In the purchase agreement for the typical M&A transaction, the seller gives the buyer representations and warranties concerning key questions affecting the value of the target company. The representations can cover, for example, the target company's compliance with applicable law, the accuracy of its financial statements and the operating condition of its physical assets. It has been estimated that in roughly 15 percent of these transactions, the buyer will assert a claim after closing that one of the representations and warranties has been breached.
In the ensuing litigation, the essential legal rules governing the determination of liability are well-established. Representations and warranties are like other contract provisions, and the claimant will have to prove both that a representation was breached and that the breach caused damages. There are thousands of court decisions analyzing the nuances of contract breaches and causation.
But there is surprisingly little law governing calculations of the amount of damages. Many cases are decided in arbitration, and those that go to court typically settle before trial. As a result, the courts rarely address issues in the calculation of damages. Most of the law on damages comes down to a few basic principles, including that the victim of the breach will be "made whole" — that is, the claimant will be put in the same position it would have been in had the breach not occurred. This is known as giving the claimant the "benefit of its bargain." When the breach is of a contractual representation relating to the value of an asset, the measure of damages will be the difference between the value of the asset as represented and the value of the asset as delivered. Thus the measure of damages will be the extent to which the breach has caused a "diminution of value" in the purchased asset. And proof of both breach and causation must be reasonably certain, but proof of the amount of the resulting damages is allowed to be more speculative. In other words, as between a victim and a defendant who has been held to be liable, the wrongdoer will bear the risk of any uncertainty in the proof of damages. This principle provides the courts with great latitude in crafting damages awards.
With only these general principles to draw on for guidance, the courts have not agreed on precise rules for measuring the diminution in the value of the purchased business. Although the courts have not spoken definitively, economists and other experts on damages have begun to agree on approaches to this issue. They focus on two core questions: To what extent has the breach caused a reduction in the earnings of the company? And if there has been a reduction in earnings, is it temporary or is it recurring?
An example shows how the analysis proceeds. Assume that the target company is a manufacturer of building supplies and the target operates a fleet of trucks that deliver the supplies to retail sellers. Assume further that some of the trucks were not working properly at the time of closing on the sale, and this breached the seller's representation that all of its assets were in good operating condition and repair. The trucks that are not operable will require repairs, and the costs of those repairs will be the "dollar-for-dollar" measure of damages for the breach. If those trucks were not needed to fill orders, then the dollar-for-dollar measure is likely to be the only damage from the breach. But if the failures of the trucks cause the company to be unable to fulfill an order, which caused a loss of company earnings, then the damages include both the repair costs and the lost earnings on that contract. And if the failure of the trucks causes the company to lose multiple customers and earnings over a long term, then the loss of earnings is long-term (and may be permanent), which can reduce the value of the company substantially, and will yield far more in damages.
Whenever the breach causes a longer-term reduction in earnings, the damages analysis will require a formal valuation of the business as it was delivered to the buyer. The measure of damages will be the difference between the purchase price and the current valuation. To make that valuation, the analyst usually will perform a discounted cash flow (DCF) or other recognized method of valuation, such as a comparable company analysis. Each of these valuation methods has inherent problems. The DCF method relies heavily on a projection of future financial performance, which requires the analyst to make estimates based on assumptions that always will be subject to attack. A comparable company approach requires the analyst to select the companies that appear to be most comparable, and that selection always raises issues as to whether the selected companies are genuinely comparable to the target.
One question that the courts have not answered definitively is whether a buyer's damages for breach of a representation will be calculated "at the multiple" — that is, as a multiple of the lost earnings of the target company. Buyers often advocate for damages at the multiple because that approach tends to yield larger amounts in damages. In urging a court to accept the multiple, the buyer will say that its own valuation of the target company was based on a multiple of earnings, and since the parties agreed to the purchase price, that is the most current and accurate measure of the target's value. Sellers will say that the multiple is only one measure of value and that the buyer may have paid more than the fair market value of the company. For example, the buyer may have anticipated synergies with other portfolio companies that would have prompted the buyer to pay more than a DCF valuation would suggest was the fair market value of the company. In resolving the dispute between buyers and sellers on this issue, the facts of the transaction are likely to matter. In some transactions the parties expressly premise the purchase price on a multiple of earnings. In others, the multiple may have been used only for the parties' internal financial modeling and there was no negotiation or agreement between buyer and seller on the correct multiple. In the absence of an express agreement on the multiple at the time of the transaction, there will be room during the litigation for both sides to make their arguments. As the number of private M&A transactions increases, these issues will be contested more often.[*]
[*] These issues were the subject of a panel discussion titled, "Measuring Loss: How Damages Can Be Calculated," at the AON Transaction Solutions Symposium, on February 13, 2018. Arthur Aufses was a member of that panel.
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