Post-closing disputes are on the rise. The post-covid M&A surge led to pressurised negotiations resulting, in some cases, in less due diligence and seller-friendly agreements. Buyers are also more frequently conducting post-closing health checks of the target company to assess ongoing risk and mitigate against any issues. Against this backdrop, and the recent slowdown in economic growth, there has been an increased focus in the market on assessing and pursuing breach of warranty claims.
It is, therefore, not unsurprising that brokers are predicting increased notification rates over the next 12 to 24 months.
Buyers who find themselves in post-closing dispute territory should investigate quickly and consider whether a warranty may have been breached: technicalities around timing and notice could result in an otherwise good claim being barred. Sellers threatened with a breach of warranty claim should also be mindful of the common early pitfalls faced by buyers and key lines of defence.
Whilst each claim is different, we set out below five practical pointers when faced with a potential claim for a breach of warranty.
1. Triage fact gathering
Uncovering the factual picture quickly and accurately is essential. A targeted investigative approach should assess the merits of a potential claim and the best way to frame it in any initial notification to the seller or insurer.
A buyer likely has the advantage of controlling most of the relevant documentation related to the company and the potential claim. However, depending on the dispute resolution mechanism and governing law, once litigation is reasonably in contemplation the parties must take reasonable steps to preserve potentially relevant documents. It is worth considering this early so as not to make any procedural missteps, bearing in mind that important information may also be in the possession of directors and/or employees of the company.
2. Identify the warranty
Once the key documents have been located, consider whether the issue uncovered falls within the scope of a warranty. Any warranties must be read alongside qualifications in the disclosure letter.
At this stage and throughout, it is important not to lose sight of any relevant indemnities that may have been breached or other claims which could be brought in parallel and by which the loss might also be recovered.
Current trends in the market (predominantly in the UK and EU) indicate that claims under W&I policies are most commonly made for breaches of warranties related to tax, financial statements and compliance with laws (see here and here).
3. Review any W&I insurance policy
W&I insurance typically covers unknown breaches of warranty arising post-completion which were not known at the time of signing / completion, although the wording of the specific policy will prevail. These are usually risks which could not have been uncovered through due diligence or disclosure against warranties, such as active seller non-disclosure, fraud and ‘black swan’ events.
An obvious first step is determining whether any W&I insurance covers the alleged breach, including if any policy exclusions apply. The transaction agreement may contain a provision precluding recovery by the buyer where there is W&I insurance in place, or requiring first recourse to the W&I insurer. Further, although it is not as common, sellers may also have their own insurance policy to backstop their liability.
4. What’s the loss?
The standard method of calculating loss in breach of warranty claims is to put the buyer in the position they would have been in had the contract been satisfactorily performed and had the breach not occurred. In a share acquisition, this is typically calculated as the difference between the hypothetical market value of the company if the warranty had been true and the actual value of the company. Given the complexity in this area, instructing an expert advisor to advise on quantum at the outset may be sensible (especially if the requisite notice provisions require the buyer to specify loss – as explained below).
Further, irrespective of the calculated loss, there may be a number of other relevant factors to consider, including liability caps as well as:
- the duty for the buyer to mitigate loss – either in accordance with the transaction documentation or under common law if applicable; and
- whether there are future payments scheduled under the terms of the deal – and whether it is available to the buyer to pause these and hold the payment monies in escrow until the alleged breach has been determined.
5. It’s all in the detail: be meticulous about notice
As soon as a potential breach of warranty is uncovered, it is important to identify applicable notice requirements in the underlying transaction documents (including in any W&I insurance policies). Inadequate notice is fertile ground for litigation. Some key risk areas are summarised below.
- Timing: Failure to serve notice of the alleged breach within the applicable agreed time limit may bar a claim being brought.
- Form: Where the documentation prescribes the form of the notice required, this must be complied with to ensure that notice is validly given. A certain level of detail in relation to the alleged breach and associated loss may be required (highlighting the need to properly investigate and corroborate the underlying facts at the outset in order to ensure the notice is accurate).
The Court of Appeal recently gave a stark reminder of the risk of non-compliance when it overturned an award for a breach of warranty claim on the basis that the form of the notice was deficient: the SPA required the notice to specify the amount claimed in respect of each breach of warranty claim, but the notice only gave the aggregate total loss.[1] Further, the High Court has also recently barred a breach of warranty claim on the basis that the notice did not adequately specify how the loss was caused by the alleged breaches, which was required by the terms of the SPA.[2]
- Service: There will likely be requirements setting out exactly how service is to be effected in the transaction documentation. To the extent there is any room for interpretation, it is better to err on the side of caution and serve notice by more than one method to mitigate the risk of inadequate service.
Move quickly, ensure strict compliance
Finally, to note that each of the practical considerations above has an equivalent significance from a seller’s perspective. From the seller’s viewpoint, these can provide an important first line of defence.
Freshfields has in-depth experience on both the buy- and sell-side of M&A disputes. This is the third blog published in our series on M&A disputes: M&A Earnout Provisions: Recent Trends in US Law and How to Draft Your Clause to Avoid Disputes (part one) and The Curious Case of Crossover Witnesses in Post-M&A Arbitration (part two). You can stay up to date with the latest trends on our Transactions blog and our Risk and compliance blog.
[1] Decision Inc Holdings Proprietary Ltd v Garbett [2023] EWCA Civ 1284
[2] Drax Smart Generation Holdco Ltd v Scottish Power Retail Holdings Ltd [2023] EWHC 412 (Comm) (note: subject to appeal as at the date of this blog)
