Arbitrating post-M&A disputes: a look forward

December 2020  |  SPECIAL REPORT: INTERNATIONAL DISPUTE RESOLUTION

Financier Worldwide Magazine

December 2020 Issue

Post-M&A arbitrations are becoming increasingly frequent. American International Group (AIG) recently published its fifth annual ‘Mergers and Acquisitions Claims Report’. The report concluded that there is a “rising tide of large claims” under policies for warranty and indemnity (W&I) insurance, with one in five deals insured by AIG resulting in a notification of a claim.

This trend looks likely to continue, or accelerate, as the disruption to the global financial markets created by the coronavirus (COVID-19) pandemic produces a further surge in post-M&A arbitrations with buyers looking for ways to exit or renegotiate deals. This article examines representative types of claims in post-M&A arbitrations, focusing on those likely to surface in the wake of the COVID-19 pandemic.

Breach of representation and warranties clauses

Representations and warranties are one of the most important set of terms in share purchase agreements (SPAs) and are frequently the subject of post-M&A arbitrations. Together, the representations and warranties clauses establish the boundaries of the seller’s liability for the condition and performance of the target company after completion.

The seller’s representations in an SPA are generally statements of past or existing facts about the target company. The purpose of such representations is to guarantee the accuracy of the information provided by the seller about the target company’s financial and operational status as at the date of closing. The seller’s warranties, on the other hand, are generally forward-looking promises about the performance of the target company, their purpose being to guarantee a certain level of future performance.

Claims for breaches of contractual terms relating to warranties and representations are probably the most common form of post-M&A dispute referred to arbitration. These claims generally arise if, after closing of a transaction, it appears that either a representation or a warranty given by the seller was untrue. In such cases, the buyer will seek to recover monetary damages from the seller for breach of the SPA. The SPA may also expressly provide for some form of post-closing indemnification of the buyer by the seller for losses arising from breaches of representations and warranties. In such cases, the buyer will generally bring a claim under the indemnity provision.

A total cap on liability is a common contractual mechanism that is included in SPAs to reduce the seller’s exposure to post-closing claims for breach of representations and warranties or indemnification. The benefit of a total cap on liability is that it provides the seller with a degree of certainty about its maximum exposure for breach of the warranty and representations clauses. Parties will often agree to place a certain amount in an escrow account and cap liability at the escrow amount. Such an escrow arrangement is beneficial to both parties. For the buyer it removes counterparty risk and provides a guarantee that funds are available. For the seller it removes any concern about being left exposed to future unknown costs.

Another purpose of including a total cap on liability is that it makes W&I insurance cheaper and easier to obtain. W&I insurance covers warranties and indemnities given in the sale of a business. Such insurance is attractive to a seller because it permits the seller to externalise the risk associated with giving representations and warranties by shifting the burden of a breach to insurers. It is also attractive to a buyer as it guarantees that warranties have real value and eliminates any risk that the seller is unable to pay a warranty claim that arises in future.

With benefits to both parties, it is unsurprising that this form of insurance is increasingly popular in cross-border M&A deals. While there have only been a handful of reported M&A disputes involving W&I insurers, this form of insurance is becoming widespread and the number of claims arising under W&I policies is growing. AIG’s report found that the size and number of claims raised under W&I policies has increased significantly in recent years, with the 2020 data indicating that 21 percent of deals valued at over $100m resulted in a W&I reported claim. The AIG report also found that the most common representations and warranties claims concern financial statement breaches, material contract warranties and compliance with laws.

There are a number of warranties and representations found in SPAs that are likely to be impacted by COVID-19. The disruption to business operations caused by COVID-19 will have an effect, in particular, on representations and warranties regarding business operations and continuity, such as the status of commercial relationships, material contracts, counterparty risks and third-party debt, including the collectability of receivables. These are the types of clauses that are likely to be the subject of future disputes arising out of the COVID-19 pandemic.

Fraud and pre-contractual failure to disclose

It is also increasingly frequent in post-M&A arbitrations for a buyer to bring a claim for fraud or similar conduct based on the seller’s failure to disclose. Such claims are generally based on the seller intentionally concealing critical information from the buyer during pre-contractual negotiations which, if disclosed, would have had a significant impact on the buyer’s valuation of the target company. Claims based on fraud in the post-M&A context have two distinct advantages over a straightforward claim for damages for breach of contract.

First, a claim for fraud offers a route to disapply any limitation or cap on the seller’s liability for breaches of warranty. In many jurisdictions, including in the UK, a party cannot exclude liability for fraudulent conduct as a matter of public policy. Furthermore, in recognition of the fact that liability for fraud cannot generally be excluded as a matter of law, it is common for clauses in SPAs that cap liability to stipulate that they do not apply where a breach arises from fraud. This means that a successful fraud claim can dramatically increase the monetary damages available to the claimant.

Second, a claim for fraud can offer the buyer a way to exit the transaction or obtain a higher measure of damages. This is because fraud, if established, will generally permit the party that is the victim of the fraud to rescind the sale contract and be restored to their original position. This means that the deal is unwound ab initio and the parties are put back in the position they were in before the purchase was concluded. In practice, this means that the buyer can seek to recover in full the purchase price paid for the target company. In contrast, a claim for breach of warranty will generally only entitle the buyer to claim the difference between the value the buyer would have received if the warranty was true and the value the buyer actually received.

An allegation of fraud is a serious one and there must be the facts and evidence to support it. The key ingredient for fraud in most jurisdictions, including England, is dishonesty. This generally means that the party alleging fraud must prove that the party accused of fraud made a false representation either: (i) knowingly; (ii) without belief in its truth; or (iii) recklessly or carelessly, whether it be true or false. In the M&A context, claims for fraud are most commonly based on the seller’s falsification of financial reporting or the provision of unjustifiable sales forecasts or other performance indicators.

It remains to be seen whether the COVID-19 pandemic will lead to an uptick in post-M&A fraud claims. In less volatile economic circumstances, these type of disputes often do not crystallise. However, as the financial crisis showed, in tough economic times investors are more willing to raise such issues, especially if doing so enables them to exit bad investments.

Other common post-M&A claims

Earn-out or other price-adjustment claims have also become increasingly common in recent years. An earn-out clause defines the purchase price of a target company partially by reference to the company’s future performance. The effect of an earn-out clause is that the ultimate purchase price will depend, at least in part, on the target company’s subsequent performance which is assessed in accordance with specific metrics. The purpose of such a provision is to align the interests of the buyer and seller by ensuring that both parties want the company to be successful post-closing.

The difficulty with earn-out clauses, and the reason they are frequently the subject of post-M&A arbitration, is that the metric for measuring the ‘success’ of the company post-closing is often poorly defined. Common performance metrics that are used in earn-out clauses are a target level of net income, earnings before interest, taxes, depreciation and amortisation (EBITDA) or earnings per share over a specified time period or as of a specified date. These performance metrics can be interpreted differently by the buyer and seller leading to dispute over the application of accounting principles, the correctness of accounts and calculation of relevant periods of assessments. Equally, the seller can often challenge the validity of the acquired company’s performance data provided by the buyer or may accuse the buyer of manipulating results.

It is not difficult to see why the COVID-19 crisis is likely to lead to disputes about whether earn-out thresholds or targets have been met. The market volatility and disruption to earnings due to COVID-19 will accentuate differences between the seller and buyer’s post-closing earn-out calculations which will, in turn, widen the gap in valuation of the target business between the buyer and seller, making a dispute more likely.

In summary, looking forward, the economic hardship and uncertainty created by COVID-19 is likely to lead to a significant rise in post-M&A arbitrations as buyers look to exit deals, delay completion or renegotiate the purchase price. Post-M&A disputes are likely to focus, in particular, on breach of warranties regarding the continuity of business operations, the seller’s failure to disclose information and whether earn-out thresholds have been met.

 

Gary Born is chair of the international arbitration group and Matteo Angelini is an associate at Wilmer Cutler Pickering Hale and Dorr LLP. Mr Born can be contacted on +44 (0)20 7872 1000 or by email: gary.born@wilmerhale.com.

© Financier Worldwide

BY

Gary Born and Matteo Angelini

Wilmer Cutler Pickering Hale and Dorr LLP

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