M&A Disputes. Biemans A. Vincent

as of the closing date. Such adjustments are made post‐closing because, among other things, it is typically not possible to correctly quantify the net working capital on the closing date itself because of the time necessary to perform a typical “closing of the books.”

      In such situations, the purchase agreement can provide for a preliminary closing statement based on which the preliminary purchase price is calculated and paid at closing. Subsequent to closing, the buyer is commonly contractually required to submit a proposed closing statement with updated net working capital amounts and any resulting purchase price adjustment. The seller may disagree with the buyer's calculations and send a – contractually provided for – objection notice. In the case of disagreement regarding any proposed adjustments, the purchase agreement commonly provides for negotiations between the parties, which are typically aided by the exchange of information between them.

      In the event the parties cannot resolve the implementation of the purchase price adjustment between them, the purchase agreement may provide for the disputed items to be submitted to an accounting arbitrator for resolution. The dispute phase will typically at least involve the parties tendering initial and rebuttal submissions (with supporting documentation) to the accounting arbitrator for consideration and resolution of the dispute.

      The focus of this book is on disputes arising after the closing of an M&A transaction and their resolution through accounting arbitration. Of course, the parties' pre‐closing activities can have an impact on the post‐closing purchase price adjustment process. For example, the level of sell‐side and buy‐side due diligence performed prior to closing can result in the preemptive identification and resolution of potential problem areas and, generally, increase the parties' knowledge of the accounting of the company being sold/acquired. Moreover, the negotiation of the purchase agreement and the precise language of its provisions can have a significant impact on the implementation of any purchase price adjustment mechanisms and the ultimate purchase price paid and received.

      CATEGORIES OF PURCHASE PRICE ADJUSTMENT PROVISIONS

      Contractual post‐closing purchase price adjustment mechanisms are found in purchase agreements that are structured as stock purchases as well as in those that are structured as asset purchases. Post‐closing purchase price adjustments can range from immaterial in the context of the transaction to large amounts that significantly impact the economics for the buyer and seller. There are three broad categories of potential contractual post‐closing adjustments to the purchase price:

      1. Adjustments to the purchase price based on the financial position or performance of the target company as of or through the closing date

      2. Adjustments to the purchase price based on the financial performance of the target company subsequent to the closing date

      3. Adjustments to the purchase price based on the allocation of financial responsibility through representations, warranties, and indemnifications in the purchase agreement

      Each of those categories of post‐closing adjustments can lead to disputes between the parties to the transaction. In addition to contractual purchase price adjustment disputes, there are also disputes related to the transaction and/or the purchase price that are based directly on the legal framework governing the transaction as opposed to the underlying contract. An example of a possible legal challenge that can lead to an adjustment to a share purchase price is a Delaware appraisal action. Another example of a legal challenge related to alleged under‐ or overpayment can be an action based on allegations of transaction fraud. Parties can also end up in dispute regarding a transaction that was never consummated based on, for example, allegations that one of the parties wrongfully failed to close. As this book focuses on accounting arbitrations, which generally find their basis in being preemptively agreed upon as a form of alternative dispute resolution, non‐contractual purchase price adjustment disputes are outside the scope of this book (although we discuss transaction fraud briefly in Chapter 22).

      As it relates to contractual purchase price adjustments, agreements governing larger transactions generally contain at least a choice of law and forum selection clause. Many agreements, however, go much further and contain arbitration and/or expert determination clauses complete with prescribed procedures and an agreed‐upon timeline for dispute resolution. The agreed‐upon choices for alternative dispute resolution and the associated procedures can differ dependent on the nature of the potential dispute. In other words, one purchase agreement can contain multiple avenues for dispute resolution. For example, an agreement can simultaneously contain (i) an overall clause that prescribes New York law as the governing law and the federal court for the Southern District of New York as the venue of choice, (ii) an arbitration clause that arranges for an American Arbitration Association appointed arbitrator to decide any indemnification‐related disputes, and (iii) a clause that provides for an independent accountant to resolve any post‐closing net working capital disputes.

      In general, the perceived benefits of alternative dispute resolution include the relative efficiency of the process, as it is often both faster and cheaper than traditional litigation, as well as the ability to tailor procedures and discovery. The limitations on discovery tend to be especially attractive to foreign transaction parties, for which the U.S. discovery process is often significantly more extensive than the obligations that are imposed by their home jurisdictions. In addition, especially in the event of a would‐be venue that is smaller and less used to foreign litigants, some foreign parties may fear that they would be at a disadvantage due to local biases. Of course, alternative dispute resolution also has downsides, including a commonly perceived tendency of arbitrators to arrive at split or compromise decisions as well as significant limitations on the ability to appeal an arbitration ruling. In the case of purchase price adjustment clauses, the efficiency benefits of alternative dispute resolution can be further increased by having, what are essentially, accounting disputes analyzed and decided by accountants.

      The first category of purchase price adjustment disputes – adjustments based on the target company's financial position or performance as of or through the closing date – is as close as it gets to contract‐based pure accounting disputes. The underlying adjustment mechanisms include those based on the amounts of net working capital, debt (or net debt), and/or cash and cash equivalents that are transferred with the company at closing. The adjustment mechanisms can also incorporate performance measures such as EBITDA, earnings before interest and taxes (EBIT), or a variety of custom measures that cover a defined period prior to closing. For example, the contractual purchase price adjustment formula can incorporate the company's Adjusted EBITDA for the 12 months leading up to closing into the calculation of the ultimate purchase price. Not surprisingly, purchase agreements routinely arrange for purchase price disputes related to category 1 adjustment mechanisms to be brought before an independent accountant. Coates (2012) – in his analysis of a sample of M&A agreements for the period from 2007 through 2008 – found that “83 % of contracts containing price‐adjustment clauses also contained clauses mandating arbitration of disputes arising out of those price‐adjustment clauses.”1

      Importantly, disputes related to category 1 adjustment mechanisms center on the quantification of an adjustment, if any. Generally, there is not the two‐step of actionable wrongful conduct and damages that is common in general civil litigation. Indeed, the need for some form of adjustment is generally not indicative of wrongful behavior. The existence of a dispute does not belie this; the parties may simply disagree on the appropriate accounting and need assistance in quantifying (part of) the adjustment.

      Category 2 adjustments – adjustments based on post‐closing performance – are commonly referred to as earn‐out provisions and allow the seller of a company to retain some interest in the upside of the company's financial performance while protecting the buyer against paying upfront for expected performance that may never materialize. In a sense, disputes in the second category are often not about adjusting an estimated purchase price, but about quantifying what should be the ultimate purchase price based on post‐closing performance. Those disputes can encompass accounting issues and/or various legal and non‐accounting factual allegations about wrongful conduct. The accounting issues are frequently resolved by accounting arbitrators. The non‐accounting aspects of such