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Sellers Might be Leaving Money on the Table on Deals with Insurance
In private company M&A, buyers typically have two mechanisms to protect themselves from losses that might arise prior to closing of a deal that are discovered after the deal closes: (a) the indemnification provisions governing a breach of a representation and warranty and (b) purchase price adjustments, otherwise known as working capital true-ups. Many have thought that both of these mechanisms were available to buyers for financial claims with purchase price adjustments resolved within weeks of deal closure, and indemnification claims available for issues that are discovered after the purchase price adjustment has been resolved. In fact, some practitioners believe both of the mechanisms may be available for the same issue. In 2006, the Delaware Chancery Court in OSI Systems v. Instrumentarium put some limits on the use of working capital adjustments as a remedy for financial losses resulting from improper or inconsistent compliance with GAAP. Then, in Chicago Bridge & Iron Company N.V. v. Westinghouse Electric Company LLC, the Delaware Supreme Court issued a ruling that could have the impact of further narrowing the scope of what can be included in purchase price adjustments depending on the language of the applicable agreements.
The facts in Chicago Bridge are unusual, but the lessons learned are valuable. In Chicago Bridge, the buyer asserted that the target’s financial statements were not GAAP compliant and submitted a final balance sheet that resulted in a $2 billion deficit to net working capital based mostly on adjustments to accounting principles. Further, the buyer had waived indemnification making the purchase price adjustment the only recovery mechanism available for such financial loss. In its decision, the court ruled that because the target’s accounting was non-GAAP compliant before signing and the purpose of the purchase price adjustment was to protect the buyer for losses that occurred solely between signing and closing, the loss resulted from a breach of a representation and warranty, and the true-up mechanisms of purchase price adjustments were not available.
The implications of Chicago Bridge potentially affect other types of adjustments typically included on closing balance sheets. While Chicago Bridge focused on challenges to the proper application of GAAP not being available to the buyer through a working capital adjustment, a merger agreement could contain a similar restriction that provides that any claim which is within the scope of what is covered by insurance must be pursued solely against the insurer. As an example of how this could come up, buyers will often include in working capital adjustments any undisclosed liabilities that were discovered after closing . If taken as a purchase price adjustment, the inclusion of these liabilities result in a reduction of net working capital requiring a true-up of cash back from sellers to the buyer. If, however, such facts also amount to an indemnification claim for breach of the financial statements, no undisclosed liabilities or material contracts representations and warranties, then sellers may push the buyer to make the claim against the insurer rather than adjusting the purchase price. This is an important distinction because working capital adjustments typically are not covered by insurance, but indemnification claims based on the same facts might be.
Because of this, shareholder representatives reviewing purchase price adjustments on final closing balance sheets need to be especially diligent in evaluating whether the cause of the adjustment is based on facts that are also a breach of an insured representation or warranty. If so, it should be discussed whether such adjustments could be reframed as an indemnification claim against the insurance. Attorneys should also consider how the merger parties would like such situations to be handled during the drafting and negotiation of the agreements. The buyer should be able to recover equally either way, but it should be clear whether the shareholders or the insurer is responsible for paying the bill.