Has the claim been made within the policy period?
The policy period will generally (but not always) reflect the duration of the seller’s liability under the transaction documents. This tends to be shorter for non-tax warranties on the basis that most major problems will come out following the first full audit cycle after completion whereas tax liabilities have a longer tail. The transaction documents usually include provisions relating to time limits on warranty claims e.g. that any claim will be deemed waived unless it is settled or withdrawn or the buyer commences proceedings within a prescribed period. This is to prevent the buyer from sitting on claims. However, these limitations are often carved out of the policy so that if a buyer does not commence proceedings against the seller within the prescribed period it will not lose its right to claim under the policy provided that the claim was notified to insurers in time. This reflects the fact that buyer-side polices do not generally require the buyer to bring a claim against the seller before making a claim under the policy.
Is the warranty that is alleged to have been breached a covered warranty and, if so, has it been re-written for the purposes of the policy?
The policy will typically include a schedule that sets out which of the warranties and/or indemnities in the transaction documents are covered or not covered. This will always need to be reviewed with care. An additional point to look out for is that a covered warranty can sometimes be re-written for the purposes of the policy. However, a buyer will always want to try and ensure so far as possible that the cover provided matches the warranties and/or indemnities given in the transaction documents as otherwise they will be left with a potential gap in cover.
Has there been a breach of warranty?
A key point that insurers will need to consider is whether there has been a breach of warranty. This will depend on the precise wording of the warranties that are alleged to have been breached as applied to the facts. Disagreement over how the warranties should be construed is not uncommon and will be resolved by contractual rules of interpretation. Buyer friendly warranties (such as sweeper warranties) may increase the risk of a breach being established. Expert evidence may be required, particularly where the alleged breach relates to the accuracy of the financial statements. Insurers may need to obtain the seller’s co-operation as part of their investigations, but difficulties can sometimes arise in this respect as liability-free warrantors have less incentive to do so. Insurers should also check for potential limiting factors, such as whether the warranties that are alleged to have been breached are qualified by the seller’s awareness. Where a warranty is qualified by the seller’s awareness and the seller is a company, the transaction documents will typically state that the seller is deemed to have the knowledge and awareness it would possess had it made due and careful enquiries of specific individuals, usually comprising of those directors and employees who report directly to the seller in relation to the relevant items being warranted. An insurers’ investigations may need to extend, therefore, to the knowledge that was held by these individuals. In some situations, however, these individuals may still be involved in and key to the operation of the business meaning that their interests may be aligned with the buyer’s.
The transaction documents will contain exclusions limiting the buyer’s ability to bring a warranty claim. One particularly important exclusion relates to disclosed matters. The buyer will want this exclusion to cover only those matters that are disclosed in the disclosure letter. The seller will want it to cover everything in the data room. However, this puts the onus firmly on the buyer to identify issues in a mass of information with little or no signposting and will be resisted. A common compromise is for the parties to agree that the disclosure must be fair (i.e. sufficient information has been disclosed that a sophisticated investor would be aware of the substance and significance of the information and the nature and extent of the breach). In most cases, therefore, insurers will need to review the contents of the data room as part of their investigations and a copy should be requested at an early stage if one was not retained as part of the underwriting process.
The policy will contain its own exclusions which will also need to be considered carefully. Most policies will exclude any claim that relates to a breach that the buyer was aware of prior to the inception of the policy. The buyer’s knowledge for these purposes is usually confined to specific individuals within the deal team. It will be necessary, therefore, to identify and review what these individuals saw as part of the due diligence process. Whilst this may not extend to the whole data room, it will almost certainly include copies of the due diligence reports prepared by the buyer’s advisors. Indeed, there is often a separate exclusion covering any breach that is disclosed in the due diligence reports. Other common exclusions that insurers should be alive to include any liability relating to purchase price adjustments and forward-looking warranties (for example, a warranty relating to the target's ability to collect debts after completion of the transaction or financial projections).
What loss (if any) flows from the breach?
Calculating what loss (if any) flows from the breach is fraught with difficulty and can give rise to substantial disagreement.
The normal principle – as a matter of English law – is that damages for breach of a warranty are calculated by reference to the amount required to place the purchaser in the same position as if the warranty had been true. This is generally calculated as being the difference between the market value of the company as warranted and the market value of the company with the warranty breached (i.e. it is necessary to show a diminution in share value). Damages are generally assessed as at the date of breach of contract.
The Court will often assume that the price paid represents the market value of the company as warranted. However, the seller may be able to show that the buyer made a bad bargain and that the true market value is less than the price paid. Alternatively, the buyer may show that he made a good bargain and that the true market value is greater than the price paid.
The market value of the company with the warranty breached can be more difficult to calculate. The value may be found by adopting the same valuation methodology actually used by the buyer, but this is not necessarily determinative. In some cases, the price agreed may be more the result of negotiation rather than the application of a scientific method. In other cases, a variety of different valuation methods may have been used. Other valuation methods may arrive at a different result. Expert evidence will be required.
One particular problem often faced by the buyer is establishing that the company’s market value has been affected at all by the breach of warranty. Take the example of a seller who warrants that the target owns 250 computers. The target’s value was calculated as a multiple of EBITDA. Following completion, the buyer discovers that the target only owns 200 computers. Whilst the net assets of the target are less than expected, the value of the shares of the target is likely to remain unaffected since the missing computers are unlikely to affect the target’s capacity to earn profits; meaning that no loss has been suffered and only nominal damages will be awarded. The position could be different, however, if the target’s value was calculated on a net asset basis.
As with any breach of contract claim, the buyer will also need to show that the loss was caused by the breach of warranty, that the loss is not too remote, and that it has taken reasonable steps to mitigate the loss.
A policy will typically contain a waiver of subrogation clause in favour of the seller. This reflects the reality that, under the transaction documents, the seller will have no liability to the buyer for losses over the maximum cap. It is important to note, however, that there is usually a carve out to the extent the loss arose out of the seller’s fraud – in those circumstances, neither the waiver of subrogation clause in the policy nor the maximum cap in the transaction documents will bite. This protects against the risk of an unscrupulous seller deliberately withholding material information from the buyer for the purposes of artificially inflating the purchase price. Although insurers may be liable to indemnify the buyer for any resulting loss, they will still be able to commence a subrogated recovery action against the seller.