Private Equity

“Excluded Loss” provisions are ubiquitous in the M&A deal world. These provisions are designed to exclude certain types of losses from the reach of the indemnification provision that is intended to provide a means of compensating a buyer (subject to the agreed caps and deductibles) for the breach of the bargained-for representations and warranties respecting the purchased business. A recent article in the Fall, 2015 The Business Lawyer by this author details the dangers of these provisions and suggests alternatives to the laundry list of excluded losses often contained in such provisions.  The recent federal court decision, Powers v. Stanley Black & Decker, Inc., out of the Southern District of New York, however, could provide some limited comfort to those buyers who have agreed, notwithstanding theses dangers, to an excluded losses provision that included an independent waiver of “lost profits.”

In this case,  a buyer of a business with a typical indemnification format was seeking to withhold distribution of an escrow fund based on the alleged failure of the seller to disclose, among other things, the fact that a decision had been rendered by the Canadian taxing authorities that subjected the business to import duties going forward.  The existence of this decision was deemed a violation of one of the specific representations and warranties in the agreement notwithstanding allegations by the seller that the buyer had actual knowledge of the issue (there was a “knowledge savings clause” in the agreement that the court found mooted this defense by the seller).  Based on this breach of warranty, the buyer’s position was that its damages could be calculated based on the difference between the value of the business that is now subject to these Canadian import taxes and the value of the business had it not been subject to these import taxes.  The definition of “Losses” subject to indemnification read as follows: 

[A]ll demands, claims, actions or causes of action, assessments, losses, damages, costs, expenses, liabilities, judgments, awards, fines, sanctions, penalties, charges and amounts paid by a Person in settlement, including reasonable costs, fees and expenses of attorneys, experts, accountants, appraisers, consultants, witnesses, investigators, and any other agents or representatives of such Person, but specifically excluding (i) any costs incurred by or allocated to an Indemnified Person with respect to time spent by employees of the Indemnified Person or any of its Affiliates, (ii) any lost profits, consequential damages, punitive damages or opportunity costs (except to the extent assessed in connection with a third party claim with respect to which the Person against which such damages are assessed is entitled to indemnification hereunder), and (iii) the decrease in the value of any Transferred Asset or any asset of a Company to the extent that such valuation is based on any use of such asset other than its use as of the Closing Date. (emphasis added)

The court dismissed any potential applicability of clause (iii) of the exclusions because the claim was not based on a different use of the Company’s assets after the Closing Date, but on the same use of the Company’s assets both before and after the Closing Date.  So the real issue was whether “diminution in value” damages were included within the precluded categories of “consequential damages” or “lost profits” in clause (ii). The court declared unequivocally, referencing Hadley v. Baxendale, that “diminution in value” damages are “general” or “direct” damages, not “consequential damages,” because “where 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.”  Thus, the frequent insistence by some on specifically including “diminution in value” damages as specific category of recoverable losses in the definition of “Losses” may be unfounded, at least in New York. 

Turning to the question of whether an independent waiver of “lost profits” indirectly waived “diminution in value” damages because the ability to generate profits from a business is the basis for determining the value of that business, the court declared this argument “specious.”   According to the court, “[d]iminution in value, a backward looking measure of damages, is fundamentally different from lost profits, a forward looking measure.” 

Specific wording and facts can make a huge difference in the outcome of these cases. It is important to know what you mean when you use these terms or don’t use them. Some loss exclusion clauses actually specifically waive “diminution in value” damages as a separate category of exclusions. Notwithstanding the seeming comfort this case provides, take another look at the alternatives suggested in the referenced Fall, 2015, The Business Lawyer article.