In this article we discuss the guidance provided on the interpretation of no 'Material Adverse Change' warranties, 'Knowledge' exceptions and 'Valuation'.

The Commercial Court has recently handed down a decision involving the review of a no 'Material Adverse Change' or 'MAC' warranty given in a share purchase agreement that was backed by Warranty & Indemnity (W&I) insurance. In reaching its decision, in the case of Finsbury Food Group Plc v Axis Corporate Capital UK Ltd [2023] EWHC 1559 (Comm) (26 June 2023), the court examined both the scope of the warranty given and what the parties meant by a material change – as well as providing guidance on issues of knowledge, causation and valuation.

Background

Finsbury Food Group (Finsbury) is a group of food manufacturing companies, including various bakery businesses. In recent years, there has been an increased demand for gluten free (GF) and other 'free from' baked goods and Finsbury had been looking for options to expand its business into those areas. Ultrapharm Limited (Ultrapharm) was an own-label manufacturer of GF speciality bread and bakery products, whose primary business was the supply of GF goods to customers in the UK. Following a period of negotiation, Finsbury purchased Ultrapharm in accordance with the terms of a Sale and Purchase Agreement dated 31 August 2018 (the SPA) for £20 million.

Also on 31 August 2018, alongside the SPA, Finsbury entered into a Buyer-Side Warranty and Indemnity Insurance Policy (the Policy) with a series of underwriting syndicates (Insurers). The Policy was taken out by Finsbury as the 'buyer', to give it protection against any loss that may be suffered as a result of any breach of the warranties given in the SPA. The Policy did not require Finsbury to sue the warrantors before a claim could be made; in the event of a breach of warranty Finsbury could just claim under the Policy (a relatively common structure for sellers seeking a clean break).

Following completion of the SPA, Finsbury alleged that Ultrapharm had breached warranties in the SPA that had been provided by its CEO, resulting in an overall reduction in the value of Ultrapharm's business by over £3 million.

The claim

Finsbury claimed under the Policy, however, Insurers rejected the claim and Finsbury commenced proceedings.

The warranties

Several contractual warranties were given to Finsbury by the sellers in relation to Ultrapharm's business. These included:

2 Changes in the accounts date

2.1 Since the Accounts Date: ...

2.1.2 there has been no material adverse change in the trading position of any of the Group Companies or their financial position, prospects or turnover and no Group Company has had its business, profitability or prospects adversely affected by the loss of any customer representing more than 20% of the total sales of the Group Companies or by any factor not affecting similar businesses to a like extent, other than as a result of factors which have affected businesses in the same industry, in general and so far as the Warrantor is aware, there are no circumstances which are likely to give rise to any such effects;

2.1.9 no Group Company has offered or agreed to offer ongoing price reductions or discounts or allowances on sales of goods relating to its business or any such reductions, discounts or allowances that would result in an aggregate reduction in turnover of more than £100,000 or would otherwise be reasonably expected to materially effect [sic] the relevant Group Company's profitability;

The Accounts Date was 31 December 2017.

Alleged breaches

After completion of the SPA, Finsbury realised that Ultrapharm had actually agreed with its key customer – before acquisition – to a change in the recipe for two key products (the Recipe Change) and to a reduction in the price of those products on two different occasions (the Price Reductions).

Finsbury alleged that the Recipe Change and the Price Reductions were MACs and were therefore a breach of warranty 2.1.2. Separately it was alleged that the Price Reductions were a breach of warranty 2.1.9. As a result, Finsbury claimed that it had overpaid for the Ultrapharm business by almost £3.1 million (on the basis of a "warranty true" vs "warranty false" analysis).

Insurers refused to pay out under the Policy. They did not accept that there had been a breach of warranty because the changes had been disclosed to Finsbury before completion. Furthermore, Insurers alleged that Finsbury would have paid the purchase price of £20 million in any event, as that was the price the CEO of Ultrapharm was willing to accept and the amount Finsbury was willing to pay for the Ultrapharm business.

Commercial court decision

In reaching their decision the Commercial Court considered three key issues:

  1. the true construction of the warranties at 2.1.2 and 2.1.9 and whether the Recipe Change and the Price Change amounted to a MAC;
  2. whether Finsbury's knowledge of the Recipe Change and the Price Change acted as a bar to any recovery; and
  3. even if there had been an actionable breach of warranty, whether Finsbury would have paid the purchase price in any event (such that there was no recoverable loss).

The warranties

As with many post-merger and acquisition (M&A) claims, the breach of warranty issues turned primarily on the construction of the relevant contractual provisions, demonstrating again the importance of carefully drafted SPAs and transactional documentation.

Insurers had argued that clause 2.1.2 required any MAC to result in the loss of sums representing more than 20% of the target group's total sales (i.e. that the 20% threshold was a fundamental part of the MAC definition).

However, recognising that there were deficiencies in the drafting of warranty 2.1.2, the court found that the warranty actually consisted of two separate elements;

  • that there had been no material adverse change in Ultrapharm's trading position or turnover; and
  • there had been no loss of a customer representing more than 20% of Ultrapharm's total sales.

The court therefore held that the 20% threshold only applied to the 'loss of a customer' rather than imposing a quantification on the reduction caused in trading or turnover. Having undertaken that analysis though, the court went on to determine (having also looked at other cases in which this issue was considered, but recognising that there was no consensus on the threshold for "materiality" in this context) that a change in trading position exceeding 10% of group sales was required to constitute a MAC. In this case, the evidence did not support an actionable breach.

In relation to clause 2.1.9 the court held that the Price Reductions were, in principle, matters that could have fallen within the scope of that clause. However, as a matter of construction, this warranty only covered Price Reductions after the Accounts Date. The reductions in question had been agreed in October 2017, before the 31 December 2017 Accounts Date. The SPA date did not trigger the warranty, despite the fact that the Price Reductions did not take effect until February and April 2018 – dates that were well past the Accounts Date.

Knowledge

The judge also considered whether the knowledge exception in the SPA and the Policy (there were two exclusions, each worded slightly differently) would operate to prevent cover in any event.

If Finsbury had actual knowledge of the circumstances of a warranty claim and was actually aware that such circumstances would be reasonably likely to give rise to a warranty claim there could be no actionable breach. In this case there was evidence to show that a representative of the insured had actual knowledge of the facts asserted to amount to a breach of warranty and that knowledge was fatal to Finsbury's claim.

Causation & valuation

Although ultimately irrelevant to the outcome given the earlier findings, the court also held that Finsbury would have faced a significant issue on causation and quantification of the claimed loss.

The court held that Finsbury would have paid the purchase price of £20 million regardless of the possibility that the Ultrapharm business may have been overvalued – i.e. even with the breaches of warranty, Finsbury would still have paid at least £20 million for the business.

There were a number of factors in play, but the court took particular account of compelling evidence that the sellers wanted £20 million for the business and Finsbury would not have walked away from the deal if a lower price could not have been agreed. Whilst often tried by sellers in cases like this, the specific approach to valuation in the underlying transaction and the factual evidence combined to create a further insurmountable hurdle for Finsbury.

Things to consider

  • Whilst a claim under a W&I Policy may allow an insurance claim to be made without the need for a breach of warranty claim to be made against the seller first, this will not negate the need to prove there has been a breach of warranty in the underlying SPA (as well as requiring careful consideration of the Policy documents). As with direct claims against sellers under an SPA, a W&I claim cannot be used to allow a purchaser to compensate for a bad bargain.
  • A MAC clause may allow a party to claim for breach of warranty and access remedies including a claim for compensation for loss of value, however what is "material" for the purposes of any given warranty will be a matter of construction of the clause in context and will depend on the facts of each individual case. As with many other elements of transaction documents, clear drafting is key to ensuring that the bargain struck is delivered, but the court will not hesitate to impose what it considers an appropriate threshold in the absence of an agreed definition.
  • Insurers will make use of knowledge exclusions in a W&I Policy (along with any other policy defences available to them) and this case is a prime example of their importance. If the evidence shows that any deal team members whose knowledge is relevant for the purpose of the knowledge exclusion had the requisite level of knowledge at the relevant time, any claim under the policy will be denied – even if there has been a prima facie breach of warranty. For this reason, it is important to make sure that the knowledge exclusion in the policy is drafted as tightly as possible and, wherever possible, to seek affirmative cover for any known risks.
  • Do not forget about causation as part of the loss calculation, in addition to the pure quantification exercise. Even if the facts illustrate there could have been a breach of warranty that breach must have caused loss. If the Insured would have paid the purchase price in any event there can be no claim (although this is often hard to prove). For buyers, the ability to clearly demonstrate a valuation methodology (and the levers to value) could be extremely important.

Our commercial disputes team regularly advises on post-M&A disputes, including breach of warranty claims against sellers and insurers (and the defence of such claims). Please contact Sean Adams & Samantha Holland for further information, or to discuss any of the key points raised in this article.