Earn out calculation suspends time limit for warranty claim

The SPA

The case involved the sale of shares in a group of telecoms services companies from an individual to a trade buyer, the terms of which were set out in the SPA.

The price to be paid by the buyer was based on the target’s estimated future cashflows by applying an agreed multiplier to a figure agreed to reflect its sustainable earnings measured by reference to EBITDA (earnings before interest, taxes, depreciation and amortisation). Since the parties were unable to reach full agreement as to the appropriate EBITDA figure, an earn-out arrangement was used. If the parties were unable to agree the amount of the earn-out, they would refer the matter to an independent expert.

The SPA included a comprehensive set of warranties concerning the target business. It also outlined limitations on the seller’s liability for any breach of these warranties, incorporating the following provisions:

• The buyer had 24 months from completion to notify the seller of a potential warranty claim.
• The buyer then had six months from giving notice of a warranty claim to initiate legal proceedings for breach of warranty unless the amount was contingent or unquantifiable, in which case the deadline was six months from the date on which “…such claim becomes an actual liability or becomes capable of being quantified”.

The dispute

The parties failed to agree the earn-out, and the matter was referred to an independent accountant (IA) for determination per the provisions in the SPA. The buyer also alleged several breaches of warranty in the SPA.

The buyer commenced breach of warranty proceedings within six months of the conclusion of the IA’s determination, which was more than six months after notifying the claim to the seller.

The sellers alleged that the warranty claims were time barred, pursuant to the contractual limitation regime set out in the SPA. The buyer alleged that the claims were contingent on the outcome of the IA’s determination.

The ruling

The judge concluded that the buyer’s claims were not time barred. His reasoning included:

• there was a risk of double recovery unless the warranty claims awaited the IA’s determination;
• linked to the above, the SPA had guidelines for calculating the earn-out that the IA must follow, without permitting any reductions based on the results of warranty claims;
• the damages for the specific warranty claims in question were dependent on the value of the business;
• the seller’s construction of the clause was impractical as the buyer would have had to commence then stay proceedings pending the IA’s determination; and
• the buyer’s approach fit the natural meaning that a “reasonable commercial person would attribute” to the SPA and led to “the outcome most consistent with business common sense”.

Lessons

• Pay particular attention to the drafting of notice of claim clauses and the interaction between warranty claim notice periods and the contractual limitation regime, where there are earn-out provisions in the SPA.
• Given the risks of seeing an otherwise valid and valuable claim become time-barred, it is imperative that notice of claim clauses are followed closely by buyers when notifying claims.
• Whilst the courts will seek to avoid being unnecessarily dogmatic, or permitting sellers to avoid liability where a notice is within the scope of the requirements of a notice clause, the precise language used in the notice of claim clause will be key in any given case.

Contact our Corporate & Commercial team if you would like help with warranty claims in SPAs.

¹ Onecom Group Ltd v Palmer [2024] EWHC 867 (Comm) (17 April 2024) (bailii.org)