Should've, would've, could've: High Court rules on the use of hindsight in the valuation of a target company
30 September 2014
In Ageas (UK) Ltd v Kwik-Fit (GB) Ltd & anr  EWHC 2178 (QB), 4 July 2014, in a claim for breach of warranty under a share purchase agreement, the defendant's warranty and indemnity insurer, AIG, argued that the assessment of damages should take into account developments after the valuation date of the target company to give proper effect to the compensatory principle and to avoid the award of a windfall. Popplewell J held that in a breach of warranty claim regarding the value of a target company, where the value depends on a future contingency, events relevant to the outcome of the contingency occurring after the valuation date may be taken into account if this: (i) gives effect to the compensatory principle; and (ii) does not cut across the contractual allocation of risk. The court refused to allow events post-acquisition to be taken into account, finding that the share purchase agreement had already allocated to the purchaser the risk of such events occurring.
The claimant (Ageas) acquired the share capital of Kwik-Fit Insurance Services Limited (KFIS, or the Target) from the defendant (Kwik-Fit) for GBP 214.75 million in July 2010 (the Acquisition). It later emerged that the warranted KFIS accounts on which Ageas had based its valuation of the Target (the Accounts) contained errors in the treatment of bad debt. The incorrect treatment of so-called "Time on Cover Bad Debt" (TOCBD) resulted in the overstatement of the profits and assets of the Target. Ageas reached a settlement with Kwik-Fit in connection with its breach of the accounting warranties in the Share Purchase Agreement (the SPA). AIG later conceded its liability under a warranty and indemnity insurance policy with Ageas. The court was required to establish the proper quantum of the breach of warranty claim and the value to attribute to the TOCBD errors in the Accounts.
Damages for breach of warranty under a SPA
The measure of loss for breach of warranty in a share sale agreement is the difference between the value of the shares as warranted and their true value. This builds on the compensatory purpose of contractual damages, which is to put the claimant in the position it would have been in had the contract been performed.
Hindsight – is it relevant?
According to Ageas' expert evidence, the understatement of TOCBD reduced the value of the Target by GBP 17.635 million. By contrast, AIG's expert evidence identified a reduction of only GBP 8.792 million. The difference resulted mainly from the approach adopted by each expert to what was known about TOCBD after the Target valuation date, ie hindsight.
Ageas' figure did not refer to hindsight and is based on the actual TOCBD incurred for the five months covered by the 2010 management accounts, which were the latest trading figures available before the Acquisition. The Ageas figure projected that TOCBD would remain constant until 2014 at the level at which it had been for the first five months of 2010. AIG's expert evidence, on the other hand, referred to the post-Acquisition incidence of TOCBD. The AIG expert valuation of the Target at the date of the Acquisition took into account the falling rates of TOCBD from 2010 to 2014 and the fact that the actual level of TOCBD (ie the figure referred to by Ageas) had been influenced by a reduction in the number of policies underwritten compared with the number of policies predicted at the time of the Acquisition and used in Ageas' valuation model.
Departure from the breach date rule?
According to AIG, therefore, when valuing the Target at the date of Acquisition, there were justifiable grounds for account to be taken of the post-Acquisition incidence of TOCBD, ie to use the benefit of hindsight. AIG argued that the valuation of the Target at the date of the Acquisition involved assumptions about the future incidence of TOCBD, that is, a contingency which was at the time of the Acquisition future and uncertain. AIG submitted that where an assessment of damages depends on a contingency existing at the date by which reference to which damages fall to be assessed (ie the date of valuation of the Target), the court can and should take into account what it knows about the outcome of the contingency by the time the assessment is made, using its knowledge of events occurring after the breach. Ageas argued that there was no good reason to depart from the breach date rule, assessing damages by reference to the value of the Target at that date without reference to subsequent events.
Popplewell J's decision is based on two points of English law, which he labels as "uncontroversial": (i) damages for breach of contract are intended to put the innocent party in the same financial position as if the contract had been performed; and (ii) damages for breach of contract will normally be assessed by reference to the position at the date of the breach, but a later date may be used for the assessment if in all the circumstances of the case to do so would accurately reflect the overriding compensatory principle.
In support of the view that hindsight should be taken into account, Popplewell J cites the approach of the House of Lords in Bwllfa and Methyr Dare Steam Collieries (1891) Limited v The Pontypridd Waterworks Company  AC 426, as applied in Golden Strait Corpn v Nipon Kubisha Kaisha (The Golden Victory)  2 AC 353, that a judge should "avail himself of all the information at hand at the time of making his award which may be laid before him" and refuse to "listen to conjecture on a matter which has become an accomplished fact". However, he applies two qualifications, namely that: (i) it is justified where necessary to give effect to the compensatory principle; and (ii) it does not cut across the contractual allocation of risk.
Popplewell J concluded that AIG had not shown that the conventional prospective approach to the calculation of damages at the breach date, as advocated by Ageas, had offended the compensatory principle and resulted in an unfair windfall to Ageas:
AIG's calculations, based on the post-Acquisition data available, were not sufficient due to the number of other variables in the business model of the Target; and
under the terms of the SPA, Ageas had assumed the risk connected with TOCBD post-Acquisition. The judge referred in particular to the fact that the SPA was for a fixed price based on what Ageas was prepared to pay for a business which was thereafter in Ageas' control. The bargain embodied in the SPA was the allocation of risk to Ageas of any benefit or loss arising either as a result of the way Ageas chose to run the business or as a result of external influences on the success of the business. The court could not therefore cut across this allocation of risk by allowing hindsight to influence the calculation of damages.
Comment: With its focus on the admissibility of hindsight, this decision highlights the tensions that can exist between the compensatory principle and contractual autonomy and risk allocation in an M&A context. As Popplewell J observed, there is scant authority directly addressing the possibility of using hindsight or subsequent events in order to value a company for a warranty claim. The application of general principles and their interplay in this decision is therefore illuminating and of relevance to those involved in the valuation of target companies, commercial bargaining, risk allocation and the drafting of contracts in connection with company acquisitions.
The case demonstrates the practical difficulties of using hindsight to present an alternative value adjustment capable of debunking the conventional prospective approach to the calculation of damages at the breach date. Where parties are aware of contingencies at completion relevant to the value of the target, therefore, they should continue to consider whether it is possible to make provision for a post-acquisition adjustment to the purchase price based on subsequent trading or the outcome of the contingency. Similarly, consideration should be given to whether the contingency in question is a risk assumed by either party, and if so the impact of this on the bargain reached pre-completion.
The decision is also of wider relevance in its consideration of the proper date for the assessment of damages in a warranty claim in connection with the value of a company. Popplewell J characterises the breach date rule at various points in his decision as "uncontroversial" and "conventional". Despite this, a body of cases supports the view that the convention of assessing damages at the date of breach is merely a convention and not a rule, and that it is based on the assumption that the parties are dealing with commodities, commoditised goods or services. In practice, and of particular relevance in the M&A context, which has little in common with scenarios related to commoditised goods or services, case law would appear to support the view that the question of what damages calculation method will put the claimant in the same position as if the contract had not been breached is often "a rule of circumstance rather than law" (Zakrzewski v Chas J Oldhams & Sons  2 EGLR 15) and that the correct date may therefore post‑date the breach.