There’s been a breach in your mergers and acquisitions (M&A) agreement—you suspect the seller misrepresented something. If you had the foresight to purchase reps and warranties insurance, you can now file a claim to recover your loss. As you analyze the facts of the claim, knowing what type of loss you are suffering will allow you to better quantify it.
Remember that in addition to proving that a breach occurred, you must also prove the insured suffered damages that can be quantified. “Damages” is a defined term in R&W policies and generally includes all losses incurred because of the breach. Note that “loss” is also a defined term under the policy, so these definitions should be scrutinized. But how does an insured determine what the dollar figure is, and how does that translate into recompense?
In this article, the last of our five-part series on the fundamentals of R&W claims, we discuss two ways to calculate loss—one-time losses and recurring losses—and how they can affect reimbursement under the policy.
One-Time Loss: Dollar-for-Dollar Measurement
Dollar-for-dollar measurements, also known as non-recurring or extraordinary losses, are one-time or highly infrequent losses that do not arise from the normal course of business operations. One example of this type of loss is the breach of an environmental representation, where the costs incurred are to remediate the problem. In some cases, the buyer may recover this loss through a working capital adjustment, resulting in no damages suffered. If that happens, the insured would not be entitled to payment under the policy. This is because there is no need to make the insured “whole.”
Diminution of Value: Application of the EBITDA Multiple
Another way to calculate loss is by using the EBITDA (earnings before interest, taxes, depreciation, and amortization) multiple, which applies to recurring loss that results in the permanent diminution of a company’s value.
|Multiples come into play in the most complex and largest claims, usually, those alleging breaches of the financial reps, where the insured alleges that the purchase price was vastly inflated due to either negligent misrepresentations or fraud. Thus, the target’s value has diminished because lost revenues into perpetuity have permanently impaired the business.|
For example, a buyer alleges that the seller misrepresented financial information during the diligence process and the ultimate purchase price of $100 million was based on incorrect information, which showed a value of $20 million, to which the buyer applied an EBITDA multiple of five. They find out the company is only worth $10 million, which would have resulted in a purchase price of $50 million, and projected earnings are thus lower than anticipated. The insured may have a claim that would entitle the indemnification not only of the difference between the actual purchase price and what they paid out (in this case, $50 million) but also of the “multiple” used to calculate the total purchase price. If the multiple is five, the insured is entitled to five times the loss, which would be $250 million. However, the amount they can recover under the policy is capped by the limit purchased; with this purchase price, the insured likely purchased a $10 million policy.
The valuation methodology is key here: How was the target’s value assessed?
The valuation methodology used by the buyer needs to be understood by the carrier so that the carrier is comfortable in providing full coverage, and this is usually requested at the quote stage. The purchase price of a target company is based on several factors, often including a multiple of the company’s EBITDA. If this multiple isn’t understood to be based on realistic factors, the carrier may not agree to match that multiple when it comes to analyzing the monetary loss incurred because of a breach. If it doesn’t agree to this, the carrier may apply a cap to the multiple used in claims.
What Existing Lawsuits Say About Multiples
R&W insurance products are relatively new. As a result, there is scant case law that attorneys can use for guidance. Hence, two existing lawsuits have been seized upon by many lawyers, carriers, and brokers when looking to determine damages and whether multiples will apply. Both cases involved companies that had recent changes of control and that experienced loss of prior customers, which they claimed breached the material contracts reps in their agreements.
Zayo Group, LLC v. Latisys Holdings, LLC (2018): In this contract dispute, the Delaware Court of Chancery rejected the plaintiff’s damages analysis, noting that its expert lacked valuation experience and chose a methodology (EBITDA multiple) that did not fit the facts of the case. The court stated (in dicta) that there must be evidence showing an alleged breach permanently diminished the value of the acquired company in order to analyze damages using an EBITDA multiple.
Precision Kidd Acquisition LLC v. Pass (2019): In an unpublished decision, the Pennsylvania Superior Court determined that revenues and EBITDA per customer will vary year over year, but an overall business’s revenues and EBITDA might be relatively stable (the ups and downs between customers largely cancel out). The parties to the lawsuit must consider the contractual rights inherent in the agreement between the customer and the buyer. It’s not a given that a multiple will apply to any discrepancy between the valuation and the projected profits. Rather, you must look at the overall effect of the discrepancy.
Measuring Lost Profits
When measuring lost profits, if the injury occurs more than once but not in perpetuity, lost profits are measured over a finite period. One example is a breach of a material contracts representation, where the seller failed to disclose the loss of a key customer. The carrier might examine the remaining term of the contract and determine lost profits, considering revenue lost and expenses saved. The carrier will also take into consideration the duty to mitigate the loss—could the customer be replaced? What is the typical renewal rate of contracts? If the lost contract renews annually and six months have passed, analysts will calculate the loss for the six remaining months of the contract.
When there is a change in ownership or control of a company, buyers often reach out to the target’s largest customers, ensuring that they plan to stay in their current contracts. Any change in key customers could negatively affect the value of the company and the purchase price.
Prosecution Costs: A New Coverage Addition
It’s becoming more common for carriers to include prosecution costs in the definition of loss covered under the policy, though it is not yet the norm. Insurance exists to make the insured whole after suffering a loss, not to enrich an insured who looks to seek a judgment in its favor proactively. Prosecution costs are not incurred to defend oneself against allegations, so they are generally not covered under the typical insurance policy. But, as the R&W market becomes more and more competitive, this is one way some carriers are looking to differentiate themselves.
Work with Specialists Experienced in Reps & Warranties Insurance Claims
In the past, insurance companies often relied on outside advisors or claims consultants specializing in D&O insurance when dealing with R&W claims. As R&W insurance has matured and the market has grown, most carriers now have dedicated R&W claims experts on staff, making the claims process much more streamlined. Having a dedicated claims consultant on the broker side is also beneficial, as they can help you navigate the claims process and be your advocate in communicating with the carrier.
If you’re facing a loss and are starting or are already in the claims process, follow these steps:
- Inform your broker and work with them on the claim. They have the experience and relationships with underwriters and claims specialists necessary to move the claim process along effectively. They can also guide your expectations so you have a clear idea of how much you may receive and how long it may take to resolve the claim. Partner with your broker, and you’ll make it over the finish line faster!
- Don’t treat carriers as adversaries. Unfortunately, many people do, sometimes because they’re tired of answering questions or think the process is taking too long. Carriers are asking for information because they need it when they need it—they’re not trying to trip you up, stall payment, or not pay valid claims. Resisting the underwriters’ requests for information will only hurt you. Remember that the sooner the carrier gets the information it needs, the sooner the claim will be resolved.
- Make sure your outside advisors—whether attorneys, forensic accountants, or engineers—have experience with R&W claims. Having an attorney who isn’t familiar with claims, doesn’t understand coverage, or is unfamiliar with M&A transactions makes it harder for the whole team. A coverage attorney can be invaluable. Likewise, while it may cost more, consider a reputable accounting firm with experts in this area rather than relying on your family accountant. Your broker can also provide recommendations for advisors they’ve worked with.
Reach out to your Woodruff Sawyer team to learn more about reps and warranties insurance and the claims process.
|Read more articles in our R&W Claims 101 series:|
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