Court interprets interaction of indemnity and price adjustment mechanism
04 December 2024The High Court has interpreted the interaction of a post-completion price determination mechanism and an indemnity in a share sale and purchase agreement, finding that the existence of an indemnity for particular matters did not prevent those matters from being factored into the price determination.
What happened?
Adie and anor v Ingenuity Digital Ltd [2024] EWHC 2902 (Ch) concerned an agreement (the SPA), under which two individuals sold all their shares in two companies to a corporate buyer.
The price payable for the shares was structured as an initial payment on completion of the sale, followed by a deferred payment to be paid after completion.
The SPA contained a schedule setting out a specific methodology for calculating the deferred payment, including a process for referring any disputes between the parties to an expert for determination. Under that procedure, the buyer would produce a completion statement and submit it to the sellers.
Importantly, the SPA stated that the deferred payment was to be calculated by taking the EBITDA for the target companies for a 12-month period, multiplying that EDITDA by a factor of six, then deducting the initial payment made on completion.
The SPA also contained some specific indemnities in favour of the buyer, including an indemnity against breach of fundamental warranties and a separate indemnity in relation to historic use of the coronavirus job retention scheme (CJRS).
Shortly before the date scheduled for signing the SPA, a key customer of one of the target companies raised a complaint about the target company’s performance under a contract. The customer stated that, unless its complaints were resolved, it reserved the right to terminate the contract, seek repayment of sums it had paid, withhold payment on outstanding invoices and claim damages.
In response to this, the buyer and sellers included a third indemnity in the SPA in favour of the buyer in relation to the alleged breach by the target company of its contracts with the customer in question.
In the event, the claim between the target company and the customer was not resolved and became a full-scale dispute.
Following completion, the buyer produced the completion statement required by the SPA and sent it to the sellers. In compiling the statement, the buyer made a deduction from the target companies’ EBIDTA to reflect the dispute with the customer, which would in turn reduce the deferred payment.
The sellers argued that the buyer was not entitled to make a deduction under the price determination mechanism, because the parties had specifically addressed the customer dispute through an indemnity.
They claimed that the indemnity was the buyer’s sole means of recovering compensation in relation to the dispute, and that the buyer’s completion statement was, therefore, erroneous. Allowing the buyer to make a deduction under the price determination mechanism and to claim under the indemnity would result in the buyer being compensated twice, which was not appropriate.
What did the court say?
The court disagreed.
If the price determination mechanism were to exclude any adjustments resulting from the customer dispute, this would need to be an express or implied term of the SPA.
There was no express term in the SPA to this effect. The sellers argued that the indemnity had been included in the SPA at the last moment before signing, and that the parties had intended it to form the buyer’s sole remedy but had neglected to amend the price determination mechanism.
The court therefore analysed whether the SPA contained an implied term to this effect. It concluded that there was no such implied term.
The judge noted that the price determination mechanism and the indemnity were designed to achieve different things. The indemnity was to provide pound-for-pound compensation for losses arising from the customer dispute. The price determination mechanism, by contrast, was designed to calculate the enterprise value (EV) of the target companies.
To achieve this, the price determination mechanism concentrated specifically on revenue (in the form of EBITDA), rather than on an absolute amount of loss, and (unlike the indemnity) it employed a multiplier as a means to value future revenue. If the buyer were not able to adjust the price to account for the customer dispute and, therefore, reduce the price, it would be undercompensated, because the indemnity would not account for projected future revenue.
In addition, the court noted that the parties had already included other specific indemnities in the SPA in relation to other matters, such as the CJRS. There was no obvious reason why these other specific indemnities should have been treated differently from the indemnity relating to the customer dispute.
If the parties had intended that matters covered by the other indemnities should not be factored into the price determination mechanism, they had had ample opportunity to make this explicitly clear in the SPA by including express exclusions in that mechanism. But they had not done so, and the express terms of the price determination mechanism required those matters to be taken into account.
The natural inference, therefore, was that the buyer was entitled to take the subject matter of the indemnities – including the customer dispute – into account under the price determination mechanism.
Finally, the judge acknowledged the sellers’ concern about that potential for double recovery. However, he said that there was no scope to take account of that in the price determination mechanism, which was a prescribed procedure. Rather, a court might take double recovery into account were the buyer to bring a claim under the indemnity.
What does this mean for me?
Although this case featured quite specific facts, it is a useful illustration of how the courts will interpret different mechanisms within a share or business sale agreement and reconcile any potential conflict.
It is often the case in an SPA that a particular state of affairs could come within the scope of multiple provisions, including warranties, indemnities, termination rights and price adjustment mechanisms. See the box below titled “Different protections in an SPA” for further thoughts.
Different protections in an SPA
Under the law of England and Wales, the general principle of caveat emptor, or “buyer beware”, applies. Under this doctrine, apart from a few basic statutory protections, a buyer assumes all of the risk in any asset they acquire.
As a result, to mitigate the risk of unknown liabilities, buyers need to thoroughly interrogate a seller, investigate the target of their acquisition and put protections in place. A buyer will typically take two main steps:
- Due diligence. A buyer can conduct due diligence on its acquisition target. This typically takes the form of a series of questions to the seller, designed to elicit responses and usually, on a share or business acquisition, disclosure of documents through a data room. Based on these responses and disclosures, a buyer can formulate a strategy, including adjusting its proposed price and including specific contractual protections.
- Contractual protections. A buyer can also include specific protections in its share or business sale agreement (SPA). There are various types of mechanism a buyer can utilise, including warranties, indemnities, conditions, termination rights and price adjustment mechanisms.
These protections are all designed to address different things.
- Warranties protect against and reveal undisclosed problems. They are statements of fact (or, sometimes, prediction). An example might be a statement that no target company is party to any legal proceedings.
If it transpires that a warranty is untrue, the buyer can claim damages, normally measured by the drop in the value of the asset it has acquired. Warranties protect only against unidentified issues. A seller can “disclose” matters against warranties, making them known and preventing the buyer from claiming in respect of them. However, the buyer can, in response, insist on other protections.
- Indemnities protect against known risks. They are often framed by reference to specific matters or events and are designed to provide a buyer with pound-for-pound recovery against losses. An example might be an indemnity against losses arising from a known act of discrimination.
- Conditions (or conditions precedent) set out criteria that need to be satisfied before the acquisition can proceed. These can be “positive” (requiring some action to be taken) or “negative” (requiring that something not happen). An example of a “positive” condition might be obtaining some regulatory clearance, such as merger control consent. An example of a “negative” condition might be that a key customer does not terminate a contract, or that no material adverse change occurs.
- Termination rights set out circumstances in which the buyer can walk away from the deal. There is some overlap here with conditions. Often, a key distinction is that failure to satisfy a condition may lead to the transaction automatically terminating, whereas a termination right gives the buyer the option to walk away or to proceed to complete the deal. Termination rights might include where a material adverse change occurs, or where a seller commits a significant breach of warranty.
- Price adjustment mechanisms are designed to refine the price payable on a transaction. There are many types of adjustment mechanism.
One approach is for the buyer to pay an estimated price at completion based on a specific metric, with a price adjustment following completion to reflect the actual value of that metric on the relevant measurement dated (which is typically completion). There will be a balancing payment after completion, payable to the seller if the actual value is higher than the estimate, or refundable to the buyer if it is lower. This is often known as a “completion accounts” mechanism, and typical metrics employed include net asset value, net debt and working capital, regulatory capital, assets under management (AUM) or specific revenue streams.
Another approach is to defer part of the price (so-called “deferred consideration”) and to calculate it by reference to future performance. An example is an “earn-out”. The deferred position of the price will typically be referenced to financial metrics, such as EBIT or EBITDA.
A single incident could feed into all of these.
Take, for example, a regulated financial services business that turns out not to hold a licence it requires to carry on one of its business lines. This might amount to a breach of warranty that the business holds all licences required to carry on its business as it does at the point of signing.
The same lack of a licence could also form the basis of a claim under, say, an indemnity against all losses arising from breaches of consumer credit law.
If the SPA contains a condition precedent that, at completion, the target business hold all authorisations required from the Financial Conduct Authority, the lack of the licence may mean that the condition is not satisfied. It may also form the basis of a termination right.
Finally, not being properly licensed may result in the target company needing to cease a particular line of business, impacting revenue, or a drop in the target’s net asset value. Either of these could feed into any price adjustment mechanism, depending on the structure employed by the SPA.
Courts are notoriously reluctant to allow a party to recover more than once, or to overcompensate a party, for loss they have suffered.
However, in the context of a commercial contract, a court needs to square this approach with giving effect to the express wording of the contract. If the language of an agreement is clear and requires double-counting, the courts will have no choice but to honour this.
This means it is of fundamental importance to ensure that different mechanisms within an SPA interact properly with each other. If the parties intend to address a matter through an indemnity to the exclusion of a price adjustment, the SPA should state this explicitly.
Alternatively, if there is to be overlap but no double recovery, the SPA should deal with this. One approach is to include a limitation stating that the buyer’s recovery in respect of a particular matter under a warranty or indemnity claim will be reduced by any compensation the buyer receives under the applicable price adjustment mechanism.
In reality, issues often emerge at late stages in the transaction cycle and the capacity to address them comprehensively is limited. Where feasible, parties should try not to be disincentivised from doing so by timetable pressures and instead take the time to ensure their agreement and intentions are clear.
Get in touch
