Metalicus Pty Ltd v Metwholesale Pty Ltd
[2011] VSC 2
•22 February 2011
| IN THE SUPREME COURT OF VICTORIA | Not Restricted | |
AT MELBOURNE
COMMERCIAL AND EQUITY DIVISION
COMMERCIAL COURT
LIST C
No. 1121 of 2010
| METALICUS PTY LIMITED (ACN 127 957 653) | Plaintiff |
| v | |
| METWHOLESALE PTY LIMITED (ACN 004 835 778) METRETAIL PTY LIMITED (ACN 109 507 904) | Firstnamed Defendant Secondnamed Defendant |
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JUDGE: | CROFT J | |
WHERE HELD: | Melbourne | |
DATE OF HEARING: | 27 and 28 September 2010 | |
DATE OF JUDGMENT: | 22 February 2011 | |
CASE MAY BE CITED AS: | Metalicus Pty Ltd v Metwholesale Pty Ltd & Anor | |
MEDIUM NEUTRAL CITATION: | [2011] VSC 2 | |
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CONTRACT – Construction of commercial contracts – Sale of business – Earn out clause – Purpose of an earn out clause – Dispute in relation to the calculation of normalised earnings before interest, tax depreciation and amortisation (“EBITDA”) – Whether the purchaser must strictly comply with the 2008 Budget – meaning of ‘budget’ – Whether purchaser must notify vendors of certain costs – adjusting for unrealised profit in any stock – Declarations regarding the interpretation of the contract.
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APPEARANCES: | Counsel | Solicitors |
| For the Plaintiffs | Mr D B Studdy SC Mr S J Maiden | Minter Ellison |
| For the Defendants | Mr J G Santamaria QC Mr J P Moore | Clayton Utz |
HIS HONOUR:
Background
The Court has been asked to determine the proper construction of an agreement whereby the defendants sold two clothing businesses (‘the Businesses’) to the plaintiff. The Businesses were comprised of a wholesale business previously operated by the first defendant and a retail business previously operated by the second defendant.
The plaintiffs entered into a Business Sale Agreement (“BSA”) dated 2 November 2007, following negotiations and a process of due diligence. The parties subsequently entered into a Deed of Variation to the Business Sale Agreement, dated 18 December 2008 (“the Deed of Variation”). The amendments to the BSA were marked up in Annexure A of the Deed of Variation – “Amendments to relevant provisions of Business Sale Agreement”. The principal amendments were to clause 10, which contains provisions for the adjustment of EBITDA (earnings before interest, tax, depreciation and amortisation). Amendments were also made to the defined terms and interpretation clause, and to Schedule 7 – Principles for Normalisation (of EBITDA). As part of the sale process, the defendants published an information memorandum (“IM”) to assist prospective purchasers in considering the possible acquisition of the Businesses. The plaintiff considered the provisions of the IM prior to purchase.
The defendants’ final day operating the Businesses was 2 December 2007 and completion of the sale and purchase occurred on 3 December 2007.
The plaintiffs agreed to pay for the businesses in four components:
i. A fixed sum of $33 million payable on completion;
ii. an amount equal to Prepayments made by the vendors;
iii. An ‘Earn Out Amount – Working Capital’ to be calculated as at the date of completion and paid shortly thereafter; and
iv. An ‘Earn Out Amount – EBITDA’ to be calculated and paid following FY2008.
The Businesses were acquired based on an earning multiple of approximately 4.95 times the normalised EBITDA for FY2008. The EBITDA for the financial year ended 30 June 2007 was $5,477,000. The defendants projected a FY2008 EBITDA of $9,097,000 in the IM and the price was based on this projection. The ‘Earn Out Amount – EBITDA’ was $10 million if the Businesses achieved a Normalised EBITDA of $9.097,000 plus $4.95 for every further $1 of Normalised EBITDA.[1]
[1]Plus or minus working capital adjustments and plus prepayments.
The purpose of the fourth component was to ensure that part of the purchase price was calculated, at least in part, on the actual earnings of the business in FY2008. This was to be achieved by deferring calculation of part of the purchase price until after the agreed “Earn Out Period”,[2] which was from the completion date until the end of FY2008. As was submitted by the defendants, EBITDA is commonly used to compare or assess businesses because it represents the earnings generated by a business independent of its capital structure and its historic level of capital investment.
[2]See Amended Agreement, sub-clause 1.1 which contains the defined term “Earn Out Period”.
When a business is sold part way through a financial year and where the earn out amount is based on the profitability of the business in that financial year, the profitability will be affected by many circumstances, including the conduct of the vendor from the start of the financial year to the day which the sale is completed and the conduct of the purchaser from the completion date until the end of the financial year. Under this arrangement, part of the purchase price is based on the actual profits of the business – the lower the profits in the earn out period, the less the purchaser must pay and vice versa. This results in something in the nature of a conflict of interest between the purchaser and vendor as part of the consideration payable is to be assessed on the basis of the profit that is made by the business in the earn out period.
To date, the plaintiff has paid the defendants $46,626,700 and this comprised of:
i. The completion amount of $33 million;
ii. The parties agreed that there were no prepayments;
iii. The “Earn Out Amount – Working Capital” which totalled $3,626,700; and
iv. $10 million of the ‘Earn Out Amount – EBITDA’.
In the latter part of 2008, a dispute arose between the plaintiff and the defendants in relation to the calculation of the Earn Out Amount – EBITDA. As a result, the parties executed the Deed of Variation in an attempt to resolve the dispute.
Presently, the parties remain unable to agree on the calculation of the Earn Out Amount – EBITDA and the construction of parts of the BSA as amended by the Deed of Variation. The provisions of the BSA as amended are referred to as “the Amended Agreement”. The issues in dispute centre upon the element of consideration referred to in sub-clause 4.1(b) as “the Earn Out Amount – EBITDA”. “Earn Out Amount – EBITDA” is defined in sub-clause 1.1 as “… the amount payable by the Purchasers to the Vendors (if any) pursuant to clause 10.4”.
The matters to be determined by the Court were settled by orders made on 20 August 2010, with reference to elements of the Further Amended Statement of Claim (dated 6 August 2010). These issues raised questions of construction of the Amended Agreement, issues which are to be resolved applying the principles of construction applicable to commercial agreements, as discussed below.
One of the main aspects of the conflict relates to the expenditure that is to be taken into account in assessing the earnings of the Businesses for purposes of the earn out calculation. In this context it is noted that it is in the purchaser’s interest for every dollar spent by the Businesses to be taken into account and in the vendor’s interest for only usual and ordinary business expenses to be taken into account when calculating the earn out amount.
Other aspects of the conflict between the parties lie in the manner in which the Businesses were to be operated during the earn out period and the nature, extent and timing of any expenditure. In relation to the timing of expenditure, the point was made that the plaintiff, as purchaser, may have an incentive or feel inclined to conduct the Businesses in such a way as to minimise the earn out payment; perhaps by bringing forward into the earn out period, expenditure that might otherwise have been incurred at a later period. An example of this, which was cited, would be an expensive advertising campaign undertaken and incurred just before the end of the earn out period. The benefit of this advertising campaign would accrue to the plaintiff, the purchaser, with no benefit to the defendants, the vendors, though they would have the expenditure accounted against them for the purpose of calculating the earn out payment.
Principles of Construction of Commercial Agreements
In the construction of a commercial agreement, the Court must consider the commercial circumstances which its terms address, and the objects which it is intended to secure.[3] Knowledge of the transaction’s purpose “presupposes knowledge of the genesis of the transaction, the background, the context, the market in which the parties are operating.”[4] There is no requirement for patent ambiguity before context is considered as “what seems clear by reference only to the words on the printed page may not be so clear when one takes into account as well what was known to both parties but does not appear in the document”.[5] The interpretation must be businesslike[6] and commercially sensible[7] and the court will avoid a construction that results in commercially absurd or capricious consequences which could not have been objectively intended by the parties, even if that is the consequence of a literal construction of the words in question.[8]
[3]McCann v Switzerland Insurance Australia Ltd (2000) 203 CLR 579 at 589 (Gaudron J).
[4]Reardon Smith Line Ltd v Hansen-Tangen [1976] 1 WLR 989 at 995-996 (Lord Wilberforce), quoted in Codelfa Constructions Pty Ltd v State Rail Authority of New South Wales (1982) 149 CLR 337 at 350 (Mason J) and Pacific Carriers Limited v BNP Paribas (2004) 218 CLR 451 at 462 (Gleeson CJ, Gummow, Hayne, Callinan and Heydon JJ).
[5]Ryledar Pty Ltd v Euphoric Pty Ltd (2007) 69 NSWLR 603 at 626 (Tobias JA).
[6] McCann v Switzerland Insurance Australia Ltd (2000) 203 CLR 479 at 589 (Gaudron J).
[7]Upper Hunter County District Council v Australian Chilling and Freezing Co Ltd (1968) 118 CLR 429 at 437 (Barwick CJ).
[8]Australian Broadcasting Corporation v Australian Performing Rights Associate Ltd (1973) 129 CLR 99 at 109 (Gibbs J).
In the context of these principles, it is useful to make particular reference to the authorities in relation to the construction of commercial agreements in light of their commercial purpose. In Skanska Rasleigh Weatherfoil Ltd v Somerfield Stores Ltd, Neuberger LJ sounded a warning:[9]
[9][2006] EWCA (Cid) 1732 at [22].
“[I]t seems to me that the court must be careful before departing from the natural meaning of the provision in the contract merely because it may conflict with its notions of commercial commonsense of what the parties may must or should have thought or intended. Judges are not always the most commercially-minded, let alone the most commercially experienced, of people, and I should I think, avoid arrogating to the themselves overconfidently the role of arbiter of commercial reasonableness or likelihood.”
Additionally, the English Court of Appeal sounded a further caution in Bank of Nova Scotia v Hellenic Mutual War Risks Association (Bermuda) Ltd:[10]
“It is nonetheless important, in attributing a purpose to a commercial transaction, to be sure that it is the purpose of both parties and not just one. If the purpose of the transaction is seen through the eyes of one party only an unbalanced view of the transaction may result. Many contracts represent a compromise between what one party wishes to obtain and the other is willing to give”.
Nevertheless, having expressed similar sentiments in MFI Properties Ltd v BICC Group Pension Trust Ltd, Hoffmann J concluded:[11]
“I think the court is entitled to select the meaning which accords with the apparent commercial purpose of the clause rather than one which appears commercially irrational.”
[10][1990] QB 818 at 870 (May LJ delivering the judgment of the Court to which Ralph Gibson and Bigham LJJ are noted as having contributed.
[11][1986] 1 All ER 974 at 976.
As to the general process of construction, in relation to commercial documents, with particular reference to a commercial lease, Winneke P said in Highpoint Homemaker Centre (Vic) Pty Ltd v Sanatar Pty Ltd:[12]
[12](1997) V ConvR ¶54-564 (CA) at 66, 775.
“It is not in dispute that in construing an instrument of the type which we are asked to construe, it is the Court’s duty to endeavour to discover the intention of the parties from the words of the contract. As Gibbs J said in Australian Broadcasting Commission v Australasian Performing Rights Association Ltd (1973) 129 CLR 99 at 109:
‘Of course the whole of the instrument has to be considered, since the meaning of any one part of it may be resolved by other parts, and the words of every clause must, if possible, be construed so as to render them all harmonious one with another. If the words used are unambiguous the court must give effect to them, notwithstanding that the result may appear capricious or unreasonable, and notwithstanding that it may be guessed or suspected that the parties intended something different.’
These principles were expressed as part of a dissenting judgment but the principles cannot be thought to be in doubt because Barwick CJ, who with Stephen J formed the majority, said (at p 105):
‘But if that result is produced by the application of the words in which the parties have expressed themselves, it is not part of the function of a court by some process of divination as distinct from the construction of the language employed, to attribute to the parties an intention to do something for which their express words do not provide.’
The court has no power to re-make the contract to avoid an unjust or inconvenient result. On the other hand, if the language of the instrument is open to two constructions, preference will be given to the one which will avoid the result which is considered inconvenient or unjust (per Gibbs J Australian Broadcasting Commission Australian Performing Rights Association Ltd, supra, at 109). It is the effect of these rules of construction that where a court can glean from the written instrument what can be seen to be the real intention of the parties, it is bound to give effect to that intention even to the extent of rejecting as superfluous whatever is repugnant to the intention which is discerned (NGL Properties Pty Ltd v Harlington Pty Ltd [1979] VR 92 at 95 per Kay J; Gwyn v Neath Canal Navigation Co (1868( LR 3 Ex 209 at 215, per Kelly CB).”
See also Lewison, The Interpretation of Contracts.[13]
[13](2007) ¶2.07, at pp 36-45.
Critical provisions of the Amended Agreement
In order to appreciate the issues and arguments with respect to the proper construction of the Amended Agreement, it is helpful to set out the critical provisions of that agreement, which are clause 9 and sub-clause 10.4. Other related provisions of relevance are referred to below and reference has already been made, or will be made, to defined terms as set out in sub-clause 1.1 to the extent that they are relevant. Finally, it will be seen that reference is made to Schedule 7 – Principles for Normalisation, which is part of the Amended Agreement. The relevant parts of Schedule 7 are also set out below.
These provisions are as follows:
“9. Earn Out Period
9.1 Conduct of the Businesses during the Earn Out Period
The Purchaser covenants and undertakes to the Vendors that, during the Earn Out Period:
(a)the Businesses will be conducted in a manner consistent with how the Businesses have been conducted by the Vendors in the 12 months preceding the Completion Date;
(b)if not already completed by Completion, it will ensure that the roll out of the store at the Property listed in paragraph 6 of Schedule 5 is completed as soon as reasonably practicable following Completion and the Vendors agree to reimburse the Purchaser for any costs incurred by the Purchaser in completing that roll out, within seven days of receipt by the Vendors of evidence of payment by the Purchaser of those costs, up to (in aggregate) the amount of $250,000 (or such greater amount approved by the Vendors (acting reasonably));
(c)the Businesses will be conducted in accordance with the 2008 Budget;
(d)it will ensure that the Businesses are provided with adequate funding, capital expenditure and Working Capital as is necessary to fund ongoing operational and capital expenditure as is in turn necessary for the Businesses to optimise their prospects of achieving the 2008 Budget; and
(e)it will substantially maintain the roles and responsibilities of the Management Team of the Businesses consistent with their roles and responsibilities immediately prior to Completion. The parties agree that:
(i)this clause 9.1(e) does not prevent the Purchaser from terminating a member of the Management Team for cause in accordance with that person’s contract of employment; or
(ii)the Purchaser is unable to prevent a member of the Management Team from resigning from his position, and the Purchaser will not be in breach of this clause 9.1(e) in the event that such resignation occurs.
If a member of the Management Team ceases to be employed by the Purchaser (either because that person is terminated for cause or because that person resigns), the Purchaser must, as soon as reasonably practicable, appoint a person to perform substantially the roles and responsibilities of that member of the Management Team who is no longer employed by the Purchaser.
9.2 Operation of Businesses
The Vendors covenant that they have operated, and will operate, the Businesses in accordance with the 2008 Budget in the period up to Completion.
9.3 Material outlays
(a)The Purchaser must give the Vendors prior notice in writing in relation to all proposed costs, expenses or outlays during the Earn Out Period which have not been provided for in the 2008 Budget and which:
(i)involve an amount of $100,000 or more; or
(ii)involve an amount of less than $100,000 but which the Purchaser estimates may impact the Normalised EBITDA by $100,000 or more.
(b)If the Purchaser gives notice to the Vendors pursuant to clause 9.3(a) (Notice), the Vendors (acting reasonably) will be entitled to:
(i)request such further details relating to the cost, expense or outlay referred to in the Notice, including sufficient explanatory supporting information, as may be reasonably required to enable the Vendors to reach an informed view about the necessity for incurring the cost, expense or outlay; and
(ii)object to the Purchaser incurring the cost, expense or outlay referred to in the Notice being made or incurred by the Purchaser. Any such objection must be made by notice in writing to the Purchaser within seven days of the later of receiving the Notice or (as the case may be) receiving the additional information which they request pursuant to clause 9.3(b)(i).
(c)Subject to clause 9.3(d), if the Purchaser either:
(i)does not give the Vendors prior notice in writing of a cost, expense or outlay during the Earn Out Period which has not been provided for in the 2008 Budget and which:
(A)involves an amount of $100,000 or more; or
(B) involves an amount of less than $100,000 but which has a negative impact on the Normalised EBITDA of $100,000 or more; or
(ii)gives a Notice to the Vendors and, notwithstanding that the Vendors object to the cost, expense or outlay being made or incurred by the Purchaser in accordance with clause 9.3(b)(ii), the Purchaser nonetheless makes or incurs that cost, expense or outlay,
the relevant cost, expense or outlay will be excluded from any calculation of the Normalised EBITDA under clause 10.
(d)Notwithstanding any other clause in this clause 9.3, where:
(i)the Vendors object to a cost, expense or outlay being made or incurred in accordance with clause 9.3(b)(ii) and notwithstanding such objection, the Purchaser nonetheless makes or incurs that cost, expense or outlay but that cost, expense or outlay does not in fact have an impact on the Normalised EBITDA of $100,000 or more; or
(ii)the Vendors do not object to a proposed cost, expense or outlay in accordance with clause 9.3(b)(ii),
then such cost, expense or outlay will not be excluded from the Normalised EBITDA calculations under clause 10.
9.4 Continuing Provisions
If, prior to the payment of the Earn Out Amount – EBITDA and the Earn Out Amount – Working Capital, the Wholesale Business, the Retail Business or all or substantially all of the Assets of either or both of the Businesses are transferred by the Purchaser, or the shares in the capital of the Purchaser or any holding company of the Purchaser are sold (other than where the issued share capital of PAS HoldCo is sold) to another party, which is not, prior to that sale, an Associated Entity of the Purchaser (Third Party Acquirer), then:
(a)the Purchaser must ensure that all provisions of this agreement not yet fully performed or completed as at the date of such transfer or sale are reflected in any subsequent sale and purchase agreement such that any Third Party Acquirer is bound to comply with those provisions as if that Third Party Acquirer was named as the Purchaser under this agreement; and
(b)the Purchaser’s Guarantor must, to the extent the Third Party Acquirer fails to do so, pay the Earn Out Amount – EBITDA and the Earn Out Amount – Working Capital (as the case may be) to the Vendors if and when due in accordance with this agreement, notwithstanding the fact that the shares in the capital of the Purchaser or any holding company of the Purchaser are sold or the Purchaser has sold the Wholesale Business, the Retail business or all or substantially all of the Assets of either or both of the Businesses.
10. EBITDA Adjustment
…
10.4 Earn Out Amount – EBITDA
(a)If the Normalised EBITDA (as agreed by the parties or otherwise determined in accordance with clause 10.6) is equal to $9,097,000, then the Purchaser must pay the Vendors, in their Respective Proportions, an amount of $10,000,000, and the parties agree that, subject to clause 27.19, this amount will be paid by way of the Vendors presenting the Bank Guarantee – EBITDA for payment.
(b)If the Normalised EBITDA (as agreed by the parties or otherwise determined in accordance with clause 10.6) is more than $9,097,000, then the Purchaser must pay to the Vendors, in their Respective Proportions, an amount of $10,000,000 plus an amount equal to $4.95 for every $1.00 that the Normalised EBITDA is more than $9,097,000, and the parties agree that this amount will be paid by way of:
(i)subject to clause 27.19, the Vendors presenting the Bank Guarantee – EBITDA for payment; and
(ii)the Purchaser paying the Vendors, in their Respective Proportions, by way of bank cheques, an amount equal to $4.95 for every $1.00 the Normalised EBITDA is more than $9,097,000.
(c)Subject to clause 10.5, if the Normalised EBITDA (as agreed by the parties or otherwise determined in accordance with clause 10.6) is less than $9,097,000, then the Purchaser must pay to the Vendors, in their Respective Proportions, an amount of $10,000,000 less an amount equal to $4.95 for every $1.00 the Normalised EBITDA is less than $9,097,000 and the parties agree that this amount (EBITDA Amount Payable) will be paid, subject to clause 27.19, by way of the Vendors presenting the Bank Guarantee – EBITDA to the issuing bank for payment of the EBITDA Amount Payable and the Vendors must, upon receipt of payment, instruct the issuing bank to cancel the Bank Guarantee – EBITDA in respect of the balance of the face value of the Bank Guarantee – EBITDA.
(d)The parties agree that any amount payable by the Purchaser to the Vendors under this clause 10 must be paid by the Purchaser as soon as practicable but in any event not later than the tenth Business Day after the Normalised EBITDA is agreed by the parties or otherwise determined in accordance with clause 10.6 (Payment Date).
(e)In the event that the Purchaser fails to pay the Earn Out Amount – EBITDA on or before the Payment Date, the Purchaser agrees to pay the Vendors (in their Respective Proportions) interest accruing daily at 8% per annum on any unpaid portion of the amount of the Earn Out Amount – EBITDA from 1 November 2008 to the date of payment.
Schedule 7 – Principles for Normalisation
1.The Normalised EBITDA will be calculated by each Auditor from the 2008 Audited Accounts as audited and delivered by that Auditor under clause 10.1(a), as being the amount equal to the consolidated EBITDA of the Businesses for the year ending 30 June 2008:
(a)adjusted as follows (to the extent that such adjustments have not already been included in the 2008 Audited Accounts):
…
(ii)eliminating any movement in unrealised profit in any stock of the Retail Business between 30 June 2007 and 30 June 2008;
…
(b)plus or minus any other normalisation adjustment that are one off or of a non-recurring nature to the Businesses, including any one off adjustments or costs relating to the booking of the Assets on acquisition by the Purchaser and backing out any remuneration paid to Employees as a retention remuneration or in excess of what has been included in the 2008 Budget (other than as agreed with the Vendors), and excluding:
…
(vii)any outlays or expenses which are excluded from the calculations of Normalised EBITDA under clause 9.3(c).
..
4.Any negative impact on the earnings of the Businesses as a result of the Purchaser not complying with clause 9.1 will be added back to the EBITDA based on the 2008 Budget.
…”
The expressions “Businesses” and “Business” is defined in sub-clause 1.1 as:
“Businesses means the Wholesale Business and the Retail Business and Business means the Wholesale Business or the Retail Business”
The expressions “Retail Business” and “Wholesale Business” are defined in sub-clause 1.1 as follows:
“Retail Business means the business conducted by the Retail Vendor prior to Completion and which includes the retail sale of clothing.
…
Wholesale Business means the business conducted by the Wholesale Vendor prior to Completion and which includes the wholesale selling of clothing.”
Budgetary Compliance
Sub-clause 9.1(c) stipulates that the purchaser covenants and undertakes to the vendors that during the Earn Out Period “… the Businesses will be conducted in accordance with the 2008 Budget”. The expression “2008 Budget” is defined, in sub-clause 1.1, as meaning:
“… the budget of the Businesses for the financial year ending 30 June 2008, as set out in the following documents identified in the Due Diligence Index:
(a) document numbered 0453 titled ‘2008 Budget’ and
(b) document numbered 0423 titled ‘Revised P & L forecasts FY08 and FY09’.”
The budget, so described, was nothing out of the ordinary by comparison with budgets for similar types of trading entitles; and contained various line items for revenue and expense items. The defendants submitted that only the document numbered 0453 and titled ‘2008 Budget’ should be relied upon. It was submitted that document 0453 was created after 0423 and was a consolidation of the figures in 0423. Consequently, the defendant submitted, document 0423 was superseded. In my view, as both documents have been included in the definition of the “2008 Budget” it is a matter for the independent accountant to decide which figures are relevant.
The defendants submitted that the plaintiff was obliged to observe the budget to the extent that the actual expenditure on each line item in the 2008 Budget must be equal to the amount specified for that line item in that budget; and when the amounts spent by the Businesses were tallied at the end of FY2008, any overspend or underspend constituted a breach by the plaintiff of sub-clause 9.1(c). The defendants also submitted that the impact on the EBITDA of every such breach, line by line of the budget, must be calculated by the independent account and the EBITDA increased to “write back” any negative effect.
The plaintiffs submitted that sub-clause 9.1(c) did not require the plaintiff to expend money strictly in accordance with each line item of expenditure in the budget but that it was “to have regard to” the items of revenue and expense set out in the budget and its other obligations in sub-clauses 9.1 and 9.3. The plaintiffs submitted that the position as put by the defendants should be rejected on the basis that it was an opportunistic attempt by the defendants to increase the Earn-Out Amount – EBITDA by reading sub-clause 9.1(c) in an over-simplified manner, divorced from its purpose and context, and ignoring the common meaning of its constituent words. It was also submitted that if the defendant’s interpretation of sub-clause 9.1(c) were to be accepted, the Earn-Out Amount – EBITDA could be significantly inflated because every dollar spent in excess of the 2008 Budget has the potential to increase the purchase price of the Businesses by $4.95. The plaintiff submitted that the parties could not have intended to place all the risk of spending in excess of the budget on the plaintiff. On the defendants’ interpretation, if the extra spending increased EBITDA the defendant would receive a higher earn out amount, and if the spending was found to have a negative impact on EBITDA the negative effect would be added back on. The defendants submitted that:[14]
“… [clause] 9.1(c) doesn't impose upon the purchasers a commercially unrealistic way of running a business. Rather when read together with the companion provision … it can be simply seen as the standard against which the auditor was to determine whether or not there was a negative impact on the earnings by reason of the conduct of the purchasers. The vendors were prepared to sell the business on condition they were protected, held harmless against negative impact. And how … is negative impact to be determined? It has to be determined A by someone, B by someone who is possessed of some sort of a standard … We say that the standard is comprised by the integers found within the 2008 budget.”
[14]Transcript of proceedings, page 124, beginning line 18.
The plaintiffs submitted that the estimated EBITDA figure of $9,097,000 was merely a projection or estimate and that in the preparation of the IM in August 2007, the defendants could not have been binding themselves to spend the precise amounts specified in the 2008 Budget. This, it was said, amounted to nothing more than an estimate that the Businesses might achieve an EBITDA of $9,097,000; or a lesser or higher amount. It was submitted that this was demonstrated by the three possible outcomes contemplated in sub-clauses 10.4(a) to (c) – EBITDA of equal to, or more or less than $9,097,000.
The principal intention of the parties as revealed from the words of the Amended Agreement appears to be to maximise the plaintiff’s chances of achieving an FY2008 EBITDA of at least in the vicinity of $9.2 million,[15] which was slightly more than the defendant’s projection in the IM. The clear inference is that the defendants expected their manner of operations, which they had applied to the Businesses, to produce the projected EBITDA and wanted the plaintiff to operate the Businesses similarly, to produce the projected result (and therefore achieve the desired sale price).
[15]The two documents that together form the 2008 Budget gave different estimates of EBITDA for FY2008. Document number 0453 titled ‘2008 Budget’ estimated $9,200,475 and document number 0423 titled “Revised P&L forecasts FY08 and FY09” estimated $9,317,000.
The plaintiff contended that the intention of clause 9 was to ensure that the plaintiff endeavoured to achieve the EBITDA target having regard to the 2008 Budget in the context of the obligation to conduct the Businesses in a manner consistent with the manner in which it had been conducted by the defendants in the preceding 12 months, as required by sub-clause 9.1(a). These provisions did not, it was said, require the plaintiff to spend money strictly in accordance with each line item of the 2008 Budget. Together with the obligations imposed by sub-clauses 9.1(a) to (e) and 9.3, the plaintiff was, it was submitted, to act consistently with the manner in which the Businesses were conducted in the 12 months prior to completion, to adequately fund the Businesses, to substantially maintain the management team and to seek the defendants’ approval for any non-budgeted expense of, or with an EBITDA impact of, more that $100,000. The defendants, on the other hand, argued that these provisions, nevertheless, required the plaintiff to adhere strictly to the expenditure specified in each line item of the 2008 Budget.
It was further argued that the defendant’s interpretation failed to take account of other surrounding provisions of the Amended Agreement, as compliance with sub-clause 9.1(d) would cause the plaintiff to breach sub-clause 9.1(c) to the extent that the 2008 Budget had failed to predict precisely the actual capital expenditure and working capital needs of the Businesses. Alternatively, strict compliance with sub-clause 9.1(c) might result in a breach of sub-clause 9.1(d) by starving the business of necessary capital to comply with other provisions of sub-clause 9.1 such as paragraphs (a) and (c), itself thereby undermining its capacity to reach the projected EBITDA.
In particular, the use of the word “optimise” in sub-clause 9.1(d) is, in my view, indicative of the parties’ intention that the 2008 Budget was designed to give the plaintiff operating guidance to help it achieve the projected EBITDA, and not to interfere in the minutiae of its spending decisions or impose a “straightjacket” on the conduct of the Businesses which, in a variety of unanticipated circumstances, may be very destructive in terms of business performance.
Additionally, the defendant’s interpretation of sub-clauses 9.1(c) and 9.1(e) would, for example, prevent the plaintiff having a replacement employee commence work before a departing employee left; thus potentially undermining the effectiveness of the incoming employee, and possibly adversely affecting the revenue side, hence the whole 2008 Budget outcome.
These views are strengthened by the provisions of paragraph 4 of Schedule 7, which, in the language used, point strongly to these provisions being directed to the overall outcome of the plaintiff’s conduct of the Businesses. First, there is a reference to “negative impact” as a result of the plaintiff not complying with the provisions of sub-clause 9.1, as a whole. Secondly, there is a reference to a measure of performance merely “based on the 2008 Budget”.
The defendant’s interpretation would also make sub-clause 9.1 impracticable and fails to take account of the commercial reality that a business needs to spend money as dictated by the demands of the market and the vicissitudes of trade. A budget applied strictly cannot respond to the usual unpredictable changes in turnover or revenue which inevitably impacts on variable expenses. Moreover, the 2008 Budget was itself an imprecise tool. Many line items would be commercially impracticable to meet as they included line items for stores in Kotara and Chapel Street which had not opened at the time the budget was prepared, and consolidated amounts that necessarily must have included amounts allocated to those stores.
Additionally, it should be borne in mind that strict compliance with the 2008 Budget was not possible from the outset. The defendants had already overspent the entire amount allocated to some of the line items in the 2008 Budget at the completion date of the purchase. While the defendants conceded that the plaintiff would not be in breach merely because the defendants had spent over the budget amounts, they maintained that if the defendants spent up to the Completion Date one dollar less than the amount budgeted for a particular category for the entire FY2008, and then the plaintiff spent two dollars more on the category for the rest of the year, the plaintiff would be in breach.
If the defendants’ interpretation were to be accepted, the defendants could have spent one dollar less than the total amount allocated to each budget line item up to the Completion Date, and then the plaintiff could either breach clause 9.1(a) by only spending what was allocated in the budget for FY2008, and, consequently, not conduct the Businesses in a manner consistent with how the Business had been conducted by the defendants in the 12 months preceding the Completion Date; or breach clause 9.1(c) by spending over the amounts set in the 2008 Budget. In both circumstances the plaintiff would carry the risk of any negative impact of the breach of clause 9 on EBITDA.
When such potential circumstances are taken in to account it is, in my view, not tenable that the parties would have intended that the plaintiffs would be bound to strict observance of a spending limit, line by line of the 2008 Budget, and which the defendants had put beyond their reasonable grasp before the BSA and the Amended Agreement had been signed; and for the plaintiff, as a consequence, to be required to account to the defendant for any negative impact. In particular, the 2008 Budget also failed to allocate any actual monetary amount for foreign exchange expenses; in circumstances where the plaintiff submitted that foreign exchange transactions are an important aspect of the Businesses.
Further, the plaintiff submitted that its interpretation was consistent with the common meaning of the words of sub-clause 9.1(c); in particular, taking “budget” to mean “an estimate of income and expenditure for a set period of time”. The plaintiff’s submission in this respect is supported by the observations of Emmett J in Brasington v Overton Investments Pty Ltd:[16]
“108. In its ordinary meaning, a budget is an estimate of expected income and expenditure or operating results for a given period in the future (see D v Macquarie Dictionary, Second Revision, the Macquarie Library Pty Ltd, Macquarie University, 1987). It might also be described as a periodic, especially annual, estimate of the revenue and expenditure of an organisation (see Shorter Oxford English Dictionary on Historical Principles, 5th Edition, Oxford University Press, Oxford, 2002). Thus, the essence of the concept of the budget is that it is an estimate for the future. The actual expenditure and income may produce a result that is different from the budget because either expenditure or income is underestimated or overestimated.”
A similar definition is contained in the first meaning ascribed to the word “budget” in The Macquarie Dictionary, 4th Edition, 2005. Similarly, though in part referring to the public sphere, the Oxford English Dictionary[17] contains the following definition:
“4.a a statement of the probable revenue and expenditure for the ensuing year, with financial proposals founded thereon, annually submitted by the Chancellor of the Exchequer, on behalf of the Ministry, for the approval of the House of Commons. … also to a prospective estimate of receipts and expenditure, or a financial scheme, of a public body, or to the domestic accounts (of income and its manageable expenditure) of a family or individual; …”
[16][2003] FCA 1523 at [108].
[17] (13/1/2011).
Although dictionary definitions of words are not necessarily decisive, as the meaning of the word may be critically affected by the linguistic and substantive context in which it is used, dictionary definitions are, nevertheless, useful.[18] In this respect, Lewison comments:[19]
[18]See Lewison, The Interpretation of Contracts (4th ed, 2007) ¶5.03, pp 152-5.
[19]The Interpretation of Contracts (4th ed, 2007) ¶5.03 at pp 154-5.
“Reference to a dictionary is permissible to show not only the meaning of a word but also its application. Thus in Pepsi-Cola Co of Canada v Coca-Cola Co of Canada Ltd,[20] Lord Russel of Killowen, delivering the advice of the Privy Council, said:
[20](1942) 49 RPC 127 (concerning the meaning of the particle “Cola” in Pepsi-Cola and Coca-Cola respectively).
‘there can … be no doubt that dictionaries may properly be referred to in order to ascertain not only the meaning of a word, but also the use to which the thing (if it be a thing) denoted by the word is commonly put.’
Of course, the fact that a word is defined in a dictionary does not mean that the court will automatically apply the dictionary definition to the contract. As Lord Herschell said in Southland Frozen Meat and Produce Export Co Ltd v Nelson Brothers Ltd:[21]
[21][1898] AC 442.
‘… the words must not be applied to everything that might be said to come within a possible dictionary use of them, but must be interpreted in the way in which business men would interpret them, when used in relation to a business matter of this description.’”
Further, in Heronslea (Mill Hill) Ltd v Kwik-Fit Properties Ltd,[22] Sharp J said that:[23]
“It [is] clear … that the Court is entitled to have regard dictionary definitions as an aid to construction to ascertain the natural and ordinary meaning of the words in their relevant context.”
Her Honour added:[24]
“When construing the natural meaning of the language in its context I see no reason why the court should not derive assistance from various dictionary definitions, in particular where the ambit of the activities covered by a particular word is in doubt or dispute, as it is here. Indeed it is clear from the judgment of Sir Anthony Clark MR in the Crystal Palace case,[25] that such an approach (while not sufficient in itself) is permissible.”
[22][2009] EWHC 295, QBD; and see Lewison, The Interpretation of Contracts (First Supplement to the Fourth Edition, 2010) ¶5.03, pp 51, 52.
[23][2009] EWHC 295, QBD, at [19].
[24][2009] EWHC 295, QBD, at [36].
[25]Crystal Palace FC (2000) Limited v Simm Paterson (as Liquidator of Crystal Palace (1986) Limited) [2005] EWCA Civ 180.
As has been noted, the defendants contended that the plaintiff was required, under the terms of the Amended Agreement, to spend the exact amount of money specified in the expenditure line items as set out in the 2008 Budget. The contention is at odds with the conventional and ordinary understanding of the meaning of the word “budget” and, further, in my view, is not warranted by the terms of the Amended Agreement. In my opinion, this is clear from a consideration of the operation of some of the other express provisions of the agreement and the consequences that would flow from the application of these provisions if such a limited and prescriptive meaning were to be applied to sub-clause 9.1(c) with reference to the “budget”.
Also, the 2008 Budget includes revenue items: and revenue items which, by their nature, are not predictable having regard to the nature of the Businesses. On this point the defendants submitted:
“… the obligation is an expenditure obligation … The conduct of a business … is a reference to what one as the conductor does. And the conductor simply spends. It's somebody else in a sense who purchases. So to the extent that, you know, the obligation, all contractual obligations are expressed in terms of verbs, the relevant verb here is conduct.”
In my view, there is no justification for the reading in of the words “items of expenditure” into the provisions of sub-clause 9.1(c) in order to confine the strict meaning of “budget” for which the defendants contend to expenditure items only. Also, no rectification claim is made in this respect, which might be taken to be an indication that such an interpretation was unsupportable as a result of the prior dealings or any agreement between the parties.
Consequently, there being no basis to distinguish between expenditure and revenue items, the restricted meaning contended for by the defendants would require the plaintiff to target the earnings of the Businesses to those forecast in the 2008 budget, rather than to achieve a better result. Restrictions on revenue on this basis would, in my view, be nonsensical and clearly contrary to the mutual interests of the parties and a consequence which the construct and structure of the Amended Agreement itself, particularly the provision for adjustment of EBITDA, indicates that the parties would not have intended.[26] Clearly, there was no intention that the plaintiff should be obliged to shut the doors of the Businesses once the sales budget had been met.
[26]For example, variations in EBITDA were contemplated by the Amended Agreement in clause 10.4.
On this basis, I am satisfied that none of the parties could have intended the unworkable and impractical interpretation which the defendants seek to put on sub-clause 9.1(c) with respect to compliance with the 2008 Budget; or the micro-management which would follow from the limited interpretation which the defendants submit should be placed on the word “budget”. Further, I am of the view that it is no answer to the language of these provisions and the difficulties that would flow from the construction proposed by the defendants to say, as they do, that the construction advocated by the plaintiff would be “inconsistent with the rationale of earn out clauses”. In my view, to give pre-eminence to such a general commercial objective would be to ignore the words of the critical provisions, at odds with the principles of construction to which reference has been made.[27]
[27]See above, paragraphs 14 to 16.
In the event that I accepted the defendants’ interpretation of sub-clause 9.1(c), the plaintiff submitted that savings and over-expenditure with reference to the 2008 Budget should be netted off. This would mean that a $1000 over-expenditure on one item could be balanced against a saving of $1000 on another budget item. Given that I have accepted the plaintiff’s interpretation of sub-clause 9.1(c) this question does not arise for my decision. However, if the defendants’ strict compliance interpretation of sub-clause 9.1(c) was accepted, it is my view that the plaintiffs would not be able to net off under and over expenditure. The independent accountant would need to assess the negative impact of each digression from the budget, rather than taking a net figure. An extreme example would be an underspend of $100,000 on wages and an overspend of $100,000 on travel. It can not reasonably be said that these should be netted off so that there would be no breach of sub-clause 9.1(c).
Modified Budgetary Compliance
If I were to find that strict compliance with the 2008 Budget was required and that “netting off” was not available, the plaintiff’s alternative argument was that in determining its compliance with the requirements of sub-clause 9.1(c) it is necessary to consider the defendant’s expenditure in the pre-completion period and the effect that expenditure had on the plaintiff’s ability to comply with the 2008 Budget. It was also said that this would be consistent with the use of the words “as a result of the Purchaser not complying with sub-clause 9.1” in Schedule 7, paragraph 4, and the limitations of the plaintiff’s obligations under sub-clause 9.1 with respect to the Earn-Out Period.
The plaintiff submitted that such a construction is also to be favoured, as it avoids the absurd result of requiring the purchaser to pay the vendor an amount equal to 4.95 times the negative impact on earnings caused by the vendors’ own overspend in circumstances where the defendants themselves had exhausted, in the sense of having fully spent, the entire budget line item allocation before the completion of the purchase. Another example is that a situation in which the defendant spent nearly all the amount allocated to a particular line item in the 2008 Budget at the Completion Date.
The plaintiff submitted that in instances where the defendants had spent more than their proportionate share of the line item in the budget, the Independent Accountant must determine the effect of the defendants’ overspend in order to determine what (if any) “negative impact” on EBITDA resulted from the plaintiff’s non-compliance.[28]
[28]See sub-clause 10.6 which makes provision for the resolution of disputes with respect to the Earn Out Amount – EBITDA by the “Independent Accountant” (as defined in sub-clause 1.1).
On the other hand, the defendants submitted that their expenditure in the pre-completion period under the Amended Agreement could not have an impact on the plaintiff’s obligation to comply with sub-clause 9.1(c) as, on its proper construction, it required the plaintiff to ensure that its own spending in the post-completion period did not have the result that the budgeted amount for the year for each line item of expenditure was exceeded. For the reasons indicated previously, this does not, in my view, overcome the problems highlighted by the plaintiff in circumstances where the defendants had exceeded expenditure under a 2008 Budget line item; even on the basis of an adjustment of that line item by reference to the period pre-completion as a proportion of the financial year.
The plaintiff sought, in the event that the Court found that the construction of sub-clause 9.1(c) requires exact compliance with each 2008 Budget expenditure line item, a declaration to the effect that sub-clause 9.2 of the Amended Agreement required the defendants not to exceed a proportionate part of the budgeted expenditure for each line item during the period which they managed the Businesses. Alternatively, the plaintiff sought a declaration that the defendants are not permitted to exceed the entire budgeted amount for a particular line item.
As discussed above,[29] the defendants conceded that they were obliged not to overspend the entire 2008 Budget in the period between 1 July 2007 and completion, but said that they could spend just less than the amount budgeted for the entire year. The ability of the plaintiff to comply strictly with each line item of expense in the 2008 Budget, as argued for by the defendants, would be significantly affected if this were regarded as the proper interpretation of these provisions. It was submitted by the plaintiffs that if the defendants could spend up to $1 less than the amount budgeted for on each line item, the plaintiff would, effectively, be left with no scope for further spending during the remainder of the financial year. In such a extreme situation, the plaintiff would have to pay the defendants $4.95 for every dollar of negative impact to the earnings of the Businesses in addition to its obligation to pay 4.95 times the earnings of the Businesses.
[29]See, paragraph 30.
The defendants argued against the declarations on the basis that neither the budget for the consolidated business nor the budget for the wholesale business contained reference to weekly or monthly figures. This was important as the Businesses were, it was said, affected by seasonal factors which varied throughout the year. Accordingly, expenses would vary according to the seasons. Given the seasonality of the Businesses and the consequential variability of expenditure, it would not have been appropriate to have forecasted expenditure on a particular line item apportioned on a monthly basis.
While this question does not arise for my decision, in my opinion, the provisions of the Amended Agreement which require the plaintiff, in summary, to continue to operate the Businesses in a similar manner to that which was adopted by the defendants is indicative of the underlying and guiding purpose of the critical provisions of the Amended Agreement, to which reference has been made. For reasons indicated previously, this is an entirely understandable position, commercially, for the protection of the interests of both the defendants, as vendors, and also of the plaintiff, as purchaser. In other words, the parties’ expectations and understanding were that the Businesses were to be conducted in its ordinary course, which had been established by the defendants over the previous year. This position is also supported, in my view, by the provisions of sub-clause 9.3, which, for the reasons indicated below, provide for circumstances which were not anticipated in the budget for the Businesses, hence might be regarded as unusual and unanticipated circumstances or events on the basis of the ordinary course in which the Businesses had been conducted in the previous year. Further, the alternative arguments in relation to the budget demonstrate the need to read sub-clause 9.1(c) subject to the statement of fundamental agreement contained in sub-clause 9.1(a). For these reasons, I am of the opinion that these provisions should be read on the basis that an “overspend” by the defendants, the vendors, in terms of the 2008 Budget in effect “re-sets” the relevant line item in that budget for the purposes of the plaintiff’s obligations, as purchaser, under sub-clause 9.1(c), on the basis of this spending pattern by the defendants, or either of them, for the purposes of sub-clause 9.1(a). In other words, this spending pattern goes to the manner in which the businesses were conducted for the purposes of clause 9.1(a).
Notification of Costs, Expenses and Outlays
Sub-clause 9.3(a) provides that “the Purchaser must give the Vendors prior notice in writing in relation to all proposed costs, expenses or outlays during the Earn Out Period which have not been provided for in the 2008 Budget and which (i) involve an amount of $100,000.00 or more; or (ii) involve an amount of less than $100,000 but which the Purchaser estimates may impact the Normalised EBITDA by $100,000 or more”.
The plaintiff contended that this notification requirement was limited to the situation where there was no entry in the 2008 Budget for the relevant category of outlay, applied to “one-off” items of expenditure and did not apply to foreign exchange expenses, agents’ commissions and cost of good sold (“COGS”). It was common ground that no written notice had been given by the plaintiff for the purposes of sub-clause 9.3(a).
The defendants contended that the proper interpretation of the notification requirements of sub-clause 9.3 was that: (a) applied to any items of expenditure which appeared in the 2008 Budget but in respect of which the plaintiff had over-spent by $100,000 or more; (b) applied to aggregated categories of expense; and (c) applied to foreign exchange expenses, car allowances, agents’ commissions and cost of goods sold.
For the reasons previously indicated, it is, in my view, clear from the provisions of sub-clause 9.1 and its context that its provisions are designed to require and ensure that the Businesses were conducted by the plaintiff, as purchaser, in a relevantly similar way to the manner in which the defendants conducted their respective wholesale and retail business. In this context, sub-clause 9.3 is, in my view, intended to give the defendants direct control over significant items of expense which were not provided for as categories of line items in the 2008 Budget which might have a significant impact on the EBITDA. In forming this view, I am persuaded by the plaintiff’s submissions that sub-clause 9.3 is intended to focus on “one-off” expenditure as a result of the requirement of prior notice in writing because, otherwise, compliance with this requirement would not be reasonably possible if costs, expenses and outlays were being incurred gradually within existing budget categories or line items. It was submitted by the plaintiff that by the time the $100,000 threshold was reached, it would be too late for the defendants to object to the bulk of the expense as sub-clause 9.3(a) requires notification of “proposed” costs. In my view, this is significant and I accept that this construction is confirmed by other parts of the text of sub-clause 9.3 where there are references to “an amount of $100,000 or more” and “the cost, expense or outlay” (emphasis added). Significantly, the text does not refer to “amounts” or “aggregate amounts” or to “those costs, expenses or outlays”.
The plaintiff also submitted that the defendants’ submissions ignored the position that the “impact” on the normalised EBITDA is a “net concept” as the defendants contend that the negative impact on normalised EBITDA is the sum of all excess spending on the relevant line items, together with any further expenses incurred as a result of incurring that expense. In my view, this approach does fail to consider that spending can have a positive effect on the EBITDA and so it would, in my view, follow consistently with the apparent commercial purpose of clause 9, particularly sub-clause 9.1, that it is only the net impact which must be excluded for the purpose of calculations of normalised EBITDA under sub-clause 9.3. If this were not so, the plaintiffs would be required to pay the defendants 4.95 times both the total of the extra spending (as the Normalised EBITDA would have been adjusted upward by the amount of the excess) and also 4.95 times the extra revenue earned as a result of the extra spending. This could not be regarded as a sensible commercial outcome or, consequently, the likely intention of the parties to this Amended Agreement, as a commercial contract.
The plaintiff also argued that even if the defendant’s contentions were correct, it would be unthinkable that the parties intended the plaintiff seek the defendant’s concurrence in the incurring of foreign exchange expenses, agents’ commissions and COGS.
Foreign exchange gains or losses are, it was submitted, unpredictable, uncontrollable and inevitable due to the defendants’ business practices as the business has no control over when invoices are paid. For that reason, it was submitted, foreign exchange losses could never be “proposed” – they are an unpredictable outcome of the Businesses, not a planned input to them. Further, in order to comply with the notification requirements, the plaintiff would have to have tracked all movements in the relevant rates, applied those movements to all foreign debtors’ and creditors’ balances and totalled the results with prior foreign exchange gains and losses, in order to determine whether and when to make notification – on an ongoing basis. I accept that this would be entirely impracticable.
Agents’ commissions are a percentage of gross sales. It was submitted by the plaintiff that on figures provided in the IM, every dollar of agents’ commissions means approximately $8 in increased sales. I accept that the parties had no reason to empower the defendants to object to increased sales. Further, including agents’ commissions in sub-clause 9.3 would mean there would come a point where the plaintiff required its agents to seek its permission before every new sale was made (for the purpose of giving the defendants the opportunity to object to the corresponding increase in commissions). That would, in my view, be uncommercial and unworkable.
For the same commercial and practical reasons as relate to agents’ commissions, I accept that COGS cannot fall within the ambit of sub-clause 9.3. COGS relates only to sold goods - not stock on hand. It follows that every dollar of COGS creates revenue. Why, the plaintiff asked rhetorically, would the parties give the defendants the opportunity to object to that? Most importantly, the defendants’ arguments would, in my view, have the perverse effect of rendering the plaintiff liable to pay $4.95 for every extra dollar of COGS, and $4.95 for every extra dollar of earnings generated by that dollar of COGS – effectively inflating the earnings multiple paid by the plaintiff. I accept that it is not in accordance with commercial realities, hence the likely expectation of commercial parties, that the parties contemplated these provisions operating in such a fashion.
For the reasons indicated, I accept the plaintiff’s submissions that the notification requirements do not apply other than in respect of expenditure not provided for in the 2008 Budget by way of an entry for the relevant category of outlay, applies only to “one-off” items and does not apply to foreign exchange expenses, agents’ commissions and COGS.
Unrealised Profit in Stock
The plaintiff seeks a declaration that the Amended Agreement required the Normalised EBITDA to be adjusted by eliminating the movement in unrealised profit in stock in the Retail Business between 30 June 2007 and 30 June 2008 in the amount of $378,860. That figure represents the difference between the unrealised profit in stock of the Retail Business at 30 June 2007, of $131,188, and the sum the plaintiff submits the parties are bound to as the unrealised profit in stock of the Retail Business at completion, of $510,048.
The defendants seek a declaration that the Normalised EBITDA calculation required the elimination of any movement in the unrealised profit in stock in the Retail Business between 30 June 2007 and 30 June 2008 by deducting the amount of unrealised profit in stock on 30 June 2007 from the amount of unrealised profit in stock on 30 June 2008 and adjusting the consolidated EBITDA of the business by the resulting amount.
The issues raised by those claims are to be determined by the court, but only to the extent that the amount the subject of the relevant declaration can be determined by the court on the basis of:[30]
(a)the defendants’ admissions that unrealised profit in stock of the Retail Business was $131,188 as at 30 June 2007 and nil as at 30 June 2008; and
(b)the court’s determination of the allegation that the defendants are bound by the amounts set out in the plaintiff’s statement setting out (inter alia) the plaintiff’s calculation of the “Earn Out Amount – Working Capital”;[31] and the plaintiff’s “Completion Accounts”.
[30]Order of Croft J made on 20 August 2010, para 1(b).
[31]Further amended statement of claim, para 7H.
Prior to the sale, the Wholesale Business sold goods to the Retail Business. As each business was owned by a separate trust, the price paid by the Retail Business to the Wholesale Business for each item so sold had a positive impact on the EBITDA of the Wholesale Business.
When the Wholesale Business and the Retail Business, which now constitute the Businesses, are considered as a consolidated entity (as required by the Amended Agreement), the profit component of the price charged by the Wholesale Business to the Retail Business became artificial. The “profit” was unrealised, because the Businesses, now a consolidation of the two former businesses, had earned no money – the goods had not been sold to any third party. The earnings of the Businesses would be overstated. To illustrate, a garment which cost the Wholesale Business $10 to make, and which was “sold” to the Retail Business for $20 but not on-sold to a customer, did not generate $10 in profit. The $10 in profit would be recorded in the accounts of the Wholesale Business, but would not have really been earned by the Businesses, as consolidated. While that unrealised profit remains in the books, the earnings of the Businesses would be overstated by $10.
For these reasons, to accurately measure the earnings of the businesses considered together (i.e. as they were sold), the unrealised profit had to be “written back”.[32] It follows that for this reason the Amended Agreement required Normalised EBITDA to be adjusted by “eliminating any movement in unrealised profit in any stock of the Retail Business between 30 June 2007 and 30 June 2008”.
[32]See e.g. IM, p 41.
It was submitted by the plaintiff that:
(a)unrealised profit at beginning of the period (X) is the profit component of the price paid by the Retail Business to the Wholesale Business for goods which remain unsold in the Retail Business at the beginning of the period;
(b)unrealised profit at end of the period (Y) is the profit component of the price paid by the Retail Business to the Wholesale Business for goods which remain unsold in the Retail Business at the end of the period;
(c)the movement between those two amounts (Y-X, or Z) is the profit component of the price paid by the Retail Business to the Wholesale Business for goods sold by the Wholesale Business to the Retail Business during the period;
(d)Z is not real earnings of the consolidated Businesses over the period, because it has not come form outside the Businesses; and so
(e)to measure the real earnings of the business over that period, earnings must be reduced by Z.
For that reason, as the unrealised profit in stock of the Retail Business at 30 June 2007 was $131,188 (as the parties agree), if the unrealised profit at 3 December 2007 was $510,048 (as the plaintiff contends) the movement in unrealised profit in stock over that period was $378,860. However, the factual basis of this submission was contested by the defendants on the basis that the figures were not based on available evidence and that, in any event, these are matters for determination by the Independent Accountant under sub-clause 10.6 of the Amended Agreement.
In any event, the plaintiff submitted that, in contrast, the evidence of Mr Krowitz was that in the period between 3 December 2007 and 30 June 2008, there were no sales between the Wholesale Business and the Retail Business – stock was transferred at wholesale cost. There was therefore no movement in unrealised profit of the Businesses during that period, and no need to “write back” any artificial earnings. Consequently, there was no unrealised profit to eliminate, so making an elimination for unrealised profit in respect of the post-completion period would create a windfall for the defendants. That is the effect, the plaintiff submitted, that the defendants’ contention would have: by incorrectly equating the absence of any unrealised profit in the plaintiff’s accounts at 30 June 2008 with a $0 figure for unrealised profit, the plaintiff submitted the defendant would obtain a windfall of:
(a)4.95 times the difference between the closing balance of unrealised profit in their books on 30 June 2007 and the closing balance of unrealised profit in their books on 2 December 2007 (which would not be written back); and
(b)4.95 times the difference between the closing balance of unrealised profit in their books on 30 June 2007 and $0 (which would be incorrectly accounted for as EBITDA).
Thus, the plaintiff submitted that the only movement in unrealised profits of the Retail Business between 30 June 2007 and 30 June 2008 was the movement in the pre-completion period. So, to measure the movement in unrealised profit in stock, it is necessary to determine the unrealised profit in stock at 30 June 2007, and the unrealised profit in stock at the completion date (3 December 2007). The parties agree that unrealised profit in stock at the opening of the financial year was $131,188. The plaintiff contended that the unrealised profit in stock at 3 December 2007 was $510,048.
The defendants prepared a Stock Statement which was used by the plaintiff to prepare the draft Completion Accounts and the “Statement” under sub-clause 7.1. Those documents were provided to the defendants by the plaintiff pursuant to sub-clause 7.1. The defendants then had fifteen days to dispute the draft Completion Accounts and any of the amounts stated in the Statement pursuant to sub-clause 7.4. The plaintiff submitted that as they did not do so, they are taken to be bound by each of the Completion Accounts and every item in the Statement in accordance with the provisions of sub-clause 7.4.
The Stock Statement valued the finished goods held by the Retail Business at $342,603 at 3 December 2007. Pursuant to sub-clauses 1.1, 8.1 and 8.3, that figure was net of any unrealised profit in stock in the Retail Business. The “Actual Working Capital Amount” calculation valued the finished goods held by the Retail Business at 3 December 2007 at $852,651, and applied an “intercompany elimination” of $510,048 to the finished goods. The gross value of $852,651 is the sum of the net value of $342,603 from the Stock Statement and the intercompany elimination of $510,048. There being no other item which the value of stock in the Stock Statement was required to be net of, it was submitted that the court can only conclude that the intercompany elimination of $510,048 is the unrealised profit in the Retail Goods as at 3 December 2007.
Consequently, the plaintiff submitted that there was a movement of unrealised profit between 30 June 2007 and the date of completion of $378,860; that there was no movement in unrealised profit from completion to 30 June 2008 and so the normalised EBITDA must therefore be adjusted downward by $378,860.
The plaintiff, in its Further Amended Statement of Claim (dated 6 August 2010), sought, among others, the following declaration:
“N.A declaration that on a proper construction of the Amended Agreement including paragraph 1(a)(ii) of Schedule 7 to the Amended Agreement that when calculating the Normalised EBITDA the consolidated EBITDA of the Businesses was required to be adjusted by eliminating the movement in unrealised profit in stock in the Retail Business between 30 June 2007 and 30 June 2008 in the amount of $378,860.”
In relation to this declaration, the orders of 20 August 2010 provided for determination of the issues relevant to this head of relief sought to the following extent only:
“1.(b)the declaration sought in paragraph N of the prayer for relief in the [Further Amended] Statement of Claim, but only to the extent that the amount the subject of that declaration is able to be determined by the Court on the basis of:
(i)the facts admitted by the Defendants in paragraphs 13B and 13G of their defence to further amended statement of claim and counterclaim dated 13 August 2010 (the Defence); and/or
(ii)the allegations made by the Plaintiff in paragraphs 7H and 7I of the Further Amended Statement of Claim;”
The admission of paragraphs 13B and part of 13G of the Further Amended Statement of Claim means that it can be taken that as at 30 June 2007 the unrealised profit in stock of the Retail Business was $131,188 and that on 30 June 2008 the unrealised profit in stock of the Retail Business was nil. Further, the plaintiffs said in paragraph 13G (and by reference to paragraph 13F): that “As the opening unrealised profit in stock was reset to nil as referred to in paragraph 13F … and the closing profit in stock was nil at 30 June 2008, there was no movement in unrealised profit in stock for the period 3 December 2007 to 30 June 2008”. In paragraph 13F the plaintiffs stated that: “Effective 3 December 2007 (Completion Date) the unrealised profit in the stock of the Retail Business was reset to nil by the Plaintiff when the assets of the Retail Business were transferred to the Plaintiff. The effect of this entry was to reduce stock by $510,048 and increase goodwill by $510,048”.
The defendants, on the other hand, denied the allegations contained in paragraphs 7H and I of the Amended Statement of Claim in the following terms:
“7H.They deny each allegation in paragraph 7H, and say further that:
(a)on the proper construction of clause 7.4 of the Amended Agreement, the Completion Accounts and the items set out in the Statement were final and binding only for the purposes of the calculation of the Earn Out Amount – Working Capital, and not for the purposes of the calculation of the Earn Out Amount – EBITDA;
(b)further or alternatively, the Statement did not record that the item with a value of $510,048 was the amount of unrealised profit in stock at 3 December 2007, but merely said that that amount was ‘an intercompany elimination’, and accordingly there was no binding determination pursuant to clause 7.4 of the Amended Agreement that the amount of unrealised profit in stock at 3 December 2007 was $510,048.
7I.They deny each allegation in paragraph 7I, and refer to and repeat the matters in paragraph 7H above.”
I accept the plaintiff’s submissions that if the unrealised profit in stock were to be calculated in the manner the defendants contended for the defendants would receive a windfall. Consequently, I am of the opinion that the plaintiff has established the basis for the declaration sought in paragraph N of the prayer for relief, but that the court is not able, on the evidence available, to determine the relevant sum of money for the purposes of this declaration in accordance with the Amended Agreement. I accept the submissions of the defendants that the determination of this sum is a matter for determination in accordance with clause 10 of the Amended Agreement and, in particular, for determination by the Independent Accountant under sub-clause 10.6 should this be required.
Summary and Conclusions
For the preceding reasons, I will make various declarations sought by the plaintiff as set out in paragraph 1 of the orders of 20 August 2010; but subject to the position set out in paragraphs 72 to 75 (and the reservation contained in paragraph 77) of these reasons. I reserve the question of costs and reserved costs in these proceedings. I will hear the parties both in relation to costs and the final form of orders.
Subject to hearing the parties further in relation to the final form of orders I propose to make the following declarations as set out in the plaintiff’s prayer for relief:
D. A declaration that on a proper construction of the Amended Agreement the requirement in clause 9.3(a) that the Plaintiff give prior notice in writing to the Defendants in relation to proposed costs, expenses or outlays during the Earn Out Period which:
1.involve an amount of $100,000 or more; or
2.involve an amount of less than $100,000, but which the Plaintiff estimates may impact the Normalised EBITDA by $100,000 or more;
is limited to the situation where there is no entry in the 2008 Budget (as defined in the Amended Agreement) for such categories of costs, expenses or outlays.
E.A declaration that on a proper construction of the Amended Agreement the requirement that the Plaintiff give prior notice in writing to the Defendants pursuant to clause 9.3(a) only requires the Plaintiff to give the Defendants notice of single or ‘one off’ items of expenditure incurred during the Earn Out Period which exceed the amount specified in the 2008 Budget by $100,000 or more, or which involve an amount of $100,000 or less but which the Plaintiff estimates may impact the Normalised EBITDA by $100,000 or more.
F.A declaration that on a proper construction of the Amended Agreement foreign exchange losses are not costs, expenses or outlays within the meaning of clause 9.3(a) which require the Plaintiff to give prior written notice to the Defendants.
H.A declaration that on a proper construction of the Amended Agreement the Plaintiff’s obligation in clause 9.1(c) of the Agreement to conduct the Business in accordance with the 2008 Budget;
(a)required the Plaintiff to endeavour to achieve the EBITDA figure in the 2008 Budget;
(b)required the Plaintiff in endeavouring to achieve the EBITDA figure in the 2008 Budget to have regard to items of revenue and expense set out in the 2008 Budget;
(c)required the Plaintiff in endeavouring to achieve the EBITDA figure in the 2008 Budget to have regard to its other obligations in clauses 9.1(a), (b), (d), (e) and 9.3 of the Amended Agreement; and
(d)the Plaintiff was not obliged to expend money strictly in accordance with each line item of expenditure specified in the 2008 Budget.