What can the buyer of an operating business recover as damages when the seller fails to indemnify the buyer for harm caused by the seller’s breach of a representation or warranty in the transaction contract? Modern case law and commentary describe mutually exclusive options: either dollar-for-dollar damages to recover out-of-pocket losses, or damages equal to the diminution in value of the business, which is often misleadingly described as damages “subject to a multiplier” or “at the multiple.”[1] The determinative question for deciding between these options, we are told, is whether the business has been permanently injured as a result of the issue giving rise to the breach. For example, if the breached representation concerns the status of a material customer relationship, some would suggest that the buyer must establish lost revenues from that customer “into perpetuity” to be entitled to diminution in value damages.[2] However, the notion that diminution in value damages are only appropriate if the business has suffered harm that will linger for eternity is a false construct, and a confusing way of expressing the simple concept that diminution in value damages are warranted only when the value of the business as acquired has actually been diminished by the seller’s breach. The confusion is compounded when the best way of calculating the diminution in the entity’s value involves using a multiple of earnings, and the valuation methodology is mischaracterized as producing a multiple of damages. Determining whether the value of a business has been diminished by a seller’s breach of representation or warranty (really, its breach of its obligation to indemnify for the loss caused by that breach) is hard enough, without muddying the waters with a misleading standard. This article will endeavor to dispel some myths haunting the measurement of damages in representation and warranties claims arising out of mergers and acquisitions.
Absent an express remedy in the contract, state common law is the starting point for determining damages for a breach of contract. While many states express the measure of damages arising from a breach of contract as “the amount of money that would put the non-breaching party in the same position that the party would have been in had the breach never occurred,”[3] that simple phrase leaves much open to interpretation and offers little real guidance in the M&A context. To place the buyer of an operating business into the position it should have held but for a breach of representation concerning the business, a court will typically award either the cost to “remedy the defect” caused by the breach (an out-of-pocket loss), or the diminution in the value of the business.[4] Ostensibly, the court selects an option which makes the buyer whole without an unwarranted windfall.
The easiest way to illustrate these damages options is through hypotheticals at the extremes. If the seller’s breach of warranty is an inflated representation of one, relatively minor, account receivable, the buyer could be placed in the position it would have been in but for the breach by awarding damages in the amount of the difference between the receivable as represented and in reality. This remedy makes the buyer whole, because the value of the entire business really has not been diminished by one inflated account receivable. At the other extreme, if the seller has fraudulently and grossly inflated its last twelve months’ earnings by using fictitious revenue from fictitious customers, then the value of the business as delivered to the buyer is materially different than the value as warranted. In that case, diminution in value damages are the only way to make the buyer whole.
But consider a more nuanced situation where the breach of representation or warranty concerns the status of a material customer relationship, and the relationship disappears upon the buyer’s purchase. Should the buyer be compensated for the lost profit from the relationship for some fixed period of time, maybe tied to the length of the business’ contract with the customer (if such a contract exists)? Or, should the buyer be compensated for the difference between the value of the business with an unimpaired customer relationship (as warranted) and the value without the relationship at all (as delivered)? There is scant case law from which to answer these questions, which only causes undue emphasis on the few cases that strive to do so.
Zayo Group, LLC v. Latisys Holdings, LLC, C.A. No. 12874-VCS, is one of the rare cases that does consider the type of damages to be awarded in a situation somewhat similar to the one described above, albeit only in dicta and limited to some very specific facts. Zayo involved the sale of an information technology infrastructure services business that primarily employed short-term contracts with its customers. The seller warranted that it had not received notice of the termination of, material modification of, or refusal to perform, its material contracts. The seller, however, did not warrant lack of notice of a customer’s intent not to renew a material contract. When several material contracts did not renew post-acquisition, the buyer brought suit. After trial, the court entered judgment for the seller, finding no breach of contract. Although the decision on liability was determinative of the case, the court considered the buyer’s claim for damages. A careful reading of the damages portion of the Zayo opinion reveals the court’s reliance on the seller’s expert as the source of what could be misunderstood as statements of the law of damages. For example, the court stated:
Benefit of the bargain—or expectancy—damages measure the difference between the as-represented value of a transaction (typically the purchase price) and the value the purchaser actually received. The actual value the purchaser received, in turn, must assume, and account for, a diminution of the company’s earnings into perpetuity. The “benefit of the bargain” methodology is appropriate for calculating damages only when the alleged breach of the representation or warranty has caused a permanent diminution in the value of the business (as a result of lost revenues into perpetuity) and the business has thereby been permanently impaired.[5]
As explained below, the italicized sentence, for which no legal authority is cited, is ripe for misinterpretation and serves as a poor teacher for any court seeking to determine whether out-of-pocket loss or diminution in value is the appropriate measure of damages.
Precise word choice matters, and this portion of the Zayo opinion uses temporal terms that cannot be read literally, leaving courts and practitioners alike to wonder how they should be applied. No buyer of a business could ever prove lost revenues from any customer into perpetuity. “Perpetuity” is defined as “eternity,” and “eternity” is defined as “infinite time.”[6] It is hard enough (impossible, actually) to prove that a customer would be a customer for eternity, but if the customer relationship has been lost, how does the business buyer prove that the customer would have been a customer for eternity after the customer is no longer a customer by its own volition?
Similarly, “permanent” is defined as “continuing or enduring without fundamental or marked change.”[7] While the loss of a material customer relationship could permanently diminish the value of a business, it is equally possible that such a loss could materially diminish the value of the business as sold (at the time of the acquisition), but over the course of time the business could recover.[8] Is the buyer only entitled to diminution in value damages in the former scenario, but not the latter? And, if the question turns on whether the value of the business will forever be diminished, or might at some point in the future recover, how could the parties and court even determine that within the timespan of a litigation commenced shortly after the sale?
The manner in which valuation professionals value businesses may be to blame for the misleading suggestion that lost revenue into perpetuity is a prerequisite for diminution in value damages. Valuation professionals typically value a business by making an informed estimate of the business’s future using its present and past performance as indicia of its prospects. Typically, the income stream used in the valuation of a business should be the expected income into “perpetuity,” but, that income into perpetuity is then discounted (through a discount rate or embedded within an earnings multiple) to capture the increasing and compounding risk that the income stream could stop after a given year and, therefore, not last into perpetuity. Effectively, depending on the discount rate, after about 15 to 20 years the expected discounted annual income could quickly approach $0. In other words, while “perpetuity” is the standard terminology used in valuing a business, it is a risk adjusted perpetuity, such that the valuation models typically reflect little incremental benefit from the income after 15 to 20 years in the future. The buyer of a business does not typically actually expect any business condition, let alone a revenue stream, to continue into perpetuity, further divorcing the aforementioned Zayo standard for the award of “expectancy damages” from the reality of what a business buyer expects from a transaction. This therefore begs the question of why, if the status of a material customer relationship is misrepresented and the objective value of the business as delivered is less than as warranted, a court would require a buyer to prove loss of perpetual income that no one contemplated simply to recover the difference in the value of the company as promised and as conveyed?
The use of the misnomer “damages subject to a multiplier” to explain diminution in value damages compounds the confusion caused by the misunderstanding of “perpetuity” for valuation purposes.[9] This phrase conflates the nature of the harm with the valuation methodology used to calculate the harm. A brief hypothetical illustrates the point: Assume a business is purchased for $100 million, and the purchase price was established under a market approach valuation using a 5x multiple against a trailing 12-month EBITDA of $20 million. The seller represents that it is unaware of any indication that its top ten customer relationships are in peril. That representation proves to be false; the seller was aware that a top, longstanding customer was planning to terminate its relationship, and the customer does so right after the sale. The customer was responsible for $2 million of EBITDA over the trailing 12 months. The buyer may argue that the appropriate calculation of damages is to use the market approach to determine the difference between the value of the business as warranted ($100 million) and as delivered. The buyer might then argue that the court should back out the lost customer’s contribution to the trailing 12-months EBITDA ($2 million) from the company’s total, and then reprice the business as it was originally priced, using a 5x multiple. This would result in an “as-delivered” value of $90 million (5 x $18 million). The difference between the business as warranted and as-delivered now is $10 million ($100 million – $90 million), thus the buyer’s diminution in value damages are $10 million.
Too often, however, the buyer’s damages in this scenario are described as “damages at the multiple” or as consequential damages, as if the buyer’s damages were actually $2 million, and are somehow being multiplied like a statutory enhanced damages award.[10] In fact, the buyer’s damages are $10 million, the difference between the price paid and the value of the company as delivered, and are only being calculated using a multiple in the market-based valuation methodology. Indeed, it is likely that the business without the customer relationship could be valued (and the same damages amount reached) using an income approach without a multiple but with a discount rate. Awarding any plaintiff or injured party a “multiple” of its actual damages sounds extreme, to be applied only in the most egregious of situations. But, in this hypothetical the buyer is not recovering a “multiple” of its damages, it is recovering the base value of its actual damages. Characterizing the amount as damages “at the multiple” or “subject to a multiplier” simply because a market approach is used to calculate the diminution in the company’s value will consciously or unconsciously bias courts against what is a just award.
A more honest – if not better – standard for determining when diminution in value damages are appropriate in mergers and acquisitions representations and warranties claims is akin to Justice Potter Stewart’s famous definition of pornography: “I know it when I see it.”[11] Notwithstanding its misleading use of “damages at the multiple” and “perpetuity” terminology, the AICPA Practice Aid that was heavily relied upon by the seller’s expert (and thus the court) in Zayo provides a simpler analysis: “Claims that result in dollar-for-dollar damage are typically those that have a one-time effect on the target and that do not impact the target financial condition in future periods (in other words, will not affect future cash flows).”[12] To determine whether a diminution in value has occurred, the AICPA Practice Aid advises that “[t]he primary question that should be asked and evaluated is, Has the buyer’s business been damaged into the future?”[13],[14] Damage that lasts into the future is more likely to be damage that affects the underlying value of the business at the time of the sale, but as suggested above, the future is not necessarily eternity.
Rather than trying to understand and adhere to misused concepts like “perpetuity,” “permanent,” or “at the multiple,” courts should employ a more holistic approach, focusing on the buyer’s actual expectations, the impact of the misrepresentation on the business after the transaction,[15] and a healthy dose of common sense. In Zayo, for example, a host of factors contributed to the court adopting the seller’s damages calculations, including that (i) no breach occurred (which explains why the damages portion of the opinion is dicta), (ii) the buyer’s expert had no valuation experience, and (iii) no buyer witness testified that the buyer would have paid less but for the alleged misrepresentation. However, the core of the court’s reasoning was that the underlying business “was a revolving door” of short-term contracts with short customer loyalty.[16] The loss of a few of these short-term customer relationships was to be expected and did not devalue the overall business in an amount greater than the lost contract renewal revenue (the out-of-pocket loss). Therefore, a “dollar-for-dollar” damages award would make the buyer whole, whereas a diminution in value recovery calculated using a multiple of EBITDA would result in a windfall to the buyer.
As the case law in this area develops, one would expect and hope to see more clarity around the standard for determining when diminution in value damages are appropriate. Diminution in value, after all, is the traditional remedy for a breach of warranty under the “benefit of the bargain” rule, i.e., the difference between the actual value of the property and the value which it would have had absent the breach.[17] As a result, one would expect diminution in value to be the default remedy for a contractual misrepresentation in the sale of a business, generally applicable absent a showing that it would result in a windfall. Eliminating the misconceptions that diminution in value damages require proof of lost revenue for eternity or that they equate to enhanced damages may hasten the arrival of such much-needed clarity.
[1] See, e.g., American Institute of Certified Public Accountants Forensic & Valuation Services Practice Aid for Mergers and Acquisition Disputes (“AICPA Practice Aid”), at 19 (“Depending on the nature of the alleged breach, claims for indemnification may result in dollar-for-dollar damages to recover out-of-pocket losses or damages subject to a multiplier in situations when a buyer can demonstrate that it overpaid for the target based on the alleged breach.”)
[2] Zayo Group, LLC v. Latisys Holdings, LLC, C.A. No. 12874-VCS, 2018 WL 6177174, *16 (Del. Ch. Nov. 26, 2018).
[3] Cobalt Operating, LLC v. James Crystal Enterprises, LLC, Civ. A. 714-VCS, 2007 WL 2142926, *29 (Del. Ch. July 20, 2007) (citing Del. Limousine Serv., Inc. v. Royal Limousine Serv., Inc., 1991 WL 53449, *3 (Del. Super. 1991)). See also, Merrill Lynch & Co., Inc. v. Allegheny Energy, Inc., 500 F.3d 171, 185 (2d Cir. 2007) (“A party injured by breach of contract is entitled to be placed in the position it would have occupied had the contract been fulfilled according to its terms.”) (citation omitted).
[4] See Universal Enterprise Group, L.P. v. Duncan Petroleum Corp., C.A. No. 4948-VCL, 2013 WL 3353743, *19 (Del. Ch. July 1, 2013). There is certainly an argument that the correct measure of damages is always, or almost always, diminution in value: “[W]here the seller makes misrepresentations about the business he is selling, the natural and probable result is that the business is actually worth less than the buyer paid, and diminution of value damages therefore compensate the buyer for ‘the value of the promised performance.’” Powers v. Stanley Black & Decker, Inc., 137 F. Supp. 3d 358, 386 (S.D.N.Y. 2015) (quoting Schonfeld v. Hilliard, 218 F.3d 164, 176 (2d Cir. 2000)).
[5] Zayo, C.A. No. 12874-VCS at 16 (citations omitted; emphasis added).
[6] https://www.merriam-webster.com/dictionary/perpetuity; https://www.merriam-webster.com/dictionary/eternity.
[7] https://www.merriam-webster.com/dictionary/permanent.
[8] Damages are measured at the time of the breach. Comrie v. Enterasys Networks, Inc., 837 A.2d 1, 17 (Del. Ch. 2003); Sharma v. Skaarup Ship Mgmt. Corp., 916 F.2d 820, 825 (2d Cir. 1990). For a breach of representation or warranty arising from the sale of a business, that time is typically the date the transaction closes.
[9] See supra, n.1.
[10] See AICPA Practice Aid, at 57 (“Indemnity claim damages can be measured two ways: dollar for dollar over a finite period or into perpetuity or at the multiple ….”); Powers, 137 F. Supp. 3d at 385-86 (holding that diminution in value damages are direct, not consequential, damages).
[11] Jacobellis v. Ohio, 378 U.S. 184, 197 (1964) (Stewart, J., concurring).
[12] AICPA Practice Aid, at 57.
[13] Id. at 59.
[14] In the sale of an operating business, past harm can create damage into the future. The import of representations and warranties is to protect against the possibility that the earnings assumptions on which the buyer relies in purchasing the business are not sustainable on a going-forward basis. Cobalt Operating, at *27. Thus, past harm (e.g., inflated revenue figures, or concealment of material customer relationship problems) often affects future cash flows.
[15] A word of caution: As noted above, damages are measured as of the date of the breach, which is usually the date of the transaction. See supra, n.5. Courts have taken very divergent views on whether the company’s performance after the transaction is probative of its value as of the date of the transaction. See, e.g., Merrill Lynch & Co., 500 F.3d at 185 (“The district court’s inquiry into [the business’s] performance and market conditions in the months following the acquisition was improper because events subsequent to the breach, viewed in hindsight, may neither offset nor enhance [the buyer’s] general damages.”)
[16] Zayo, C.A. No. 12874-VCS at *16.
[17] See, e.g., Clearview Concrete Products Corp. v. S. Charles Gherardi, Inc., 88 A.D.2d 461, 453 N.Y.S.2d 750, 756 (Sup. Ct., App. Div. 2nd Dept. 1982) (citations omitted).
