Protecting buyers’ value in M&A: Part 1- Warranty claims
The purpose is to provide the buyer with a mechanism for retrospective price adjustment if any of the warranties are untrue (provided the seller has not fairly detailed in the disclosure letter why the warranty is untrue, thereby bringing the matter to the buyer’s attention). If, following completion, the buyer discovers that a warranty was untrue, it has the right to bring a claim against the seller for breach of that warranty (subject to any restrictions or limitations on bringing claims in the share purchase agreement, which we'll ignore for the purposes of this article). What can often come as a surprise to buyers in these circumstances, is how the value of a warranty claim is quantified.
What are the basic principles?
The basic premise is that the damages for a breach of warranty should compensate the claimant such that it is put in the position it would have been in had the information warranted been true. In M&A, this means that in the case of warranties given by a seller to a buyer, the damages are calculated by reference to the difference in the market value of the target at the time of completion had the warranties been true (the market value of the target "as warranted") and the true value of the target given the actual position (the value of the target "as is"). The purpose of the damages awarded is not to reimburse the buyer for the financial loss suffered. This means that there is often a difference between the cost to a buyer of remedying a breach of warranty and the value of the claim against the seller.
What was market value of the target presuming the warranties were true?
When assessing the market value of the target on the basis that the warranties were true, the starting point is generally that the price the buyer paid reflected this market value. It is however, open to a seller to argue that the market value was lower than the price paid and for the buyer to argue that it was higher.
What was actual value of the target?
When assessing the actual value, again this is something that the buyer and seller will need to make representations to the court to establish (likely involving expert evidence). A starting point is often to look back at the valuation methodology used as part of the transaction process to value the target (whether an EBITDA multiple or otherwise). It will however always be open to the court to decide that a different methodology for valuing the target is appropriate.
Let's look at an example where a buyer (Buyer) agreed to pay £20m to the seller (Seller) for the entire share capital of the target (Target). Amongst other things, Seller warranted to Buyer that it wasn't aware of the Target having supplied any products to its customers that were faulty, defective or didn't comply with any warranty made in connection with their sale. Following completion, customers of Target begin returning faulty products and Target has to issue refunds of £1m. Buyer learns that Seller knew of the existence of an issue with a particular product run prior to completion, giving Buyer a right to sue Seller for breach of warranty.
So, to quantify the claim, we need to:
- assess the market value of Target at completion on the basis that the warranties were true (Warranted Market Value); and
- assess the actual value of Target at completion (Actual Market Value).
Let’s assume that the £20m paid by the Buyer did reflect the Warranted Market Value. In the above circumstances, many buyers will see their loss as £1m and expect to be able to recover this from the seller. In reality however, whilst the breach has cost Target / Buyer £1m to remedy, it is unlikely that the value of Target was £1m less by virtue of an issue with a single product run. The Actual Market Value of Target might only have been say £350,000 less by virtue of the issue with the product run and so this would be the value of Buyer’s warranty claim, leaving it £650,000 out of pocket.
What can buyers do to better protect themselves?
The above example highlights why detailed warranties don't negate the need for a detailed due diligence exercise. Where a buyer identifies areas of specific risk during due diligence, it can seek specific indemnities from the seller in the share purchase agreement. Indemnities, unlike warranties, provide for £ for £ reimbursement for a buyer. If in the above example Buyer had examined samples from Target's recent product runs and identified an issue it could have sought a specific indemnity in respect of customer returns of products manufactured in the defective run and recovered the full £1m the issue cost Target.