In March 2024, the Christchurch High Court released its brief ruling on a case that addresses how damages for breach of a turnover warranty in a business sale and purchase agreement may be measured (Cunningham v European Interiors Limited [2024] NZHC 618). Turnover warranties are commonly included in business sale and purchase transactions and feature as a standard warranty in the ADLS Agreement for Sale and Purchase of a Business. Generally, a turnover warranty refers to historic turnover figures of a business, rather than future turnover to be generated by the business when it is in the buyer’s hands.

Notably however, the Court in this case awarded damages based on the buyer’s loss of expected profits, as opposed to the more common approach of assessing the difference between the actual value of the business and the ‘as warranted’ value.

This case highlights the implications of financial warranties, the significant potential consequences of inaccurate or overstated turnover warranties, the importance of sound financial due diligence, and consideration of how a buyer will recover damages in the event of a breach.

The Facts

Palazzo Kitchens and Appliances (Palazzo) was owned by European Interiors Limited (European). In 2019, European decided to sell the Canterbury part of Palazzo. An agreement for sale and purchase of the business (agreement) was entered into with Kate Cunningham and subsequently her nominee company (Cunningham), subject to a satisfactory due diligence investigation of the business.

In the agreement, European provided a turnover warranty in relation to the business for the preceding nine month period. The shareholder and director of European (covenantor) also guaranteed the warranties in the agreement. Based on the turnover warranty, other financial information provided by European, and independent supporting advice, Cunningham confirmed the agreement.

The turnover warranty stated in the agreement was over $2.25 million. However, Cunningham discovered after settlement that the actual turnover for the relevant period was less than half of that at just over $1.05 million.

Cunningham alleged that the turnover warranty and information provided by European was incorrect and misleading and sued European and the covenantor for breach of contract. A claim against European for misleading and deceptive conduct under the Fair Trading Act 1986 was also made.

Prior to this case being heard, the covenantor was declared bankrupt and European placed into liquidation. Neither the covenantor nor European provided any defence so the matter was dealt with by formal proof. The Judge relied solely upon the evidence provided by Cunningham and her forensic accountant which he found to be reliable. Ultimately, the Judge concurred that the agreement had warranted the turnover at around $2.25 million, but it was actually around $1.05 million.

Cunningham pleaded two claims for losses:

1. that had the turnover warranty been correct, Cunningham would have recovered additional profits of approximately $2.3 million;
2. in the alternative, approximately $1 million, being the difference between the purchase price and the true value of the business, combined with approximately $300,000 for the direct consequential trading losses for the financial years ending 2020, 2021, and 2022.

The Decision

The Judge held that when a turnover warranty is breached, it is common to approach the calculation of the plaintiff’s loss by reference to its loss of profits. This was to fulfil the expectation loss that Cunningham had by restoring her to the financial position that she would have been in had the turnover warranty been correct.

The income period to assess damages for loss of profits is a matter of professional judgment. In this case, the Judge had the benefit of extensive forensic accounting evidence from Cunningham’s accountant and relied on his uncontradicted opinion that a three-year period was reasonable. Accordingly, judgment was entered against European and the covenantor jointly and severally for approximately $2.3 million plus interest and costs.

Analysis

In our view, it is less common for the Courts to award expectation losses for a historic, or backward-looking warranty, as if the warranty was a term of the contract that must be performed. This line of reasoning is judicially supported by Superior Vending Ltd v Superior Vending Company (New Zealand) Ltd (High Court Auckland, CP704/98, 18 August 2000) in which a claim for annual losses after settlement was not allowed. The Judge found that future profitability was not warranted, and that the business was the buyers’ to run from settlement. As the judgment in the Cunningham case departs from this rationale, it is somewhat surprising.

However, in deciding to award a loss of profits in Cunningham, the Judge relied upon the 1987 case of Herbison v Papakura Video Ltd (No 2) [1987] 2 NZLR 720 (HC). In Herbison, the turnover warranty of a video rental company was represented as being $250,000 when it was actually less than $83,000. The Judge acknowledged that the warranty was not a promise of future profits, but that a particular profit had been achieved. However, the Judge held that a loss of profits was still appropriate as the industry was one where the running of the business would have little impact on profits and the buyer’s management and control were not at fault. That is, the loss of profits was a direct consequence of the business and agreement not reflecting the warranted turnover.

This contrasts with the approach taken in the more recent case of Dangerous Goods Compliance Ltd v Farquhar Lelean Holdings Ltd (in liquidation) [2022] NZHC 3041. In this case, the turnover warranty related to the total revenue of the business when the buyer was only acquiring part of the business. The Judge held that damages should be calculated between the warranted position of the business and its actual value. The difference between those two positions was $2.4 million which was awarded in damages.

Accordingly, how the Courts will assess damages for breach of a turnover warranty is divergent, and depends on the relevant circumstances.

Dual Approach to Damages

The respective Judges do not explain why they elected to observe different precedents, and in Cunningham, why a significantly older precedent from 1987 was relied upon. However, an explanation for assessing damages based on a loss of expected profits could be drawn from the egregiousness of the breach in terms of how blatantly wrong the turnover warranty was, coupled with an absence of mitigating factors. In Herbison, for example, the turnover was represented as $250,000 whereas the actual turnover was a mere $83,000. Further, the Judge considered the stable nature of the industry in Herbison, and the buyer’s competence was of a nature that profits could confidently be predicted. Likewise, in Cunningham, the turnover represented was more than twice the actual turnover, and the evidence of the forensic accountant as to expected profits was deemed reliable and uncontradicted.

In contrast, where damages have been assessed based on the actual vs warranted value of the business, the turnover represented in Dangerous Goods mistakenly reflected the whole of the business rather than the part of the business being sold (perhaps by way of mistake or oversight as opposed to outright misrepresentation).

On the basis of these cases, the Courts have two available modes of assessing damages for breach of a turnover warranty, so the point is somewhat unsettled at law, and dependent on the precise circumstances of the case. What is certain though, is that significant damages, however assessed, can be awarded by the Courts against a seller which represents an incorrect or misleading turnover warranty. Like all warranties, a turnover warranty should only be made by sellers with due enquiry and rigorous verification.

Outcome and Prevention

Even though Cunningham was successful in this case, the practical reality is that Cunningham will likely struggle to enforce this decision. As European and the covenantor have now been placed in liquidation and bankruptcy, they may be unable to pay out, particularly if Cunningham’s award for damages is an unsecured claim, which is likely.

This highlights the key points of firstly, doing your best to avoid a warranty claim altogether, and secondly, ensuring that funds will be available to pay out if a claim needs to be made. Some common mechanisms to achieve this are as follows:

• To avoid a financial warranty claim, sellers should be confident that their financial representations are accurate. Correlatively, buyers should verify these via robust financial due diligence and specialist adviser support.
• Ascertain who a warranty claim may be made against, and assess their financial strength to respond in the event of a claim.
• If the purchase price for a business is reliant on achieving certain future profit levels, the buyer should consider utilising mechanisms such as earn-outs for protection, as historic turnover warranties will be of limited assistance to a claim relating to future profits.
• Holding back escrow funds or deferring consideration to fund warranty claims can be an important element of the deal, especially in a distressed sale or economy.

Conclusion

Overall, the Cunningham line of cases sheds light on the complex interplay between financial information, financial warranties, including turnover warranties, financial due diligence, and ultimately, the financial strength of your recourse options and mitigation measures in business sale and purchase transactions. Whether you are a buyer or seller, specialist legal and financial advice can help you navigate the complexities and avoid the pitfalls of a business sale and purchase transaction, and hopefully, result in a clean acquisition or exit.

How can we help you?

If you would like assistance with a business sale and purchase, please get in touch with the contacts listed with this article or your usual Dentons relationship manager.

This article contains contributions by Chloë Almey, Solicitor.