Page 56 - M & A Disputes

Chapter 5

Representation and Warranty Disputes

Calculating Economic Damages — Indemnification Claims

This chapter discusses the quantitative and qualitative aspects involved to determine whether the buyer
is entitled to economic damages regarding indemnification claims and whether the damages should be
based on a dollar-for-dollar adjustment or an adjustment based on a multiple of adjusted earnings.

In most acquisition agreements, the seller will make certain indemnification provisions to the buyer re-
garding the financial condition of the target company. Indemnification provisions protect the parties
from certain matters that occur after the closing and allocate the risks and responsibilities for these oc-
currences between the buyer and seller. Indemnification provisions typically address breaches of cove-
nants or representations and warranties that are discovered after the closing. In addition, indemnification
provisions address items that are disclosed in the seller’s representations and warranties for which the
seller retains responsibility after the closing. As discussed in chapter 2, "Postclosing Purchase Price Ad-
justments," of this practice aid, working capital claims are typically measured dollar for dollar. Indemni-
ty claims, on the other hand, can result in damages that are measured dollar for dollar (either over a fi-
nite period or into perpetuity) or at the multiple.

Claims regarding indemnification provisions can arise in situations in which a buyer believes that the
seller has materially misrepresented the financial condition of the target or engaged in fraudulent activi-
ties to mislead the buyer prior to the consummation of the transaction.

Indemnity claims can result in damages measured at the multiple. This measurement implies the occur-
rence of permanent impairment to the value of the business. In such instances, the buyer’s expectation of
the transaction has been materially affected. The multiple is determined based on the purchase price val-
ue and the stream of earnings analyzed when deriving the purchase price value. The stream of earnings
used in the deal could be net income; earnings before interest, taxes, depreciation, and amortization
(EBITDA); net operating income (NOI); revenue; or any other metric relevant to assessing the value of
the target. The purchase price multiple is often calculated as the EBITDA multiple implied by the deal
price. For example, company A was purchased for $400 million, and the company A annual EBITDA
was $50 million. As such, the implied multiple is 8; in other words, company A was purchased for 8
times it’s annual EBITDA.

As discussed later in this chapter, although EBITDA is typically the most common measure of adjusted
earnings used in determining the purchase price multiple, it is important to consider how the deal was
negotiated and how the purchase price was determined when calculating damages.

The question that the practitioner should consider when evaluating whether the seller has materially or
intentionally misrepresented the financial condition of the target is, Did the buyer in the transaction ob-
tain the benefit of its bargain?

Merrill Lynch & Co. Inc. v. Allegheny Energy, Inc., 500 F.3d 171 (2d Cir. 2007), further expounds on
the concept of the benefit of the bargain. The court stated that a party injured by breach of contract is en-
titled to be placed in the position that it would have occupied had the contract been fulfilled according to

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