Didn’t Get What You Paid For? Addressing a Breach of Representations and Warranties: Part 2

Didn’t Get What You Paid For? Addressing a Breach of Representations and Warranties: Part 2

September 01, 2014

Merger and acquisition (“M&A”) transactions involving middle-market companies are often subject to increased risks. In Part 1 of this article in SRR’s Fall 2013 Journal, we defined representations and warranties, and discussed related claims and their potential financial impact. We also provided examples of specific types of financial-based breaches of representations and warranties. In Part 2, we provide examples of non-financial breaches and their potential financial impact on the buyer in addition to other considerations in M&A transactions.

As discussed in Part 1 of this article, the financial statements, underlying records and contractual agreements of middle-market, privately held companies are often subject to less regulatory and/or market scrutiny than those of larger companies.1 This can result in increased risks of post-acquisition disputes in transactions involving middle-market companies, including disputes relating to breaches of representations and warranties.

In Part 2, we will provide examples of non-financial breaches of representations and warranties, defined as statements of fact made to the counterparty in the transaction to allocate risk between the parties, and discuss their potential financial impact on the buyer. We will also briefly cover the role of due diligence and data rooms in these types of disputes, “sandbagging” provisions, the structure of agreements for successful claims, and possible alternative insurance options.

Examples of Potential “Non-Financial” Breaches of Representations & Warranties

We use the term “non-financial” for the representations and warranties described herein as they do not specifically relate to the financial statements or financial condition of the company, such as an undisclosed departure from GAAP, undisclosed contingent liabilities, or financial fraud. However, breaches of “non-financial” representations and warranties can result in economic damages to the buyer.

Labor/Employment Breaches

Representations and warranties relating to labor and employment may include, but are not limited to, the following:

  • Expiring employment agreements and/or union contracts
  • Non-existence of non-competition, non-disclosure, and confidentiality agreements
  • Non-compliance with laws and regulations relating to labor, such as fair employment practices, proper documentation of the right-to-work of the labor force, and compliance with federal and state payroll tax laws
  • Failure to retain seller’s employees post-closing

For example, the authors were engaged as experts on a matter that included labor and employment representations in which the seller represented to the buyer that all employees were properly authorized to work in the United States. Subsequent to the transaction closing, the buyer discovered that a substantial portion of the labor force at one of the acquired facilities was comprised of persons not authorized to work in the United States. As a result, we were retained to investigate the related financial impacts including:

  • Assessing the cost of penalties and fines
  • Assessing the cost to hire and train the replacement
    labor force
  • Quantifying lost profits due to forced shutdowns and/or reductions in production while replacing the unauthorized workforce, including possible permanent loss of customers

Intellectual Property Breaches: Sellers often represent the company’s ownership and/or right to use intellectual property such as patents, copyrights, trade names, and trademarks. The seller may also warrant that there is no known infringement by the company of other’s intellectual property or known infringement by others of the company’s intellectual property. Additional intellectual property representations and warranties may also cover the ownership, right to use and adequate protection of the company’s trade secrets, customer lists, software, and other confidential information and know-how used in the business.

Should the seller be found to have breached a representation relating to the intellectual property rights of the company, it may be liable for damages related to the following:

  • Undisclosed, pre-existing improper activities of the seller, resulting in infringement claims
  • Third-party claims for infringement should the intellectual property rights either not exist or are challengeable as to validity
  • Trade secret violations by current or former employees due to inadequate protection policies
  • Undisclosed issues surrounding ownership and rights to use/licenses, including oral agreements

For instance, we were involved in a matter in which the seller’s employees had conspired with a third-party competitor. Two company employees resigned from the company prior to the close of the transaction and departed with certain trade secrets. Shortly after the deal was closed, a third employee with the capability to utilize the trade secrets also resigned, citing the transaction as the impetus to his resignation. Ultimately, all three became employed by a competitor of the acquired company and used the trade secrets to create a new product line. Our forensic investigation uncovered evidence that the seller was aware of the conspiracy and actually received an ownership stake in the competing business, which significantly enhanced the buyer’s breach of representations and warranties claims. We also quantified damages related to the trade secrets theft.

Real and Personal Property Breaches

Purchase agreements will often include representations and warranties relating to the real and personal property owned or leased by the target company. These representation and warranties may include:

  • All leases to which the company is a party are currently in full force and effect, and no party thereto is in default.
  • The company owns all of the real and personal property and none of its assets are subject to mortgages, liens, pledges or other charges except as is specifically identified by the seller.
  • All equipment owned or leased by the company is in good repair and in working order, except for ordinary wear and tear.

For example, assume that a seller has warranted to a buyer the three representations above. Subsequent to the closing of the transaction, the buyer discovers a piece of production equipment that is in need of significant repair, which is not the result of normal wear and tear. If the seller is found to have breached the representation and warranty relating to the equipment being in good repair and working order, it could be subject to claims such as the following:

  • The cost to repair or replace the equipment at issue
  • The cost to replace or repair goods sold not meeting customer specifications due to production on faulty equipment
  • Lost profits suffered as a result of unscheduled production shut downs or delays
  • Lost profits suffered as a result of diminished or lost customer relationships relating to production shutdowns or the sale of goods not meeting customer specifications

Other Considerations When Assessing Breaches of Representations and Warranties Claims

Due Diligence

Due diligence is defined as “a process whereby an individual, or an organization, seeks sufficient information about a business entity to reach an informed judgment as to its value for a specific purpose.”2 It is the process by which the buyer in a transaction attempts to minimize the risks that can arise when entering into an acquisition transaction.3 During the due diligence process, the buyer can review operational, financial, contractual, employment, and other pertinent business records of the target company that it deems necessary in order to verify the assertions made by the seller during the transaction negotiation process. While it may not be feasible for the buyer and its advisors to perform detailed due diligence on all aspects of the target company, especially in middle-market transactions, due diligence procedures can be focused on areas of particularly high risk and/or importance to the buyer. For example, in the event the target company is a service organization such as an accounting or consulting firm, the buyer may elect to utilize due diligence resources more heavily on verifying the status of employment contracts and non-compete agreements rather than on verifying the existence, ownership, and working condition of fixed assets.

While some level of due diligence is performed on nearly all M&A transactions, it clearly does not alleviate all risks inherent in the transaction as evidenced by disputes relating to breaches of representations and warranties. This may be due to failures on behalf of the buyer during the performance of due diligence and/or failure on behalf of the seller to provide adequate information to the buyer. In circumstances when disputes over representations and warranties arise, it can be beneficial to review the due diligence processes completed or attempted by the buyer and its advisors.

Virtual Data Room & Preservation

It can also be beneficial in the scope of a dispute arising from a breach of representations and warranties to review the data that was made available by the seller to the buyer for purposes of assessing the target company and performing due diligence. Oftentimes, this information is provided to the buyer through the use of a Virtual Data Room (“VDR”). VDRs are secure online repositories used for the storing and distribution of documents. In M&A transactions, VDRs provide the ability to set user- and group-specific permissions to limit access to documents in addition to allowing access to users around the globe. They also allow the seller to monitor who has accessed, viewed, and downloaded documents. Once a transaction is completed, the contents of the VDR can be inexpensively maintained for future access. Data typically is maintained for a time period that coincides with the time periods defined in the deal documents related to potential claims, including those for breaches of representations and warranties. The VDR can provide valuable information to the parties in the context of a post-transaction dispute as it provides the exact data that was made available to the buyer for the due diligence process. This can help establish what was known or should have been known by the buyer prior to closing the transaction.

Sandbagging4,5

During the negotiation and due diligence process, the buyer may become aware that the seller has breached a representation or warranty that will be included in the final purchase agreement.6 The buyer may determine that its best course of action is to close on the transaction and then hold the seller liable for its breach post-closing. In this circumstance, the buyer is said to be “sandbagging.” The buyer’s position is that it is paying for the right to rely on the representations provided by the sellers, despite the fact that the breach was found prior to the transaction close. Sellers tend to view sandbagging as unfair and ethically questionable. The timing of the discovery of the breach could also have an impact — did it occur before signing, or between signing and closing?

Pro- or anti-sandbagging provisions may be included in the purchase agreement. If the purchase agreement is silent as to the permission of sandbagging, buyers may still have some sandbagging rights under common law. Should sandbagging have occurred, damages issues will need to be considered within context of applicable legal claims. For instance, had the buyer notified the seller of the potential breach prior to closing, the seller may have been able to rectify it at that time, thereby minimizing or reducing a potential indemnification claim or claim on escrow related to the alleged breach of representations and warranties.

Representation and warranties insurance7

Insurance policies that provide protection for unintentional breach of representations and warranties in a purchase agreement are available. These policies can be purchased at the time of closing and anytime thereafter. They will only cover breaches of representations and warranties made at the time of closing and the breaches must be unknown at the time of closing. Representation and warranties policies fall under two categories: “buy-side” and “sell-side.” Buy-side policies are generally purchased by the buyer to recover losses directly from the insurer without having to pursue the seller. Sell-side policies generally provide indemnification for defense costs and losses resulting from claims made by the buyer for breaches of representations and warranties. The primary benefits of representations and warranties policies are that they provide the buyer with assurance that the value of the acquired company will not be reduced by unexpected liabilities and provide the seller with protection from loss of the sales proceeds from post-acquisition claims.

Holdback escrow8

Nearly every M&A transaction involves a holdback escrow, where a portion of the purchase price is set aside in a third-party escrow account to serve as security for the buyer related to potentially disputable items such as working capital adjustments or claims of breach of representations and warranties. Holdback escrows can also provide the seller with a negotiated cap for its indemnification liability relating to breaches of representations and warranties. However, claims for breaches of representations and warranties found to be fraudulent will not typically be limited to the amount in escrow.

Conclusion (Part 2)

Representations and warranties in M&A transactions, particularly those given by the seller to the buyer, are commonly the subject of post-acquisition disputes. The proper measure of damages in many circumstances is to assess what the buyer would have done had it known about the issues underlying the breaches of representations and warranties at or around the date of transaction close. An understanding of the potential financial and non-financial claims, as well as other relevant transaction considerations such as sandbagging, escrow structure, due diligence efforts and virtual data rooms, and insurance options may help both buyers and sellers to avoid or mitigate financial damages due to post-acquisition disputes.

 


 

  1. See “Didn’t Get What You Paid For? Addressing a Breach of Representations and Warranties, Part 1 of 2” SRR Journal Fall 2013.
  2. Due Diligence Handbook; William M. Crilly; American Management Association, 1998.
  3. In the event the seller is receiving consideration other than cash, due diligence may be necessary by the seller to verify the value of other consideration received.
  4. Sandbagging in M&A Deals: Silence May Not be Golden; Luke P. Iovine, III & Heather Davis.
  5. The Importance of Sandbagging Provisions from a Buyer’s Perspective: What You Know May Harm You; Howard T. Spilko & Darius J. Goldman.
  6. It is most often the case that sandbagging occurs with the buyer, but can occur with the seller as well.
  7. What is a Representations and Warranties Policy?; Pamela W. Mason, AAI.
  8. Holdback Escrows in M&A Transactions; Mark A. Cassanego.