Court of Appeal considers the approach to assess a "material adverse change"

In Decision Inc Holdings Proprietary Ltd v Garbett [2023] EWCA Civ 1284, the Court of Appeal considered whether the High Court erred in finding that the sellers of a company had breached a warranty that there had been no material adverse change in the company’s prospects.

The Court of Appeal allowed the appeal. It held that the High Court’s approach to assess whether there was a material adverse change in the company’s prospects was incorrect and the buyer’s claim failed.

 

Background

The dispute concerned the sale of shares in an IT consulting company pursuant to a sale and purchase agreement (SPA). Under the SPA, the sellers warranted that as at the date of the SPA, there had been no material adverse change in the “prospects” of the company since the Accounts Date (which was 31 December 2017).

During negotiations, the buyers were provided with the company’s accounts up until July 2018, as well as profit forecasts concerning the company’s “pipeline” of work based on several key contracts. The parties signed the SPA on 8 October 2018. Subsequently, the buyers were also provided with the company’s accounts for August and September 2018.

Following the acquisition, the company performed significantly worse than the profit forecasts. In light of this, the buyers commenced proceedings for, among other things, breach of warranty that there had been no material adverse change in the company’s prospects.

 

High Court’s decision

The High Court held that the sellers breached the warranty in question as there was a material adverse change in respect of the company’s prospects. In making its decision, the Court identified three stages to determine how a breach of a such a warranty is established:

1. Determine the “baseline figure” – the forecast of the company’s prospects according to what a reasonable buyer and seller would have agreed to be the forecast at the time the parties signed the SPA. The Court held that this assessment was to be conducted in terms of the expected levels of EBITDA, as the parties’ negotiations were based on EBITDA levels.
2. Determine the “actual figure” – the actual position of the company’s prospects at the time the parties signed the SPA.
3. Consider the difference between the “baseline figure” and “actual figure” of the company’s prospects, and assess whether it is material.
   

The High Court held that the “baseline figure” for expected profits in 2018 was approximately £1 million, and the “actual figure” was approximately £300,000 which indicated that the company would be loss-making. The Court concluded that this change in the company’s prospects was material as substantially less revenue was in fact generated than expected.

 

Court of Appeal’s decision

The Court of Appeal overturned the High Court’s decision. In doing so, the Court of Appeal held that the test applied by the High Court to assess whether there was a material adverse change was incorrect. The Court identified the following reasons:

1. The High Court had regard to the wrong date to assess whether the warranty was breached: The sellers warranted that there had been no material adverse change in the company’s prospects since the Accounts Date. Therefore, it was necessary for the High Court to have assessed whether the company’s prospects had worsened since 31 December 2017, not make the assessment as at the date of signing the SPA on 8 October 2018.
2. The High Court did not compare the same things: The warranty was concerned with the company’s prospects at two points in time – as at the Accounts Date (31 December 2017) and the date of signing the SPA (8 October 2018). Therefore, whether the warranty had been breached required an assessment of the company’s actual position on these two different dates. Instead, the High Court incorrectly compared the forecast of the company’s prospects, and the actual company’s prospects, on the same date – the date of signing the SPA.
3. “Prospects” was assessed partly in hindsight: “Prospects” requires a consideration of how a company might perform at some date in the future. However, the High Court focussed on the EBITDA for the year 2018, despite the fact that when the SPA was signed in October 2018, 9 months of EBITDA had already been reported. In other words, the High Court’s analysis reflected the company’s historical financial position for most of 2018, not what might happen going forward.
4. The High Court was wrong to equate “prospects” with EBITDA: “prospects” does not mean EBITDA (otherwise the parties would have referred to EBITDA in the SPA). “Prospects” means more “chances or opportunities for success in a more general way”.

The Court of Appeal also held that the buyers’ claim for a breach of the warranty failed as their claim notice was defective. The provisions of the SPA required that the notice set out the amount claimed in respect of each alleged breach of warranty. This was not the case – the sellers only included an aggregate figure in their notice. Accordingly, the buyers’ claim must fail.

 

Key takeaways

This case reiterates that assessing whether there has been a material adverse change is not straightforward. The English courts have considered this issue relatively sparingly and therefore, there is somewhat limited guidance for parties. However, by ensuring that material adverse change clauses are clearly drafted with sufficient detail for the particular transaction (particularly the threshold for a material adverse change), parties can reduce the risk of a dispute ensuing about their meaning.

This case is also a reminder that where a contract imposes an obligation on a party to provide a written notice of its claim(s) against the other party, the serving party must issue the notice in accordance with the prescribed contractual requirements to ensure that the notice is valid.