M&A Disputes. Biemans A. Vincent

their respective bargained‐for items as documented in the purchase agreement. In many transactions, there is a purchase price adjustment mechanism that allows for upward or downward adjustments to the purchase price based on a specific metric. If the parties cannot agree on the purchase price adjustment, the purchase agreement commonly provides for an accounting arbitration process.

      Following are the typical steps the parties go through from the closing of a transaction to the commencement of an accounting arbitration:

      1. After the closing of the transaction, the buyer obtains control of the company and gains direct access to the company's books and records. The purchase agreement typically provides for a defined period of time for the buyer (e.g., 30 days) to prepare a proposed closing statement that contains, among other things, a proposed final amount of net working capital as of the closing date and any resulting adjustment to the purchase price.

      2. After the buyer submits its proposed closing statement to the seller, the seller typically has a predetermined period of time (also, e.g., 30 days) to analyze the proposed closing statement and to assess whether the seller agrees or disagrees with one or more of the buyer's proposed adjustments. If the seller agrees with all of the proposed adjustments, the purchase price is updated and the transaction is finalized. If, after review and the exchange of information between the parties, the seller rejects all or part of the buyer's proposed adjustments, the seller submits a written response detailing any objections (commonly referred to as an “objection notice”).

      3. If an objection notice is submitted, the parties enter a contractually agreed‐upon negotiation phase. In this phase a further exchange of information and negotiation takes place to attempt to resolve or narrow the adjustments that the seller objected to prior to entering the dispute phase.

      4. Any remaining unresolved adjustments are then submitted to an accounting arbitrator for resolution in accordance with the relevant purchase agreement.

      In the remainder of this chapter, we first discuss the common steps reflected in the previous summary in more detail. We then provide and discuss the common steps that are part of the dispute process.

The Proposed Closing Statement and Proposed Purchase Price Adjustment

      For a transaction with a purchase price adjustment provision, the first step in the post‐closing process is the buyer's assessment of its acquisition and the preparation of a “proposed closing statement” or “closing balance sheet.” Most purchase agreements provide an agreed‐upon time period, often 30 to 90 days, for the buyer to prepare the proposed closing statement.

      The proposed closing statement contains the adjusted net working capital as well as the impact of any adjustments on the purchase price. Specifically, the adjusted net working capital amount is compared to the (preliminary) amount of net working capital used as of the closing date. Any surplus or deficiency is used to calculate the proposed purchase price adjustment. By means of example, if the purchase price paid at closing was $100 million based on a preliminary net working capital amount of $20 million and the buyer's post‐closing calculation of net working capital shows $15 million, the buyer would propose a $5 million purchase price reduction.

      The above is a simplistic summary of what can be a complicated process. Purchase agreements can vary in their definition of net working capital, its components, and the standard for quantifying it. By means of example, the purchase price can be calculated on a cash free/debt free basis. For some transactions, that can mean that the cash is retained by the seller and the company's debt is paid off at closing. For other transactions, that can mean that the purchase price is negotiated without giving consideration to cash and debt. As of the closing date, the cash that transfers with the company will have to be added to the purchase price and the debt, potentially including a variety of debt‐like items, will have to be deducted. In such instances, the purchase agreement will have to carve‐out cash and cash equivalents from the net working capital definition and set the boundaries between net working capital and debt, which could otherwise overlap. Purchase agreements can also provide for a host of other exclusions, additions, or limitations, which may or may not be GAAP compliant. Such transaction‐specific items can include a wide variety of items such as, for example, an agreed upon cap on warranty accruals or the contractual exclusion of certain inventory items from the net working capital calculation.

      Finally, there are also purchase agreements that provide for the seller to prepare the proposed closing statement. This is much less common because for most transactions the seller already prepares the net working capital or other metric that is used to derive the purchase price paid at closing. Moreover, after the closing, the buyer has control of the company and, in many instances, direct access to its books and records.

Accepting or Objecting to Post‐Closing Purchase Price Adjustments

      Upon receiving the buyer‐prepared proposed closing statement, including any proposed purchase price adjustment, the seller commonly has a contractually agreed‐upon opportunity to review and either accept or object to the buyer's calculations. Purchase agreements commonly provide for (i) a specified time for review by the seller, (ii) a requirement for the seller to prepare an objection notice that specifically addresses any adjustment that the seller disagrees with and identifies the grounds for its disagreement, and (iii) any items to which the seller has not objected to be deemed accepted and final.

      The proposed closing statement is typically the buyer's only opportunity to propose adjustments to the purchase price based on a net working capital adjustment mechanism and the objection notice is typically the seller's only opportunity to dispute such proposed adjustments.

      Under normal circumstances, the objection notice should not contain a blanket objection to all adjustments proposed by the buyer. The individual objections are generally required to have a basis in the purchase agreement. On some occasions, the parties are still in the process of exchanging information as the objection notice becomes due. In such instances, the parties can agree to extend the deadline for the seller's objection notice or the seller can object pro forma to the items for which it has not yet received sufficient information to come to a fully informed conclusion. Extending the deadline may result in a cleaner process, but the latter approach has the benefit of taking a series of uncontested items off the table.

The Negotiation Period

      In the event the seller submits an objection notice, many purchase agreements provide for a period of negotiation (e.g., 30 days) between the parties to resolve the objections prior to a formal dispute resolution process.

      During this negotiation period, the parties will share and discuss information regarding their positions on the adjustments proposed by the buyer. Frequently, the seller will request additional supporting documentation from the buyer to more fully understand the basis for the buyer's proposed adjustments. It is not unusual for several of the proposed adjustments to be resolved between the parties during this negotiation period.

Example: Misplaced and Found Inventory

      ◼ After the closing, the buyer counts the inventory, finds items missing, and adjusts the inventory balance to incorporate the results of the count in its proposed closing statement. The proposed closing statement, thus, reflects a variety of missing items and a downward adjustment of the purchase price.

      ◼ The seller objects to the adjustment as it believes there was no inventory missing as of the closing date.

      ◼ Subsequent to the objection notice, the seller is able to help the buyer find the missing items, which the company keeps in a special supply closet in one of its offices.

      The negotiation process is not only an opportunity for the parties to exchange information. It also allows the parties to critically assess their positions and the positions of their counterparty. As various items are often discrete, as opposed to interdependent, it is common for multiple items to be resolved as the parties trim and exchange their respective “weak” positions. We discuss the negotiation process and the “resolution matrix” that can assist a party in analyzing its position across various items in Chapter 10.

Unresolved Disputed Items Submitted to an Accounting Arbitrator

      If the parties are unsuccessful in reaching an agreement on all of the seller's objections to the buyer's proposed closing statement,