Be Fruitful and Multiply: Pursuing Diminution in Value Damages With Respect to RWI Policy Claims—Part II

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.^[1] 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 II of this article; it addresses the evolution of cases involving DIV Damages calculated using a discounted cash flow methodology (“DCF Methodology”) under Delaware M&A damages law. 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 DCF Methodology and (ii) the evolution of cases involving DIV Damages calculated using an MOE Methodology under Delaware M&A damages law. Part III of this article will discuss the requirements for a DIV Damages award as part of an RWI claim. 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.

Calculating DIV Damages Using a DCF Methodology Rather Than an MOE Methodology

Several different situations exist in which DIV Damages calculated using a DCF Methodology may be preferable to, or even required instead of, DIV Damages calculated using an MOE Methodology. These principally include the following:

• when the buyer used a DCF Methodology to calculate the purchase price it offered or paid for the target business
• when the buyer is trying to claim the loss of future profits, including future synergistic profits, of the target business through DIV Damages
• when the revenues or expenses impacted by the R&W Breach (or by the fraudulent misrepresentation or deceit, in the case of noncontractual representations^[2]) were not reflected in the Measurement Period EBITDA but were reflected in the projected financial results of the target business

A discounted cash flow methodology^[3] can also be used to calculate damages in other scenarios, such as (i) when a prospective seller jilts a prospective buyer by breaching one or more of its binding covenants in a letter of intent or an Acquisition Agreement, or (ii) when a prospective joint venturer or joint development party jilts its prospective counterparty by breaching one or more of its binding covenants in a letter of intent or a joint venture agreement or joint development agreement. However, in those scenarios, the discounted cash flow methodology is being used to calculate the jilted buyer’s or jilted counterparty’s damages in the form of lost anticipated profits resulting from such breach or breaches rather than DIV Damages, and RWI coverage is not implicated because of the absence of an R&W Breach covered by an RWI policy.^[4]

While there are differences between DIV Damages calculated using a DCF Methodology versus those calculated using an MOE Methodology, it is still important for attorneys for an insured that is pursuing DIV Damages calculated using either methodology to be familiar with the case law involving the other methodology.^[5]

Evolution of Cases Involving DIV Damages Calculated Using a DCF Methodology Under Delaware M&A Damages Law

The Case That Began the Line: Tam v. Spitzer

The seminal case involving DIV Damages calculated using a DCF Methodology under Delaware M&A damages law is the 1995 Delaware Chancery Court case of Tam v. Spitzer.^[6] Tam involved the sale of the assets of a business known as Data Works, a data processing company owned by Lisa A. Spitzer, to Tam Management, Inc., a corporation owned by Coretta C. Tam, for a purchase price of $103,500. The purchase price was calculated by Tam’s accountant, Robert L. Siegfried Jr., using a DCF Methodology and certain valuation data.^[7]

After finding that Spitzer had committed fraud with respect to the sale of Data Works to Tam by failing to disclose the erosion of the business and the impending loss of Data Works’ largest customer, St. Francis Hospital, Vice Chancellor Jacobs awarded Tam DIV Damages of $45,290, based on the difference between (i) the valuation of the Data Works business as represented to Tam, in the form of the purchase price paid by Tam to acquire the assets of the target business, and (ii) the valuation of the Data Works business without St. Francis Hospital as a customer, with the valuation in each case calculated using the same DCF Methodology and valuation data that Siegfried had used in calculating the purchase price paid by Tam for the target business, but excluding the St. Francis Hospital business in the latter calculation.^[8]

In support of the award of DIV Damages to Tam, Vice Chancellor Jacobs made a number of factual and legal findings, including the following:

• Tam was entitled to “damages measured by the ‘benefit of the bargain,’ i.e., the difference between the actual and the represented values of the object of the transaction.”^[9]
• “The only credible valuation of Data Works without St. Francis is that of Siegfried, who employed the same discounted cash flow methodology and valuation data he had previously used to arrive at the 1991 purchase price, but then deducted the revenue and expenses attributable to St. Francis. By that method, Siegfried arrived at an adjusted value for Data Works of $58,210.”^[10]
• “Spitzer offer[ed] no independent, alternative valuation of her own. Instead, she rest[ed] upon her challenges to certain of Siegfried’s valuation assumptions.”^[11]
• “Because Spitzer has offered no credible alternative to the valuation performed by Siegfried, and has not demonstrated that Siegfried’s valuation assumptions were either unreasonable or erroneous as a matter of law, I accept Siegfried’s valuation of $58,210 as the actual value of Data Works at the time of the sale to Tam. Because Tam overpaid for Data Works by $45,290 ($103,500 – $58,210), the $103,500 purchase price must be downwardly adjusted by that amount, to $58,210.”^[12]

Tam continues to stand as the preeminent Delaware M&A damages law case involving an award of DIV Damages calculated using a DCF Methodology.^[13]

The Case That Was Reversed on Other Grounds: S.C. Johnson v. DowBrands

A Delaware M&A damages law case involving DIV Damages calculated using a DCF Methodology and relying on Tam is the 2003 U.S. District Court for the District of Delaware case of S.C. Johnson & Son, Inc. v. DowBrands, Inc.^[14] S.C. Johnson involved the sale by DowBrands of a home products business (principally, plastic bags and wraps) to S.C. Johnson for an aggregate purchase price of $1.125 billion, which was calculated using a DCF Methodology.^[15] Judge Farnan held that (i) DowBrands had committed fraudulent misrepresentation with respect to diversion to the United States of Latin American revenues of the target business, notwithstanding (a) the inclusion in the Acquisition Agreement of an independent review provision with respect to S.C. Johnson’s due diligence of the target business and (b) DowBrands’ contentions with respect to S.C. Johnson’s lack of reasonable reliance on DowBrands’ purported noncontractual representations regarding such diversion; and (ii) as a result, S.C. Johnson was entitled to DIV Damages in the form of the difference between (a) the value of the target business as represented to S.C. Johnson, in the form of the purchase price it paid to acquire the target business, and (b) the value of the target business after “backing out” the value of the Latin American portion of the target business.^[16]

However, the U.S. Court of Appeals for the Third Circuit reversed Judge Farnan’s holding of justifiable reliance by S.C. Johnson on DowBrands’ purported noncontractual representations with respect to the Latin American portion of the target business, thereby reversing the holding that DowBrands had committed fraudulent misrepresentation with respect to the Latin American portion of the target business.^[17] As a result, Judge Farnan’s holding with respect to DIV Damages was rendered inapplicable.

Because the Third Circuit’s reversal of Judge Farnan’s fraudulent misrepresentation holding in S.C. Johnson means that his DIV Damages holding has no precedential import, S.C. Johnson may be overlooked in the line of cases beginning with Tam. Nevertheless, Judge Farnan’s factual and legal findings with respect to DIV Damages calculated using a DCF Methodology are still instructive for practitioners evaluating an RWI claim including such DIV Damages. Among such findings were the following:

• “[S.C. Johnson] was harmed as a result of DowBrands’ misrepresentations regarding the profitability of the Latin American business, and therefore, is entitled to the benefit of its bargain. . . . The . . . most commonly accepted measure [of damages for fraud or deceit under Delaware law] is the benefit of the bargain rule, [u]nder [which] the plaintiff recovers the difference between the actual and represented values of the object of the transaction.”^[18]
• S.C. Johnson calculated its damages by using the same DCF Methodology it had used in preparing its final bid for the target business, to arrive at a $23.6 million figure for the Latin American portion of the target business lost due to DowBrands’ fraudulent misrepresentations.^[19]
• However, because S.C. Johnson’s final bid of $1.125 billion was only 93 percent of the $1.2 billion valuation of the target business that S.C. Johnson had calculated in preparing its final bid, Judge Farnan proportionately reduced S.C. Johnson’s $23.6 million figure to $21.948 million as its DIV Damages (in other words, Judge Farnan proportionately reduced the DIV Damages award to correspond to the purchase price that S.C. Johnson paid DowBrands for the entire target business).^[20]
• The fact that S.C. Johnson did not make any sales of the target business products in Latin America in the five months, and sold less than $1 million of plastic bags and wraps in the seventeen months, after the Acquisition was considered persuasive evidence of the effect of diversion on the Latin American portion of the target business.^[21]
• None of the following contentions by DowBrands merited a reduction of the DIV Damages award to S.C. Johnson:
  • S.C. Johnson had “improperly assumed that the diverted sales were worth nothing at all”
  • S.C. Johnson would not have reduced its bid for the target business by $23.6 million had it known of the diversion because its bid already was $63.4 million below its calculated valuation for the entire target business and because the purchase price that S.C. Johnson paid was within the range of purchase prices authorized by its board of directors
  • the overall target business sales and operating profit reported in the first full calendar year after the Acquisition were $45 million and $14 million, respectively, above what S.C. Johnson had anticipated.^[22]

In summary, while the Third Circuit’s reversal of Judge Farnan’s holding regarding fraudulent misrepresentation rendered his DIV Damages holding of no precedential import, his findings described above may still be instructive to an insured that is evaluating the assertion of DIV Damages as part of an RWI claim, particularly if calculated using a DCF Methodology.

The Case in Which the Buyer’s Assertion of Synergistic Losses Was Rejected: NetApp v. Cinelli

This brings us to the 2023 Delaware Chancery Court case of NetApp, Inc. v. Cinelli.^[23] NetApp involved the sale by Albert E. Cinelli and other equity holders of Cloud Jumper, LLC, a company that provided virtual desktop infrastructure, storage, and data management across cloud-based programs, to NetApp, Inc., for a purchase price of $35 million.^[24]

After holding that the target Cloud Jumper had committed R&W Breaches and fraud with respect to a number of representations and warranties in the Acquisition Agreement, centered around Cloud Jumper’s failure to disclose that it had been recording internal software transactions as if they were sales to unrelated external customers, Vice Chancellor Will devoted the remainder of her opinion in NetApp to the appropriate measure and quantification of damages to NetApp with respect to the R&W Breaches and fraud.^[25]

Both NetApp and Cinelli proposed an award of DIV Damages based on the difference between the value of Cloud Jumper as represented and the value of Cloud Jumper after giving effect to the R&W Breaches and fraud. What makes the NetApp case unusual and therefore significant is that the buyer NetApp chose not to treat the purchase price it had paid to acquire Cloud Jumper as the value of Cloud Jumper as represented,^[26] but instead chose to treat a DCF Methodology valuation of the future synergistic value to NetApp of Cloud Jumper as the value of Cloud Jumper as represented.^[27] In essence, NetApp was contending that Cloud Jumper was worth more to NetApp than the purchase price NetApp paid to acquire Cloud Jumper because of the synergies that NetApp anticipated achieving in the future operation of Cloud Jumper as part of NetApp (discounted to present value by the application of a discount factor).

It is important to note that Vice Chancellor Will did not simply reject out of hand NetApp’s assertion that Cloud Jumper was worth more to NetApp than it had paid to acquire Cloud Jumper because of such synergies. Instead, Vice Chancellor Will found that NetApp’s synergistic DCF Methodology valuation of Cloud Jumper did not satisfy applicable Delaware M&A damages law, both because (i) the valuation was speculative, and thus did not meet the certainty limitation of applicable law,^[28] and because (ii) the loss of synergies that NetApp was asserting was not the proximate result of the R&W Breaches and fraud committed by Cloud Jumper, at least not in its entirety.^[29]

After rejecting NetApp’s assertion of synergistic DIV Damages of $37.7 million calculated using a DCF Methodology, Vice Chancellor Will did award NetApp DIV Damages of approximately $4.6 million, based on the difference between (i) the purchase price paid by NetApp to acquire Cloud Jumper, treating that as the as-represented value of Cloud Jumper, and (ii) the defendants’ expert’s calculation of the actual value of Cloud Jumper using a multiple of revenues methodology derived from guideline comparable public companies’ stock values and reported revenues.^[30]

NetApp continues to stand as the preeminent case under Delaware M&A damages law rejecting an assertion of lost synergies as DIV Damages.

Practice Tips for Attorneys for Insureds

In the policy arrangement and negotiation phase, consider the following:

• Ensure that “diminution in value,” “multiple of EBITDA,” “multiplier damages,” “lost profits,” or the like are not excluded by the definition of Loss in the policy or in an exclusion to the policy (whether or not set forth in the “Exclusions” clause of the policy).
• Ensure that any provision in the Acquisition Agreement that purports to disclaim or waive “diminution in value,” “multiple of EBITDA,” “multiplier damages,” ”lost profits,” or the like, or “consequential” or “indirect” damages or the like, is excluded from application under the policy (for example, as “Limitation Provisions” to be disregarded for purposes of the policy).
• Try to ensure that the mitigation provision of the policy only requires “mitigation to the extent required by law” or the like, and that reasonable costs and expenses incurred in pursuing mitigation efforts are treated as Loss under the policy.^[31]

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

1. This article focuses on buyer-side RWI policies and U.S. law (principally Delaware case law). For purposes of this article:

   • DIV Damages are a form of expectation damages in which the amount of the damages is the difference between (i) the value of the target business as represented to the buyer, almost always the purchase price paid for the target business by the buyer, and (ii) the value of the target business after giving effect to the diminution in the target business resulting from a breach of the Acquisition Agreement representations and warranties (“R&W Breach”) or from fraudulent misrepresentation or deceit regarding the target business.
   • Although there are other methods to calculate DIV Damages, this article focuses on those calculated by using either (i) in the case of a multiple of EBITDA methodology (“MOE Methodology”), (a) an actual or deemed shortfall in the EBITDA of the target business for a specified measurement period (“Measurement Period EBITDA”) caused by the R&W Breach or the fraudulent misrepresentation or deceit, times (b) the multiple applied by the insured to the Measurement Period EBITDA in determining the purchase price to pay for the target business; or (ii) in the case of a discounted cash flow methodology (“DCF Methodology”), the loss of future cash flows and of terminal value over a specified period caused by the R&W Breach or the fraudulent misrepresentation or deceit, discounted to present value by the application of a discount factor.
   • As used in this article:
     • the term Loss has the definition set forth in the RWI policy;
     • the term Acquisition Agreement includes stock purchase agreements, merger agreements, asset purchase agreements, and other types of business combination agreements by which a buyer acquires a target business from a seller;
     • the term Acquisition refers to the business combination contemplated by the Acquisition Agreement;
     • the term the buyer and the term the insured are often used interchangeably;
     • the term target and the term target business are used interchangeably;
     • the term R&W Breach also includes a claim under an RWI policy with respect to a tax indemnification provision in the Acquisition Agreement; and
     • the phrase without required disclosure by the seller refers to a failure by the seller to make a disclosure to the buyer even though required to do so by a representation and warranty in the Acquisition Agreement.

   ↑

2. At least two of the leading Delaware M&A damages law cases involving DIV Damages calculated using a DCF Methodology concerned a holding of fraudulent misrepresentation or deceit with respect to noncontractual representations regarding the target business, with the court also holding that no breach of representation or warranty in the Acquisition Agreement had occurred relevant to DIV Damages. Although the M&A damages case law regarding DIV Damages applies to either a breach of representation and warranty in the Acquisition Agreement or to fraudulent misrepresentation or deceit with respect to a noncontractual representation regarding the target business, an RWI claim can only be made with respect to an R&W Breach covered by the RWI policy. ↑

3. The phrase “discounted cash flow methodology” is used here and subsequently in this Part II rather than the defined term “DCF Methodology” to differentiate the use of that methodology to calculate damages in contexts not involving the calculation of DIV Damages, such as the calculation of lost anticipated profits. ↑

4. This distinction between DIV Damages and lost profits damages can be critical in a situation in which the Acquisition Agreement contains a waiver by the buyer of “lost profits” or “consequential or indirect damages.” See, e.g., Powers v. Stanley Black & Decker, Inc., 137 F. Supp. 3d 358, 385–86 (S.D.N.Y. 2015) (under New York M&A damages law, DIV Damages are not “lost profits” or “consequential or indirect damages”). Note, however, if such a waiver is not applicable to recovery under an RWI policy, and the policy itself does not exclude such damages, this distinction may not be relevant to the insured. ↑

5. For example, as will be discussed in Part III and Part IV of this article, the requirements for and the limitations on DIV Damages are addressed in cases under Delaware M&A damages law involving DIV Damages calculated using either type of methodology, MOE or DCF. ↑

6. Tam v. Spitzer, No. 12538, 1995 WL 510043 (Del. Ch. Aug. 17, 1995). ↑

7. Id. at *12. ↑

8. Id. Forensic accountants often refer to this as running the DCF analysis “with” and “without” the revenues or expenses in question to ascertain the difference. ↑

9. Id. (citations omitted). ↑

10. Id. ↑

11. Id. ↑

12. Id. ↑

13. For an example of a recent case involving the use of a DCF Methodology to calculate DIV Damages, see Surf’s Up Legacy Partners, LLC v. Virgin Fest, LLC, No. N19C-11-092, 2024 WL 1596021 (Del. Super. Ct. Apr. 12, 2024). ↑

14. S.C. Johnson & Son, Inc. v. DowBrands, Inc., 294 F. Supp. 2d 568 (D. Del. 2003), rev’d on other grounds, 111 F. App’x 100 (3d Cir. 2004). ↑

15. S.C. Johnson, 294 F. Supp. 2d at 576–77, 594. ↑

16. Id. at 577. ↑

17. S.C. Johnson, 111 F. App’x 100, 108–10. ↑

18. S.C. Johnson, 294 F. Supp. 2d at 593–94 (citations omitted). ↑

19. Id. at 594. ↑

20. Id. at 595–96. ↑

21. Id. at 588. ↑

22. Id. at 594–95. ↑

23. NetApp, Inc. v. Cinelli, No. 2020-1000, 2023 WL 4925910 (Del. Ch. Aug. 2, 2023). ↑

24. Id. at *1, *5. The NetApp opinion did not identify one specific methodology by which the purchase price was calculated. ↑

25. Id. at *17. ↑

26. Id. Indeed, the buyer NetApp unsuccessfully argued that using the purchase price it paid to acquire Cloud Jumper as the as-represented value of Cloud Jumper would only measure NetApp’s out-of-pocket damages, not its expectation damages. Id. ↑

27. Id. at *17, *21. ↑

28. Id. at *23–26. ↑

29. Id. at *26–27. ↑

30. Id. at *29. Because Cloud Jumper was not profitable, an MOE Methodology could not be used. ↑

31. It is a judgment call whether or not to try to expressly include in the RWI policy’s mitigation provision the treatment of costs and expenses incurred in unsuccessfully attempting to mitigate losses as Loss covered by the policy. Particularly if applicable law may allow for the recovery of such costs and expenses, discretion may be the better part of valor in resisting trying for such an express inclusion since it may only cause the RWI carrier or its counsel to expressly exclude such costs and expenses. ↑