After the sale of a business, a variety of disputes may arise between the buyer and the seller. In prior editions of Raising the Bar, we described common disputes that arise involving post-closing working capital adjustments and involving earnout payments. Those cases typically focus on accounting calculations, where the parties involved often use an accounting expert to arbitrate the disputes.

In this issue, we focus on indemnification claims involving representations and warranties within a purchase agreement. Unlike working capital and earnout disputes, representation and warranty claims are often adjudicated in court or by lawyers serving as arbitrators, rather than by accountants. Moreover, these indemnification claims may relate to many issues other than accounting calculations upon which working capital and earnout payments are often rooted.

Representations and Warranties Within Purchase Agreements

A buyer and seller typically provide certain representations and warranties within a business acquisition contract in M&A transactions. Some of these representations and warranties may be fundamental to any potential deal. For example, the buyer may represent and warrant that it has the authority to execute the agreement and has financing available to close the deal. The seller may represent and warrant that it owns the target company and has the authority to sell it. 

Beyond such fundamental elements, the seller often makes more extensive representations and warranties regarding specific elements associated with the target company. These may include representations and warranties, such as:

· The company’s financial statements were prepared in accordance with GAAP.

· The company has no undisclosed liabilities.

· The company’s receivables are collectible, and its inventory is saleable.

· The company has paid all taxes owed for historical periods.

· The company is not in violation of any law, including any environmental and employment laws.

· The company has identified all its significant contracts, real property and intellectual property in a disclosure schedule.

As shown by these examples, while some representations and warranties may not be directly premised on financial issues (e.g., compliance with environmental regulations), others expressly relate to accounting issues (e.g., compliance with GAAP). In addition to M&A counsel, buyers and sellers may engage experts (e.g., CPAs, environmental experts, investment bankers) to assist them in drafting the representations and warranties contained in the purchase agreement unique to the company’s circumstances. Carefully written representations and warranties (and associated disclosures) can provide the buyer with critical information regarding the business. The parties often specify that they are making no representations or warranties regarding the transaction other than those expressly written in the purchase agreement.

Representations and Warranties Disputes – Breaches and Losses

Typically, in evaluating representation and warranty disputes under a purchase agreement, one must address two questions to assess a claim.[1]

· First, did either party breach a warranty within the agreement by making an inaccurate representation? 

· Second, what amount (if any) is the opposing party entitled to recover as a result of any such breach? 

With respect to the first question, each party should carefully analyze the specific representations and warranties within purchase agreement. For example, the seller may have represented and warranted that the company’s financial statements were in accordance with GAAP “in all material aspects.” After the closing, the buyer may identify errors in the company’s historical financial statements that it believes are material but that the seller asserts are immaterial. Other sections within the purchase agreement may explain how such materiality phrasing (e.g., a “materiality scrape provision”) is to be interpreted. Further, interpretation of any contract is subject to the law governing that contract.[2] Experienced M&A counsel or dispute advisors may be aware of precedent cases in which courts of the relevant jurisdiction have addressed similar contractual language.

With respect to the second question (i.e., the amount that can be recovered), the parties should analyze what remedies the purchase agreement provides in the event of a breach.  Often, a purchase agreement will identify an indemnification mechanism (discussed in the following section) to permit a party to recover losses that it suffered as a result of such a breach. Each party may require an expert who specializes in post-acquisition disputes to quantify any such losses. For example, if a party determines a breach of contract occurred because the company’s historical financial statements were not prepared in accordance with GAAP, the party may require an accounting and M&A dispute expert to quantify both (i) the misstatement from an accounting perspective and (ii) how that misstatement likely affected the purchase price negotiated between the buyer and the seller. Again, the quantification of such losses may be impacted by the law governing the transaction, and a party’s counsel should provide guidance regarding such law.

Typical Indemnification Mechanisms

As noted above, a purchase agreement often identifies the indemnification mechanism available for a party to recover from a breach of contract resulting from an inaccurate representation. These purchase agreements typically will specify which indemnification procedure is the exclusive remedy available to the parties for such a breach.

Some purchase agreements severely restrict a party’s ability to bring representation and warranty claims (e.g., terminating all the representations and warranties on the closing date).  Alternatively, a purchase agreement may specify a period of time (e.g., 24 months after the closing date) in which a party may assert an indemnification claim. The purchase agreement may cap the amount that can be recovered through such a claim and may specify that an amount must be paid at closing into an escrow account until the expiration of the period to bring a claim. In addition to a cap limiting the maximum claim, the purchase agreement may include a minimum deductible that a party must incur before it is permitted to assert an indemnification claim. Moreover, the purchase agreement may provide specific rules as to what amounts may be recovered through an indemnification claim. For example, the purchase agreement may specifically permit or prohibit:

1. the recovery of attorney fees,
2. the use of a multiple to calculate damages,
3. claims for punitive damages, or
4. the recovery of amounts already included in working capital.

The purchase agreement may also prohibit a party from asserting a breach claim, if that party was aware of the alleged breach prior to executing the agreement (referred to as an “anti-sandbagging provision”). The law governing the transaction may similarly prohibit such claims if the agreement is silent with respect to “sandbagging.” 

Finally, although the purchase agreement may limit the buyer’s ability to recover from the seller for representation and warranty disputes, it may expressly contemplate that the buyer shall purchase a representation and warranty insurance policy (i.e. R&W insurance). In such instances, the buyer then will be required to raise a claim with the representation and warranty insurance provider to seek recovery from the alleged breach.[3]

Conclusion

Any buyer and seller should take caution in drafting the representations and warranties included within a purchase agreement to ensure they are accurate and correspond to the parties’ intentions.  Moreover, the parties should specify how any disputes regarding those representations and warranties will be resolved. 

Buyers and sellers routinely only engage experts after the closing of a transaction and subsequent to the rise of a representation and warranty dispute. Retaining experts prior to executing a purchase agreement may help a party clarify the representations and warranties within the purchase agreement. Once a dispute arises, a party should work with its counsel and experts to evaluate the claim, understand the legal remedies available to it and the opposing party, as well as  navigate the dispute resolution process.