Hong Kong – M&A – Case Review – Interpretation Of A Seller Indemnity.

12 October, 2015

 

Indemnities are integral to the allocation of risk in M&A transactions.  Unlike warranties, indemnities serve as a promise by one party to reimburse the other party on the occurrence of a specified type of liability.  An indemnity provides full recourse for the indemnified party against the indemnifying party and, unlike warranties, the indemnified party will typically not need to mitigate their loss.  As they are powerful tools for allocating risk, due care should be attributed to the drafting of indemnities.  A recent English case, Andrew Wood v Sureterm Direct Ltd & Capita Insurance Services Ltd [2015] EWCA Civ 839 (the "Case"), illustrates just this.

Background

Capita Insurance Services Ltd (the "Buyer") entered into a sale and purchase agreement (the "SPA") with Mr Andrew Wood (the "Seller") for the acquisition of the entire share capital of Sureterm Direct Limited ("Sureterm").  Under the SPA, the Seller provided the Buyer with an indemnity in respect of losses pertaining to the mis-selling or suspected mis-selling of insurance products or services "following and arising out of claims or complaints registered with the [UK Financial Services Authority[1] (the "FSA") or other regulator]".  This indemnity was in addition to warranties given by the Seller that the conduct of its business was in compliance with applicable laws.  Following the acquisition, the Buyer became aware that Sureterm had been conducting suspected mis-selling activities prior to the acquisition.  The Buyer subsequently reported the activities to the FSA and agreed to pay compensation to the affected customers.  The Buyer subsequently sought recovery and sued the Seller under the indemnity whilst the Seller claimed that the indemnity could not be construed to cover instances where the Seller or Sureterm reported mis-selling itself. The High Court agreed with the Buyer and allowed the claim. The Seller's appeal was subsequently heard in the Court of Appeal.

The indemnity and High Court decision

The relevant indemnity contained within the SPA was worded as follows:

[The Seller] undertake[s] to pay to the Buyer an amount equal to the amount which would be required to indemnify the Buyer and each member of the Buyer's Group against all actions, proceedings, losses, claims, damages, costs, charges, expenses and liabilities suffered or incurred, and all fines, compensation or remedial action or payments imposed on or required to be made by the Company following and arising out of claims or complaints registered with [the Financial Services Authority or other regulator]… and which relate to the period prior to the Completion Date pertaining to any mis-selling or suspected mis-selling of any insurance or insurance related product or service.

Both Buyer and Seller agreed that the indemnity covered two categories of loss: (i) actions, proceedings, claims, damages or losses suffered or incurred, and (ii) fines or compensation required to be paid.  It was agreed that both categories of loss must have been prior to completion and pertain to suspected or actual mis-selling.  The Buyer stated that only the second category of loss needed to arise out of claims or complaints registered with a regulator whilst the Seller's view was that both categories of loss needed to arise out of regulator registered complaints or claims; the significance being that in the current instance no customers had registered complaints or claims against Sureterm with the FSA or another regulator, Sureterm had reported itself to the FSA.

The High Court agreed with the Buyer's interpretation and amongst the factors motivating this decision was that Court's belief that the Buyer's interpretation made more commercial and practical sense, especially given that in many situations customers will not become aware of mis-selling until a regulatory investigation has been made public.

Court of Appeal's decision

The Court of Appeal overturned the High Court's decision and agreed with the Seller's interpretation of the indemnity.  Christopher Clarke LJ emphasised that where the language used is capable of having more than one meaning it is possible to prefer the construction based on what would make most sense in a business context, but a balance has to be struck between the simple meaning of language used and the necessities of business common sense. In relation to this Clarke LJ pointed out that businessmen sometimes make poor bargains and drafting can at times be inadequate to the requirements of the commercial context; it is not for the Court to rescue a bad bargain or reword a poorly drafted clause.

Clarke LJ noted that the warranties under the SPA also provided protection to the Buyer in the event of mis‑selling or suspected mis-selling.  Unlike the indemnity claims, warranty claims were subject to time and monetary limits.  Clarke LJ therefore envisaged a two-tier framework where mis-selling claims were generally claimable under the warranties and subject to time and monetary limits, whereas customer's claims of mis-selling that were registered with regulators were a loss that was not to be subject to these constraints.  That this may have represented a bad bargain for the Buyer was not a reason to interpret the clause in any other manner.

The Court of Appeal examined the syntax and wording of the indemnity with the above factors in mind and concluded that the clause required that each of the categories of loss had to flow or arise from a claim made against Sureterm or from a complaint registered with the FSA or appropriate regulator.

Position in Hong Kong case law

General discussions on the interpretation of contracts in Hong Kong case law reciprocate the notion explored by Clarke LJ in the Case that there is a principal need to strike a balance between the natural meaning of the chosen language in a clause and so called commercial common sense. In Urban Renewal Authority v Agrila Limited and another HCA 1582/2002, the judge commented that as the parties have made a conscious decision to choose the wording in a clause, the starting point should always be the natural meaning of those words. It is only when those words produce an outcome "so commercially nonsensical" that the parties could not have intended for that outcome to occur or where it is clear from the background or context that a specific commercial outcome was intended but not achieved that the court should consider re-interpreting a clause along commercial lines.

Our comment

It is clear from the Case that great care must be taken when drafting indemnities.  Since indemnities are not usually subject to time and monetary limits, like the indemnity in the Case, they are often preferred over warranty claims as a means of recovery.  However, it is exactly for this reason that the envisaged recoverable losses must be precisely set out so that they will not be challenged in court. In this example the indemnity was ambiguous enough to be interpreted in completely contrasting ways by the High Court and the Court of Appeal.  Vital clarity would have been achieved had the drafter of the SPA broken down the indemnity further into sub-clauses or listed out the types of losses recoverable and the means by which each type of loss must arise or used language to indicate that all losses must arise in a single manner. It is apparent that the Court of Appeal viewed that the High Court had placed undue influence on achieving a commercially sensible outcome.  The general position is that it is not for the court to save imprecise drafting by imposing a commercially sensible outcome on the parties where the language chosen by those parties has a clear meaning.  This is especially true in circumstances, like the Case, where the literal meaning may represent a bad business bargain for one or all of the parties. It is only in exceptional circumstances where (upon an examination of the wider context of the agreement) the literal or clear meaning would go so completely against the commercial intentions of the parties that a court will resort to an interpretation along commercial lines so as to avoid an absurd or nonsensical outcome.  It is further worth noting that M&A transactions are predominately between two sets of commercial parties; consequently the court from the outset will be unsympathetic to a party's requests to re-interpret or reword a clause in a sale and purchase agreement.  The Court is there to add legal certainty, not to reword agreements which are functional and valid.
 
[1] As a result of the UK's Financial Services Act 2012, the FSA was abolished on 1 April 2013 and regulation of the UK's financial services industry passed on to the Prudential Regulatory Authority, the Financial Conduct Authority and the Bank of England's Financial Policy Committee.