Claims trends give deal-makers clues to pitfalls

Liberty GTS has recently published its annual Claims Briefing for 2021.  The study gives us in-depth insight into key points that M&A transaction teams and advisors need to be alive to, including accounting and financial issues, the importance of contract checking and the emergence of cyber claims.

Tax is a common source of smaller claims

Large tax-related claims remain uncommon, however, smaller tax claims do come through regularly, and typically involve either corporation tax or sales tax issues.  We are seeing more import tax claims, relating to increasingly complex global supply networks.  Environmental tax claims are also increasing as governments drive greener corporate practices via the tax system.

Accounting & financial issues are behind some of our largest claims

Accounting and financial issues remain significant, especially in the Americas.  Many of these claims involve stock and inventory issues and can be very large, some in excess of $50m.  We also see a high number of claims relating to revenue recognition issues, including overestimation of expected revenue, reallocation of costs, or even management fabricating revenue for goods yet to be supplied.

These are not the only ways that financials can be manipulated.  Others include delays in the recognition of impairments to assets, the understatement of allowances or overstatement of accounts receivables.  Dealmakers beware – lack of due diligence here can be hugely expensive to all sides.

Contracts need checking with counterparties

In last year’s study, we reported that claims involving contract-related issues were on the rise, especially in the Americas, and this trend has continued. The most common issues involve the failure to disclose changes to high-revenue contracts.  In a number of these cases, had the buyer spoken to the key customer concerned, the issue would most likely have been discovered prior to the deal signing – a point to note for future deal diligence.

Wage-related disputes are on the rise

These types of claims can be surprisingly expensive and can result in additional tax liabilities plus an increased wage bill.  Wage claims are a growing risk area and carry an added ‘social inflation’ exposure, especially in the U.S., where they are susceptible to plaintiff-friendly jury awards.  

Cyber claims are an emerging area of risk

It will come as no surprise to hear that in the last 12 months there have been ever more claims involving cyber-attacks, with victims including financial institutions, healthcare companies, education establishments and infrastructure. 

M&A insurers increasingly see this as a risk that businesses ought to be managing by purchasing a bespoke cyber policy with suitable cover and adequate limits, and our advice is that M&A advisers now need to consider specific cyber-related warranties when insuring a deal. 

IT claims look set to continue to rise

Claims involving software licensing shortfalls also continue to grow, and we believe this is an unstoppable trend, given the rise in audits carried out by software vendors. 

We are also finding that major IT projects part way through being rolled-out at the time of the sale are becoming an increasingly common source of claims.  These claims typically relate to missed milestones, higher than expected costs, or the failure of the project. 

Be wary of ongoing disputes during a deal

Third-party claims, relating to a dispute that was already ongoing at time of acquisition, make up a more significant portion of claims notifications than many appreciate, and the number has been steadily increasing: around 39% of our notifications so far this year have involved a third-party claim (which is up from around 21% in 2020). 

We expect this to become an increasingly common issue going forward, and we advise M&A teams to do careful due diligence around possible disputes in the target company.

Check, check and check again

The summary above highlights growing sources of dispute after a deal is transacted.  As such, they may provide a useful checklist to those involved in making deals.  As can be seen, there are multiple ways in which sellers can manipulate values, but the answer to many of them is check, check and check again.  Due diligence must mean just that.