Breach of warranties in a share sale agreement

Summary

Warranty and indemnity (W&I) policies are designed to insure against breaches of the representations and warranties provided by sellers in contracts for the sale of businesses. We consider recent English law W&I disputes in our A Year in Insurance Law 2024 publication.

Here we look at a decision of the Supreme Court of New South Wales, handed down last week. DTZ Worldwide Limited v AIG Australia Limited highlights the importance of accurate disclosure in share sale agreements and the challenges in proving damages when alleged breaches of warranty do not materially affect the value of the business acquired.

Background

The dispute related to a buyer's W&I insurance policy following the acquisition of an international property services business.

In 2014 DTZ Worldwide Limited (DTZ) agreed to buy a group of companies from the United Group (the Seller) for AUD 1.215 billion pursuant to a share sale agreement (SSA).

The dispute centred on one particular contract – a facilities management contract in Singapore entered into by one of the target group companies (known for these purposes as Premas). This, known as the FM Contract, was part of the Singapore Sports Hub Project, a large-scale redevelopment initiative involving construction of various facilities, including a national stadium and an aquatic centre. Under the FM Contract, entered into by Premas in 2010, Premas was obliged for the 25-year life of the project to provide certain property management services, including in respect of cleaning and security at the Sports Hub. Its charges for providing those services were fixed at the outset, but there was provision for those charges to be reviewed at 5-year intervals in line with indexation and/or by comparison with then prevailing standard market rates.

By the time the SSA was entered into in 2014, shortly before the first 5-year milestone in the FM Contract, the FM Contract had proved loss-making for Premas. Not least, since 2010 the costs of providing cleaning services had risen because of new employment rules/minimum wage requirements introduced by the Singaporean Government.

DTZ claimed the Seller had breached several Accounting Warranties in the SSA concerning the FM Contract, by:

(i) incorrectly accounting for certain payments;
(ii) wrongly capitalising mobilisation costs; and
(iii) failing to recognise the FM Contract as an “onerous contract” (i.e. as recognised by relevant accounting standards, one which on the balance of probabilities was loss-making) and to make provision for it in their accounts.

DTZ also put forward an alternative case that the Seller failed to disclose a number of problems with the FM Contract (thus breaching the Disclosure Warranty).

DTZ claimed that by reason of alleged breaches of these warranties in the SSA, it suffered loss of c.AUD 215 million.

Pursuant to the SSA, DTZ was required to obtain warranty and indemnity insurance in the form of a policy issued by the defendant insurers on the date of the SSA (the W&I Policy). That policy took the form of an insurance tower with a total limit of indemnity of AUD 300m consisting of an underlying policy issued by the first defendant, AIG Australia Limited (AIG), and eight excess policies. The retention in the Policy was AUD 12.15m and the Primary Layer’s Limit of Indemnity was AUD 30m in excess of the retention.

DTZ brought a claim against the Insurers of the W&I Policy for its alleged losses (given the SSA contained nil recourse against the Seller for breach of these warranties). Shortly before the hearing, DTZ settled its claim against AIG (as primary) and certain other insurers on the 4th – 8th excess layers. This meant that the 1st – 3rd excess Insurers remained defendants to the claim, as well as one Insurer in the 4th excess layer.

The DTZ decision

We have summarised below what we consider to be some of the key points from the judgment in DTZ Worldwide Limited v AIG Australia Limited:

• the Seller had not breached the Accounting Warranties:

  (i) The Court found that the impugned payments were correctly characterised as compensation for services provided, rather than as a sham to disguise foregone indexation rights. The Court therefore concluded that the accounting treatment of the payments was appropriate and did not constitute a breach of warranty;

  (ii) In respect of allegations as to wrongly capitalising mobilisation costs, the Court concluded that DTZ's evidence only suggested potential inaccuracies, insufficient to prove the figures were misleading. The Court emphasised that DTZ bore the burden of proving the unreliability of Premas's estimates and the evidentiary record was incomplete. However, on balance, Premas's approach was reasonable, as it sought to estimate the time spent on manual preparation based on input from those involved. Further the Seller’s management and KPMG were satisfied with the conclusions of Premas’s accounts at the time;

  (iii) Finally, the Court decided there was insufficient evidence to suggest that the FM Contract should have been recognised as onerous in the accounts as of 31 March 2014. The Court noted that the FM Contract was in its early stages, and while there were initial challenges, these did not conclusively indicate long-term unprofitability. For example, while the cleaning costs to Premas had proved higher than anticipated in the first few years of the FM Contract, causing that contract to be loss-making at that point, as at the date of the SSA there was every reason for the Seller’s management to believe that the FM Contract would become profitable over the remaining years of the contractual period: the management was therefore entitled to regard the problems/losses experienced in the first few years as the kind of “teething problems” that were to be expected in such a large and complex project. The court also highlighted that management's judgment, supported by expert advice, is crucial in determining whether a contract is onerous.

However, the Court did find that there was a breach of the Disclosure Warranty. The Court concluded that the materials disclosed were misleading in three respects: they failed to disclose significant issues with the FM Contract (in relation to the the costs of cleaning at the venue), the Seller did not update its response to a key question about the contract's performance (as set out in the transaction’s Q&A document), and the Seller provided misleading answers regarding deductions related to cleaning costs. The Court therefore inferred that a key executive of the Seller was aware of these issues and that the answers provided were misleading, thus breaching the warranty.

Damages

DTZ put its claim for damages in two ways: first, it claimed the present value (at the time of breach) of the losses which it said arose from the FM Contract; second, the difference between the value of the business on the assumption that the warranties were true (i.e. the purchase price) and the actual value of the business. In the alternative, DTZ claimed for the difference between the purchase price it paid and the purchase price a hypothetical reasonable buyer would have paid if it had known the true facts relating to the FM Contract.

However, the Court dismissed DTZ’s arguments in respect of both approaches, and decided that DTZ was only entitled to recover damages consequent on the breach of the warranties arising from the Seller’s failure to disclose the fact that the costs of cleaning were substantially more than budgeted, and that these were likely to mean that, contrary to expectations, the FM Contract was likely to be loss-making at least for the first two or more years of its operation. A reasonable method of assessing those damages would be to determine the present day (as at the date of breach) value of the difference between the profits originally forecast to be earned under the FM Contract up until the end of the first benchmarked period with the profit or loss during that period arising from the increase in cleaning costs.

In the event, given that any amount calculated in that way would be substantially less than the threshold for the cover provided by the first excess policy (i.e. was below AUD 42,150,001), no damages were recoverable against the remaining defendants. The overall result was that the defendants, being certain of the excess layer insurers in the tower at or above 1st excess layer level, were victorious: the claim against them was dismissed, with costs payable by the Insured.

In dismissing DTZ’s approach, the Court noted that:

• While the use of a discounted cash flow (DCF) analysis was appropriate, the adjustments made to the discount rate and cashflows were questioned. Reliance by DTZ on academic studies about stock price reactions to accounting restatements was deemed irrelevant, as these studies pertained to publicly listed companies and did not apply to DTZ’s circumstances. The Court further noted that the alleged accounting errors were minor, relative to the size of the DTZ business, and did not justify a higher discount rate. Furthermore, the Court found no evidence of fraud or egregious conduct by Premas, undermining the basis for adjusting the discount rate. Ultimately, the court concluded that DTZ's claims for damages were not substantiated by the evidence presented; and
• DTZ's alternative approach was found to be convoluted and inconsistent with the principles of assessing damages for breach of warranty. The Court emphasised that the assessment should focus on the objective value of the business, comparing the value assuming the warranties were true with the actual value. The Court also found no basis for awarding additional damages for other risks, as the evidence did not support such adjustments. The Court concluded that DTZ's approach lacked a logical foundation and amounted to speculation rather than a substantiated claim for damages.

Comment

This judgment underscores the importance of accurate and comprehensive disclosure in corporate transactions, and highlights the potential for liability when material information is omitted or misrepresented. It also throws into relief the need for a proper foundation when proposing adjustments to valuation methodologies and the importance of considering the specific circumstances of the company in question.

In addition, the decision is a clear demonstration of the challenges in proving that a contract is – to the Seller’s actual, subjective knowledge at the time of the SSA – an “onerous contract” (applying the correct accounting standard, and without the benefit of hindsight) and contesting accounting practices without comprehensive evidence.