Conventus Law: Why are post-M&A disputes becoming increasingly frequent?
In our previous discussions, we observed that disputes may increase due to the current geopolitical climate such as the strained relations between the United States and China. This inevitably leads to more difficulties whenever parties are conducting trade globally and when conducting M&As which are often international in nature.
Furthermore, the economic downturn experienced by several Western economies, coupled with mounting inflationary pressures, is likely to further complicate matters. Typically, when these economic issues are present, there is increased scrutiny of financial statements and accounts. This additional scrutiny has led to the discovery of fraud in various cases. In M&A disputes, a common reason for disputes is because the underlying financial statements of the target company are not as accurate as it was represented.
Recently there was an AIG claims report and they found that there’s been a significant increase in warranty and indemnity insurance in claims. Can you just explain to us what a warranty and indemnity insurance is and why is this as important in the context of M&A’s?
Warranties and indemnities insurance, commonly known as W&I insurance, serves as a risk mitigation tool similar to other types of insurance. When engaging in a merger, there are inherent risks involved, and some of these risks can be mitigated through insurance coverage. Typically, the buyer assumes the responsibility of obtaining this insurance since they possess less information about the target company compared to the seller.
The W&I insurance policy provides indemnification to the buyer against certain potential losses arising from the merger. For example, undisclosed or unreported tax liabilities in the financial statements could result in financial losses. The insurance policy acts as a protective measure by indemnifying the buyer against such losses.
In the context of M&As, an increase in claims may indicate underlying issues with these mergers. Conversely, a rise in claims could also signify heightened merger activity, with more companies opting to purchase these policies. This suggests greater awareness of such policies and recognition of associated risks when engaging in merger activities.
Do you have any tips on how best to handle Post- M&A disputes or even how to avoid them altogether?
Prevention is often preferable to dealing with disputes, rather than after they arise. To avoid disputes, it is crucial for parties to seek clear advice and establish well-defined roles and responsibilities from the outset when entering into agreements. While legal advisors are typically consulted, the involvement of forensic accountants and valuers can be valuable in addressing accounting or finance-related issues.
Thorough due diligence plays a vital role in preventing disputes. For instance, we were involved in a dispute where a significant inventory write-off in one of the target company’s subsidiaries emerged after the acquisition. This became one of the major sources of claim in the dispute, as it was discovered that the recorded inventory on the balance sheet did not actually exist. Conducting comprehensive due diligence could have helped the buyer identify this issue beforehand. However, accessing relevant information can sometimes present challenges for buyers.
By prioritising due diligence and obtaining comprehensive information, parties can mitigate potential disputes and proactively address any issues before they escalate.
What are representation and warranty clauses?
Representations and warranties are conditions within a sales and purchase agreement (SPA). While the main terms of the SPA encompass elements like the purchase price and date of transfer, the warranties provide additional conditions. The specific issues covered by these warranties depend on the nature of the acquisition. Common warranties often include ensuring that the underlying financial statements present a true and fair view of the company’s financial situation. Tax compliance issues and the absence of undisclosed litigations are also commonly addressed.
In certain cases, there may be more specific warranties tailored to the circumstances. For instance, in an assignment we were involved with, there was an ongoing recovery action, and it was required that the seller make efforts to recover as much of the debts as possible within one year after the target acquisition date.
These warranties serve to provide assurances to the buyer regarding various aspects of the target company’s condition and performance along with minimising potential risks associated with undisclosed liabilities or misrepresented information.
My understanding is that breaches of these clauses are common causes for dispute. Can you explain why this is and what is the best way to mitigate this?
As with most contractual disputes ensuring the wording of the contracts is clear and unambiguous and conducting a comprehensive due diligence exercise are essential.
However, it is also important to note the representation and warranties dispute process is a mechanism to help the parties have clarity on the agreement and it’s a form of protection for the acquirers of the target company. Due to the information asymmetry between buyer and seller, the representation and warranties in the SPA effectively act as a guarantee made by the seller that the business is as they presented it, and the buyer has recourse to protect themselves.
For instance we were involved in a matter involving a large global conglomerate that purchased a local company as a joint venture. After the purchase, the global conglomerate discovered the local entity was not paying the correct amount of social insurance for its employees. Our analysis determined that the social security payments had been underpaid for decades, leading to a potentially massive liability for the purchaser. Without the recourse of the representations and warranties, the purchaser would have been liable for those payments were the tax authorities investigated further.
Once the dispute is underway, what tips do you have for parties on how to navigate this situation?
In any commercial dispute the parties need to understand their respective positions from both a legal and financial perspective. In relation to an M&A dispute, if there is a financial reporting issue, advice from forensic accountants as to which party has a stronger position will be a part of understanding each party’s potential legal strategy. In particular, parties would want to understand how the financial reporting issues could be interpreted? Does the other side have any valid points in comparison?
For financial reporting issues, most jurisdictions have a principle based, not rules based system. As a result, when these principles are applied to the relevant accounting standards, this can lead to two parties having different views. For the parties, it is important they understand the different permutations of each side’s arguments, and regardless of the interpretation of the issue, what amounts are at stake. Once the parties have this information, they will have a better picture of how to proceed, and deal with the proceedings.
What common forms of fraud scenarios are you seeing during a typical M&A transaction?
In order for an M&A to occur, there must be a buyer who wants to purchase the target company after having reviewed its financial results. The buyer is unlikely to purchase a company that is sustaining losses (unless its for a very low price and/or its highly confident of performing a turnaround). Therefore, a seller would be attempting to prepare the financial statements to provide the best financial picture of the target company. It is with this goal in mind, when some sellers might consider embellishing its financial performance/position.
These actions will most likely occur for transactions that are close to the transaction date, or where set date where the financial statements have to be prepared by, which is going to be the basis of the transaction price. There may also be write offs near the transaction date for certain amounts or, they may not write off receivables that haven’t been received for quite a while, which is not typical for their financial policy.
It should be noted that some of these actions conducted by sellers during the transaction process aren’t necessarily fraud and would more likely be considered a breach of the warranties in the SPA.
So what would be the difference between fraud and a breach of contract or warranties?
We should begin by caveating this response noting that we aren’t lawyers. Fraud typically involves the intent to deceive for personal financial gain. When it comes to M&A disputes, the situation can become more complex due to the principle-based accounting system and the grey area between intentional deception and presenting the best representation of the target company.
Differentiating between outright fraud and a breach of warranties can be challenging, as the intent behind the actions may not always be clear. Breaching warranties may result in adverse damages awards, where no specific blame is assigned. On the other hand, fraud is considered a criminal offense and carries punitive penalties imposed by governments.
How does a company prevent fraud and what should a buyer do if they suspect fraud has occurred in the target company?
When looking at fraud the framework typically referred to as the fraud triangle created by the Criminologist Donald Cressey should be considered. The fraud triangle, consisting of motivation, opportunity, and rationalization, helps identify the factors that contribute to fraudulent activities.
In M&A transactions, it’s crucial to be vigilant about potential red flags in the financial statements. Sellers may have incentives to present a more favourable financial picture than the reality, which could involve fabricating transactions or manipulating financial data. Analysing financial statements and identifying discrepancies such as high reported profits without corresponding cash inflows can raise suspicions of potential fraud.
If a buyer suspects fraudulent activity in the acquired company, engaging external parties such as external counsel or forensic accountants is advisable. These independent professionals can conduct thorough investigations and provide an impartial review of the accounts. This is particularly important when there are concerns about collusion between employees and the seller or when there is a lack of trust in the target company’s accounting team.
By involving external experts who specialize in fraud investigations, buyers can gain an unbiased assessment of the situation and gather evidence to support any potential legal actions or remedies that may be necessary.
What are earn out clauses and how are the claims typically made During Post-M&A disputes?
Earn-out clauses are provisions in a contract that outline contingent payments to be made by the buyer to the seller after the completion of a transaction. These contingent payments are typically based on achieving specific financial targets within a defined time period, which can range from one to several years.
Disputes commonly arise regarding the interpretation of whether the agreed-upon financial conditions have been met. The construction of financial statements and the appropriate treatment in accordance with financial reporting standards often come into question, especially when the contract does not provide clear guidelines on how to calculate or determine specific metrics or conditions.
In such cases, it becomes essential to carefully analyse the terms of the contract, assess applicable financial reporting standards, and potentially seek expert opinions or engage in dispute resolution mechanisms to resolve disagreements over earn-out payments.
How difficult is it to quantify these claims?
Typically challenges arise in regards to the language relating to the earn-out clauses in the sales and purchase agreement (SPA) not being clear. Determining the specific financial targets and metrics can be complex when there are ambiguities or lack of definitions in the contractual documents.
One key issue is defining what constitutes “profit.” It is crucial to clarify whether it refers to gross profits, net profits, or cash profits. Without clear definitions, different interpretations can lead to conflicting answers and potential disputes. Parties involved should carefully consider the wording of such clauses to avoid ambiguity and multiple interpretations.
Another common challenge relates to the exclusion of extraordinary items from profit calculations. The term “extraordinary” does not have a standard definition in financial reporting, leading to differing views between parties. For instance, determining whether COVID-related impacts should be considered extraordinary can be a point of contention. These types of questions often arise during dispute resolution processes.
To mitigate these challenges, it is advisable for parties involved to seek both legal advice and financial advice. Financial experts, such as forensic accountants, can help interpret and quantify the potential impact of earn-out clauses while ensuring consistency with recognized financial reporting standards. By having clear definitions and expert guidance, parties can reduce the likelihood of disputes arising from ambiguous language or conflicting interpretations in earn-out clauses.
Have you seen a rise in these sorts of earnout claims? Why do think this has occurred?
In the last three years, we are seeing a rise in these types of claims, which is largely due to the COVID pandemic, political tensions and the economic downturn in various countries. These disruptive events have caused significant changes in the business environment, leading to unforeseen circumstances that were not anticipated when drafting these agreements.
Factors such as soaring energy prices and increased raw material costs have created macroeconomic challenges, further impacting businesses. These changes have made it more difficult for sellers to achieve earn-out targets, while buyers may seek to tighten capital outflows and save costs. This misalignment of motivations can lead to conflicting interpretations of contractual clauses as both parties try to achieve their desired outcomes.
