Are W&I claims a viable option in the current climate? has been saved
Are W&I claims a viable option in the current climate?
This article shares our thoughts on some issues that clients should consider when executing deals to reduce the risk of having to make a claim, and some hints on successfully navigating the W&I claims process, if necessary.
The volume and value of M&A transactions has grown significantly in recent years and as a result, buyers and sellers have shown increasing demand for W&I insurance coverage to protect their deals. This trend has given rise to increased competition in the insurance sector and the need for comprehensive policies, swift claim resolution and competitive pricing arrangements.
The ability to make a W&I claim, be it directly under the Sale and Purchase Agreement (SPA) or under a W&I insurance policy, provides some protection following a transaction, but parties often underestimate the burden of pursuing a successful claim. In the current climate, the number of claims is likely to increase and, with that increase, come a number of challenges.
Read the contract carefully
Most SPAs include a range of warranties made by the sellers. Both parties need to consider very carefully what financial information is being warranted and the level of assurance this provides. In particular, attention should be given to whether the warranties cover the accounts relied upon by the buyer in its due diligence and valuation of the target entity. Buyers should also consider the extent to which their valuation hinges upon forecast earnings which although rarely warranted still play a key part in the pricing process.
In the context of a W&I insurance claim, the Buyer should be aware of any claim limit attached to the insurance taken out and whether the limit is adequate for its needs. In consultation with legal advisors, the parties also need to understand the process for pursuing a W&I insurance claim with the insurer and how to go about recovering any further losses, if the loss suffered is greater than the insured limit.
W&I is not a substitute for due diligence
The main purpose of warranties is to flush out additional information as part of the diligence process. A warranties claim is comparable to a reserve parachute: you would never want to jump without one, but you do not really want to have to use it. Solid warranties are no substitute for thorough due diligence and a careful reading of the disclosure letter. Neither warranties nor indemnities are an effective price adjustment mechanism; they are fall-back positions at best.
Although indemnities are an effective tool for mitigating the risk in any material uncertainties, they are limited to those situations where liabilities or losses are quantifiable and indeed the extent of recovery from an insurer may not necessarily reflect the true loss, for example in terms of brand damage from the loss of a regulatory claim.
Misrepresentation in times of hardship
We typically see a surge in instances of financial misrepresentation during times of economic challenge and uncertainty. In an M&A context, there can be a strong temptation to manipulate financial performance to help boost the value of the target company and/or meet earn out thresholds. Parties should remain vigilant and scrutinise financial information carefully, within the bounds of what is commercially reasonable in the deal process.
In the current economic circumstances, we expect an increase in the gap between expected and actual performance of acquired assets. This inevitably increases the buyer’s feeling of remorse and, in our experience, typically drives an increase in the whole range of mechanisms to adjust deal value after the event.
As a consequence, warranties given in the SPA will be subject to greater scrutiny as parties explore potential options for recovering financial outlays. Material adverse changes/events clauses may also be an avenue for the buyer to withdraw from the acquisition, although some recent cases suggest that alleging departure from the ordinary course of business may also be a possibility.
Challenges of making a W&I claim
Sometimes, no amount of careful due diligence can prevent an issue from arising after the deal. In this case, warranties can be a useful tool to recover some of the lost value.
The losses directly attributable to a warranty breach, in particular, can be difficult to prove. They rely on accurately assessing the difference between the value of the asset as warranted (taking into account the Buyer’s knowledge) and the actual (or true) value of the asset.
Identifying a robust methodology for calculating loss in a breach of warranty context is crucial to a successful W&I claim. Contemporaneous evidence is also of paramount importance in supporting this quantum and demonstrating the misalignment between Buyer’s actual knowledge and the true position. An experienced expert will understand these challenges and assist with presenting this loss calculation in a comprehensive and coherent manner.
We are happy to assist you, either with advice on resolving a contentious matter at an earlier stage, or with navigating the W&I claims process. If we can help, please get in touch.