Post-M&A and W&I insurance disputes
May 2021 | TALKINGPOINT | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
May 2021 Issue
FW discusses post-M&A and W&I insurance disputes with Ingo Schleis and Christoph Kaiser at KPMG Germany.
FW: Could you provide an overview of M&A and insurance disputes in the European market? What developments have you seen in this area over the last 12 months or so?
Kaiser: Companies face an increasing amount of complex M&A disputes and warranties and indemnities (W&I) claims. This is no surprise given the complexity of M&A transactions and current market developments. Buyers and sellers often find themselves in dispute over contractual provisions of sale and purchase agreements (SPA), concerning, for example, purchase price adjustments or warranties due to complexities of the deal, differing interpretations of accounting principles and the lack of specific wording around the financial provisions in many SPAs. Additionally, inadequate pre-deal due diligence can often lead to unforeseen obligations or exposures that may not have been contemplated by the parties. This is an extraordinary challenge for all parties involved.
Schleis: M&A disputes and claims are a fact of life in today’s fast-paced and complex business environment. Companies are faced with an increasing number of complex M&A disputes. Large sums, usually in the millions, are regularly at stake in post-M&A disputes and W&I claim discussions. According to market studies and our own observations, between 10 and 20 percent of M&A transactions result in an M&A or W&I claim. After the sale of a company, buyers and sellers often find themselves in discussions on purchase price adjustments with reference to working capital, net debt and earn outs. They may allege breaches of representations and warranties or assert fraud claims. Cross-border disputes can involve complex economic, financial and technical issues, as well as multiple languages, client locations and applicable laws and standards. Parties with an understanding of the issues can make better decisions when responding to disputes.
FW: To what extent has the impact of coronavirus (COVID-19) affected the number and nature of European post-deal disputes?
Kaiser: Seismic events such as coronavirus (COVID-19), and the financial crash of 2008/09, typically arrive suddenly and have a dramatic downward impact on valuations. When these events happen, it is perhaps understandable that expectation and valuation gaps in a transaction are increasing. As a result of the pandemic, buyers now find themselves under even more pressure to reflect the impact of pre and post-completion disruption of the business in the final purchase price. Therefore, we expect an increase in the number of M&A disputes caused by COVID-19 and we already observe this development in our business practice.
Schleis: The speed and breadth of the unfolding COVID-19 crisis is putting nearly every facet of business to the test. In many cases, the impact of COVID-19 is likely to lead to disillusionment after the signing of an M&A transaction. The specific expectations regarding the performance of the target will likely be missed. This means that buyers are increasingly looking for ways to subsequently reduce the purchase price and generate urgently needed liquidity. In addition, economic downturns generally lead to more disputes. This is a key observation of economic downturns in the past and also applies to the COVID-19 downturn. Parties in a transaction are under pressure to maximise deal value.
“Issues relating to financials are the key drivers of M&A disputes and W&I claim notifications.”
FW: Based on your experience, what are some of the common M&A claims that lead to post-M&A disputes? Are you seeing certain types of disputes more than others?
Schleis: The best way to understand problematic M&A areas is to understand what issues are typically disputed between buyer and seller. Issues relating to financials are the key drivers of M&A disputes and W&I claim notifications. This comes as no surprise as financial data is of utmost importance in valuing a target company and is therefore reflected in contractual representations, warranty and indemnity provisions. More than 50 percent of all M&A agreements include purchase price adjustments, such as working capital and net debt adjustments or earn outs, determining the final purchase price of a company post-closing. A conflict often arises due to differing interpretations of the contractual basis of preparation and the relevant accounting principles to be applied. Specific language setting out the methodology to be applied when calculating purchase price adjustments post-closing is helpful to avoid M&A disputes. However, one should be aware that accounting principles are not only complex but also contain judgemental elements subject to interpretation.
Kaiser: No two purchase price disputes are the same. However, many share common underlying issues and themes. Disputes regularly arise when the buyer receives the post-closing adjustment calculation and asserts that the seller has overstated assets or undisclosed liabilities. Common examples of this are the understatement of accruals and provisions, the impairment of inventories and trade receivables and cut-off issues in general. The application of generally accepted accounting principles (GAAP) versus consistency with past practice is another recurring issue in purchase price disputes. The parties disagree about whether GAAP or consistency should be the overriding principle for the post-closing adjustment. Breaches of warranties and indemnifications are further key drivers of post-M&A disputes and W&I claim notifications. Breaches concern mainly financial statements, tax issues, compliance with laws, employee-related aspects and intellectual property.
FW: What options are generally available to parties seeking to resolve a post-M&A dispute in Europe? What considerations need to be made throughout the process?
Schleis: When M&A claims arise, it is important to gather the relevant facts, isolate and understand the key commercial and financial issues and identify the economic implications as soon as possible. M&A claims can involve complex economic, financial and technical issues, as well as multiple languages, client locations, applicable laws and accounting standards. The documentation and enforcement of claims is very challenging. During the entire process it is essential that the lines of argumentation presented in reports and statements issued to the other party, the independent expert or the arbitration court are clearly comprehensible for a third party. A party should only submit comprehensively and professionally prepared documentation and reports, which convincingly supports and substantiates its own position entirely. Support from dedicated experts who regularly deal with such M&A claims is essential. Experts have extensive experience of presenting evidence based on thorough research and responding to challenging enquiries.
Kaiser: As a first step when a post-M&A dispute arises, parties always have the option to engage in good faith negotiations. Fortunately, many M&A disputes can be resolved in this way, which is a good outcome considering that any further dispute resolution step is time consuming and expensive. During good faith negotiations the party facing the claim might request further information, evidence or clarification from the other party. Both parties and experts involved may discuss facts and circumstances of the claims which, especially in complex cases, requires external experts. If no settlement can be reached, the parties must agree on an independent expert to resolve the purchase price-related dispute. The independent expert must combine accounting expertise, deep knowledge of M&A transactions and an understanding of legal issues in an SPA. In contrast, a dispute involving warranty claims is typically resolved in arbitration.
FW: How would you describe the appetite to include warranty and indemnity (W&I) insurance in European M&A deals? How have awareness and demand for W&I evolved in recent years?
Kaiser: The use of W&I insurance policies increased significantly from 10 percent in 2010 to 19 percent of all M&A transactions in 2019. Based on our experience, this trend continues. Dealmakers appreciate the benefits of W&I insurance policies. So-called ‘buy-side policies’ provide protection against damages from warranty breaches or indemnity claims directly to the buyer. This type of policy has achieved a market share of more than 90 percent. Obviously, a buy-side W&I policy protects buyers against breaches of warranty or indemnity claims and ensures a solvent debtor in the event of damages. But sellers also benefit from the fact that the risk of a breach of contract is covered and transferred to the insurer. In this way, sellers can fully protect themselves and use the final proceeds from the transaction much earlier for new investment or return funds to investors much sooner. The need for an escrow may become obsolete.
Schleis: W&I policies ensure a prompt, clean and final deal exit, which is a vast advantage in many cases, such as the exit of a private equity company or a sale out of insolvency. W&I insurance is especially used for bigger deal sizes. Half of deals in excess of $100m include a W&I insurance policy. The growing popularity is also a result of declining insurance premiums. In Europe, they are now around 1 percent of the risk to be insured, or even lower. At the same time, insurable amounts have risen, with cover exceeding € 500m now available. Therefore, policy premiums and retention levels remain very competitive. Another driver of the growing interest in W&I policies is the fact that insurance companies have hired employees with excellent M&A expertise, who are able to provide tailor-made products even within the typically tight time frame of an M&A transaction.
“We expect an increasing number of post-M&A claims overall. This will be a direct consequence of the economic downturn caused by the pandemic.”
FW: How would you describe the W&I claims process in Europe? Are there any particular aspects worth highlighting?
Schleis: The analysis of the legal and economic basis for claims and the subsequent damage assessment are anything but trivial. M&A SPAs are individually negotiated, with many different factors and aspects coming into play in the challenging situation of a claim notification that need to be considered against the background of the terms of a W&I policy. Support from dedicated experts who regularly deal with M&A claims is essential in successfully handling W&I claims. It is critical that these experts can provide extensive experience of presenting well-researched evidence and responding to challenging enquiries. A realistic view of the reasonable settlement range allows both sides to negotiate from an informed position and to settle the claim efficiently. At the same time, this forms the basis for developing trust and a long-term business relationship.
Kaiser: Many of the recommendations for handling M&A disputes can also be applied in W&I insurance claims. For the assertion of claims, it is key to undertake a systematic and in-depth analysis of potential claims, including all related information, documents, financial data, relevant accounting standard, SPA provisions and the terms of the W&I policy. Lines of argumentation presented in professionally prepared reports and statements must be easily comprehensible by a third party. Support from dedicated experts is essential in successfully handling W&I claims. The insurer’s coverage decision must be based on the facts and circumstances presented. The insurer is therefore obliged to reject inadequately argued or insufficiently documented claims, which is a bad outcome for all parties involved.
FW: Looking ahead, what is the outlook for post-M&A disputes over the coming months? What trends do you expect to unfold with regard to W&I claims?
Kaiser: We expect an increasing number of post-M&A claims overall. This will be a direct consequence of the economic downturn caused by the pandemic. Before the pandemic, post-M&A disputes was already an increasing trend, observed in 10 to 15 percent of all transactions. We expect this trend to intensify as a result of the pandemic. We already observe this in the rising demand for M&A dispute services.
Schleis: The global challenge of COVID-19 and high market prices are putting companies under increasing pressure to actively assess purchase price clauses, representations and warranties to maximise deal value. Overall, on both current and future deals, we anticipate that the M&A agreement is going to become increasingly important for both buyers and sellers in trying to protect deal value. W&I claims will continue to rise, given how popular the W&I product is in the current M&A market. Studies and our own observations indicate that between 10 and 20 percent of M&A transactions with a W&I insurance policy result in a W&I claim. The boom in popularity of W&I insurance on deals will inevitably lead to an increasing frequency of W&I claims merely through the increased number of W&I policies.
Ingo Schleis is a German public accountant, German tax adviser and director and leads KPMG Germany’s M&A dispute service solution. With more than 15 years of experience, he has advised numerous clients on more than 100 M&A claim projects with dispute volumes from €400,000 to several billion. He combines accounting, financial, SPA and legal expertise. He can be contacted on +49 (69) 9587 2509 or by email: ingoschleis@kpmg.com.
Christoph Kaiser is a German public accountant, German tax adviser and a partner and leads KPMG transaction services in Germany and in the EMA region, as well as being a sponsor of the deal analytics team. He has advised many international and national companies on M&A transactions, IPOs and refinancings. He also has extensive experience in transactions, auditing and corporate finance. He can be contacted on +49 (89) 9282 1432 or by email: ckaiser@kpmg.com.
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