Financial Statements Breach

A global manufacturer of sporting goods purchased a buy side Representations and Warranty (R&W) policy on an acquisition. The buyer calculated the purchase price by applying a multiple to the target company’s annual earnings as reported in the company’s audited financial statements. After the transaction closed, the buyer re-audited the financial statements of the company in anticipation of a public offering, resulting in a calculation of lower earnings.

The difference between the two earnings calculations arose in large part from a lower valuation of the company’s inventory and accounts that were prepared for the later public offering. The buyer argued that the higher valuation at the time of the transaction caused it to overvalue the company in the purchase price. More specifically, the buyer argued that the seller had breached its representation that the company’s financial statements complied with generally accepted accounting principles, and its separate representation that the company had an adequate system of accounting controls. The buyer also alleged breaches of representations that the company was in compliance with applicable laws, and that the company did not have any liabilities, commitments, or obligations that were not disclosed.

AIG engaged forensic accountants to work with the insured company’s accounting and internal financial personnel to evaluate the alleged breaches and quantify the amount of the buyer’s losses from any breaches found. AIG’s experts confirmed that breaches of representations had occurred and that the buyer had provided documentation to support its claim for loss. AIG quantified the amount of the buyer’s loss and paid a significant amount to cover the losses incurred by the buyer.

Misstatement of Inventory

AIG insured an international industrials group in connection with the acquisition of an EMEA-based engineering services business. Following the transaction, the insured’s auditors identified a failure by management to make the correct adjustments in respect of the erroneous booking process for certain stock. As a result, the insured argued that accruals were understated in the target by several million dollars, which led to an overstatement of earnings.

The insured had therefore suffered loss by significantly overpaying for the target and sought recovery under its R&W policy. A breach of the financial statement warranties was claimed, and our M&A claims adjusters were able to quickly confirm a breach. A lack of evidence presented some challenges in quantifying the loss. However, by engaging forensic accountants, the adjusters were able to work proactively with the insured’s advisers to verify the analysis behind the claims against the evidence actually available. Following this review process, AIG paid out an amount in the tens of millions of dollars.

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