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Maximising recovery in a warranty and indemnity claim

Once breach of an insured warranty is established, the next step is to calculate the loss flowing from that breach. Here are three tips to consider at this stage in the claims process.

1. Know the contractual basis for the calculation of “loss”.

The first step is to look at the policy wording for the definition of “loss”, as well as the sale and purchase agreement (SPA). For UK buy-side policies, it is typically defined as the amount the buyer would be contractually entitled to recover from the seller under the SPA, bar the warranty cap and sometimes the time limitation cap.

For UK sell-side policies, it is typically the contractual amount for which the seller would be liable to the buyer. In principle, damages are calculated as the difference between the objective market value of the business as warranted, and the objective market value of the business with the breaches (the ‘actual’ market value).

While some policies do contain express provisions in respect of the calculation of loss – for example, prohibiting the use of a multiple, or taking an indemnity (dollar-for-dollar) approach to the loss – most UK policies do not, and leave it up to insureds and insurers to measure and eventually agree the loss arising as a result of the breach.

2. Obtain expert, robust, and appropriate forensic accounting and valuation advice at an early stage, in order to properly assess the correct methodology for calculating loss, and to fully support the claimed quantum.

If the policy wording does not prescribe a method for calculating loss, UK businesses need to look at the principles used when valuing the company at the time of purchase, and calculate the impact on value as a result of the breach, based on those principles. The loss may be a ‘one-off’ that does not go to the valuation of the company – for example, where a company does not own as much equipment as it warranted (that is, the net assets are less than expected); this would not necessarily result in any change to the value of the company if it was calculated using an earnings-based approach. Alternatively, the loss may have a direct impact on the value of the company itself – for example, financial misstatements or treatment of liabilities in the accounts, which have an effect of inflating earnings before interest, tax, depreciation, and amortisation on an earnings-based approach.

Where a multiple is being claimed, be prepared to fully explain and justify the multiple as it is likely to significantly increase the value of the claim.

Insurers may also consider factors outside of the financials of the business – for example, whether the acquisition price was good or bad.

3. Consider defence costs cover.

Under a buy-side policy, defence costs cover is typically triggered only by the defence of a third-party claim against the target or insured. However, under some policies, cover can also be triggered by investigation, negotiation, or settlement of a breach, or a potential breach event. In some cases, it is therefore possible to claim professional costs incurred from the outset. This possibility should be considered early on, and prior consent should be obtained from insurers if required by the policy terms. Insurers should also be kept advised of any costs being incurred as the claim progresses.