Understanding breach of warranty claims

Thursday February 17, 2022

What steps should a buyer of a business take if it underperforms post-transaction?

COVID-19 continues to have a profound impact on businesses. While there are some winners, many more have suffered as demand for their products and services collapsed.

The impact has been keenly felt by those businesses that embarked on a merger, acquisition or buyout in the run up to the pandemic, without knowing what was around the corner.

For companies that agreed acquisitions in late 2019 or early 2020, a buoyant transactions market meant that many of the deals that were agreed were valued based on forecasts of strong growth and profitability. Although some buyers were able to abort or renegotiate transactions when the pandemic struck, many were committed to paying the sum that was agreed beforehand.

Understandably, in some cases, investments that were set in motion before the pandemic will now be falling short of expectations, due to ongoing COVID-19 challenges affecting business performance. So, is there any way for buyers to recoup financial losses, and what steps should they take to pursue a breach of warranty claim?

Where post-transaction performance has been below expectations, the important question a buyer should be asking is whether this is entirely due to the impact of COVID-19. If it is due to other factors, then buyers should consider whether these other factors could give rise to a claim against the sellers for a breach of the warranties agreed in the sale and purchase agreement. As the typical time period for bringing claims under general warranties is 18 to 24 months, the deadline is likely to be imminent for transactions impacted by the pandemic.

In assessing whether there might be recourse against the sellers, buyers should consider:
What is driving post-deal financial performance?

Establishing whether any downturn in financial performance can be attributed to COVID-19 or to other factors is likely to be complex. The first step for buyers should be to establish what is driving any reduction in revenue or increased costs and, importantly, to support this with evidence.

Unravelling the impact of COVID-19 will be important in rebutting any defence the seller may make which claims poor financial performance is simply attributable to the pandemic, rather than as a result of factors which should have been disclosed to the buyer.

What does the buyer know now that it wishes it had known then?

Following completion, the buyer will have had multiple competing priorities, not least dealing with the impact of the pandemic. They will also have received full access to the books and records of the business in question, which undoubtedly will have uncovered facts and circumstances that were not identified during due diligence or disclosed by the seller.

The buyer should consider what information has come to light that, had they been aware of initially, might have influenced their decision to proceed with the transaction or reassess the purchase price. Of particular importance will be anything that suggests that historic financial performance of the business in the run up to the transaction was artificially inflated.

What protections did the buyer negotiate?

Buyers should then consider the warranties, or written guarantees, covering the areas where a potential breach has occurred. When it comes to financial information, it’s typical for sellers to provide a warranty for audited accounts, but to what extent has the accuracy of management accounts or other financial information, which is more likely to have been used to inform the valuation, been rubber stamped? Sellers will often be reluctant to give strong warranties over unaudited financial information, preferring to use terms such as ‘reasonably accurate’ to ‘true and fair’, so it may be harder to prove a breach.

Would the buyer have revised its valuation as a result?

Just because a warranty has been breached does not automatically mean the buyer has suffered a loss. The measure of damages for a breach of warranty claim is the difference between the value of the shares as warranted – which is typically, but not always, the purchase price – and the value had facts and circumstances giving rise to the breach been known.

It is important to establish at an early stage whether the breach of warranty would have an impact on valuation. If it does, then buyers should consider whether the impact is on a standalone basis, such as in the case of an undisclosed liability or a missing asset, or a multiple basis – if there is a reduction in ongoing profitability, for example.

Is there an ability to recover?

The chances of a successful outcome for the buyer are often enhanced by the ability to recover from a retention account – otherwise understood as the part of the purchase price that acts as security after the deal. Alternatively, they are strengthened by the buyer’s ability to offset losses against any deferred consideration, which is the portion of the purchase price they will pay at a future date.  However, the latter may not be relevant if any deferred consideration is based on post-acquisition performance which has been adversely impacted by COVID-19.

If the buyer has obtained warranty and indemnity (W&I) insurance that may present a route to recovery, however an insurer won’t have the same incentive to ‘do a deal’ and may push back harder on any claim.

Buyers who entered into transactions prior to the pandemic and have seen their acquisitions underperform may consider themselves a victim of unfortunate timing.

While it might be easy to point to COVID-19 as the reason behind this, buyers should take an objective view of performance and determine whether there are other factors at play.

To the extent evidence shows the target’s warranted pre-pandemic financial performance was overstated or adverse facts and circumstances are discovered in areas there are subject to warranties, there may be a claim against the sellers.

Buyers should act now, before the expiry of the period under which claims can be notified as complying with the rules is a must. Breach of warranty claims are complex and getting an independent assessment as to the merits and potential value of any claim is critical, particularly if the strategy is to seek a resolution with the seller at an early stage.

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Henry Pocock

Henry Pocock

Henry Pocock

  • Partner
  • Forensic Services
  • Birmingham