UK Corporate Law Developments: Extending the Scope of Warranties?

June 17, 2013

The UK Court of Appeal recently held in the Belfairs Management case[1] that a warranty in a sale and purchase agreement should be interpreted with regard to all of the background knowledge reasonably available to the parties at the time the agreement was entered into.  The decision highlights the growing trend of the UK courts to adopt a more purposive, rather than a literal, approach to the interpretation of contracts under English law in order to give effect to the commercial intentions of the parties where the facts underlying the dispute clearly support such an interpretation and where those commercial intentions are clear.  This alert provides a short summary of the facts of the Belfairs Management case, as well as a discussion of the potential implications of the decision for buyers, sellers and their advisers.

The Facts of the Dispute and the Decision of the UK High Court

Belfairs Management Limited ("Belfairs") had, by way of a share purchase agreement (the "SPA"), agreed to buy a 60 per cent. stake in Waveform Solutions Limited ("WS Ltd") from Matthew and Christie Sutherland (the "Sutherlands") for £2 million.  As part of the transaction, Belfairs agreed to provide an additional £600,000 to WS Ltd by way of an interest-free loan, and the Sutherlands agreed to lend WS Ltd £1 million from their sale proceeds by way of a convertible loan and an interest-free loan.  The SPA included a warranty that "[WS Ltd] is not a party to any agreement, arrangement or commitment which cannot be readily fulfilled or performed by it on time" (the "Warranty"). 

WS Ltd, along with seven other companies, had previously been selected to enter into a framework agreement with the UK’s National Health Service (the "NHS") (the "Framework Agreement") but, as WS Ltd required a capital injection in order to meet its obligations under the Framework Agreement, it delayed entering into the Framework Agreement until that additional funding (by way of the aforementioned shareholder loans) was secured.  The Framework Agreement was signed shortly after the SPA was entered into and required WS Ltd to meet certain specific technical and regulatory milestones within 12 months of signing and, assuming those were met, would afford WS Ltd the opportunity to bid for potentially extremely lucrative contracts with various NHS Primary Care Trusts.

Approximately six months after the SPA was entered into, WS Ltd became unable to meet its obligations under the Framework Agreement and shortly thereafter entered into administration.  Belfairs brought a claim against the Sutherlands for, among other things, breach of the Warranty.  The Sutherlands argued that the Warranty had not been breached because WS Ltd had not entered into the Framework Agreement at the time that the SPA was signed, and therefore it could not be considered to be an "agreement, arrangement or commitment" of WS Ltd for the purposes of the Warranty.  The High Court upheld this view on the basis that when the SPA was entered into the non-binding offer by the NHS to WS Ltd to enter into the Framework Agreement did not subject WS Ltd to any legally binding obligations (including any obligations that could not be "fulfilled or performed by it on time") and accordingly the Warranty could not apply to the Framework Agreement.  

The High Court also held that in determining whether the Warranty had been breached regard should be had to the subjective assessment of the Warranty by the Sutherlands in determining whether the Sutherlands considered the Warranty to be misleading or inaccurate as at the date of the SPA.

The Decision in the Court of Appeal

The Court of Appeal held that:

(i)         the Framework Agreement should be within the scope of the Warranty as an "agreement, arrangement or commitment" to which the Warranty applied; the construction of the Warranty turned on whether a reasonable person with all the background knowledge reasonably available to the parties at the time the SPA was entered into would regard the Framework Agreement as an "agreement, arrangement or commitment" of WS Ltd, even though at the time the SPA was signed the Framework Agreement had not been formally entered into;

(ii)        accordingly, on a commercially sensible construction, the Warranty must have been intended to apply to the Framework Agreement; and

(iii)       in order to determine whether the Warranty had been breached, it was necessary to conduct an objective, rather than a subjective, assessment as to whether the Framework Agreement could be fulfilled or performed by WS Ltd at the time the SPA was signed.

In reaching these conclusions, the Court of Appeal noted that the Framework Agreement "was at the very heart of the commercial deal" and the deal had been structured such that following the entering into of the SPA and the capital injection contemplated by it, the newly capitalised WS Ltd would be able to sign up to the Framework Agreement (and ultimately bid for the contracts with the various NHS Primary Care Trusts).  The Court of Appeal considered that on balance the commercially more sensible construction of the Warranty, given the commercial intentions of the parties, was that the Framework Agreement fell within its scope.

The Framework Agreement was also referred to in the disclosure letter which qualified the warranties under the SPA (although there were no disclosures against the Warranty).  In the High Court, Belfairs argued that although the Framework Agreement may not be an "agreement" for the purposes of the Warranty it was certainly an "arrangement" on the basis that it was the subject of disclosures in the disclosure letter, despite the fact that the relevant provisions of the disclosure letter explicitly stated that the disclosure of any matter "shall not . . . be taken as extending the scope of any warranty".  This argument was rejected by the High Court.  As the Court of Appeal was able to conclude that the Warranty was intended to apply to the Framework Agreement on the basis of other considerations, it was not required to consider the potential impact of the references in the disclosure letter, although it should be noted that the Court of Appeal "did not find [those arguments] obviously convincing".

The Implications of the Decision and Comments

This case highlights how in limited circumstances the UK courts may be prepared to reject a literal reading of a warranty where such an interpretation clearly contradicts with the intention of the parties, for example as evidenced by other sale documentation and supporting materials.  Historically, the UK courts have been reluctant to attempt to determine the commercial intention of contractual parties, particularly if such an approach would be contrary to a literal reading of a contract. 

However, we think it is arguable that the decision in this case may be capable of being limited to its facts on the basis that:  

(i)         it was clear that both parties intended WS Ltd, once recapitalised, to enter into the Framework Agreement (as it did shortly after the SPA was entered into) and that the Framework Agreement was at the heart of the commercial agreement and was in reality the driving force behind Belfairs’ investment;

(ii)        the disclosure letter disclosed certain information relating to the Framework Agreement, indicating that the Sutherlands themselves considered the Framework Agreement to be an "agreement, arrangement or commitment" of WS Ltd although, as referred to above, both courts were not persuaded that those disclosures could be invoked to assist in the construction of the Warranty given the limitation included in the disclosure letter; and

(iii)       the court’s decision that the Warranty required an objective, rather than a subjective, assessment to determine if it had been breached can be justified on the basis that the Warranty was not limited to the actual knowledge or belief of the Sutherlands and the Court of Appeal found no other reason to suggest that a subjective test should be applied (indeed, it referred the determination (using an objective basis) of whether on the facts the Warranty had actually been breached back to the first instance judge).

The willingness of the courts to potentially adopt a more purposive approach and consider the parties’ commercial intentions when entering into a contract has potentially important implications.  Sellers, as well as buyers, should carefully consider whether the warranties adequately cover the key commercial imperatives for the transaction and their approach to disclosure if it is felt that the warranties do not expressly do so (in addition to  the more normal disclosure exercise).  The inclusion of language such that any disclosures will not extend the scope of any warranty should offer sellers comfort that there is no need to omit what is considered to be a relevant disclosure where they are seeking to avoid liability as a consequence of a warranty being interpreted purposively.  Buyers should continue to ensure that warranties are carefully drafted so as to explicitly cover their key commercial imperatives for the transaction, as well as any specific issues which are particularly important to them in the context of the transaction as a whole.  As always clarity is the key.