The euphoria from a recent business acquisition or sale does not come without its share of potential conflicts. Whether it is a disgruntled buyer disappointed after a drop in market value or a buyer who discovered an undisclosed liability such as a large warranty expense, post-acquisition disputes are occurring more frequently given our current economic climate.1
This article discusses how economic analysis can assist in both liability and damages determination in such disputes. At the onset, economic and accounting analysis can help discover if there were misstatements or breaches of sale contract when assessing liability and, subsequently, can assist in determining what damages would therefore arise. Also, as will be seen, sometimes it can be prudent to put forth multiple damages calculations to best protect one’s position in a post-acquisition dispute.
Post-Mergers and Acquisitions Disputes in the Current Economic Climate
A dispute regarding an acquisition of a company, division, or asset can derive from a number of circumstances and accusations, including, but not limited to, disagreements over:
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Breaches of representations and warranties in the sales documents including alleged misstatements of pre-acquisition financial statements;
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Purchase price adjustments (e.g., working capital);
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Earnout disputes; and
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Accusations of pre-acquisition fraud.
Although the last decade has seen a rise in mergers and acquisitions activity, the prosperous economic times experienced for most of the past decade sometimes caused parties to overlook disputes or claims of wrongdoing on the part of the sellers. Though buyers may have incurred losses from fraud or misrepresentations when times were good, they might not have been aware of those losses or willing to undertake the hassles of litigation to recover the losses.
As Warren Buffett famously said, “it’s only when the tide goes out that you learn who has been swimming naked.” Well, the tide has gone out.
The current economic times have prompted a less forgiving scenario. As companies struggle to meet projections, recovering money from prior deals through litigation becomes an attractive method to help maintain earnings at desired levels. In fact, managers may even pursue a post-acquisition claim in order to blame the previous owner for disappointing earnings.
Not only do buyers have greater incentives to capture some of the lost value from allegedly negligent transactions, but sellers also have the incentive to engage in fraudulent activity prior to the sale and/or during the sale process. The Association of Certified Fraud Examiners (ACFE) noted that during times of economic hardship, conditions are more conducive for fraudulent activity.2 Forced budget cuts and workforce reductions place added pressure on corporations to meet performance targets, increasing the risk of fraudulent misrepresentation. Further, an ACFE survey of more than 500 certified fraud experts conducted throughout February and March of 2009 showed that more than half (55%) of those polled said they had seen an increase in fraud over the past year.3 Therefore, there is an increased likelihood that sellers may have attempted to hide or downplay material adverse changes or other facts in order to close the deal.
In addition, as deal flow has diminished, corporate development professionals are not as active in generating new transactions. As a result, some have used their “free time” to review past acquisitions as a method of generating value for their company.
All of these factors have led to greater propensity for friction between buyers and sellers following the closing of deals. Mike Rhodes, Chair of Cooley Godward’s Litigation department, notes that “courts are applying greater scrutiny than ever to whether the parties have met their fiduciary obligations.”4
Key Questions in Post-Acquisition Disputes
When post-acquisition disputes do arise, financial analyses can be very beneficial in assessing liability. The following three questions are generally asked, each of which financial and accounting experts can assist in answering.
1. Did the buyer receive the value represented by the seller?
If the seller made misstatements or breached the sale agreement in some other manner, the buyer could seek restitution from the seller. Some typical damages methodologies are outlined in the next section.
2. Were the alleged misstatements or breaches known to the purchaser prior to the sale?
Forensic accountants can trace financial transactions to ensure that they comply with the representations and warranties, indemnifications, due diligence, and other provisions contained in sale agreements. In addition, forensic accountants can present factual information that may assist with proving (or disproving) whether or not the seller committed fraud prior to the sale. Even if the seller’s representations were accurate, the seller could still be in breach if the representations were not properly presented in GAAP-compliant financial statements.
3. Can the diminution in value be proximately tied to the misstatements or breaches?
Care must be taken to ensure that the alleged misstatement or breach caused the buyer to receive less than what was believed to be received at the time of the sale. The buyer cannot claim as damages the diminution in value of the acquired company due to external factors such as the general decline in overall economic activity or a customer leaving for unrelated reasons.
Damages in Post-Acquisition Disputes
If the buyer was harmed in some way by the alleged misstatements or breaches, damages can be derived using a simple framework. Damages equal The Economic Position the Buyer would have been in “But For” the alleged misstatements or breaches less the Economic Position the Buyer is actually in or would have been in had it properly mitigated its damages. While this framework is simple, its application is often not straightforward. For example, governing law can impact whether damages are recoverable based on a Rescission theory or a Benefit of the Bargain theory. If damages are based on the Benefit of the Bargain theory, the impact of the misstatement (finite v. perpetual) also should be determined.
Rescission v. Benefit of the Bargain
Depending upon the facts of the case and the appropriate governing law, courts can award Rescission Damages or Benefit of the Bargain Damages, the latter otherwise known as Expectancy Damages. In addition, language in the sale agreement could specify the method of determining damages and/or limit any damage award.
A court could determine that Rescission damages would be appropriate. With Rescission damages, the Buyer and Seller return to status quo ante (i.e., the economic position they were in prior to the sale). In such a case, the company is returned to the seller, the purchase price refunded, and the buyer is reimbursed for any losses it incurred prior to the company’s return. If it is impractical to return the company, damages can mirror the Benefit of the Bargain damages discussed below.
The court could apply the Benefit of the Bargain damages theory. Benefit of the Bargain damages are defined as allowing the buyer “to recover the difference between the value of the property received and the value the property would have had if it had been as represented.”5 This measure of damages puts the buyer in the position they would have been but-for the fraudulent misrepresentation at the time of sale.
Benefit of the Bargain: Finite Life v Perpetual Impact
When assessing Benefit of the Bargain damages, it is important to determine if the misrepresentation by the seller will have a continued impact. If the impact is found to be a one-time charge, an “out-of-pocket” damages assessment is appropriate. For example, assume that the seller knew, but did not disclose to the buyer pre-sale, the existence of a $5 million one-time charge (e.g., a charge for environmental remediation) that does not impact future income. If the facts demonstrate that that this liability is unlikely to reoccur, the buyer should be rebated $5 million under the Benefit of the Bargain theory. Similarly, a detailed investigation of the actual liability may show that the buyer would experience a loss relating to the liability for only a few periods. The present value of this multi-period loss could then be quantified and awarded as damages.
On the other hand, if the facts demonstrate that the $5 million charge is going to reoccur and/or affect future projections, damages may be greater than $5 million. If the liability will impact future income, it may be appropriate to multiply the liability by the pricing multiple used in the deal or to adjust future cash flow projections for the recurring charge.
Cobalt v. Crystal Case Study
A 2007 Delaware Chancery Court case Cobalt Operating LLC (Cobalt) v. James Crystal Enterprises, LLC, et al. (Crystal) reviewed a post-acquisition dispute regarding an allegedly fraudulent transaction and weighed in on both Benefit of the Bargain and Rescission damages theories. The Court awarded Cobalt Benefit of the Bargain damages arising from a fraudulent misrepresentation of pre-sale cash flows by Crystal.
In the matter, Cobalt purchased a radio station from Crystal based on representations of the station’s broadcast cash flows. After purchasing Crystal for $70 million, Cobalt realized they could not fit the necessary amount of commercials to generate the broadcast cash flows represented to them at the time of the sale.
Cobalt claimed Benefit of the Bargain damages stating that the misrepresentations inflated broadcast cash flow by roughly $1 million, causing it to overpay for the station by $12 million; in other words, had Cobalt known of this issue, it would have only paid $58 million for the station.
On the other hand, Crystal argued that Rescission damages were more appropriate as it would not have done the deal for
$58 million.
The judge ruled that Crystal’s argument “misses the point of awarding a remedy in a breach of contract case like this, which is to compensate the non breaching party for the injury caused by the breach,”6 and cited to a previous Delaware decision where a party “fraudulently induced to enter into a contract … may elect to either affirm the contract and sue for damages or disaffirm the contract and seek Rescission.”7 Furthermore, the judge ruled that “Rescission of a transaction like this, nearly five years after it was consummated would be an extraordinary remedy, and Crystal has not demonstrated that it is even capable of buying back [the radio station].” Moreover, the judge interpreted the sale agreement contemplated monetary relief in response to contractual breaches by Crystal.
The judge also indicated that he could have potentially arrived at a different Benefit of the Bargain damage award had Crystal provided another number. In particular, he stated that “having not been presented with any countervailing valuation evidence from Crystal, I have no reason to question the accuracy of [Cobalt’s] analysis.”
Absent information to the contrary, the judge accepted that the value of the radio station was within the range of $56 -$62 million that Cobalt’s expert offered. He selected the midpoint of that range, or $59 million, which implies that Cobalt overpaid by $11 million and should be awarded that amount in damages.8
Conclusion
In light of the current economic times and post-acquisition dispute environment, it is prudent to elicit the help of economic and accounting analysis to assess questions of liability, causation, and subsequent damages. Economic and accounting professionals can assist in answering these key questions, as care should be taken in selecting the proper damage theory or theories.
