When an insured is pursuing a representation and warranty insurance ("RWI") claim, a critical consideration is whether diminution in value damages ("DIV Damages") can be asserted as "Loss" covered by the RWI policy. This article, being published in four parts, discusses Delaware mergers and acquisitions ("M&A") damages law regarding DIV Damages and describes how an insured can pursue them as part of an RWI claim.

This is Part III of this article; it discusses the requirements for a DIV Damages award as part of an RWI claim. Part I of this article addressed (i) the principal differences between DIV Damages calculated using a multiple of EBITDA methodology ("MOE Methodology") and DIV Damages calculated using a discounted cash flow methodology ("DCF Methodology"), and (ii) the evolution of cases involving DIV Damages calculated using an MOE Methodology under Delaware M&A damages law. Part II of this article addressed the evolution of cases involving DIV Damages calculated using a DCF Methodology under Delaware M&A damages law. Part IV of this article will discuss the limitations on, and other matters regarding, a DIV Damages award as part of an RWI claim.

Each part of this article contains practice tips for attorneys for insureds seeking recovery of DIV Damages as part of an RWI claim.

There are three basic requirements for any RWI claim, and therefore for any claim for DIV Damages under an RWI policy. An insured must establish that:

A different way to say the foregoing is that after the Acquisition, (i) the insured becomes aware of revenue or expense information about the target business without required disclosure by the seller, and (ii) had the insured known about the problem prior to the Acquisition, the insured would have reduced the purchase price that it paid for the target business.

Effectively, the DIV Damages serve as a post-Acquisition purchase price adjustment in favor of the insured.

Some types of R&W Breach are more likely to lead to a claim for DIV Damages, while others are more likely to lead to a claim for out-of-pocket damages (i.e., a "1x claim").

The following types of R&W Breach are more likely to lead to a claim for DIV Damages:

One other note regarding R&W Breaches: Very rarely does an Acquisition Agreement contain a representation and warranty with respect to the Measurement Period EBITDA itself or with respect to projections provided for the target business. Even though Measurement Period EBITDA or projections may be a critical piece of information regarding the target business and the purchase price to be paid therefor, buyers typically do not request and sellers typically do not offer such a representation and warranty.

Two types of loss can result from an R&W Breach:

DIV Damages are expectation damages that are a type of first-party loss. Although there may be other types of methodologies to calculate DIV Damages, they almost always are calculated using an MOE Methodology or a DCF Methodology.

Certain issues are similar regardless of the methodology used in calculating DIV Damages.

The Loss must be in the form of an adverse effect on the target business.

A claim for DIV Damages can only readily be made if the buyer can prove that the purchase price for the target business was based on either an MOE Methodology or a DCF Methodology.

The simplest and most effective proof of that is if the indication of interest ("IOI") or the letter of intent ("LOI") for the Acquisition explicitly sets forth the metrics of the methodology that the buyer used in arriving at the proposed purchase price for the target business.

Short of such explicit proof, evidence that the buyer established the purchase price for the target business on such a basis and that the seller knew the buyer was doing so should be sufficient under Delaware M&A contract damages law.

Short of that would be proof that the buyer primarily used such a methodology and that it was the most appropriate way to have valued the target business or established the purchase price for the target business.

The determination of the diminution in value resulting from an R&W Breach is more of a forensic science than a legal analysis, and even then with some art mixed in.

The first step is to identify the actual or deemed adverse effect of the R&W Breach on the Measurement Period EBITDA or on the projected cash flows and terminal value. It may seem obvious, but if, for example, a significant customer has been lost prior to the consummation of the Acquisition without required disclosure by the seller, then the adverse effect is not measured by the revenue received from that lost customer during the Measurement Period but instead by that amount of revenue net of the costs that would have been incurred to earn such revenue and that can be avoided by the target business, often referred to as "avoided costs."

The second step is to determine whether or not such net revenue (i.e., EBITDA or cash flow) from that customer would have been recurring enough to justify the award of DIV Damages.

An MOE Methodology is composed of two elements: (i) Measurement Period EBITDA and (ii) a multiple applied to the Measurement Period EBITDA.

In addition to add-backs for I, T, D, and A, EBITDA is often adjusted to add back certain other costs and expenses to arrive at an "Adjusted EBITDA" for the target business. The buyer's accounting expert's quality of earnings ("Q of E") report is the best source for an explanation of such adjustments and for information about a target business's EBITDA generally.

If the purchase price for the target business was calculated using an MOE Methodology, then the multiple used in calculating DIV Damages should be the same multiple that was used in calculating the purchase price. If a multiple has more than one number right of the decimal point, it is most likely an implied multiple (i.e., a multiple derived simply by dividing the purchase price by the Measurement Period EBITDA).

A DCF Methodology is composed of three elements: (i) cash flow projections, (ii) terminal value, and (iii) a discount rate applied to each of the projected cash flows and the terminal value.

Because such projections are of cash flows, not of financial accounting income, noncash charges such as depreciation and amortization typically are not treated as reductions to revenue, unlike cash charges such as cost of goods sold ("COGS") and selling, general, and administrative expenses.

If the purchase price for the target business was calculated using a DCF Methodology, then the calculation of DIV Damages may not require an in-depth analysis of the cash flow projections that were so used, but instead may only require use of the same projections but with the effects of the R&W Breach in question (including any avoided costs) backed out to calculate the deemed actual value of the target business as of the date of the R&W Breach.

There essentially are two types of terminal value used in a DCF Methodology:

The first type (which is more of a "continuing value") assumes that the target business will experience steady growth after the final period of the projections, and then applies a mathematical formula to the final period's net cash flow amount to calculate a sum of the infinite, growing cash flows, with that result discounted to net present value by application of the chosen discount factor.

The second type (which is more of an actual "terminal value") takes the final period's net cash flow amount and multiplies it by a market multiple, with that product discounted to net present value by application of the chosen discount factor.

In either case, the terminal value will constitute a significant portion (often 70 percent or more, pre-discounting) of the aggregate cash expected to be received from the target business.

Except to the extent that the cash flow projections were themselves adjusted for risk, the discount rate used should account for risk, and not solely to account for the time value of money (often referred to as the "risk-free rate"), to arrive at the DIV Damages -- that is, the appropriate post-Acquisition purchase price adjustment discounted to then-present dollars and to reflect the probability of future risk.

A typical factor to use to account for risk is the buyer's weighted average cost of capital ("WACC"). However, if DIV Damages are being calculated on a "with/without" basis, then the same discount rate used by the buyer in calculating the purchase price for the target business (the "with" case) should be used to calculate the deemed actual value of the target business backing out the effects of the R&W Breach in question (the "without" case).

It is often the case that the buyer did not actually use a DCF Methodology to "set the purchase price" for the target business, but instead only to confirm that the purchase price was within a range in line with the buyer's expectations for its return on the Acquisition. In that context, it may be necessary to resize the DIV Damages calculated from the "with/without" analysis to correspond to the purchase price.

For DIV Damages to be recoverable Loss under an RWI policy, it is not sufficient merely to identify an R&W Breach and a Loss in the form of a shortfall in Measurement Period EBITDA or with respect to projected cash flows of the target business. That R&W Breach must have been the proximate cause of that Loss.

The typical process for an insured to formulate an RWI claim is to identify an R&W Breach and then to determine what losses have been proximately caused by that R&W Breach and whether such losses are recoverable under the RWI policy.

However, sometimes the script is flipped, and the insured identifies a loss impacting the target's post-Acquisition business and then tries to find an R&W Breach that might have "caused" that loss (a "loss in search of a breach").

In the case of an R&W Breach or Breaches with respect to the target's historical income statement(s), the R&W Breach(es) needs to cover the entire Measurement Period for DIV Damages calculated using an MOE Methodology to be recoverable. Since the Measurement Period will often be a last twelve months ("LTM") or trailing twelve months ("TTM") period that does not match up with a single historical income statement covered by the financial statements representation and warranty, the R&W Breaches will need to apply to more than one such financial statement.

In the RWI policy claim evaluation phase, consider doing the following:

This article is the third in the RWI Practice Insights series by John T. Capetta.