The measure of damages for breach of warranty – under a SPA
In 2020, I commented on a breach of warranty case, using the theme of a cautionary tale about due diligence[1]. Another recent decision, again from Christchurch, contains another stark illustration of the need for caution – this time coupled with a damages award, for breach of warranty under a SPA, that seems out of kilter.
The 2024 decision, Cunningham v European Interiors Limited (in liq), involved a claim about a turnover warranty in a SPA. Unfortunately, during the 2 years that the case was going through procedural skirmishing, the defendant and its sole director went broke. As a result, when the case came to trail, the only defendants left standing were the purchaser’s accountants – who settled out of court. As a result, there was little or no active defence. Despite this, aspects of the judgment seem quite curious.
The widely-used, at least for sales of SMEs, ADLS form of SPA contains a turnover warranty. The warranty speaks to past performance. Curiously, in this case, the Court awarded damages for breach of the turnover warranty in the SPA based on loss of [expected] profits – which appears to be out of step with the usual basis for compensating the purchaser on a diminution in value basis for receiving something that was worth less than what they contracted for.
Once again, if there is a cautionary tale – it hinges on due diligence.
Background
The buyer in this case had agreed to buy the Canterbury regional component of a kitchen supply and installation business. The SPA included a turnover warranty for the 9 months prior to the date of the SPA. The warranted turnover was $2.2 million – when the plaintiffs claimed that it was less than half that figure. The plaintiffs also brought a claim under the Fair Trading Act saying that the information provided by the vendor misrepresented business margins and the profit and loss information misrepresented matters relating to product cost price and the profitability of the business for that 9-month period. They also sued the sole shareholder and director of the vendor (as covenantor) for his personal covenants under the SPA – backstopping the warranties.
Because of the lack of any active defence by the (insolvent) defendants, the evidence comprises briefs of evidence (largely by experts – including the plaintiffs’ accountants – before they settled the claim against them).
Decision
Finding that the turnover warranty had been breached, the judge noted that, on the breach of contract causes of action, the plaintiffs must be put as nearly as possible into the position they would have occupied if the contract (SPA) had been performed. And that where a turnover warranty is breached, it is common to approach the calculation of the plaintiffs’ loss by reference to its loss of profits. In other words, the innocent party has an expectation interest, which the law requires to be fulfilled, by financially restoring them to the position they would have occupied if the contract had been performed.
He continued by noting that whilst the appropriate income period from which to assess damages arising from loss of profits is a matter for professional judgement – in this case the Court has the uncontradicted opinion of the plaintiffs’ expert that the 3-year period commencing with the (financial) year of purchase is reasonable. He said that there is no reason not to adopt that assessment.
It is noted that the plaintiffs pleaded that, had the turnover warranty been correct, they would have recovered profits of $2.3 million (in excess of what was recoverable as the business truly existed). Alternatively, they said the true value of the business at the date of settlement was $194k – and therefore (in the alternative) they claimed $1.1 million being the difference between the purchase price and the true value. And, they also claimed direct consequential trading losses of approx. $300k for the 3 financial years following the purchase – giving an aggregate for the alternative claim of approx. $1.4 million.
There was also a large costs award – largely relating to the costs of the plaintiffs’ expert accountant.
Comments
It is a pity that this case suffered from a lack of active defence. On its face, the truncated (for the reasons noted above) decision seems to depart from the usual approach for assessing damages for a breach of warranty. That approach, based on such notable decisions as that of the Privy Council in Lion Nathan Ltd v C-C Bottlers Ltd (1996), is on a diminution in value basis.
Applying that approach to damages claim for a breach of warranty requires a comparison between the actual value of the business with the value that [it] would have had if the warranty had been true. Importantly, in C-C Bottlers, the Privy Council drew an analogy between the sale and purchase of a company, and the sale and purchase of goods. In each case, the purchaser was entitled to assume that what it stood to receive would be of the warranted quality, which means that the purchaser could claim damages to compensate them for having received something that was worth less than what they contracted for.
As noted above, by definition a turnover warranty is backwards-looking. The outcome might be different had the warranty been about future performance (which itself would be quite rare). Instead, warranties as to historic matters (for example as to the performance or state of affairs disclosed by historic financial statements) are treated as a warranty as to quality – like that in a sale of goods context. And in such cases the usual (correct) measure of damages for claims for breach of warranty as to quality is the diminution in value measure – the difference between the value of the position as warranted and the actual value.
And whilst an application of usual valuation methodology (by capitalising future maintainable earnings – utilising past performance to determine the future maintainable earnings and capitalise those earnings by an expected rate of return on investment) to calculate the loss suffered contains an element of extrapolation of past earnings, that was not the measure applied here. Consequently, by using the loss of profits measure – the measure of damages appears to be greatly overstated.
Takeaways
Noting the truncated nature of the case and therefore the scarcity of evidence, this seems to be another example of due diligence gone wrong.
Even more distressing here for the plaintiffs is that, depending of course on the terms of the settlement reached with their accountants, the plaintiffs could have ended up seriously out of pocket. This is because both the defendants (the vendor company and the shareholder/director) are insolvent.
As a result, the additional takeaway is the importance of developing an understanding of the ability of those providing warranty cover to respond to a claim. If in doubt, any one or more of security for the warranty claim period, an earn out or an escrow arrangement may be called on to provide a would-be buyer with the necessary comfort that warranty claims can be met. In larger purchases, warranty & indemnity insurance cover may be obtainable.
Once again, for those who have experienced an economic cycle or two, a contracting economy with a lot of businesses seeking to jettison non-performing / non-core activities, will mean that such comfort will assume greater significance.
For more information, please do not hesitate to contact me.
[1] See https://stephenlayburn.co.nz/due-diligence-a-cautionary-tale-for-all-parties
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