The purchase of reps and warranties insurance is an increasingly common part of mergers and acquisitions transactions. However, a frequently recurring question with respect to this type of insurance is how it 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.
By way of background, 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.
As discussed in a prior post (here), the acquisition price in many M&A transactions are based on multiples of items in the target company’s financial statement. A misrepresentation regarding the financial statement items could result in a faulty transaction valuation – and for the buyer, the misrepresentation could mean overpayment for the acquisition.
According to a July 25, 2014 memo from the Kirkland & Ellis law firm (here) , a “long-standing concern” of dealmakers considering buying reps and warranties insurance is “whether these policies will in fact pay out in the event of claims, and more specifically, whether in appropriate circumstances the policies will pay out on a ‘multiple,’ ‘diminution in value,’ or similar basis.” (In my prior post to which I linked above, I described a settlement last year in which the reps and warranties insurer agreed to a payout based on a calculation that largely reflected a multiple-based calculation of damages for a breach of a financial statement representation that had affected the deal valuation.)
The law firm memo discusses a recent decision in the High Court, Queen’s Bench Division, in England, which the memo describes as the “first publicly available evidence that a properly drafted M&A insurance policy can protect a buyer from diminution in value of the target where inaccurate facts, that the seller had warranted, were used in the buyer’s financial model to determine price.” The July 4, 2014 decision in the Ageas v. Kwik-Fix case to which the law firm memo refers is summarized here. A copy of the court’s opinion can be found here.
The case arose out of Ageas’s acquisition of Kwik-Fix, in connection with which Ageas purchased a buyer’s side warranty and indemnity insurance policy. The parties agreed that subsequent to the merger transaction the seller had breached the financial statement representations and warranties with respect to bad debt reserves on its balance sheet. The insurer conceded that its policy covered the difference between the actual purchase price and the price the buyer would have paid had the correct bad debt reserve information been reported on the target’s balance sheet and used in the discounted cash flow analysis on which the deal price had been based. Ageas and the insurer agreed that the attachment point of the policy – the seller’s £5 million indemnification cap – had been exceeded. However, Aeges and the insurer disagreed with assumptions to be used in the cash flow analysis to determine the corrected valuation and sale price.
According to the case summary, the buyer contended that proper value of the warranty claim was £17.635 million, supporting a claim under the policy of £12.635. The insurer contended that the proper value of the warranty claim was £8.792 million, supporting a warranty claim under the policy of £3.792. The insurer argued that the methodology the buyer urged the court to adopt would have resulted in a “windfall” to the buyer. However, the court stated that the insurer has “simply not shown that the conventional prospective approach of assessment at the breach date offends the compensatory principle or results in a windfall to Ageas,” The Court held that the buyer’s claim against the insurer was “entitled to succeed in the principal sum of £12.63 million.”
The law firm memo says about this ruling that it is “further evidence that damages based on an EBITDA-multiple or other diminution in value – under a carefully crafted and marginally more expensive insurance policy and the appropriate circumstances – are available to compensate a buyer for a loss caused by the seller’s breach of representations and warranties.”
With respect to its reference to the marginal additional expense, the law firm memo notes that “some underwriters — for a higher premium than charged for off-the-rack policies – will not exclude certain types of damages such as consequential, special or multiple damages, which are regularly excluded a seller-friendly purchase agreement with traditional indemnity provisions. “
One other interesting comment in the law firm memo is its statement, with respect to dealmakers’ increasing acceptance of reps and warranties insurance, that there are “some auction processes where the failure to largely replace the traditional survival/indemnity/escrow package with a policy …can place a bidder at a significant disadvantage.”
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.
Thinking About K&R: While I am on the topic of insurance coverage ancillary to D&O insurance, I thought it might be worth calling readers’ attention to the front page article that appeared in today’s New York Times entitled “Paying Ransoms, Europe Bankrolls Qaeda Terror” (here). The article describes an all-too-well established pattern that has emerged in which terrorists affiliated with the Al Qaeda network are now routinely taking Europeans hostage for ransom – as a means of fundraising for the group’s terrorist activities.
According to the article, “Al Qaeda and its direct affiliates have taken in at least $125 million in revenue from kidnappings since 2008, of which $66 million was paid just last year.” The United States Treasury Department has cited ransom amounts that, taken together, put the total at around $165 million over the same period. The article states further that “counterterrorism officials now believe the group finances the bulk of its recruitment, training and arms purchases from ransoms paid to free Europeans.”
The article reports that these ransom payments largely were made by European governments. The story is a harsh reminder that it is a dangerous world out there. And a reminder that kidnap and ransom (K&R) insurance potentially could be an extremely important part of the insurance program for companies whose operatives travel in and near the danger zones.