Treatt Plc v Barratt & Ors

This appeal raises a short point of construction of the provisions for the ascertainment by calculation or expert determination of the deferred price payable under an agreement for the sale and purchase of shares (“the SPA”). The price, defined as the “Earn-out”, was to be a multiple of the average of the aggregate pre-tax profit or loss of the two groups of companies, the shares in which were being sold, as ascertained from audited accounts of each group for two calendar years ending 31^st December 2011, with certain specified adjustments, a floor and a ceiling.

In outline, the Earn-out was to be ascertained by a two-stage process. The first consisted of the delivery during a specified period ending in May 2012 of an Earn-out Notice by the Buyer (the Appellant) to the Sellers (the Respondents), specifying the Earn-out, and setting out, in reasonable detail, the basis upon which it had been calculated. The second stage was, if there was either no Earn-out Notice or a challenge to it by the Sellers within a specified period, the resolution of any outstanding dispute as to the Earn-out by a chartered accountant acting as an expert, to be nominated by the parties or, in default, by the president of the ICAEW.

Morgan J held that a document purporting to be an Earn-out Notice was duly delivered within the specified period. I will call it “the Notice”. No reference of any dispute about the Notice was made to an expert accountant within the time specified in the SPA so that, pursuant to its terms, the amount specified in the Notice was to be the Earn-out, provided only that the Notice was a valid Earn-out Notice pursuant to the SPA. The judge held that it was an invalid notice, because the sum which it specified as the Earn-out had not been calculated by reference to the audited accounts of the two groups of companies as required by the SPA. The result was that the amount of the Earn-out remains at large, pending determination by the expert accountant.

It is common ground that the calculation of the Earn-out specified in the Notice was not, on the face of the Notice or in fact, based in any respect upon audited accounts of the two groups of companies for the relevant period. Rather, it was based upon audited consolidated accounts of the Buyer (as parent) for a different period, and otherwise upon management accounts.

The question on this appeal is whether upon the true construction of the SPA the Notice was invalidated by reason of the basis upon which the Earn-out which it specified had been calculated (as the judge held), or whether the use of that incorrect basis was merely a defect in the Notice not going to its validity, properly to be put right by the invocation by the Sellers of the process for reference to an expert accountant (which, as is common ground, the Sellers did not implement in time).

Prior to 2007, the Sellers owned all the shares in the parent companies of the two relevant groups, namely Earthoil Plantations Limited (“Plantations”) and Earthoil Kenya EPZ Pty (“Kenya”). In February 2007 the Buyer Treatt PLC acquired 50% of the shares in each of those companies. By the SPA, dated 10th April 2008, the Buyer acquired the other 50% of the shares in each of Plantations and Kenya from the Sellers, with immediate effect.

Save only for one subsidiary of Plantations, all the companies in both groups prepared their statutory audited accounts by reference to a 31^st December year-end. The sole exception, Earthoil (India) Limited, used a 31^st March year-end. By contrast, the Buyer used a 30^th September year-end.

The effect of the SPA was immediately to transfer control of Plantations, Kenya and their associated groups of companies to the Buyer. Although some of the Sellers were directors or employees of companies subject to the sale, the terms of the SPA did not preserve for any of them an entrenched right to retain a role in their management. It was understood by all parties when the SPA was being negotiated that, on or after completion, the Buyer might wish to change the accounting year-end of the companies being acquired to its own September year-end for the purposes of their statutory accounts. Nonetheless, as will appear, the parties deliberately adopted a December year-end for the purposes of audited accounts to be prepared in connection with the calculation of the Earn-out.

The provisions of the SPA of direct relevance to the issue of construction are as follows. Other provisions, of less immediate relevance, may be found extracted in paragraphs 9 to 12 of the Judgment. In clause 1, containing definitions:

““Earn-out Notice” means a notice from the Buyer to the Sellers in accordance with clause 3.2;

“Earn-out” means the amount which is the average of the aggregate pre-tax profit or loss of the Earthoil Plantations Group and of the Earthoil Kenya Group as shown in the audited accounts of the Earthoil Plantations Group and of the Earthoil Kenya Group for the two calendar years ending 31 December 2011 (and adding back the aggregate value of (i) all or any claims, expenses, liabilities paid by the Companies to any of the Sellers arising directly in connection with the unfair or wrongful dismissal of such Sellers prior to 31 December 2011 which is determined by an employment tribunal or at a court of competent jurisdiction and (ii) all professional or other fees and expenses incurred by the Companies in connection therewith, to the extent that such payments affect the Earn-out) multiplied by 11, divided by two PROVIDED THAT all profits and/or losses generated pursuant to transactions between Group Companies shall be disregarded in determining the aggregate pre-tax profit or loss; PROVIDED FURTHER THAT the value of the Earn-out shall not be less than zero;”

Under clause 3, headed “Consideration”:

“3.1

The total consideration for the sale of the Sale Shares shall be such amount as is equal to the Earn-out provided that:

…

3.2

At any time during the five months prior to 31 May 2012 the Buyer shall deliver to the Sellers an Earn-out Notice. The Earn-out Notice shall specify the Earn-out and, setting out in reasonable detail, the basis on which the Earn-out has been calculated.

3.3

If the Buyer has not delivered the Earn-out Notice to the Sellers by close of business on 31 May 2012, the Earn-out Notice will be deemed to have been served on that date and the matter shall be deemed to be a dispute and referred to accountants in accordance with clause 3.5 and the following provisions shall apply.

3.4

In the absence of referral of any dispute to accountants in accordance with clause 3.5 within 30 Business Days after delivery to the Sellers of the Earn-out Notice, the amount of the Earn-out shall be as specified in the Earn-out Notice and the Buyer shall pay the Earn-out to the Sellers in accordance with clause 3.7.

3.5

If, within 30 Business Days after delivery to the Sellers of the Earn-out Notice, there remains an outstanding dispute in respect of the audited accounts of the Earthoil Plantations group or the Earthoil Kenya Group or the calculation of the Earn-out, the dispute may be referred by either the Buyer or the Sellers (acting together) to a firm of chartered accountants, nominated jointly by the parties or (failing nomination within 10 Business Days after request by either party) nominated at the request of either party by the president of the Institute of Chartered Accountants in England and Wales.

3.6

The chartered accountant so nominated shall:

(a)

be instructed by the referring party to determine as soon as practicable the matters in dispute having regard to the relevant accounts;

(b)

for the purpose of making his determination under paragraph 3.6(a) determine any issue as to interpretation of this agreement, his jurisdiction to determine any matter or his terms of reference;

(c)

adopt such procedures to assist with the conduct of the determination as he reasonably considers appropriate including instructing professional advisers to assist him in reaching his determination; and

(d)

act as an expert and not as an arbitrator,

and his decision will be binding on the parties except in the case of manifest error. His fees will be payable by the Sellers and the Buyer in such proportions as he reasonably decides. If either party fails to give him any required undertaking or advance contribution as regards its fees it will be open to the other party to give such undertaking or make such contribution and to the extent the chartered accountant so decides such party shall be entitled to be reimbursed by the other parties. No party shall be entitled to make any objection to the appointment of the accountant on the ground that he imposes limits on his liability in relation to the carrying out of his instructions under this agreement.

…

3.10

For the avoidance of doubt, the Earn-out shall be calculated by reference to the profits and/or losses of the Earthoil Plantations Group and the Earthoil Kenya Group for the calendar years ending 31 December 2011 notwithstanding that the financial period(s) to which such Group Companies prepare accounts may not end on such date(s).”

Clause 6 of the SPA, headed “Earn-out Protections”, contained various forms of restriction upon the Buyer’s freedom to manage or sell the relevant companies, a requirement for the Group Companies to keep separate books of account from those of the Buyer, and (save in respect of accounting reference dates) not to change the accounting policies, bases and practices as applied by the Group Companies before the date of the SPA, other than where inconsistent with those of the Buyer. Clause 6.1(n) required the Buyer to procure that each relevant company prepared monthly unaudited management accounts and provide copies of them promptly to the Sellers.

As anticipated, the Buyer did change the year-end of the companies in the two relevant groups to 30th September for the purposes of statutory audited accounts, so as to bring them in line with the Buyer’s accounting year-end, and thereby to facilitate the preparation of consolidated group accounts. But it might have been thought, having regard to the unqualified requirement that the Earn-out be calculated by reference to audited accounts of the relevant companies for the two years ending 31^st December 2010 and 2011, that the Buyer would have exercised its shareholder powers to ensure that, in addition, audited accounts for those two December year-ends would have been prepared for those companies. This was not done. As a result, when the time came for the Buyer to calculate and specify an Earn-out for the purposes of serving an Earn-out Notice during the first five months of 2012, it had no qualifying audited accounts with which to do so, although it became common ground during the trial that there was nothing which had prevented the Buyer from having those audited accounts prepared. The result was that the Notice was prepared, and the figure purportedly specified as the Earn-out within it calculated, by reference to what the Buyer regarded as the best available alternative, namely the audited consolidated accounts for the Buyer’s group for the years ending 30^th September 2010 and 2011, and from December management accounts of the Earthoil Group for three month periods ending in December 2009, 2010 and 2011. The calculations in the Notice sought to extrapolate from those documents what might have been calculated from qualifying December year-end audited accounts of the two relevant groups, had they been prepared. It was common ground at trial, and on this appeal, that this (as I see it) manifest departure from the terms of the SPA was undertaken by the Buyer in good faith, that is, deliberately rather than accidentally, but in the mistaken belief that the process was not out of conformity with the requirements of the SPA.

This was, in my view, no mere technical breach of contract. The obligation to go first in calculating the Earn-out was placed by clause 3 of the SPA squarely on the shoulders of the Buyer. Where a corporate business is sold through a share-sale for a price payable later by reference to its performance following sale, in circumstances where the buyer is in complete control, the protection afforded to the seller by a requirement that the performance-related Earn-out be calculated by reference to audited rather than management accounts is plain. First, it provides an important measure of objectivity in the preparation of the underlying accounts, and in the application for that purpose of appropriate accounting policies and standards. Secondly, audited accounts provide, in their notes, independent professionally verified explanation of the basis upon which the important parts of those accounts have been prepared, all of which would be available to the Sellers for the purpose of forming their own views about whether, and if so to what extent, to challenge the accounts pursuant to any procedure (such as that set out in clause 3.5 of the SPA) for disputing the Earn-out derived from those accounts.

By contrast, a calculation and determination of Earn-out based only on management accounts, or upon consolidated audited accounts of a different group, such as the Buyer’s group, would provide no such protection. To the extent that they were based upon management accounts, the Sellers would be exposed to the Buyer’s own uncontrolled decision-making as to how they should be compiled, and to the temptation upon the Buyer to compile them on a basis likely to reduce, rather than increase, the amount of the Earn-out. Similarly, management accounts contain no notes explaining the basis upon which important items have been compiled, still less notes prepared or verified by independent professionals.

It is, for present purposes, nothing to the point that the management accounts upon which the Buyer in fact relied in preparing the Notice may have been models of even-handed objectivity. The point is simply that the requirement that the Earn-out be calculated upon the basis of the relevant audited accounts was a form of contractual protection to the Sellers of real importance, rather than a mere formality.

The judge resolved the issue as to the validity of the Notice by a typically tightly reasoned process of analysis. First, he noted that the agreement as to the substance of the Earn-out (the formula as it might be described) was to be found in the definition in clause 1, whereas clause 3.2 merely contained part of the machinery for its calculation. He continued (at paragraphs 37 and 38):

“37.

When clause 3.2 states that the Buyer may serve an Earn-out Notice which specifies (and sets out in reasonable detail) the basis on which the Earn-out has been calculated, that provision is not designed to give the Buyer a choice as to what that basis is to be. The Buyer has no such choice as the basis of calculation is imposed on the parties by the definition of Earn-out. The purpose of clause 3.2 in requiring the Earn-out Notice to specify and set out the basis of the calculation is for the benefit of the Sellers in that the Buyer must explain how it has calculated the Earn-out using the basis in the definition of Earn-out, and not otherwise.

38.

I consider that a notice given pursuant to clause 3.2 must use the basis for calculation in the definition of Earn-out. This involves reading the words "shall specify the Earn-out and, setting out in reasonable detail, the basis on which the Earn-out has been calculated" in clause 3.2 as requiring the Buyer to set out the calculation on the only basis permitted by the definition of Earn-out. Another approach is to say that the Buyer is required by clause 3.2 to set out the basis of the calculation "in reasonable detail" and the basis of the calculation will not be "in reasonable detail" if it is a basis which is not permitted by the definition of Earn-out.”

Two bases for a conclusion that the Notice was invalid may be discerned from that analysis. The first is that the Notice failed to specify an Earn-out as defined because it did not conform (or even attempt to conform) to the definition of Earn-out incorporated by the use of that defined term in clause 3.2. The second is that even if it did, the Notice failed to provide reasonable detail of the basis upon which the Earn-out had been calculated, because detail which merely identified irrelevant accounts as the basis of the calculation could not, objectively viewed, be regarded as reasonable detail. On either basis, the Notice was not an Earn-out Notice, as defined in the SPA.

Both before the judge and on this appeal, Mr. Paul McGrath QC and Mr. James Cutress for the Buyer strove hard to challenge that simple analysis. The judge dealt with their submissions at some length. I mean no disrespect if I address those submissions more briefly.

Their first and main point was that, in a contract which contained ample provision for the speedy and economic resolution of any challenges to the content of the Earn-out Notice, it was wrong in principle to treat mistakes in the Notice as going to its validity. To do so would, counsel submitted, tend to undermine the parties’ evident desire for speed and economy (by the use of a process of expert determination rather than, for example, arbitration) by the requirement that issues as to validity be determined in court, unfettered by any time-limit for the commencement of proceedings, in sharp contrast with the 30 Business Days specified in clause 3.5 of the SPA for a challenge to an Earn-out Notice.

In my view that superficially attractive submission is gainsaid by the consequences, in terms of expense and delay, likely to be visited upon the parties by the proposition which it sought to justify, namely that a valid Earn-out Notice could be based upon calculations derived from contractually irrelevant accounts. If the Buyer had sought from the outset to comply with its contractual obligations under the SPA with reference to the Earn-out, it would have procured, in good time, that qualifying audited accounts for the two December year-ends were prepared by the beginning of 2012, so that an Earn-out Notice could then be based upon them and served upon the Sellers, thereby providing for the Sellers a sufficiently detailed basis (when read with the underlying relevant accounts) to enable them to decide whether to accept the Earn-out specified in the notice, or to challenge it, and if so in what specific respects. In that context it is to be borne in mind that the task of the independent expert in the event of a challenge to an Earn-out Notice was, under clause 3.5, not to carry out his own evalutation of the Earn-out from scratch, but simply to resolve the parties’ outstanding disputes, with reference either to the calculations in the Earn-out Notice, or to the underlying accounts upon which those calculations were based. A compliant approach to the Earn-out by the Buyer would therefore have secured, both for the parties and for the expert, the materials with which to identify and to resolve those disputes by reference to the relevant audited accounts, and to a simple explanation of how the Earn-out had been derived from them, applying the various provisos set out in the definition of Earn-out in clause 1.

By contrast, the Buyer’s approach was that, provided some good faith figure was specified as the Earn-out in the Notice, it did not really matter how divergent the Buyer’s basis of calculation was from its contractual obligations, because all could be resolved by the expert. But this would be a recipe for difficulty and expense, and likely to make it impossible for the parties to identify any concise areas of relevant dispute. The expert would have to decide either to request the Buyer to procure that, albeit very late, the requisite audited accounts were prepared, or he would have to undertake such an audit himself, with all the difficulties that an audit by a complete stranger who had not been duly appointed as auditor by any of the companies would be likely to encounter.

Against that, the Buyer’s next submission, that since clause 3.5 enabled the expert to go behind qualifying audited accounts, the judge had over-estimated their importance in the process, strikes me as being equally misplaced. Clause 3.5 does indeed permit the expert to do so, because it enables the Sellers to seek the determination of disputes “in respect of the audited accounts”. But if there are no audited accounts, and the calculations in the purported Earn-out Notice are not based upon them, the identification of the type of dispute contemplated by clause 3.5 becomes almost meaningless.

I recognise in that context that where, due for example to the absence of requisite audited accounts, the Buyer either serves no purported Earn-out Notice at all, or a notice which is invalid because it is not based upon such accounts, then clause 3 of the SPA contemplates nonetheless that the amount of the Earn-out will still have to be determined by the independent accountant, notwithstanding those difficulties. In my judgment however, the true construction of a commercial contract (where issues arise as to the practicability of alternative constructions) is to be addressed primarily by reference to an analysis of how the contract works when the parties comply with it, rather than when they ignore it, as the Buyer did in the present case. From that viewpoint, the plain contemplation of the parties was that the Earn-out specified in an Earn-out Notice would be based upon the relevant audited accounts, that the reasonable details of the calculation would also be based upon those accounts, and that outstanding disputes would be both identified and resolved by reference to those accounts, albeit that the expert would not in every respect be bound by them.

The Appellant submitted that the judge had, in effect, sold the pass by acknowledging that, where the phrase “Earn-out” first appears in clause 3.2, it referred only to the Buyer’s good faith opinion as to what that figure should be, so that it was perverse to construe it when it later appeared in the phrase “the basis upon which the Earn-out has been calculated” in a more restricted way. Since it was common ground that the Buyer had specified an Earn-out in good faith, then reasonable detail as to the basis used need only specify the basis which it in fact used, however divergent from the requirements of SPA.

I am not by any means persuaded that the judge did adopt that rather subjective interpretation of “Earn-out” in any part of clause 3.2. In my view the phrase means precisely what it is defined to mean in clause 1, wherever it appears in the SPA, namely (in summary) an amount duly calculated in accordance with the formula contained within the definition in clause 1, by reference to the audited accounts there specified. As the judge said in paragraph 36 (albeit at that stage only describing a submission by the Sellers):

“A Notice which does not adopt that basis is not an Earn-out Notice. A Notice which specifies a figure on a basis which is not within the definition of Earn-out does not specify the Earn-out; instead, it specifies something which is not an Earn-out.”

That does not, of course, mean that an Earn-out Notice is invalidated by some accidental mathematical error in calculations which are based on the relevant accounts. That is indeed a part of what the procedure for expert determination is designed to put right. There is a boundary which may be hard to define in the abstract, between errors of that kind which do not invalidate such a notice, and substantial departures from the contractual provisions, which do. It is not in my view necessary to have regard to decided cases in which boundaries of that kind have been addressed. All that I need to say in this case, as did the judge, is that the wholly non-compliant basis upon which the Buyer presented the Notice in this case is plainly on the invalidity side of that line.

In that context, I would also reject the Appellant’s submission that recognition that a purported Earn-out Notice may be invalid, rather than merely specify a wrong figure for the Earn-out, is a recipe for legal dispute. Disputes as to validity may arise wherever the validity boundary is set. The delays which have bedevilled the final determination of the Earn-out in this case are in my view not the result of the judge’s recognition that the Notice was invalid, but the result of a combination of the non-contractual basis of the preparation of the Notice by the Buyer and its refusal, once challenged, to accept that the Notice was indeed invalid.

For those reasons, which largely replicate those given by the judge, I would dismiss this appeal. We notified the parties shortly after the end of the hearing that we had so concluded, with reasons to follow. The result was that the issues raised by the Respondents’ Notice did not have to be argued or decided.

I agree.

I also agree.