Scottish Court of Session Decisions

[1] This is an action of damages for breach of warranty. The issue arises out of an agreement dated 6 November 1996 in terms of which the two pursuers and another investor agreed to provide financial facilities to Peak Scientific Limited ("the company") on certain terms and conditions. Under the agreement the first pursuers subscribed £225,000 and the second pursuers £25,000 in exchange for shares in the company. The defenders were the shareholders in the company and both the company and the shareholders were parties to the agreement. The defenders were also directors of the company. The section of the terms and conditions headed "Warranties" contained a number of warranties, but for present purposes we are concerned only with the warranties in Clause 19.1. The provision is in these terms:

[2] The parties are agreed that by Clauses 19 and 19.1, read together, the defenders gave the pursuers three warranties. First, they warranted that the financial position of the company and its subsidiaries as at 31 August 1996 was as disclosed in the Management Accounts which were true and accurate in all material respects. Secondly, they warranted that, except in the normal course of business, the company had not disposed of nor acquired assets except as disclosed to the pursuers. Thirdly, they warranted that there had been no event since 31 August 1996 which had led to a material adverse change in the financial position of the company and its subsidiaries. In each case the warranty was qualified by the words "except as disclosed in the disclosure letters" issued on the same day as the subscription agreement was signed. For present purposes it is unnecessary to examine the terms of those letters, except to notice that the disclosures were deemed to cover a number of matters including those contained in a report on the company prepared for the first pursuers by Grant Thornton and dated 15 August 1996. The letters also contained particular disclosures which were said to apply to Clause 19.1 of the subscription agreement.

[3] Although the pursuers originally had averments in Article 4 of Condescendence relating to a supposed breach of the first of these warranties, after debate the Sheriff excluded those averments from probation and the pursuers have not appealed that aspect of his decision. For the rest, the Sheriff allowed the pursuers a proof of their averments before answer, while excluding two passages in the defenders' answers from probation. Before us Mr. Sellar, Q.C., who appeared for the defenders did not challenge the Sheriff's decision in respect of the defenders' averments which were supposed to relate to personal bar but he did argue that the Sheriff had been wrong to exclude averments in Answer 3 relating to the Grant Thornton report. In the light of the discussion in this court, however, Mr. Sellar acknowledged that, as they stand at present, the averments are lacking in specification. He therefore moved the court, in the event that we did not give effect to his principal argument for the dismissal of the action, to put the case out By Order so that he could have an opportunity to amend his pleadings in this respect. On behalf of the pursuers Mr. McIlvride was content for that course to be followed.

[4] Mr. Sellar's principal submission was, however, that we should sustain the defenders' first plea-in-law and dismiss the action. In advancing that argument he focused on the pursuers' remaining averments of breach of the warranty. They are to be found in Article 4 and are in these terms:

As Mr. Sellar pointed out and as Mr. McIlvride freely acknowledged, in this passage the pursuers simply aver that there had been a materially adverse change in the financial position of the company between 31 August 1996, the date of the Management Accounts, and 6 November 1996, when the parties entered into the agreement. Mr. Sellar contended that, in that form, the averments were irrelevant.

[5] The averments of breach in Article 4 have, of course, to be read in the light of certain other averments in the pursuers' pleadings. In Article 3 the pursuers aver that the balance sheet in the Management Accounts for the period ending 31 August stated that the company's assets exceeded its liabilities by £26,000. Furthermore, they aver that on 30 November 1996, taking into account the further share capital invested by the pursuers and the other investor on 6 November, the assets of the company exceeded its liabilities by only £86,000. If that investment were left out of account, the liabilities of the company exceeded its assets by £214,000. Indeed, if certain research and development costs were treated differently in the accounts, in November 1996 the liabilities of the company exceeded its assets by £319,000. Mr. Sellar did not dispute that, if proved, these averments were capable of showing that there had indeed been a material adverse change in the financial position of the company between 31 August and 6 November 1996.

[6] Mr. Sellar submitted, however, that proof that there had been such a material adverse change in the financial position of the company between those dates was not proof that there had been a breach of the terms of the third warranty in Clause 19.1 of the agreement. What the defenders had warranted, rather, was that there had been no "event" between 31 August and 6 November which had led to a material adverse change in the financial position of the company. It was, accordingly, necessary for the pursuers to prove not simply that there had been a material adverse change in the company's financial position but that there had been an event which had led to that change. Since the pursuers were not offering to prove that there had been an event leading to the material adverse change in the company's financial position, they were not offering to prove a breach of the warranty. For his part, Mr. McIlvride argued that the warranty in Clause 19.1 was simply a warranty that "nothing had happened" since 31 August 1996 which had led to a material change in the financial position of the company. That was tantamount to warranting that there had been no material change in the company's financial position. So, by offering to prove that there had been such a material change, the pursuers were offering to prove a breach of the defenders' warranty in Clause 19.1. An alternative way of looking at the matter was to say that, where there had been a material change in the company's financial position, one could inevitably infer that there had been an "event" which had led to that change. So, by averring that there had been a material change in the financial position, the pursuers were, by necessary implication, averring that there had been an "event" leading to it.

[7] The question for decision by the court arises out of, and falls to be determined by reference to, the particular terms of the provision in the subscription agreement entered into among the parties. For that reason, although we were referred to a number of authorities on the interpretation of other, differently worded, agreements of a similar kind, we did not find them of any material assistance in resolving this basic question. Similarly, although we were reminded of what had been said about the interpretation of commercial agreements by Lord Hoffmann in Investors Compensation Scheme Ltd. v. West Bromwich Building Society [1998] 1 WLR 896 at pp. 912 - 913 and by this court in Bank of Scotland v. Dunedin Property Investment Co. Ltd. 1998 SC 657, we did not find any real help for present purposes in those authorities. In particular, we were referred to no matrix of fact which would have cast light, one way or the other, on the interpretation of the provision in question. We should add that neither side relied on the Sheriff's reasoning.

[8] In the light of the argument to which we listened, it seemed to us that the principal strength of the defenders' position was that it proceeded on the basis of, and sought to give effect to, all the words of the provision. By contrast, as Mr. McIlvride accepted, on his principal approach the provision would have meant exactly the same if it had made no reference to any event and the defenders had simply warranted that "there has been ... since 31st August 1996 ... [no] material adverse change in the financial position of the Company and its subsidiaries."

[9] On the other hand, again in the light of the argument to which we listened, the principal weakness of the defenders' position appeared to us to be that Mr. Sellar found it hard to identify what would not constitute an "event" in terms of the provision. Both he and Mr. McIlvride found it relatively easy, of course, to suggest contingencies which might constitute an "event" for these purposes - for instance, the death or retirement of a key employee, such as a designer, who played a significant part in attracting customers, or a decision by a foreign government on environmental grounds to withdraw import licences for the company's generators. But Mr. Sellar had much greater difficulty in explaining, or giving examples of, what would lead to a material change in the company's financial position and, yet, not count as an "event" in terms of the provision. He did not, for instance, maintain that the event had to be altogether extraordinary and he readily accepted that the decision of a major customer to remove its custom and obtain its generators from a rival supplier could amount to an "event" for these purposes. Similarly, he accepted that there could, of course, be more than one "event" leading to the change in the company's position. So the loss of two or more customers in such circumstances could constitute "events" in terms of the warranty. As we understood him, Mr. Sellar's ultimate submission was that, for there to be an "event" in terms of the provision, the material change in the company's financial position had to have been caused by something other than general adverse trading conditions. The pursuers were aware of the company's financial position as at 31 August and must be expected to use their own judgment as to the general trading conditions affecting its performance both at that date and, more particularly, on 6 November when they decided to proceed with the investment by signing the agreement. The defenders' warranty should not be interpreted so extensively as to amount to a warranty that there had been no (continuing) general adverse trading conditions leading to a material change in the company's financial position. It was more restricted and related only to more specific events affecting the company's financial position.

[10] Mr. Sellar pointed out that, when the subscription agreement had been drafted, both sides had been represented by firms of lawyers with experience of such work. We must therefore proceed, he urged, on the basis that the wording had been deliberately chosen, perhaps as the result of extensive negotiation among the various interests. That may indeed be so, even though, equally, the reality may be that little thought was given to the particular words which we are now asked to construe. On the other hand, we accept that any detailed and semantic analysis of the words in a commercial agreement such as this must be made to yield to business commonsense if such an analysis would otherwise lead to a conclusion which flouted that business commonsense. See Antaios Compania Naviera S.A. v Salen Rederierna A.B. [1985] A.C. 191 per Lord Diplock at p. 201, cited by Lord Hoffmann in Investors Compensation Scheme [1998] 1 W.L.R. at p. 913 E - F. We therefore accept that, if the defenders' construction, placing emphasis on the "event", were to flout business commonsense, then that construction would have to yield. And indeed Mr. McIlvride's argument was, in essence, that the defenders' construction flouted business commonsense because the only thing that mattered to investors such as the pursuers was "the bottom line", viz. any material change in the financial position of the company between 31 August and 6 November. Since that was all that would interest them, the only warranty which would interest them would be a corresponding warranty that there had been no material change in the financial position of the company. They would not be interested in the event giving rise to any such change and so they would not be interested in a warranty that there had been no event which had led to such a change.

[11] We have not found it easy to resolve the disputed issue of construction, turning, as it does, entirely upon the expressions which the parties have used. As we have explained, Mr. McIlvride's principal argument was, in essence, that it was sufficient for the pursuers to aver that there had been a material change in the company's financial position, since the warranty was simply a warranty that nothing had happened since 31 August which had led to the material change. It is clear, however, that the effect of Mr. McIlvride's preferred construction would be to empty the word "event" of any content so that it would fall to be regarded as mere surplusage. For our part, we do not consider that the words "event ... which has led to" can properly be regarded as otiose since content can be given to them without flouting business commonsense. More particularly, a warranty in these terms can actually be seen to be consistent with business commonsense: those who were investing in the company might well have been concerned not just with the fact that a material adverse change in the company's financial position had occurred and with the extent of that change, but also with the cause of that change. We therefore feel unable to interpret the provision by ignoring the parties' chosen expression "event" and treating the warranty as if it related only to a material change in the company's financial position. It follows that we reject Mr. McIlvride's principal argument on behalf of the pursuers.

[12] We turn accordingly to Mr. McIlvride's secondary argument. This was to the effect that the pursuers' averments of breach of warranty fell to be construed as averments that an "event" had occurred which had led to a material adverse change in the company's financial position, since such a change necessarily presupposed an event which had led to it. Adapting Mr. McIlvride's contention, we prefer to ask ourselves whether, when the pleadings are considered as a whole, the pursuers must necessarily fail to prove anything which could amount to an "event" within the terms of the warranty. As we have explained, the defenders admit that there was a material adverse change in the position of the company between 31 August and 6 November 1996, a period of less than ten weeks. The pursuers' averments as to the extent of the material adverse change in the company's financial position indicate a steep decline in the company's fortunes over that relatively short period. Moreover, as we have also noted, Mr. Sellar conceded that the warranty would not be limited to the occurrence of a single event and that it could properly be read as referring to an "event" or to "events". But he contended that, if the material change in the company's financial position had been due to general adverse trading conditions, those trading conditions, however bad, could not in themselves constitute an "event" or "events" within the scope of the warranty. There is, however, nothing in the terms of the provision as agreed among the parties to exclude general adverse trading conditions from the scope of the term "event". That being so, it cannot in our view be said at this stage that general adverse trading conditions, leading to such a rapid and significant decline in the company's financial position, could never be capable of constituting an "event" or a series of "events" within the scope of the warranty. In these circumstances we are not prepared to hold that the pursuers' action for breach of warranty must necessarily fail because they have not averred a specific event or specific events. We cannot therefore conclude that the pursuers' averments are irrelevant and that the action falls to be dismissed.

[13] While, of course, the question of the relevancy of the pursuers' pleadings has to be determined by reference to their averments alone, the conclusion which we have reached is fortified by the following considerations. In Answer 3 the defenders themselves aver that they had disclosed certain "events" - such as a delay of two months beyond the expected date of relocation of the company from Abbotsinch to Inchinnan and a delay in receiving investment funds - which had led to the company's position being materially weaker. In that situation it seems to us to be artificial for the defenders to admit that there was a material adverse change in the financial position of the company over a relatively short period, themselves to make averments of events leading to that change and, at the same time, to seek to found on the failure of the pursuers to aver that there had been any specific event or series of events leading to the change in the company's position. Moreover, when considering the defenders' attack on the relevancy and specification of the pursuer's pleadings, we think it right to bear in mind that the pursuers are, inevitably, less well placed than the defenders to pinpoint the event or events affecting the company's financial position. On that approach an investigation of the facts averred by the pursuers may indeed reveal circumstances - whether or not they were such as would fall within the scope of general adverse trading conditions - which led to the adverse change in the company's financial position and which could appropriately be described as an "event" or "events" within the terms of the warranty, without doing violence to its language. As we have said, these considerations serve to bolster our view that the pursuers' averments call for an inquiry before answer.

[14] For these reasons we consider that the Sheriff was right to allow a proof before answer on this matter. The defenders' appeal in this respect accordingly falls to be refused.

[15] Despite Mr. McIlvride's skilful criticisms of the defenders' averments relating to the terms of the disclosure letters and their application to the warranties in Clause 19.1, having agreed with the Sheriff in allowing the pursuers a proof before answer, we consider that the Sheriff was also correct to allow these averments of the defenders in answer to go to proof. We accordingly refuse the pursuers' cross-appeal on this matter. As we have mentioned already, the relevancy of the defenders' averments relating to the Grant Thornton report will fall to be determined in the light of any amendments of their averments on this matter which the defenders are able to make. We shall accordingly put the appeal out By Order to give counsel for the defenders an opportunity to indicate whether he does indeed intend to amend the pleadings in this respect. If he does, we shall consider whether to allow any minute of amendment tendered by him to be received. At that stage also we can decide what procedure should be adopted in that respect.