefully prepared. In particular, they failed to take into account requirements for buffer stock, reduced arrears, increased labour and scrap costs, and consequential delays in moving the subsidiaries’ business from the UK to Thailand. At one point, Primus had updated the figures in the FLPs without updating the underlying assumptions. The court described this as a careless omission.

Importantly, the court found that the FLPs had not been prepared carelessly in the beginning. Rather, it was the failure to keep the metrics in the FLPs and the assumptions on which they were based aligned, which effectively resulted in “carefully” prepared FLPs becoming “carelessly” prepared.

Triumph therefore succeeded in its claim.

How did the court calculate Triumph’s damages?

The court assessed the damages as the difference between the price Triumph paid (based on the carelessly produced FLPs) and what it would have paid had the FLPs been carefully prepared. This required the judge to identify what adjustments should have been made to the FLPs and to consider their impact on how the price.

The parties’ experts put forward three different bases for valuing the subsidiaries and the impact of the breach of warranty. Primus argued for an asset-based approach, valuing the subsidiaries by reference to their underlying assets after deducting their outstanding liabilities.

Triumph, meanwhile, argued that the subsidiaries should be valued on a discounted cash flow (DCF) basis, which would involve converting the subsidiaries’ future cash flows into a single net present value and applying a discount rate to reflect future risks and the time-value of money. DCF was, in fact, the basis on which Triumph had constructed its financial model of the business, which ultimately fed into its purchase price.

Finally, the experts also suggested calculating the value of the subsidiaries according to a “market approach”, by using values from publicly available sources for comparable businesses.

The judge agreed with Triumph. She said that a DCF valuation was the appropriate approach, as the business was being sold as a going concern and its value lay in revenue production, not assets.

How does this affect me?

The decision on the FLP claim is a cautionary tale. A seller will often want to provide a potential buyer with forecasts and projections in order to demonstrate the growth and revenue potential of the business it is looking to sell.

It is rarely, if ever, justified to require a seller to warrant that forecasts and projections are accurate, given that they are forward-looking and, in essence, a best estimate. Projections are also often prepared purely for a business’s internal purposes, rather than for third parties to rely on.

But, where a potential buyer is basing its offer substantially on projected income streams, a seller may (as in this case) need to give some comfort in relation to those projections. Often this will come in the form of a warranty that the projections have been prepared “carefully” or “with due care and attention”.

Before providing a warranty of this kind, a seller should consider the following:

  • What is the basis of the forecasts being warranted? Were they prepared for a particular purpose and are they likely to have taken account of all relevant information? In particular, do they reflect the latest operational and financial information available to management?
  • Were the forecasts prepared on the basis of any assumptions? If so, are those assumptions clear from the face of the forecasts or otherwise documented somewhere? Have all relevant assumptions been factored into the forecasts?
  • Has anything happened since the forecasts were prepared that might mean they are no longer reliable? Do any of the figures or underlying assumptions need updating?
  • If the forecasts have been updated or changed at any point, can the seller identify a clear basis for the changes and explain that basis, if need be, to the buyer?
  • Should the seller ask its accountants to review the forecasts to provide some comfort that they are not out of line with the business’s performance to date?

Partnership agreement was not varied by conduct

The High Court has held that the partners in a partnership had not varied their profit-share entitlements merely by their behaviour when signing off partnership accounts.

What happened?

Patel v Patel concerned a partnership between a man (D) and his nephew’s wife (K), formed to carry on a dental practice. The two individuals signed a partnership agreement, which stated that they would share all profits and losses equally.

The common understanding was that K would conduct and manage the practice’s day-to-day affairs, and that D would not carry out any dental work. In line with this, for the first two years, 100% of the partnership profits were allocated to K. D not only agreed to this, but specifically instructed the partnership’s accountant to record this profit allocation in the partnership’s accounts.

In 2015, D’s nephew and K separated and, ultimately, divorced.

When it came to finalising the next set of accounts, the individuals could not agree on the correct profit allocation. D said the profits should be shared equally, in line with the partnership agreement.

K said that all profits should be allocated to her. She argued that, by agreeing to allocate 100% of the profits to her during previous years and recording this in the partnership’s accounts, the two individuals had varied the partnership terms so as to allocate 100% of future profits to K. She cited section 19 of the Partnership Act 1890, which states that a partnership can be varied by the consent of all of the partners through a course of conduct.

The individuals brought the issue to an arbitrator, who found in K’s favour and awarded her 100% of the partnership’s profits. D appealed to the High Court.

What did the court say?

The court agreed with D and allowed the appeal. In doing so, the judge gave some useful indications of when a partnership agreement might be varied by a course of conduct. He said:

  • For a partnership agreement to be varied by conduct, the conduct must indicate an unambiguous intention to vary the existing contractual terms of the partnership.
  • It is wrong to focus on the number or frequency of actions that allegedly show an intention to vary the partnership agreement. That said, a small number of actions may be more difficult to interpret objectively than a longer period of behaviour, and so may be more ambiguous.
  • Ultimately, what matters is whether the partners have reached a consensus on a variation.

In this case, D had only waived his entitlement to profits for two financial years. He had not agreed to give it up entirely. He therefore retained his entitlement to 50% of the partnership profits. This conclusion is perhaps not surprising, given that, only a few years ago, the Court of Appeal reached a similar conclusion in a case with very similar facts (Hodson v Hodson).

The judge said his decision was also underscored by the fact that the partnership agreement required any variation to be in writing and executed as a deed. However, that had not been done in this case.

What does this mean for me?

This case is clearly important for partners in a partnership, but the same approach is also likely to be relevant for members of a limited liability partnership (LLP). The decision shows the importance of documenting any changes to the terms of a partnership or LLP. In particular:

  • If partners want to vary the terms of their partnership, they should set the variation out specifically in writing. It can be risky to rely on one or two instances of deviation from the partnership terms as a formal variation.
  • In particular, the partners should check whether the partnership agreement contains a “no oral modificationclause requiring any variation to be set out in writing. Following the Supreme Court’s decision in Rock Advertising v MWB, the courts will generally uphold this kind of restriction.
  • Finally, where partners do agree a variation in writing, ideally they should execute the variation as a deed. This will avoid any argument that the partners have not provided consideration to each other, which would otherwise prevent the variation from becoming effective.

Proposed changes to directors’ remuneration reporting published

The Government has published draft regulations (and an explanatory memorandum) that would amend the current regime for reporting on directors’ remuneration. That regime requires certain companies to publish a directors’ remuneration report every year as part of their annual report, and to submit a directors’ remuneration policy to their shareholders every three years.

The Regulations would update this regime to incorporate parts of the Second European Union Shareholder Rights Directive (SRD II) that have not been implemented in UK domestic law. To illustrate this, the Government has published a table of transposition notes, explaining how each Directive requirement is being implemented.

The UK has already implemented the majority of SRD II, so the Regulations would merely “plug a few gaps”. The key changes are:

  • The requirement to produce a remuneration report and policy would be extended to “unquoted traded companies”. These are companies that are traded on a regulated market but not officially listed (such as High Growth Segment companies). In practice, this affects very few companies.
  • The remuneration report and policy would extend to any person who is not a director but acts as the chief executive officer (or deputy CEO). In practice, the CEO of a UK company is almost always a director, although this could have an impact on hand-over and transitional arrangements.
  • A company would be required to publish the results of a shareholder vote on its remuneration policy on its website as soon as reasonably practicable after the vote, including the number of votes cast for and against. In practice, many companies already do this and the Investment Association actively monitors shareholder votes on remuneration resolutions.
  • If a company loses a shareholder vote on its proposed remuneration policy, it would need to put a new remuneration policy to a vote at its next general meeting. (At the moment, a company needs to put a new policy to a vote only if it loses a vote on its remuneration report or if its last remuneration policy vote was three or more years ago.)
  • The remuneration report would need to set out the annual percentage change in each director’s remuneration over the previous five years, as well as the percentage change in average employee remuneration over that period. (Currently, companies only need to report on changes in the CEO’s and average employee remuneration since the previous financial year.)
  • Currently, a company can make a payment outside the scope of its remuneration policy only if the shareholders approve the payment. Going forwards, a company would need formally to amend its policy to allow the payment. Although this doesn’t alter the requirement for shareholder approval for an out-of-scope payment, it may shift the focus of shareholders’ attention from the proposed payment in isolation to the payment in the context of the company’s policy overall.
  • Remuneration policies would include additional detail around vesting, deferral and holding periods for variable, on the length of directors’ service contracts, and how the company manages conflicts of interest. Although many companies already provide this information voluntarily, this new content requirement may result in policies being put back to shareholders more frequently.
  • The single figure table in the remuneration report would include new subtotals for total fixed and variable pay. There would also be additional disclosure of changes to executive pay compared with average employee remuneration.

The Regulations would come into effect on 10 June 2019 and apply to remuneration reports and policies produced on or after that date.