Fraud risks in M&A transactions

December 2024 | SPOTLIGHT | MERGERS & ACQUISITIONS

Financier Worldwide Magazine

December 2024 Issue

Treatment of fraud is increasingly a heavily negotiated point in M&A transactions – and rightly so, given the increasing reports of investments and transactions going bad because of fraud.

M&A transaction documents often include fraud carve outs, which are provisions that exclude fraud from limitations typically placed on representations, warranties and indemnification obligations. These carve outs ensure that even if caps or time limits restrict the seller’s liabilities, fraud claims can still be pursued.

There is also well-settled jurisprudence in some common law countries, such as India, that says fraud vitiates the contract (including limitation of liability) and provides the victim grounds to claw back the entire transaction cost and, in addition, claim damages.

Over the years, frequent litigation over fraud claims in M&A transactions has led many practitioners to take a non-boilerplate approach to clauses relating to fraud. There are two interesting approaches possible here.

The first is to define fraud explicitly within acquisition agreements. This approach helps both buyers and sellers establish a shared understanding of what constitutes fraud, thereby minimising ambiguities that could lead to disputes. Key considerations in these negotiations include determining what actions or omissions qualify as fraud – such as whether recklessness is included – and clarifying the scope of statements that can be challenged, ranging from formal representations to informal disclosures made during the transaction process.

The second is to have a broad understanding of the consequences if a party commits fraud without defining fraud, as most countries have well-settled principles of what constitutes fraud. This approach has the advantage of not limiting or extending the definition of fraud to what is allowed under law.

In both cases, however, the degree and burden of proof required to prove fraud is very high in most jurisdictions. Therefore, the evidence required to build a case of fraud is often more challenging than it sounds when drafting the transaction documents.

Getting the basics right: avoiding ‘tick box’ due diligence

Due diligence is supposed to detect non-compliance, material deviations and even fraud before a transaction is completed. However, most often this is reduced to a paper exercise which depends on the information disclosed by the relevant party. While in some cases tick box diligence may suffice, in most cases the process should be used to get an in-depth picture of the company’s compliance, conduct and governance.

In high-risk industries, such as those with complex operations or volatile sectors with disparate revenue streams and varying asset classes, the due diligence process should be even more intelligent where the diligence teams are working together, sharing information and drawing conclusions based on red and amber flags, leading to further forensic examination of red flags if required. Parties should have the time, investment ability and more importantly the corporate will to make the diligence meaningful.

Post-closing fraud risks and remedies

Even the most meaningful diligence can miss fraudulent activities. In many cases, it is only post-closing that the buyer is able to get control of the underlying financials, undisclosed arrangements (if any) and, most importantly, people involved in such activities.

Buyers should conduct post-closing audits or reviews to detect such fraudulent activity early. These audits often focus on verifying the accuracy of financial statements by reviewing the underlying financials, assessing the legitimacy of business contracts, and assessing the value of disclosed and undisclosed assets and liabilities.

Transaction structuring

In addition to diligence (post and pre-closing), escrows, hold backs, deferred consideration, and good leaver and bad leaver consequences are all partial risk mitigation measures available to the buyer. These may not make the buyer’s loss whole but may partially be able to mitigate monetary losses and inform the behaviour of both parties.

Reading governance warning signs

Buyers often rely heavily on paperwork such as diligence and transaction structure at the risk of not paying sufficient attention to or willingly ignoring corporate misbehaviour.

In many cases when lawyers and management do a post mortem assessment of the events that led to the fraud, there are early signs of management behaviour which should have been picked up by the buyer’s transaction team.

Lack of governance standards, conflicted relationships, concentrated decision making, weak middle management, repeated whistleblower complaints and a history of non-compliance indicate that diligence should be escalated to the governance level. Empowered non-conflicted decision makers should take a serious look at the transaction.

When it all breaks open

When fraud is discovered post-closing, buyers have to first contain the fallout on business, deal with regulatory action (if any), preserve value in the business and its reputation, and then think of possible legal remedies.

These remedies can vary depending on the jurisdiction and the specifics of the acquisition agreement. Some buyers may seek to rescind the contract, essentially undoing the transaction and recovering their investment. Others may pursue damages to compensate for the loss caused by the fraudulent misrepresentation (of warranties), while not rescinding the transaction.

Proving fraud in such cases requires demonstrating that the seller knowingly made false representations with the intent to deceive, which can be a complex evidentiary process. In cases where management is not under the control of the buyer, access to records and people to collect this evidence becomes crucial and can make or break the case.

Loyalties and complicity often lead to investigations hitting a wall, with data becoming unavailable and employees closing ranks. Effective audit clauses and board control when fraud is alleged are critical to replacing existing management and bringing in investigators to access data.

Buyers often prefer to claim fraud rather than a breach of warranty for two primary reasons, as outlined below.

First, fraudulent misrepresentation offers remedies such as rescission of the contract (complete reversal of the deal) and tortious damages, which are not subject to limits based on the remoteness of the loss. In contrast, breach of contract typically only allows for contractual damages, limited by the remoteness of the harm.

Second, sellers cannot exclude or limit liability for fraud through exclusion or limitation clauses under Indian law. Any attempts to do so are legally ineffective, as the principle that ‘fraud unravels everything’ applies. However, the legal treatment of fraud varies across jurisdictions. Some legal systems permit non-reliance clauses that may limit liability for fraud, provided they are drafted with sufficient specificity, though case law on this issue remains fluid and fact-specific in many regions.

Recovery

Getting a successful award against a fraudulent party is not the end of the story in most cases. Recovering from the judgment debtor is often very convoluted, not just in terms of enforcement action but also because most smart fraudsters have thought this through and have dissipated their assets in locations or with individuals where recourse is difficult, if not impossible.

For this reason, a freezing order against the assets of the fraudulent party early on is advisable. However, this is more difficult to obtain in practice, with courts and tribunals being very conservative (and rightly so) about awarding a tough interim order.

Conclusion

Sophisticated frauds have a way of getting around the best diligence, which by nature is limited in what it can achieve. This means there is no foolproof, single method of avoiding frauds in transactions.

That said, a combination of meaningful diligence, smart transaction structuring, a sensitive approach to behavioural red flags and tough decision making will go a long way to mitigate the chances of fraud.

When buyers are faced with value destruction resulting from fraud, it is a hard truth that they will probably not be able to recover the entire loss via legal remedies, especially in jurisdictions such as India where courts have traditionally been circumspect with respect to computation of losses.

However, we have recently seen jurisprudence develop in a number of cases where courts have awarded parties that suffered fraud the value of their investment and, in addition, damages based on tort, which opens up the value of loss claimed to far above the value of the investment.

This is an extremely important and interesting development, and necessary for effective recovery.

Prashant Mara is managing partner and Pratik Bakshi is a counsel at BTG Advaya. Mr Mara can be contacted by email: prashant.mara@btgadvaya.com. Mr Bakshi can be contacted by email: pratik.bakshi@btgadvaya.com.

Prashant Mara and Pratik Bakshi

BTG Advaya