Parker v Harman International Industries Ltd.

By an agreement in writing dated 18^th September 1998 (‘the 1998 Agreement’) the claimant, Mr Parker, sold to the defendant Harman International Industries Ltd all the issued shares in Digital Audio Research Ltd (‘DAR’). The claimant is an engineer. He was the sole shareholder and Managing Director of DAR. This is a manufacturing company, designing, manufacturing and selling high value digital audio editing equipment for television, film, advertising and multi-media production. The defendant is part of a quoted American public company. The agreement is a long document drafted by solicitors. The 1998 Agreement was subsequently varied by an agreement set out in a letter dated 25^th November 1999 signed by both parties (‘the 1999 Agreement’). A dispute has arisen as to the meaning of the 1999 Agreement, and this is the trial of a preliminary issue at which I have to answer a number of questions of construction. At this hearing the claimant has represented himself. His submissions have been helpful, clear and to the point, as have been those of Miss Alison Green of counsel who has represented the defendant.

The consideration for the sale of the shares under the 1998 Agreement was to be in two parts. First there is what is called an Initial Consideration of £400,000. Next there is what is called Additional Consideration for which provision is made in clause 3.2 of the agreement as follows:

“3.2.1

The First Additional Sales Consideration shall be equal to the aggregate of:

3.2.1.1 3% of DAR Product Sales during the First Earn Out Period; and
3.2.1.2 £10 per Lexicon Unit sold during the First Earn Out Period.

3.2.2

The First Additional Profits Consideration shall be equal to 50% of Net Profits for the First Earn Out Period provided that in no event shall the First Additional Profits Consideration exceed £50,000.

3.2.3

The Second Additional Sales Consideration shall be equal to the aggregate of:
3.2.3.1 3% of DAR Product Sales during the Second Earn Out Period; and
3.2.3.2 £10 per Lexicon Unit sold during the Second Earn Out Period

“provided that” in no event shall the aggregate of the First Additional Sales Consideration and the Second Additional Sales Consideration exceed £150,000.

3.2.4

The Second Additional Profits Consideration shall be equal to 50% of Net Profits for the Second Earn Out Period provided that in no event shall the aggregate of the First Additional Profits Consideration and the Second Additional Profits Consideration exceed £100,000.”

The First Earn Out Period was from 1^st October 1998 to 30^th September 1999 and the Second Earn Out Period was from 1^st October 1999 to 30^th September 2000. The 1998 Agreement contained detailed provision as to what the Defendant was and was not entitled to do during that period to effect a balance between the claimant’s interest in ensuring that the sales and profits of DAR should be high and the Defendant’s interests as purchaser of the shares.

By the 1999 Agreement the parties made a new agreement to replace the Additional Profits Consideration for the Second Earn Out Period in substitution for clause 3.2.4 of the 1998 Agreement. On this occasion the draft was prepared, not by lawyers, but by non-legal representatives of the Defendant. The Agreement is in the form of a letter from Mr Hart, President of the Defendant. It reads as follows:

“Earn Out provisions of the agreement (“Agreement”) dated 30^th September 1998 between M.A.Parker and Harman International Industries Ltd concerning the acquisition of the entire issued share capital of Digital Audio Research Ltd (“DAR”).
_________________________________________________________

I refer to our recent discussions. The situation is as follows.

The poor performance of DAR in its first year of Harman ownership (for the period from 1^st October 1998 to 30^th September 1999) has been a disappointment to me, and furthermore there is no profit related earn out payment due to you under the Agreement.

With the current sales projections, I am sure we both agree there is a need to reduce costs. I therefore, propose to close manufacturing in Chessington, to move it to Amek and to utilise Amek’s administrative infrastructure. A combination of the Amek and DAR sales forces should yield extra sales personnel for DAR. However, DAR sales are the overriding priority.

To improve the performance of the DAR business and to enable you to achieve some personal financial reward in the second year of your earn-out (from 1^st October 1999 to 30^th September 2000) we have agreed to vary the basis of the payment as follows:

1.

Instead of being profits related, your earn-out will become totally sales related.

2.

For achieving net monthly sales above £130,000 up to £180,000, you will be paid an earn-out of 20% of net sales.

3.

For achieving net monthly sales above £180,000, you will be paid an earn-out of 30% of net sales.

4.

No earn-out will be paid for monthly net sales below £130,000.

5.

You will continue to be eligible for an earn out of 3% on DAR Product Sales (as defined in the Agreement) and £10 per Lexicon Unit sold during this second earn-out period.

The conditions attached to these revised arrangements are as follows:

1.

The maximum earn-out payable is £250,000 (the same maximum as in the Agreement).

2.

No payments will be made (although they may be earned) until the receivable are brought under 60 days sales outstanding (DSO), per the Harman corporate definition, except that, in any case, all payments earned under the terms set out in this letter will be made by 31 December, 2000.

3.

Contribution margin must be at least 50% where, for the purposes of this contract, contribution margin is defined as:

(Net receivable to DAR – Cost)/Net receivable to DAR

where “Cost” means the cost of parts for the particular sales which have been incurred by the Harman group.

4.

In months where sales are below £130,000, the shortfall below £130,000 will be carried forward and deducted from subsequent month sales so that the average net monthly sales must exceed £130,000 for any earn-out to be paid. Additionally, the earn out based on monthly sales above £180,000 is only payable once the average monthly sales for the second earn out period exceed £180,000,

I believe this is a sensible revision to the original arrangement and will allow us to reduce the cost base of DAR in the manner we have discussed. We need to reduce the cost structure so that the business is profitable at the level of £130,000 sales per month.

This re-arrangement will allow you to refocus your energy on the sales of DAR products and to fully realise the potential of the DAR Research & Development Team, whether for specific DAR applications or across other parts of the Harman Pro Group.

Please sign the duplicate copy of this letter as acceptance of the revised arrangements and return such signed copy to me”.

By order made on 15^th April 2003 Master Leslie ordered that there be a split trial of liability which is to be tried first, followed by a trial of causation and quantum so far as may be necessary. He further ordered that the trial of the issue of liability include the following preliminary issues on the construction of the provisions of the 1999 Agreement. I shall consider each of these questions in turn.

The claimant contends that the effect of clause 2 of the 1999 Agreement is that when net monthly sales are above £130,000 and below £180,000 the payment to which he is entitled is 20% of the entire figure. The defendant contends that the effect of the clause is that when the relevant sales (and there is a further point as to what they are, which is dealt with below) exceed the equivalent of £130,000 per month and are below £180,000 per month then the payment to which the claimant is entitled is 20% of the excess over £130,000.

The background to this dispute is that during the First Earn-Out Period the defendant says that DAR produced losses of over £400,000. In these circumstances the defendant says it was clear that in the Second Earn Out Period the claimant was unlikely to earn any profit related payment under clause 3.2.4 and would therefore have little incentive to promote the interests of the company, with whom he still worked. The claimant ceased to be a director of the company after the sale of the shares but remained at their Chessington premises with the title of managing director.

The claimant does not agree that he would have been unlikely to earn anything under clause 3.2.4 of the agreement as originally drafted. He considered that he had a reasonable prospect of earning some or all of the maximum £100,000 for which that clause provides. He says sales were rising, and points to the Profit and Loss Account of DAR for the period ended 30^th June 2000 which shows that turnover had increased to £1.6m for that twelve month period compared with £1.3m for the previous fourteen month period (although these accounts also show the company trading at a loss). However, he was ready to enter into the variation set out in the letter of 25^th November 1999, partly because he had no control over costs after he had sold the shares. The claimant emphasizes that the agreement, whether in its original or revised form, is an agreement with a one year term for the purpose of paying a deferred consideration for the sale of shares, and is not a commission agreement for a salesman.

Both parties asked me to take into account the background with a view to construing the agreement. By this they referred to the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time the contract was made. It is common ground that I must have regard to all the circumstances surrounding the making of the contract which would assist in determining how the language of the document would have been understood by a reasonable man. For this purpose I heard evidence from the claimant himself, and from Mr Hart and Mr Sales for the defendant. Mr Jones was tendered as a further witness for the defendant, but once it had been established that his evidence went to the calculation of the figures and not to any background to the agreement, I indicated that he should not give any further evidence or be cross-examined by the claimant. His evidence may be required at a later stage of these proceedings, depending on the outcome of this preliminary issue and any further agreement the parties may reach.

If clause 2 of the 1999 Agreement stood alone I would agree with the submission of the claimant that this was the meaning of the words. There is no reference in the clause itself to the 20% earn out being in respect of the excess over the £130,000 which is the threshold that must be reached before any payment is due. However, clause 2 does not stand alone. Clause 4 provides, as noted above, that “no earn out will be paid for monthly net sales below £130,000.” The claimant submits that this is there merely to emphasize, what already is stated in clause 2, namely that nothing is payable until the threshold of £130,000 is passed. He says it has no meaning once the threshold is passed. I disagree.

It would be surprising if the claimant’s submission were correct. The agreement, and the previous discussions between the parties, contemplates a break even point of the order of £130,000, and contribution to margin of at least 50% (calculated in accordance with clause 3). Assuming breakeven at £130,000 and sales at £131,000, it is hard to see the commercial sense in an agreement which would entitle the claimant to £26,200 out of the sales figure.

In my judgment the effect of clause 4 is that no payment is due in respect of monthly net sales below £130,000 whether the threshold of £130,000 is exceeded or not. In other words, the 20% earn out is payable on the excess above £130,000 up to £180,000.

The respective contentions of the parties are set out in the question. The claimant submits that the agreement makes no explicit mention of an average of £130,000 per month applying over the entire year period. He says the purpose of this clause is to ensure that there is what he calls a rolling average in any month (that is the average for that and each of the preceding months in the period) that must exceed £130,000 before a payment is to be made or due in respect of that month. He says that if a yearly average was what was meant then there was no need to refer to monthly sales at all, and that the agreement would have stated that there was a yearly threshold, which as a matter of arithmetic, would amount to £1,560,000. He points out that if the procedure described in the first sentence of condition 4 were carried out, namely that the shortfall below £130,000 would be carried forward and deducted from subsequent months sales, that would not in fact produce an average figure for net monthly sales over the whole year, because the procedure does not envisage the carrying forward of any surpluses. On the other hand, if the average is calculated at the end of the second and each subsequent month then his entitlement to a payment depends on the shortfall of any previous month having been made up. There is no need to provide for the surplus, if any, to be carried forward, because he will have been paid the 20% in respect of that already. Further he draws attention to the wording of condition 2. He notes that the word “payments” occurs there twice in the plural, and that there is reference to receivables being brought under 60 days sales outstanding. In his submission, none of that makes sense unless what is contemplated is multiple, that is to say monthly, payments.

The defendant on the other hand submits that averaging over the year is appropriate because this gives effect to the express reference to “average”. The defendant refers to the second sentence of condition 4 (dealing with the £180,000), which refers to ‘average monthly sales’. The defendant says that is the meaning which would be understood by a reasonable person, and what was in fact understood by Mr Hart and Mr Sales. I discount the evidence of what Mr Hart actually believed, because I must approach the matter objectively.

On this issue, in my judgment the claimant is correct. I consider that that is the plain meaning of the words. And if I have regard to the commercial purpose of the agreement, it seems to me that the claimant’s construction makes better sense than the defendant’s. It is true that both constructions provide for the incentive that the defendant wished the agreement to provide, but it seems to me that the provision of a monthly non-refundable earn out payment is an incentive which is better, or at least as good as an annual one. I also have regard to the fact that from the claimant’s point of view this is, as he says, part of the consideration for shares he has sold, it is not a long term commission agreement for a salesman, and it seems to me to make good business sense to construe it as he does.

The claimant submits that “net” monthly sales, in clauses 2 and 4 of the 1999 Agreement, means the invoiced sales value of the products sold in that month minus the credited sales value of the goods returned in that month, in both cases excluding VAT. He says that this was the historical practice at DAR and it is these sales figures that the defendant has audited and published in the annual accounts.

The defendant agrees that the VAT should be excluded. But the defendant says that what must be counted is not the price invoiced but the price invoiced in respect of what are truly sales. By this the defendant means that the goods must have been delivered. The background against which this point arises is that there are some invoices dated late or at the end of a month which show on them that the shipment date is in a subsequent month. I was referred to a series of documents headed “Cost of Sales Analysis” one of which, dated December 1999, includes an invoice numbered 11103 which is said to be dated the 31^st December 1999. In fact it is dated 31^st December 2000 (which is obviously an error for 1999) and it also shows a shipment date of 28^th March 2000. The invoice is for £38,411.80. This figure is material in that the net sales given for the period December 1999 totals £166,393.84.

The witness statements for the defendant suggest that they believe that the claimant might himself personally have been responsible for this mis-allocation of invoices, as the defendant contends it to be. In evidence, the claimant made it clear that he was not responsible for the allocation of invoices to one month or another in the period after the sale of the shares, and that whoever was responsible was not acting under any direction from him. He put forward an explanation for why others in the defendant’s group might have allocated the figures in this way, which I do not need to recite. The defendant’s witnesses were in no position to contradict the claimant as to his non-involvement, and I accept the claimant’s evidence. The fact remains, however, that the documents have been prepared in this form, and it may well be that other accounting records have been prepared in a similar form. So the issue falls to be decided, even though the claimant was not responsible for the form of the accounts.

In my judgment a sale is a sale for the purposes of the 1999 Agreement if the goods have been sold and delivered. It is not a sale for this purpose if there has been an agreement to sell, and an invoice issued, but no delivery has been effected. The figures must be calculated by reference to the delivery (that is the shipment) date of the goods.

It appears that there may be a subsidiary point in relation to this issue. It may be that, in some instances, goods which had been delivered were subsequently returned and a credit given to the customer. The claimant accepts that where sales are made in the Second Earn Out Period and where returns are credited in that period, the credits fall to be deducted from the sales relating to the actual month of shipment in order to arrive at the net sales figure for the month in question. If there are any credits made between 1^st October 1999 and 30^th September 2000 in respect of goods delivered before that date, they would not fall to be deducted, because they do not relate to sales made within the relevant period.

The issue which question (E) was framed to address has been resolved. The claimant contends that “cost” includes the cost of purchasing the materials used in the products that were shipped in a particular month. At one point the defendant was contending that other costs should be included, such as stock write downs, damaged stock and loss of stock. The defendant no longer pursues that contention.

The figures for costs have to be calculated monthly, as they have to be for sales.