Cross-border M&A Disputes, Part II
The second part of the article (continued from previous issue of Arbitration.ru, August 2019) covers disputes over representations, warranties, indemnities, governing law and other aspects of M&A deals. The first part of the article was dedicated to disputes related to timing and pricing of company transferring.
Representations, warranties and indemnities – and fraud
Legal practice in the UK and the US and that of other common law jurisdictions long ago established the practice of including (in the body of the SPA – share-purchase agreement – or in an attachment) a long list of assurances in the form of representations, warranties and indemnities, subject to the disclosures in the disclosure letter. The practice has been modified in recent years to include only warranties and indemnities. This has arisen partly because it became so common to provide that the contract could not be rescinded for misrepresentation that the point of including representations was to a significant extent lost.
Other legal systems often also make a similar distinction between statements which, if untrue, should give the buyer rights to be put back into the position it was in before entering into the transaction and others give rise only to a right to damages. In cases where the first remedy is provided for in the drafting, it is often, in practice, not possible to go back to square one – once the company is transferred to the new owner it may be changed in such a way that giving it back is not feasible or appropriate. In such cases, the legal system usually provides that damages should be paid instead.
In practice, many civil law jurisdictions have evolved to provide warranties and indemnities, with similar effects as in common law systems.
However, fraud, if it occurs, is usually treated as an exceptional situation in most jurisdictions, and it is not usually possible to contract out of liability for fraud, including fraudulent misrepresentation.
Fraud is often difficult to prove because, of its nature, it is hard to detect. Also, the primary focus of the parties during the negotiation of the SPA is usually on civil remedies. Although there are civil law remedies for fraud, it is also usually a criminal offense in most countries, and therefore the burden of proof is, in practice, usually high even in a civil case.
Many a dispute has arisen out of the information provided and statements made to the buyer in the due diligence phase or afterwards or from the way the information was presented – for example in the way that the accounts have been prepared or that relationships with customers have been presented. It may involve giving false information but can also include failing to give information or failing to correct information which was (or was thought to be) correct when given. There are also, in many systems, opinions or forward-looking statements are treated differently than statements of fact.
Because so many M&A disputes are settled and others arbitrated without public disclosure, it has in the past been difficult in the past to develop any kind of reliable feel for which areas most give rise to the most claims.
However, AIG, the insurance company, has for a few years now been publishing an annual report of its claims experience with W&I (warranty and indemnity) insurance. The 2019 report indicates that they had claims on approximately 20 per cent of their policies issued and, of these, “severe” claims (over $10 million) on 19% of the claims received.
According to the AIG report relating to its international experience, the most common ground for claims -19% of the total – concerned financial statements. Given the focus of buyers and sellers on the financial statements (as indicated above in the discussion of price disputes) this is hardly surprising. Financial statements aggregate financial information and often provide only limited detail. There is an understandable tendency by the in-house accounting team preparing the accounts to try to present them in the best light to impress management. Indeed, in the run-up to many private company M&A deals, the staff of the company do not know of the prospective sale in advance and the management are at pains for them not to find out because of the potential impact on morale within the company. This can make it difficult for the management themselves to get to grips with the information or for the seller of the target company shares to get access to the information. There may, of course, be instances of the books being “cooked” in a more malevolent way, but, as with fraud, it is often difficult to prove a malevolent motive. Of course, this begs questions about the role of the auditors generally which is controversial in many “Western” countries currently.
Another big area for claims is tax – 18% of the total, mainly corporate income tax and employee and sales taxes. Again, this is hardly surprising. In many countries, the tax authorities have a long period in which they can claim for unpaid tax – six years is common. This inevitably introduces a degree of uncertainly into the financial affairs of any company which has not recently had a tax audit. The accounting staff, auditors and advisers of the target may be doing a conscientious job of providing for the tax liabilities they can foresee, but it happens not infrequently that when the tax inspectors review the same financial records during their tax audit they look at them from a different angle. Reviewers see things that are not apparent to the staff and others involved on behalf of the company.
A third major area for claims is compliance with laws – 15%. This mainly affects regulated sectors such as health and pharma and financial services, but regulation applies to a wide range of businesses. Again, there are can be malevolence involved, but in most cases the problem is not of that level.
These three areas take up 53% of the pie chart. Material contracts take up another 13% and the remainder consists of employee-related, intellectual property, litigation, operations-related, environmental and fundamentals (e.g. good title). It surprises me that litigation is only 7% but that may just indicate that sellers have good appreciation of their disputes and are also good at imparting the information to their buyers.
Measure of damages
In most jurisdictions, it is accepted in respect of a warranty claim that the measure of loss is the difference between the value of the shares as warranted and their true value. However, this can be difficult to determine in markets which are illiquid or in which there is only limited liquidity (or little comparability between companies even in the same market sector). This usually requires expert evidence, but in such circumstances, it can be difficult to find suitable experts or to compare their evidence, and this in turn makes presentation (and, for the judge or arbitrator, evaluation) of the expert evidence difficult.
There may also be issues over the basis for valuation. There is a world of difference between asset value which may be relevant for deals based on asset value and those based on a multiple of income (EBIT or EBITDA). Determining what basis for valuation is appropriate is often at issue an M&A dispute. In some business sectors there are standard methods of valuation but other there may be widely different approaches to valuation even in the same industry or service sector, The SPA may or may not give indications, and, if it does, interpretation of them may be disputed. The valuation approach used by the buyer may or may not be appropriate from the point of view of the hindsight that may be brought to bear in the dispute and it may not be clear what the relevance of it is to the issue of damages in proceedings. Issues of this kind can be particularly complex in cross-border deals where different national approaches to valuation may be relevant.
SPA’s for M&A deals usually provide for claims thresholds and baskets, caps on liabilities and time frames within which claims must be made. There may also be statutory limitations that apply if there are none specified in the SPA. Although the limitations in the SPA may seem relatively standard when is being prepared, in practice it is not always straightforward for claimants to comply with them and a surprising number of cases which come to court – including on arbitrations - concern compliance with technical details of this kind.
Arbitration clause - governing law of the agreement and law of the seat
In many deals, there is no issue between the parties as to what the governing law of the SPA should be – they may simply accept that the national law of the country in which the transaction takes place should apply or they may mutually agree on that of another country which they are used to applying in M&A deals.
If arbitration is to be used for dispute resolution, the law of the seat will govern the procedural aspects and care should be taken that this is readily compatible with the substantive governing law of the SPA, so that awkward conflict of laws issues don’t arise.
Where there is a choice as to the substantive governing law or as to the seat, the lawyers advising need to take care to avoid unintended consequences. The second part of The Guide to M&A Arbitration published by Global Arbitration Review and edited by Amy C Klaesener contains a compendium summarising the substantive laws applicable to M&A deals in a variety of jurisdictions globally. It is surprising how different they are on certain points. In some jurisdictions, for example, consumer protection laws apply to M&A deals unless excluded. In others, there are legislative disclosure requirements which are very favourable to the buyer unless excluded.
The extent to which pre-contractual communications between the parties is relevant to the interpretation of the agreement may also vary a great deal from jurisdiction to jurisdiction, and there may be issues as to the admissibility of evidence. There can also differences between jurisdictions as to what matters are substantive and which are procedural. If the substantive law and the law of the seat are the same or at least compatible, there are likely to align effectively without problems, If they take materially different approaches there can be problematic gaps or issues of characterisation.
36 Stone, Arbitrator, London