Warrant me this, warrant me that... who’s afraid of the value impact?
By Greg Huitson-Little & Rob Lockwood
Posted: 30th September 2022 08:29Warranties, warranties, warranties. It’s the small hours and the deal teams are hammering out the final pieces of an M&A transaction. Buried in one of the schedules to the sale and purchase agreement will be a long list of warranties. Promises made by the seller that everything’s all okay. Comfort for the buyer that there are no gremlins hiding in the cupboards. In most cases, there’ll be no need to look at the schedule again. But what if there is? What if the buyer finds that amongst the mogwai there was indeed a gremlin, rendering one or more of the warranties breached?
In this article, we’d like to explore a little around how an expert accountant considers the losses arising from such a breach of warranty, and highlight how, in these post-Covid pre-recession inflation busting times, there needs to be a laser focus on losses arising from the breach and the breach alone.
First some groundwork. In a typical transaction, the sale and purchase agreement does three things. It sets out:
(i) the agreement for a seller to sell, and a buyer to buy, a company (in the form of shares) or a business (in the form of trade and assets). Let’s call it the target entity.
(ii) various protections for the buyer in the form of warranties and indemnities.
(iii) the consideration for completing the SPA.
The warranties given in the sale and purchase agreement tell the buyer something about the condition of the target entity. Typically, there will be some form of accounts warranty, where the seller confirms the accounts are properly prepared, free from material error, or some variation on the same theme. There may also be warranties relating to certain assets or liabilities (with the seller confirming existence and/or confirming they are reported properly). Sometimes, there may be warranties relating to key staff members, or relating to particular contracts or relationships with customers. In all cases, the seller is giving the buyer some protection that what it has been told about the target entity is true. If it later transpires the seller was wrong (intentionally or otherwise), and the warranty was found to be untrue, then a claim for a breach of warranty may then arise.
Establishing whether there was a breach might require the assistance of accountants, especially where the breach relates to an accounts or reporting warranty. Such questions are for another article.
Once a breach has been established, the accountant’s mind then turns to the question of loss. The usual measure of loss for a breach of warranty is to consider the diminution in value arising from the breach. This calls for two separate, but related, valuations. The first considers the value of the target as it was warranted. The second considers the value of the target as it actually was. The loss is then the difference between the two valuations.
With that in mind, there are some key points for the accountant to focus on.
First, the only difference between the two valuations should be the warranted matter. In assessing the diminution in value, any changes made by the expert accountant in the valuation of the target entity in assessing loss must arise from the breach of warranty. What that means in practice is that the accountant needs to focus on the warranted matter and the implications, from a valuation perspective of that matter – and only that matter – being different.
Subsidiary to this is that the valuation date should be as at the same point in time. Generally, that date is as at completion. In this way, the exercise does not introduce value changes that arise from the passage of time: you are looking purely at the diminution in value arising from the warranted matter.
Second, it’s generally up to the accountant to decide, in their professional opinion, the most appropriate way to value the target entity and the diminution in value in assessing the breach of warranty. That is not to say the accountant is free to choose an approach most beneficial to their client! Typical approaches include the multiples approach (which could be based on comparable companies or on comparable transactions) and the discounted cash flow approach. In certain circumstances, you may see an asset-based valuation, where the value of the components of the business are more relevant than its expected future profit (or cash flows).
Regardless of the choice, the methodology needs to be capable of properly assessing any diminution in value. That also means considering what effect the breach actually has. If the effect is one-off or debt-like such that the effect can be quantified as a short string of known cash flows, then a pound-for-pound adjustment could be made. If the effect is on-going such that the effect has a continuous and lasting impact, then the valuation approach needs to be capable of capturing the long term impact on the value of the target entity.
Third, it’s important for there to be information symmetry. Both valuations should rely on the same sets of information and data. This includes any data which the accountant may obtain to use as part of the valuation exercise (such as market data, comparable transaction data, etc.). That does not necessarily mean that the accountant is limited to using information that was only available at the time of the “as warranted” valuation – sometimes information that is available post transaction, especially market data, can be very useful to establishing value. But both valuations need to use the same information basis. This ensures the diminution in value arising from the breach, and only the breach, is being assessed
So where does that leave the buyer in circumstances where the target entity has been negatively affected by the pandemic, growing inflation, rising energy prices, or a global recession?
Well, it should go without saying that what happens post sale is chiefly the buyer’s problem – the risk has transferred. A breach of warranty claim is not an opportunity to claw back bad performance, unless the bad performance can be traced back to a warranted condition. Hindsight is a wonderful thing but it can’t be used to remedy buyer’s remorse. In breach of contract cases, courts might be sympathetic to considering what actually happened and using that as the basis of damages. But in a breach of warranty assessment, what happened to the target entity post acquisition is generally not relevant: it’s the immediate point in time diminution in value that matters. The valuations need to be done at the same time on the same basis using the same information save only for the warranted item and its implications.
That also means care has to be taken to ensure macroeconomic changes are not inadvertently included. This is why information symmetry is so important. Taking into account any macroeconomic factors in only one of the two valuations would skew the diminution in value calculation, and effectively treat a macroeconomic change as a warranted condition – which, if correct, would have been a rather foolhardy move by the seller. Instead, both valuations should treat these factors similarly. Care should also be taken to make sure the conditions as existed at the time of the transaction are taken into account in the valuations. If the transaction was undertaken with post-pandemic pre-recession optimism, then that’s the framework in which diminution of value needs to be assessed. Attempts to depress the valuations for the increasingly dire global outlook should be resisted.
If the accountant keeps to the “same point in time” rule, maintains information symmetry, and is laser sharp on assessing the effect of the breach and the breach alone, then they’ll avoid many of the pitfalls that have tripped up others. None of this is particularly ground breaking, but the turbulent economic climate will likely see some claimants wanting to push the boundaries. A renewed focus will keep loss claims honest. Failure to do so adequately, much like exposure to water, could turn your gremlin into something far, far worse.
Greg Huitson-Little specialises in forensic accounting, dispute resolution and litigation support assignments. He provides advice throughout the litigation process: during pre-action stages when considering whether to bring a case, an early assessment of where losses may lie, advice in relation to information and evidence that may be required, right through to detailed assessment of losses and the preparation of expert evidence for use in court or arbitration. His M&A practice includes advice to clients during the completion phases, providing evidence in breach of warranty matters, and working in expert determination processes both as an advisor and as determining expert.
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Rob has more than 15 years’ experience as a forensic accountant working on commercial litigation, arbitration, and expert determinations in the United Kingdom and internationally across various jurisdictions. Rob focuses on the quantification of losses in relation to commercial disputes, particularly in the mining and metals, oil & gas, energy, and construction and infrastructure sectors. In addition to matters involving breaches of contract, Rob has substantial experience in SPA disputes, including breach of warranty and expert determination matters. Who's Who Legal recognised Rob as an Expert Witness Future Leader in 2020, 2021 and 2022.
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