The purchase of reps and warranties insurance is an increasingly common element of mergers and acquisitions transactions. But while the uptake of reps and warranties insurance has increased, concerns remain about how a reps and warranties insurance will respond if a claim arises based on an allegation that a seller has breached a financial statement warranty and the buyer is claiming damages because the deal price was based on a multiple of the allegedly misrepresented financial item.
A November 26, 2013 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “Multiple-Based Damage Claims Under Representations & Warranty Insurance” (here), by Jeremy S. Liss, Markus P. Bolsinger and Michael J. Snow of the Kirkland & Ellis law firm, “highlights the possibility for a buyer to recover multiple-based damages under R&W insurance.”
In an M&A transaction, either the buyer or seller can purchase reps and warranties insurance, although typically it is the buyer that purchases the policy. If the buyer purchases the policy, the insurance company agrees to insure the buyer against loss arising from breaches of the representations that the sellers have made in the transaction documents.
The claims under a reps and warranties policy can be complicated enough when there allegedly has been a breach of one of the reps and warranties. The claims can be even further complicated if the allegation is that the seller breached a financial statement warranty, and a multiple of the allegedly misstated financial statement item served as a basis of the deal price.
In the law firm memo, the authors cite an example (apparently based on an actual situation) in which the seller allegedly had breached its financial statements representation leading to an inflated EBITDA figure. Because the purchase price had been based on an EBITDA multiple, the purchase price had been inflated as well. The buyer submitted a claim under its reps & warranties insurance policy, seeking damages based the overpayment it had made due to the purchase price multiple of the misstated EBITDA amount. According to the memo, the buyer and the reps and warranties insurer were able to settle the claim based in part on a multiple of the misstated EBITDA.
The memo’s authors’ example is important because it underscores the value of the reps and warranties insurance. The purchase price in many M&A transactions similarly are based on multiples of financial statement items. This authors’ example shows how the reps and warranties insurance can protect the buyer from loss arising from a financial statement misrepresentation where the purchase price is a multiple of the financial statement item.
The authors point out that the question of whether or not a buyer can recover special damages, indirect damages and damages based on a multiple are often an important part of deal negotiations. Some deals can founder if the deal contract will include categorical damages waives (including multiple-based damages). As the authors note, “buyers often assert that excluding multiple-based damages in a transaction where buyer has priced the target based on an earnings multiple can deprive it of protection against breaches of the representations and warranties most important to pricing decision.”
However, reps and warranties insurance allows a buyer to protect itself against a breach of the “pricing representations” and to be assured that it will receive “appropriate compensation for its purchase price overpayment” This insurance alternative also allows deal negotiations to go forward without difficult discussions with the seller over damages limitations.
The example in the authors’ memo provides an illustration of an important way that the inclusion of reps and warranties can actually facilitate the completion of a deal. The use of deal insurance may help complete a deal that might otherwise have foundered over a seller’s requirement for a damages waiver.
The authors also make another good point about the advantages that reps and warranties insurance affords. That is, because the reps and warranties insurer is a repeat participant in a competitive insurance market, the insurer has “an incentive to act reasonably when responding to a claim.” The insurer “is subject to market pressures that do not similarly influence a one-time seller when facing an indemnification claim under an acquisition agreement.” The insurer’s desire to be able to continue to attract business will want to “enhance its reputation as a reliable counterparty that pays valid claims under its policies.” In other words, the insurer may be subject to influences that the seller would not, which can be critically important if claims based on alleged representations and warranties breaches arise.
In a prior post (here), I reviewed additional reasons that the participants in an M&A transaction may want to consider reps and warranties insurance.
Number of Problem Institutions, Bank Failures Continue to Decline: In its Quarterly Banking Profile for the third quarter of 2013, the FDIC provides information portraying a generally health banking sector. Among other details in the quarterly figures, the FDIC reports that the number of problem institutions continues to decline, while remaining stubbornly high.
The number of banks on the FDIC's "Problem List" declined from 553 to 515 during the quarter. (The agency calls those banks that it rates as a “4” or “5” on a 1-to-5 scale of risk and supervisory concern “problem institutions.”) The number of reporting banks also decreased during the quarter to 6,891, from 6,940 in the previous quarter, meaning the during the third quarter, problem institutions still represented about 7.47 percent of all reporting institutions, down from about 7.96 during the second quarter.
The quarterly decline in the number and percentage of problem institutions during the third quarter represented the tenth consecutive quarterly decline in the number of problem institutions. The number of "problem" banks is down more than 40 percent from the recent high of 888 at the end of the first quarter of 2011. The 888 problem institutions as of March 31, 2011 represented about 11.7% of all the 7574 reporting institutions at that time.
The number of bank failures also continues to decline. During the third quarter there were six banks failures, bringing the 2013 YTD bank failure total (through September 30, 2013) to 23, compared to 50 during the same period in 2012. Since September 30, there has been one additional bank failure. A total of about 532 banks have failed since January 1, 2008.
Russia Clarifies Director Liability Standards: According to a very interesting November 2011 memorandum from the Squire Sanders law firm (here), in August 2013, the Supreme Commercial Court of the Russian Federation issued a detailed Resolution “providing a more coherent roadmap to guiding conduct and pursuing civil relief against officers and directors ho act in violation of their fiduciary duties to the companies they serve.”
According to the memo, Russia has long provided that directors must act “reasonably” and “in the best interests of the company.” However, according to the authors, to date Russia has done a “poor job” enforcing these requirements that otherwise allow normal business efforts to go forward. Instead, the system has favored “an ineffective criminalization of conduct while at the same time failing to provide a workable civil framework to protect investors from self-dealing agents.”
The Resolution clarifies that directors may be held liable to a company for losses incurred as a result of bad faith actions. The Resolution also clarifies that bad faith may be found if a director has acted despite a conflict of interest; concealed information or knowingly provided incorrect information; entered into a transaction without having obtained the requisite approvals; entered a transaction knowing that a counterparty was unable to perform its duties; or knew or should have known that a transaction was unfavorable to the company.
The Resolution also makes it clear that directors may be held liable for “unreasonable actions,” which include failing to perform adequate due diligence and failing to comply with the company’s internal procedures.
A director may be relieved from liability if he or she can show that he or she has not gone beyond ordinary business risk; that an unfavorable transaction was part of series of transactions that were expected to be favorable to the company, or made with the intent to avoid some more adverse consequences; or the losses have been recovered from another source.
The authors conclude the memo with an example of an actual case in which the Moscow Commercial Court awarded damages against a managing director based on losses of 7.5 million rubles ($240,000) that were found to have arisen from the directors’ bad faith conduct (having knowingly entered into an unfavorable transaction and having failed to perform due diligence and without observance of the company’s internal procedures)
My day to day work does not routinely encompass issues involving the liabilities of directors of Russian companies, but it certainly appears that the potential liabilities of directors of Russian companies have changed in a way that could have important implications for the D&O insurance buying patterns of Russian companies. If there are readers out there with additional perspective on these developments, I think we would all welcome your thoughts and comments.
A Break in the Action: With the Thanksgiving holiday upon us, the D&O Diary will be taking a short break. The normal publication schedule will resume next week. Happy Thanksgiving to all.