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The High Court has held that a notice of claim under a tax covenant contained in a share sale agreement did not contain the level of detail required and so was invalid.
Dodika Ltd v United Luck Group Holdings Ltd  EWHC 2101 (Comm) concerned the sale of the shares in the holding company of a group that specialised in mobile device applications.
The sale was governed by a share sale and purchase agreement (SPA) between the buyer and nearly 200 sellers. The SPA contained a tax covenant given by some of those sellers in favour of the buyer, under which they promised to reimburse the buyer for any tax liabilities of the target group arising out of events that occurred before completion of the sale. (This is quite standard on private share sales.)
Part of the purchase price was placed into an escrow account as protection against any claims the buyer might need to make under the SPA, including under the tax covenant. Half of the escrow amount would be released to the sellers two years after completion, and the other half seven months later.
However, if the buyer were to bring a successful claim before then, it could recoup its loss out of the escrow funds. And if any claim were unresolved on a scheduled escrow release date, the estimated amount of that claim would stay in the escrow account pending resolution of the claim.
The SPA stated that, the buyer could bring a claim under the tax covenant only if it gave “written notice … stating in reasonable detail that matter which gave rise to such Claim, the nature of such Claim and (so far as reasonably practical) the amount claimed” before the second escrow release date. This effectively imposed a longstop of around 31 months for notice of claims to be brought under the tax covenant.
Finally, the SPA contained a standard provision, stating that, even if the buyer notified a claim within the deadline above, if the claim were contingent (that is, it had not yet crystallised and become a real or “actual” claim), the sellers would not be liable until it became an actual claim.
The tax covenant claim
Around 18 months after completion, the Slovene tax authority initiated an investigation into the tax affairs – specifically, the transfer pricing policies – of one of the target group’s subsidiaries. For the next 11 months, correspondence ensued between the target group and the tax authorities. The buyer kept the sellers’ appointed representatives apprised of material developments in the investigation.
Ultimately, with the tax investigation still on-going and not near a resolution, the buyer sent the relevant sellers (one week before the deadline) a written notice indicating that it was bringing a claim against the sellers under the tax covenant in the SPA.
The notice referred to the relevant provisions of the SPA, including the clause containing the tax covenant. It also noted that the claim under the tax covenant related to an investigation by the Slovene tax authority and set out a brief chronology of events concerning that investigation.
The extent of that chronology was a central factor in the court’s decision. It is impractical to cite the entire written notice in this summary. (The text of the notice can be found at paragraph 46 of the judgment.) In brief, the chronology explained that:
- the tax authority had initiated an investigation into the relevant subsidiary’s transfer pricing practices during a specified historic period;
- the subsidiary had appointed an accounting firm to advise it on the investigation and had provided information to the tax authority;
- the authority had extended its investigation and the subsidiary had provided more information; and
- at the time of the notice, the investigation was on-going and the tax authority had “declined to issue a statement of motivation for its investigation”.
The notice went on to state that the buyer was claiming “an amount equal to any Tax Liability that the Tax Authority may impose … following its investigation”. However, it stated that the amount of any tax liability remained contingent and so it was not possible to quantify the claim at that point.
Finally, the notice noted that, as the matter remained undetermined, the buyer did not intend to instruct the escrow agent holding the escrow amount to release any payments from the escrow to the sellers.
The sellers responded that the notice was not valid, because it did not set out, in reasonable detail, the matter giving rise to the claim under the tax covenant, nor did it state the amount claimed.
The issue for the court was whether the claim notice was valid. If it was not valid, the balance of the escrow funds could be released to the sellers. If it was valid, they would remain in the escrow.
What did the court say?
The court found that the notice did not meet the requirements of the SPA and was invalid.
The judge examined a number of previous cases that dealt specifically with notices of claims under warranties, indemnities or tax covenants contained in SPAs, including the recent case of Stobart Group v Stobart  EWCA Civ 1376 (which also concerned a defective notice of claim under a tax covenant and on which we reported in a previous Corporate Law Update.)
The key message from the court was that every claims notice provision must be interpreted in its own context. The court’s job is to identify the intention of the contract parties, taking into account the factual background and deciding objectively what the commercial purpose of the notice clause is.
This could naturally lead to different outcomes in different situations, but SPAs often employ very similar language and so the judge said it was possible to set out certain principles from case law.
- The reason for prescribing the contents of a claim notice is to achieve commercial certainty (Senate Electrical Wholesalers v Alcatel Submarine Networks  EWCA Civ 3534).
- The notice must allow the recipient to know the claim to which it is exposed (Laminates Acquisition Co v BTR Australia  EWHC 2540).
- The court must decide what a “reasonable recipient” would have understood by the notice, taking into account the recipient’s actual knowledge (Ipsos SA v Dentsu Aegis Network  EWHC 1171 (Comm)).
In this case, the notice was not invalid merely because it did not state the amount of the claim. The SPA had required the notice to state the amount “so far as reasonably practical”. So, if it was not reasonably practical to quantify the claim, the notice did not need to contain a figure. This was reinforced by the fact that the SPA recognised the possibility of the buyer notifying a contingent claim that had not yet become quantifiable. There was no evidence that the buyer had been in a position to quantify the claim and so the notice could not have been expected to state more than it did.
However, the notice had failed to provide reasonable details of the “matter giving rise to the claim”.
The court said that the phrase “matter giving rise to the claim” referred to the “facts, events or circumstances on which the claim is based” – that is, the “factual basis of the claim”.
The purpose of providing this information was to inform the sellers of the facts “unearthed during the tax investigation” on which the buyer was relying in support of its claim and to allow them to assess the claim and decide how to deal with it.
This meant the notice had to set out sufficient or reasonable detail of the circumstances on which the buyer was relying in support of its claim.
But the mere reference in the notice to “an investigation by the Slovene Tax Authority … into the [subsidiary’s] transfer pricing activities” did not meet this standard. The buyer’s claim would not have been based on the mere existence of the tax investigation, but rather on the “factual reasons why a tax liability … has accrued or might accrue”. The notice should instead have set out details of the particular features of the subsidiary’s transfer pricing practices, or specific transactions.
That the sellers were aware of the investigation was relevant, but it could not override the fact that the SPA explicitly required the notice to set out reasonable detail of the matters giving rise to the claim.
As a result, the buyer’s claim was dismissed.
What does this mean for me?
This is certainly a salutary warning. Although this case was superficially similar to Stobart Group, in that case the wording of the notice was muddled and quite clearly deficient and it was no surprise that the court rejected it.
The notice in this case did contain a degree of detail about the on-going tax investigation, including dates and an explicit reference to historic transfer pricing practices of a named subsidiary. Given that the buyer had kept the sellers informed of the progress of the investigation as it developed, one can understand why the buyer thought it had included sufficient information in its claims notice.
But if there is one lesson to be learned from the increasing volume of case law on claims under SPAs, it is that being economical on detail will rarely produce a good outcome. The courts see the purpose of claims notices as protecting sellers against being blindsided and allowing them to prepare themselves.
The case gives rise to several take-away points for a buyer proposing to bring a claim.
- Provide as much detail of the claim as possible (although be careful the notice does not become so exhaustive that it effectively rules out other avenues of claim and always be minded of privilege when disclosing information).
- Do not set out merely the trigger for the claim (such as an investigation or a third-party claim), but the factual circumstances that give rise to the claim. This will require some narration.
- Above all else, make sure the notice contains all the information required by the SPA. Accidentally omitting any information may result in the notice being invalid.