Representations and warranties in private M&A
Published on 14th Oct 2014
It’s often said that the British are divided from their American friends by a common language – this is particularly true when looking at legal terminology used on both sides of the pond. One area which can give rise to misunderstandings is the difference in English law between representations and warranties – in the US these terms are now used (almost) interchangeably, whereas in the UK a formalist approach rooted in years of case law means that the choice of term in a contract can have material consequences in terms of the rights and remedies of each party. In this article we look at the underlying reasons for those differences, illustrated by reference to private M&A transactions.
Just like its US cousin, an English share purchase agreement in a private M&A deal will contain certain statements given by the seller(s) as to the business and operations of the target company, expressed as a fact. So a typical statement might be “The company is not currently engaged in any litigation”. If the statement turns out to be wrong, the contract provides the buyer with recourse against the seller – usually by recovering money by way of damages. A buyer will often seek to frame these statements as “representations and warranties” in order to maximise the potential damages available to him – but why is this?
Representations and warranties distinguished
A warranty is a contractual promise that a particular statement made is true. A breach of warranty therefore gives rise to a claim for breach of contract – the most common remedy being an award of damages. The intention behind expressing the warranties as also constituting representations is to establish potential liability in tort for misrepresentation. The distinction between the two legal concepts means the difference in damages which are potentially recoverable can be significant.
In the 2012 case of Sycamore Bidco Ltd v Breslin & Anor, the buyer tried (unsuccessfully) to establish that the warranties in a share purchase agreement also constituted representations. The judge noted that the distinction had material consequences:
“The point has a real significance in terms of the measure of damages (and also the date at which damages should or can be assessed), so it is necessary to deal with it. If the claimants are right about it, and can otherwise put their claim successfully in misrepresentation, then they may be entitled to recover damages which would not be available under a contractual claim. At their highest, the misrepresentation claim damages are equivalent to or exceed the consideration paid [approximately £16 million]. At its highest the warranty damages claim is about £6 million. Hence the point’s importance.”
This passage introduces two of the key differences between claims for breach of warranty and for misrepresentation – the measure of damages and (potentially) the date of assessment of damages. We look at these concepts below, together with the rules on remoteness of damage and the availability of rescission.
The main differences between warranties and representations under English law
Measure of damages
The contractual measure of damages for breach of warranty equates (in an M&A context) to the difference between the actual value of the target being purchased and its value had the warranty been true (i.e. to put the buyer in the position as if the contact had been performed). In tort, the damages are restitutionary in nature (i.e. to put the buyer in the position it would have been in had the tort not been committed) – so the damages are the difference between the price paid and the actual value of the target (strictly speaking, putting the buyer back in its original position but giving credit for value received).
That said, sometimes the result of the assessment of damages in contract and tort will be more or less the same. This is because, when looking at a warranty claim, a court will usually (but not always) consider the sale price to be a good proxy for market value when looking at the question of what the market value of the target would have been at the time, had the relevant warranty been true.
Good and bad bargains
Sometimes it is said that contractual recovery is to be favoured where a good bargain has been made by the buyer, and recovery in tort is better where a bad bargain has been made. Why is this?
In contractual recovery, generally speaking the court will look to put the buyer in the position that it would have been in had the contract been performed, ignoring any element of bargain. So, if the buyer paid £10m for a company, but it was worth £12m (as warranted), and a breach of warranty means that it is now actually worth £8m, the buyer will in principle be able to recover £4m. Conversely, if the buyer paid £10m but it was only worth £9m as warranted, and is actually worth £8m, the buyer is only able to recover £1m.
In tort, the aim is to put the buyer back in the position that it would have been in had the tort not taken place. So, taking the above example, if £10m was paid, but the company was only worth £9m as represented, and is now worth £8m, the buyer can still recover £2m to put him back in his original position.
Relevant date for assessment of damages
Under a claim for breach of warranty, the damages are usually assessed at the time of breach (so, in an M&A context, usually looking at the value of the target at completion – being the date on which the warranties are most frequently given). For claims for misrepresentation in tort, the general rule is that damages are quantified at the date the misrepresentation is made – effectively meaning the same date of assessment for both contract and tort claims. However, for claims in both contract and tort, the court – as made clear in the 1996 House of Lords decision in Smith New Court Securities Ltd v Scrimgeour Vickers (Asset Management) Ltd – retains discretion to substitute a different date of assessment if that would give rise to a more just award of damages.
Arguably, the restitutionary principle underlying a tort claim means that a buyer may have more scope for arguing for a later date to ensure he is put back in his original position. So, for example, in the Sycamore case, the parties agreed that the date of completion was the correct date for the assessment of contractual damages, but the buyer argued (but it was not determined) that the correct date for the assessment of damages for misrepresentation was the date of trial. As the company was said to be essentially worthless at the date of trial, but was found to have been worth £12m at completion the point, as noted by the judge at trial, was of material significance.
Restrictions on the scope of liability – “remoteness” of damage
In principle a wider scope of “consequential” damages is available for misrepresentation claims than for breach of contract. In both instances the courts assess what damages are recoverable by looking at the “remoteness” of the damage suffered from the original breach. For contract claims, the test of remoteness for damage means the claimant will be able to recover:
- losses arising naturally, according to the normal (or ordinary) course of things, from the breach of contract itself (“direct” losses); and
- losses as may reasonably be supposed to have been in the contemplation of the parties at the time they made the contract, as a probable result of the breach (“indirect” losses).
In tort, the type of damage must be “reasonably foreseeable”. This has been interpreted as meaning that a particular type of damage could be recoverable provided that it is not “far-fetched”. What damages are recoverable in practice is always a question for the courts, who generally speaking will apply the relevant principles on a fact-specific basis to achieve a fair result.
Right to rescind contact
Misrepresentation also gives rise to the potential right of rescission, which means that the contract is set aside and the parties are substantially put back in their original position. The right of rescission can be barred in a number of circumstances, including where it is impossible to put the parties substantially back in their original position or where third party rights would be infringed – where rescission is unavailable for any reason, the court will usually award damages in lieu of that remedy.
Summary of key differences in an M&A context
|Claim for breach of warranty – contract claim||Claim for misrepresentation – tort claim|
|Measure of damages|
|Market value of target had warranty been true less actual value||Price paid for target less actual value|
|Relevant date for assessment of damages|
|Usually date warranties given (i.e. completion), but flexibility to assess by reference to different date||Usually date of misrepresentation (i.e. completion), but arguably greater flexibility to assess by reference to a different date to give effect to the restitutionary principle|
|Remoteness of damage|
|“Direct” and “indirect” losses recoverable||“Reasonably foreseeable” losses recoverable – generally broader concept|
|Right to rescind contract?|
|No||Yes (subject to limitations)|
What to choose?
When warranties are given by one party to a contract, what dictates whether or not the other party can insist on them also being given as representations? For that, unfortunately, there are no hard and fast rules. A variety of factors come into play, including:
- the relative strength of the negotiating position of each party;
- the expectations of each party, especially where one of the parties comes from overseas where market practice may be different; and
- the type of agreement and whether or not market practice leans in one direction or the other in respect of that deal type.
As we have seen, what might seem to be relatively minor changes in the drafting of a contract can have profound implications if the transaction later sours – having the right advice when taking a seat at the negotiating table is critical.