Damages for breach of warranty in M&A transactions

M&A transactions are usually a special situation for sellers and/or buyers that do not occur on a daily basis. Given the reach of the decisions involved, the parties often agree on a list of warranties in the acquisition agreement in order to ultimately clarify particularly important aspects of a transaction and to define the position which the parties owe under the agreement. If a breach of a warranty becomes apparent after the transaction has been completed, the buyer is entitled to damages in the best case scenario.

The situation usually fundamentally changes after the transfer of the business, and if a warranty is breached, there always arises the question of the consequences of such breach for both parties to the agreement – in particular for the aggrieved buyer – and the problem of how to calculate damages.

This article deals with the treatment of damages after the completion of an M&A transaction. Our article of June 2020 already highlighted the issue of damages in case of a breach of obligations to provide relevant information before the agreement is signed.

Warranties create a "positive interest" on the part of the buyer

With warranties made in the acquisition agreement, the parties assure one another as part of the M&A transaction that a certain position will be achieved; the buyer therefore has a claim for the fulfilment of such warranties. If, however,  the actual position of the party differs post M&A from the warrantied position, the party suffers damage as the warranty was not fulfilled. In the case of such a so-called "positive interest" the creditor is to be placed in the same position as if the debtor had properly fulfilled the warranty.

In the case of such claims resulting from warranties, priority is generally given to "in-kind" remedies that restore the position of the aggrieved party as if the damage had not occurred- i.e. the repair of a defective building or the supply of a machine that failed to be supplied contrary to what was warrantied in the agreement. In M&A transactions, however, the provision of an in-kind remedy is only possible in cases where the defect or failure had no further impact on the company's cash flows.

Financial compensation for the loss of value in cases of reduced cash flows leading to a position contrary to the warranty

If, on the other hand, a breach of a warranty also has an impact on the company's performance and reduces its cash flows, it is not possible to compensate for such breach on an in-kind basis. This can be the case, for example, if the target company lacks the warranted capabilities or customers, or does not hold the warranted patents. In such cases, in addition and subsidiarily to in-kind remedies, financial compensation for the loss of value is paid. This should place the aggrieved party in the same position as if the warranty included in the acquisition agreement had been fulfilled. Business valuation is the adequate instrument for determining compensation, especially if the consequences of damage cannot be clearly determined and additional claims for lost profits are sought.

Business valuation as a tool for determining financial compensation for the loss of value

Appropriate financial compensation for the loss of value is intended to compensate the aggrieved party for the reduced value of the target company as a result of the breach of the warranty. The calculation of such compensation usually requires comparing two business valuations: one based on planning taking into account the breach of the warranty and the actual situation caused by this breach, and the other based on the hypothetical planning scenario assuming that the warranty is fulfilled. The difference in value should be calculated on the basis of detailed integrated business planning in accordance with the IDW S1 valuation standard promulgated by the Institute of Public Auditors in Germany [Institut der Wirtschaftsprüfer e.V.] and discounted as of the relevant valuation date using the net present value method. In doing so, attention should be paid to ensuring transparency of the planning and the valuation procedure.

Simplified valuation methods – for example using multiples – however, aim at a "perpetual annuity" assumed to be indefinite and often do not take into account complex legal problems relating to damages as the calculation process is unidimensional; they are therefore no suitable methods in legal disputes.
The damage to be compensated - the "positive interest" (German: Positives Interesse, which means the interest in being placed in the position as if the contract had been properly fulfilled) - is the difference between the values determined as a result of both fundamental valuations.

The purpose of the "positive interest” provides for two essential parameters for company valuation, namely the information date [date at which information for valuation purposes is available] and the valuation date [date to which future cash flows arising post transaction are discounted]:

• The purpose of the "positive interest" is to place the beneficiary in the position he would be in if the warranty was fulfilled. The period for which damages are determined in the event of a breach of a warranty is the time of the last verbal negotiations (information date). In this respect, damages are determined based both on actual data and on planning data valid as of the information date.
• The valuation date is to be distinguished from the information date. The valuation date is the date of the effective transfer of assets; future cash flows arising post transaction are technically discounted to that date. In a second step, the present value of the company's cash flow for the hypothetical and the real scenario should then be compounded as of the date of the last verbal negotiations using an appropriate rate of return on the investment. In this respect, the value is adjusted in respect of two time components: on the one hand, it is adjusted in respect of the period between the date of the transfer of assets and the date of the last verbal negotiations and, on the other hand, in respect of the finite or infinite period after the date of the last verbal negotiations, depending on the damage caused by the failure to fulfil a warranty.

Buy-side perspective decisive for financial compensation for the loss of value

The "positive interest" is based on the buy-side point of view; consequently, damages depend on the impact of the breach of a warranty on the company's cash flows from the buy-side point of view. In this respect, decisive is the subjective valuation of the company value from the buy-side point of view.

Following the principle of "pacta sunt servanda", this means that the buyer can rely in his planning scenario on the truthfulness of the warranties given by the seller and can continue to pursue the business planning on which his acquisition decision is based from his perspective. The buyer may have entered into the transaction expecting to implement his own concept for continuing operations and to use viable synergies as well as intending to continue operations of the company in fundamentally changed circumstances after the transfer of the assets. In addition, capitalised interest should always be calculated subjectively. Given this perspective, the subjective enterprise value from the buy-side perspective may substantially differ from the sell-side perspective before the conclusion of the transaction and may be higher than the latter.

Conclusion

Warranties in company acquisition agreements are intended to ultimately clarify important aspects of the transaction and to define the position of the parties to be achieved under the agreement. In the event of a breach of a warranty, the aggrieved party is entitled to damages, alternatively financial compensation for the loss of value.
 
Their amount is often determined based on business valuation from the buy-side perspective. Because warranties given have their consequences, sellers should try to limit the impact of the warranties in terms of time, content and legal consequences.