December 17, 2013

Watch the Double-Dip: An Uptick In Attempts At Double Recovery

Here’s analysis from Shareholder Representative Services:

A recent trend in post-closing M&A has been an increase in attempted “double-dips” where the merger agreement may provide that a buyer has the ability to recover, or at least attempt to recover, twice for the same issue. Merger agreements often wrongly assume that modifications to the closing balance sheets made during the purchase price adjustment and damages claimed against the escrow later will never overlap. As a result, the “Losses” provisions in such agreements routinely fail to clarify whether a buyer should be able to claim the same damages in both the purchase price adjustment and later as an indemnification claim against the escrow.

There are many situations where such double recovery can occur. Here are a few of the most common that SRS encounters:

– GAAP issues: The final calculation of net working capital may be reduced because of erroneous accounting, and the buyer later brings an indemnification claim for a breach of representations – alleging the seller failed to adhere to GAAP.

– “Dead” inventory: A buyer may discover that certain inventory is not resalable, reducing the value of this asset on the balance sheet. After a purchase price reduction, the merger agreement may fail to clarify whether the buyer may also bring a subsequent indemnification claim for breach of representations.

– Pending lawsuits: A reserve may be taken on the balance sheet for a pending lawsuit that was not recorded correctly at close, and the merger agreement may also provide that the buyer can recoup the amount of losses related to such litigation (plus fees, in some cases) through an indemnification claim.

In each scenario the damages in the purchase price adjustment and indemnification claim are based on the same event. However, depending on the definition of “Losses,” they may be considered two different things. For example, merger agreements frequently employ a generic definition:

“Losses” means any and all Liabilities incurred or suffered by a specified Person; provided, however, that Losses will not include any indirect, consequential, special or punitive damages except to the extent (i) awarded by a court or other authority of competent jurisdiction in any Third Party Claim or (ii) arising from fraud or intentional misrepresentation.

This clause does not expressly allow for a double dip, but buyers may cite the lack of any restriction as an implicit agreement that accounting and indemnification are separate matters so the damages do not overlap. As a result, a more specific clarification of the parties’ intent may be advisable. When clarifying this issue, two related matters must be considered. First, should the buyer be allowed to recover twice for the same loss or damage? Second, if the buyer does not prevail in its first attempt at recovery, should it be able to pursue recourse on the same facts through a different channel?

On the first issue, most parties would agree that recovering twice for the same loss is not fair or appropriate as it would result in double payment. To avoid this, the parties may want to add a clause such as:

No Double Dip. In calculating the amount of Losses related to a breach of or inaccuracy in a representation, warranty, covenant or agreement hereunder (and for purposes of determining whether a breach or inaccuracy has occurred), the Sellers shall have no liability for any Losses or Taxes to the extent such Losses or Taxes were taken into account as a liability or a reduction in the value of assets in determining Net Working Capital.

The second issue is more difficult because a claim may be determined to be invalid as a working capital adjustment for reasons that should not prevent the buyer from pursuing it as an indemnification claim (such as being a long-term rather than short-term liability). Or, it could simply be invalid on the facts, in which case a free appeal may not be appropriate. To address this issue, the parties may want to add language such as:

In the event that Buyer believes there are any facts or circumstances that are the basis for any adjustments to the [Preliminary Working Capital Statement] delivered by the Company at Closing, Buyer shall be permitted to pursue a remedy based on such facts or circumstances either as an adjustment to the Preliminary Working Capital Statement (“Adjustment”) or as an indemnification claim, but not both, other than as set forth below. Nothing in the preceding sentence shall prevent Buyer from bringing an indemnification claim based on the same facts and circumstances as a proposed Adjustment if a final, independent determination is made that (i) the proposed Adjustment is not proper based solely on the long-term or short-term nature of the applicable asset or liability, (ii) the proposed Adjustment is not being considered in connection with Working Capital because it is determined to be a legal issue rather than an accounting issue or (iii) [________________].

See our article “Working Capital Adjustment AND Indemnification Claim? No ‘Second Bite at the Apple'” in our booklet Tales from the M&A Trenches for more on this second issue.