Court of Appeal considers the test for “material adverse change”

Insight

28.11.2023

In Decision Inc. Holdings Proprietary Ltd v Garbett, the Court of Appeal has provided an important insight into how “material adverse change” (MAC) warranties will be treated by the courts.

Comment

Further detail of the decision is set out below. In particular, the difference in interpretation of the MAC warranties in the High Court’s decision and the Court of Appeal’s decision should be noted.

In summary:

Whilst this decision doesn’t set any new law and is quite specific to the facts of the case, it does provide guidance on the court’s approach to interpreting MAC clauses, and specifically those concerning the financial position of a company.
It emphasises the need to include clear, precise and unambiguous wording when drafting MAC warranties to avoid any risk that parties are then unable to establish whether a MAC has occurred. Differently worded warranties might be able to cover the same exposure with less ambiguity.
It is also imperative that where the share purchase agreement (SPA) sets out a procedure for notifying a party of any claims it is important to follow such process as carefully and closely as possible to prevent a buyer from being precluded from bringing a claim purely for failing to comply with the notice provisions.

Background

The claimant, Decision Inc Holdings Proprietary Ltd (the Buyer), agreed to purchase an IT consultancy company from two individuals (the Sellers). The parties entered into a share purchase agreement (the SPA) which included a MAC warranty whereby the Sellers warranted that there had been “no material adverse change in the company’s prospects … since the Accounts Date [31 December 2017]”. A no MAC clause or warranty provides a buyer with a right to withdraw from a deal or claim compensation if something serious, ie material, happens to impact the commercial transaction. In an M&A context this would usually be an event that has a negative impact on the target business.

Before entering into the SPA in October 2018, the Sellers provided the Buyer with various financial information including monthly sales forecasts and “pipelines” and more detailed profits forecasts. Following completion, the Buyer was given the management accounts for the two months immediately prior to completion which showed significant losses. Furthermore, as the months passed post-completion, it became clear that the actual financial position of the company did not align with the prospects originally provided by the Sellers pre-completion. The Buyer subsequently issued a claim for breach of warranty against the Sellers alleging that there had, in fact, been a material adverse change in the company’s prospects.

High Court

The High Court found in the Buyer’s favour and agreed that there had been a breach of MAC warranty. The test applied by the judge was to ask three questions.

What would a reasonable buyer have expected the prospects of the company to be at the time the SPA was signed, ie a baseline figure?
What were the actual prospects of the company on the day the SPA was signed, ie an actual figure?
Was there a difference between the expected and actual prospects, and was this difference material and adverse?

The judge had to assess whether the difference between the expected and actual prospects was material, so whether it was so significant that, had the Buyer known about it, it would have entered into the transaction on significantly different terms or perhaps not even at all. The judge considered that the company’s actual prospects were materially worse than those which the Buyer had reasonably expected, and accordingly there was a breach of warranty.

Importantly, the judge stated that if the Buyer had been asked what the prospects of the company were before completion, “the resulting discussion would have been conducted entirely in terms of expected levels of EBITDA”, so this was the metric the judge used to complete the assessment.

The judge also considered a submission from the Sellers that the claim was invalid regardless as the SPA provided that all claims for breach of warranty should specify a value of claim for each alleged breach, “as far as reasonably practicable”. The Buyer had given one aggregate value for three alleged breaches but the judge allowed the claim, agreeing that it would not have been reasonably practicable to give three separate figures.

Court of Appeal

The Court of Appeal found against the Buyer and upheld the appeal. It said that the High Court had applied the wrong test and had used the wrong comparator.

Firstly, the warranty clearly referred to there being no MAC “since the Accounts Date” (defined in the SPA as 31 December 2017) so this is the date that should have been used to identify the actual position. The High Court was wrong to assess the position as at the date of the SPA (October 2018).

Secondly, the High Court was wrong to compare two different things, ie the financial position in October 2018 against the “expectation which a reasonable buyer would have had”. Instead, it should have compared the same things on different dates, ie the actual prospects on the Accounts Date should have been compared against the actual prospects at completion to determine whether a MAC had occurred.

Thirdly, the Court of Appeal rejected the High Court’s decision to define prospects only with reference to EBITDA. In part, this was because neither of the parties had actually ventured this argument at the hearing but also because prospects has a broader meaning and seems more generally to connote “chances or opportunities for success”.

Finally, the High Court incorrectly assessed the prospects by reference to historic financial information ie the profit forecast for the financial year and instead, when interpreting prospects, it should have considered the future success of the company in the coming period.

Ordinarily, the Court of Appeal might have remitted the case to the High Court to make a new decision, properly directed. However, the Court of Appeal also found that the notice of claim was invalid because it stated an aggregate amount being claimed. The SPA called for any claim notice to specify a separate amount for each alleged breach of warranty. The amount for each breach should be clear and distinct of each other amount in the notice of claim to provide Sellers with the ability to assess whether to settle a stronger claim or fight a weaker one. Accordingly, the claim was defective and there was no reason to hear it again.