Financial statement warranties in M&A insurance
Introduction
Between 13% to 23% of all claims made under warranty and indemnity (W&I) insurance policies relate to accounting and financial statement matters.1 This is not surprising given that a loss of any kind will inevitably find its way to the accounts of a company in one way or another. However, in proportion to the number of claims, relatively little time is spent talking about financial statement warranties during M&A negotiations and W&I underwriting. This is owed, at least partially, to court judgments dealing with M&A being rare, given that the majority of disputes are dealt with by way of confidential arbitration.
This article reflects on some of the most relevant considerations, pitfalls and developments of financial statement warranties.
The financial statements warranty
One of the most important provisions in an M&A agreement, be it a share or asset purchase agreement (herein referred to as SPA), is the purchase price clause. Consequently, the financial statement warranty is one of the most important warranties that a buyer will request from the seller, given that the company’s financial results and position are material to the buyer’s decision on whether or not to proceed with the transaction, and on which terms.
As with any other warranty, there is a myriad of ways in which parties can draft a financial statement warranty. It is, for example, technically possible to draft a forwardlooking warranty by which the warrantor guarantees that a certain future event may or may not occur. A warrantor (most often being the seller) could further also give warranties speaking to off-balance sheet items or single line items. All of this will depend on the negotiations between the buyer and the seller. However, W&I insurance has narrowed the playing field, at least to those who want to use the product, because no (conventional) W&I underwriter will cover such warranties. This brings, one could argue, a sense of “balance” to the warranty catalogue.
But what is a financial statement warranty and what does it mean?2
An example of a typical financial statement warranty would be:
The audited financial statements of the target group company for the financial year ending 31 December 2021 (2021 Audited Financial Statements) have been prepared with the due care of a prudent businessman and in accordance with the applicable provisions of the German Commercial Code and generally accepted accounting principles in Germany. The 2021 Audited Financial Statements present, in accordance with such principles, a true and fair view of the net assets, financial position and results of operation of the target group company as of, and with respect to the financial year ending on 31 December 2021.
There are a few essential aspects to consider: firstly, such a financial statement warranty speaks to compliance with the relevant accounting standard (here, the German Commercial Code and generally accepted accounting principles in Germany) and should be distinguished from “correctness”, “completeness” or reflecting the actual circumstances as perceived from an ex-post (or “after the fact”) perspective.
For example, if the company provides services to a customer during the 2021 financial year and assuming that the customer has not yet paid for those services by the reporting date (31 December 2021), the company is required to record the receivables in its financial statements. Even if the company establishes at a later date in the 2022 financial year, i.e. after the fact, that the customer was already insolvent on 31 December 2021, unable to pay its debt and that the receivables should be written off, the financial statements may nevertheless be compliant with the German Commercial Code, because the warranty speaks to compliance with an accounting standard and not to the absolute collectability of receivables.
Secondly, there is a normative-subjective element to the warranty. To establish breach of such a financial warranty would require a party not only to show objective breach of a statutory provision, but also to show that a prudent businessman could have recognised this breach with the knowledge he had at the reference date. The second element may seem to be somewhat subjective, but the applicable standard is not the specific businessman associated with the company, but a prudent businessman more generally. The rationale behind such a normative-subjective element is to protect the businessman, the company, and its stakeholders alike. After all, if a businessman is too risk-adverse, he would not be able to properly fulfil his role and the company would not thrive. If the businessman acts prudently and can justify his decision under the circumstances, he has fulfilled his legal obligation.
Thirdly, one could argue that the second sentence in our warranty example is redundant. If the warranty states that the financial statements were prepared in accordance with the applicable provisions of the German Commercial Code, such compliance would inevitably include (to the extent applicable to the company) that the financial statements must give a true and fair view of the assets, liabilities, financial position and profit or loss. A party wishing not to include “true and fair view” wording in the warranty should thus be warned that a mere deletion of the second sentence (in our example) does not necessarily mean that the warranty is not given to that standard.
Fourthly, it is worth referring to the notion of a “hard” or “objective” balance sheet warranty (harte oder objektive Bilanzgarantie) when dealing with warranties under German law. Few buyers will expect a “hard” or “objective” balance sheet warranty from the seller and even if they did, an underwriter will not cover it. However, the line between a normative-subjective warranty and a hard, objective warranty is arguably thin.
Much has been written about the two, somewhat controversial decisions made by the OLG Munich3 and the OLG Frankfurt4 which need not be repeated here. It suffices to say that the warranty in question assessed by the OLG Frankfurt was not too different from our example above, and was found to be objective, despite the warranty expressly referring to “the due care of a prudent businessman”.5 And if a warranty were to be held as objective, the risk would be even higher in cases of longer look-back periods – it is not uncommon for warranties to refer to the financial statements of three financial years prior to signing.
Simply adding a knowledge qualifier in the SPA or the W&I policy is not the same adding a normative-subjective element to the warranty, as some parties may believe. Because a normative subjective element refers to the knowledge of the target group management as at the financial statements reference date. A knowledge qualifier in an SPA or a W&I policy usually refer to the knowledge of the sellers (depending on how it is defined) as at the signing or closing date of the SPA.
So how do parties draft a warranty and make it clear that a warranty is not objective? One option would be to draft the warranty in such a way that it includes specific reference to the knowledge of the company management as at the reporting date. A second solution, which is more common in practice, is for the parties to clarify in the warranty wording that it is not a “hard” or “objective” balance sheet warranty.
Lastly, warranties in an SPA are not limited to financial statement warranties, but often address management accounts, liabilities, assets, accounting procedures and controls, and a range of relate topics. In assessing whether the risk underlying the warranty has been addressed or mitigated, one could ask: does the scope of the relevant warranty match the scope of due diligence review performed by the buyer? Additionally, sellers (and underwriters alike) should be aware of warranties that go beyond the scope of what is required for financial statements or accounts by law or reporting standards, as it could easily enter the realm of an ex-ante perspective. Any ex-ante perspective would mean that a warranty is most likely breached from day one, because financial statements by their very nature, are not objective or prepared on an ex-ante approach.
Purchase price adjustments and earn-out clauses
Purchase price clauses can take a number of forms. For example, the parties may negotiate a fixed purchase price as at signing on the basis of locked-box accounts, with a detailed leakage and “ordinary course of business” covenant dealing with the time between the locked-box date and signing or closing. This is the most common approach. Another approach is to agree on an initial purchase price which is then adjusted at closing on the basis of closing accounts or completion accounts. There are also a multitude of possibilities lying somewhere between these two approaches, and the ultimately favoured solution depends on the wishes of the parties and the nature of the target company. For example, an SPA for a start-up company being sold by its founders will often include an earn-out clause, especially when the founders remain with the company, in an attempt to align interests.
From a W&I insurance perspective, purchase price adjustment and earn-out clauses are relevant most prominently in two ways: firstly, a W&I policy would generally exclude losses which have been included in the purchase price calculation or adjustment. Secondly, the financial information on which purchase price adjustments or earn-outs are based, may be the same or overlap with the financial information warranted.
An earn-out clause is generally forward-looking insofar as it provides the sellers an opportunity to bear further fruit from the sale based on the future performance of the company. Given that warranties are backward-looking, these two rarely overlap, but it is not impossible. It could happen that the annual financial statements of a company will only be finalised and audited between signing and closing. The parties could agree to include in the SPA a warranty speaking to the audited financial statements, and that such a warranty is then given only at closing. A W&I insurer could similarly follow this approach. In practice, the policy is signed without the inclusion of the audited financial statements warranty, but the buyer and W&I insurer later sign an endorsement, effectively including the warranty in the policy as at closing, provided that the buyer undertakes a market-standard due diligence exercise, as would be the case during underwriting.
In a similar example, this time with a purchase price adjustment clause, the purchase price paid at signing is based on year-end management accounts, with the preparation and audit of the annual financial statements to be completed between signing and closing. The SPA provides for a possible purchase price adjustment or “true-up” for the differences between the year-end management accounts and the final audited financial statements. If the SPA contains a warranty for the year-end management accounts, differences between such management accounts and the audited financial statements could potentially fall within the scope of both the purchase price adjustment clause as well as the warranty.
Given that the SPA contains a purchase price adjustment clause (which no doubt has been negotiated vigorously), all parties involved may very well agree that differences between the management accounts and the audited financial statements should indeed be addressed via this clause – after all, that is its very purpose. It would also be fair to say that, depending on the wording in the SPA and the negotiations between the parties, such a clause’s very existence indicates that it stands first in line in the hierarchy of avenues available to the buyer, at least in front on a breach of warranty claim from an insurer. Regardless, the parties may wish to crystalise this understanding in writing in the SPA.
Memorialising this understanding has a further benefit for both the buyer and the insurer: the sellers have some skin in the game.
Multi-national group companies
Over time, accounting standards and practices internationally have to some extent been aligned but are not standardised. In the case of group companies operating across multiple jurisdictions, management accounts for each entity are usually prepared in accordance with locally applicable general accepted accounting principles (or GAAP). On a consolidated level, financial statements are often presented in accordance with International Financial Reporting Standards (IFRS), and the (GAAP) accounts would require certain adjustments to be made to be compliant with IFRS.
It is not unheard of that a financial statement warranty speaks to an accounting standard (e.g. IFRS) while some individual entity level financial statements were prepared to a different standard (e.g. local GAAP). Here, in essence, a prudent seller should first assess the warranty wording, and ask whether this corresponds to the actual state of affairs. A further layer can complicate this: for example, where target management prepares management accounts according to local GAAP and then present it to a buyer adjusted to IFRS, ensuring that the GAAP to IFRS adjustments have similarly been reviewed could further mitigate any risk, especially where the warranty speaks to IFRS.
Discrepancies can also arise with different types of auditing standards across different countries. Every country has different auditing requirements for different types of companies, but those requirements may also differ between different countries. This means that a single auditing standard set out in a warranty may not be relevant or correct for each financial statements set out across various jurisdictions. Financial statements that have been audited do not necessarily mean that they were audited to a “true and fair view” standard. For example, for smaller companies, Swiss law merely prescribes a minimum level of detail for the balance sheets and income statements and Swiss standards allow companies to reflect liabilities and assets below or above “true and fair” position. Financial reporting governed by the Swiss Code of Obligations (CO) is oriented primarily towards protecting creditors and forms the basis for taxation and, where applicable, dividend payments. Unlike IFRS, financial statements prepared in accordance with the CO are primarily driven by the principle of prudence and cannot be described as true and fair.6 Consequently, a “true and fair view” warranty would warrant these Swiss audit reports to be something that they are not.
Furthermore, group companies usually have consolidated financial statements, which requires the group to make discretionary decisions and assumptions as well as estimates to a certain extent. This is further affected by, for example, the Covid pandemic, the war in Ukraine, and recent geopolitical risks and developments. While an underwriter may not necessarily be an expert in this field, it is prudent to ensure that these discretionary decisions and measures were reviewed as part of the buyer’s due diligence, especially if a warranty speaks to such measures.
Carve-out
Financial statement warranties in a carve-out transaction present their own challenges. Risks are heightened when carving-out a business division from a larger group for which historically no standalone financial statements have been prepared.In these cases, the sellers most often prepare carve-out financial statements. While the buyer and his advisors can review and assess the carve-out financial statements, they are reliant on the disclosures of the seller, and have no way to ascertain whether costs were incurred in the running of the business, but perhaps not fully disclosed by the seller.
The principle may seem simple: the seller must disclose all costs that have been incurred in the running of the carve-out business. But in reality, these financial statements are teeming with complexities. More often than not, the exact scope of the carve-out is not as clear as the parties may believe, and a moving scope means that the financial statements are similarly a moving target. It may also be that costs were incurred in the running of the business on a different corporate level, which is not easily attributable to a specific division. For example, where an international conglomerate runs a global marketing campaign, undertakes business restructuring measures, or incurs global corporate function costs, it is not easy to split and assign these costs to a single business division (one of many), because costs most likely did not benefit each division equally. And when are costs incurred by a conglomerate to the benefit of its entire business simply too remote to say that at least part of it was incurred for a specific carved-out business division?
There are no easy answers to these questions, which ultimately means that it opens the door to disputes. And in a world where the parties are eager to sign and close a deal as quickly as possible, more often than not, these disputes arise after signing or closing.
Concluding remarks
Financial statements can be complex creatures and even standard warranties speaking to them should not be underestimated. Still waters run deep.
Each transaction is unique and a practical solution for one deal may be wholly inappropriate for the next. The best approach to mitigate risk is the age-old adage: to properly assess the warranty, consider whether it is a reflection of the actual state of affairs, and ensure that the scope of the warranty corresponds with the scope of the due diligence review undertaken by the buyer and its advisors.
1 See, for example, AIG M&A Claims Intelligence report 2020, p. 3; Liberty GTS 2021 claims briefing p. 17; Marsh JLT Speciality Transactional Risk Insurance Claims Study, EMEA, p. 8. 2 For a more indepth analysis, see for example Hennrichs: Zur Haftung auf Schadenersatz wegen unrichtiger Bilanzgarantien bei M&A-Transaktionen NZG 2014, 1001 3 OLG München Urt. v. 30.3.2011 – 7 U 4226/10, BeckRS 2011, 7200 4 OLG Frankfurt a. M. NZG 2016, 435. 5 For an analysis of balance sheet warranties against the background of the OLG Munich and OLG Frankfurt judgments, see Widder/Koffka: Bilanzgarantien inUnternehmenskaufverträgen NZG 2020, 1284. 6 Deloitte, Accounting and Auditing: Investing in Switzerland (2018), p. 3.
