In recent years an increasing number of post-merger and acquisition disputes have been triggered by the financial performance of target companies performing below buyers' expectations. In these situations, representations and warranties may not justify a cause of action or may include caps prohibiting a claim that would cover the economic loss.

Therefore, buyers try to establish a pre-contractual liability (culpa in contrahendo) based on willful deceit aiming for voidance of the Share Purchase Agreement (SPA). If successful, this enables a "re-negotiation" of the purchase price outside the limitations of liability otherwise imposed on them through the SPA.

In this issue of Raising the Bar, Alexander Demuth explores how buyers can assess potential misrepresentations and, more importantly, how to prove it.

The Action
According to the German Federal Supreme Court (Bundesgerichtshof), the seller in an M&A transaction is required to comply with heightened disclosure duties. The Supreme Court reasons this requirement based on information asymmetry and the potential for significant economical impact on the buyer. These heightened requirements call for the unrequested disclosure of any information that could potentially influence the buyer's decision to either pursue the transaction or materially adjust the purchase price offered. Examples of this information include the insolvency of the target company, important information on key employees (such as their termination or legal actions against them) and the target's sales or earnings potential. The latter typically involves disclosure of incorrect, incomplete or misleading (financial) information.

For a successful case, a liability towards the buyer needs to be established. This requires proof of deliberate deceit or at least negligence in the preparation or disclosure of financial information. As with the business judgment rule, hindsight bias needs to be avoided and the situation at the time the information was prepared or disclosed has to be reconstructed.

The Analysis
In order to support a liability case regarding the target company's sales or earnings potential, it must be established that the financial information was objectively wrong at the time of its preparation or disclosure. Therefore, the target's financial performance needs to be reviewed and analyzed in comparison to historic performance and the financial information introduced into the negotiations by the seller -- especially the business plan or other prospective financial data. The analysis ultimately aims to determine whether deviations from the business plan were known to or could be expected by the seller. In addition to financial analyses, forensic investigations and the use of forensic technology may be required to demonstrate and prove seller's awareness of any 

incorrect, incomplete or misleading information provided to the buyer.

The Review
The Financial Performance Review involves an understanding of (1) the historic financial performance of the target prior to the sale, (2) the business plan and (3) the deviations of actual results to the business plan.

The analysis of historic financial performance aims to identify all relevant sales and cost drivers and their impact on the target's profitability. Generally, this analysis should include three to five years of historic data based on monthly reporting, and should:

• Identify the most important products or product groups, including a review of:
  o Market and market trends
  o Pricing and price development
  o Margins (most likely gross margin) and margin trend
• Highlight the most important cost drivers:
  o Analyze cost components and their development over time
  o Find drivers for each cost component (e.g., headcount and salary increases for personnel expenses)
  o Segregate fixed and variable costs
• Present financial and, potentially, statistical analysis (e.g., regression analysis) of specific costs and their interaction with sales volume

The analysis of the business plan aims to confirm whether all information available at the time of its preparation has been considered and should, therefore, encompass:

• All assumptions utilized in the preparation of the business plan, including their sources and origin
• Any relevant market studies or research reports
• A comparison of the business plan with historic financial performance, especially focusing on the sales and cost drivers previously identified

The assessment of whether the business plan considered all relevant information available at the time of its preparation involves sound business judgment, as well as industry knowledge and insights.

The analysis of actual financial information or current trading aims to identify deviations from the business plan and to understand their rationale. Therefore, general and high-level deviations (e.g., sales or profitability) need to be broken down into their components to enable a comparison to the business plan assumptions and the historic financial performance. Each component's deviation will then have to be analyzed to conclude whether unpredictable changes in the economic environment have occurred or if the business plan has been prepared based on unreasonable assumption despite better knowledge.

This analysis may also include a review of prior years' budget-to-actual comparisons to assess the reliability of past business plans and to enable the consideration of historic reasons for deviations from budget to actual.

The Financial Performance Review will result in an assessment of whether the financial information provided by the seller was objectively wrong at the time of its preparation or disclosure and whether this should have been known to the seller.

Forensic Investigations
If the Financial Performance Analysis concludes that the business plan did not consider all relevant information available or information that could reasonably be expected to be available at the time of the preparation, further investigation is required to assess whether information was deliberately withheld and forensic techniques may be required as proof. Typically, this involves interviews and reviews of documents and electronic data to establish that information was available but neglected. The documents to be reviewed typically include:

• The target's weekly, monthly or quarterly management reporting, including deviation analysis
• Protocols of shareholder and management meetings
• Legal files (especially related to customers and suppliers) and communication (e.g. e-mails, text messages) of:
  o All people involved in the preparation of the business plan (e.g., controlling, sales department and human resources)
  o The target's management team
  o The seller's management team responsible for oversight of the target or representatives during the sale

The period in which such data should be reviewed commences with the preparation of the business plan and continues until closing, since (in accordance with the German Federal Supreme Court) material changes in the economic environment or of the target's performance prior to closing would require disclosure. It might, therefore, be helpful to understand the budgeting cycle of the target and refer to any group instructions, if available.

Summary
When investments fail, the tendency to sue the seller is always heightened. However, buyers need to bear in mind that their action can only be successful if a thorough analysis can, without any hindsight bias, establish whether the financial information was objectively wrong at the time of their disclosure or even their preparation to at least support negligence. Since intent can typically not be established based on financial data alone, as it requires proof of knowledge and ignorance of relevant facts, the use of forensic techniques may be required. It is our experience that these thorough analyses stand up against scrutiny and have always improved the buyer's position in either litigation or out-of-court settlements.