A typical provision in a purchase and sale agreement requires the buyer, post-closing, to provide a “true-up” of the target's net working capital agreed upon by the parties at closing. If the seller disagrees with the contents of the true-up (items or amounts) it is normally required to send the buyer a Notice of Objection to such calculation and, if the parties cannot thereafter amicably resolve their differences, such dispute is typically referred to an accounting firm designated in the purchase agreement as an independent expert to render a “final, conclusive and binding” decision resolving such dispute.
What is involved in retaining the independent expert? First, note that this is a joint retention by buyer and seller. So, notwithstanding that a certain Big 4 or other accounting firm has been designated to so act in the purchase agreement, the parties, unless otherwise specified, have the ability to agree, or not, to the terms set forth in the engagement letter as proposed by the independent expert. Thus, each side has leverage to either expedite, delay or derail the arbitration process and thwart the original selection of the independent expert. Such tactics can take the form of objecting to the terms of the engagement letter or to the selection of the individuals at the accounting firm proposed to make the final determination. Second, the parties must agree upon the terms of the independent expert's engagement. The standard independent expert engagement letter usually contains two attachments: Attachment “A,” which typically sets forth three columns, i.e., “Items in Dispute,” “Buyer's Position” and “Seller’s Position,” and Attachment B, which sets forth timeframes and events. When the decision letter is ultimately rendered by the independent expert at the end of this process, a fourth column will be added by the independent expert which will reflect such final determination and either increase or decrease the target working capital established by the parties at closing. Notwithstanding the contents of the true-up and the Notice of Objection, the parties usually have the ability to mutually add additional items and amounts in dispute to Attachment “A.” Often, the parties cannot agree as to the characterization of the items in dispute. Some independent experts allow the conflicting points of view to each be set forth in the applicable “Items in Dispute” column. Others refuse to act until the parties are in agreement.
One item in dispute that often generates considerable controversy is whether the refund to the seller of taxes with respect to pre-closing periods and loss carrybacks not yet received should be determined and/or paid only after the buyer receives same from the IRS, or whether an estimate of such refund should be included in the working capital calculation determined by the independent expert. The standard net working capital adjustment provision in most purchase agreements provides that any such refunds received by the buyer post-closing must be transmitted to the seller only upon receipt thereof by the buyer from the IRS. As we all know, waiting for the IRS to act could result in a significant delay in the seller receiving such payment. That language, however, by itself, is not necessarily dispositive as to the timing of transmission of refunds because typical purchase agreements also provide that the parties can, if they so desire, treat such refunds as part of the working capital computation. That would allow the independent expert to include such refunds within its final determination, if they are based upon reasonable estimates, which is what GAAP requires in order to do so.
To illustrate the point, in a recent dispute the independent expert stated that GAAP requires tax assets to be recognized in the period when it is more likely than not that an entity is entitled to the economic benefits of those tax assets. So, for example, if transaction bonuses in a leveraged buyout are payable and become a liability and an expense at the time of closing, then the related benefits of the net operating loss (NOL) tax asset created by the transaction bonuses also become more likely than not and should be recognized at the time of closing. As a result, such NOL tax asset was determined by the independent expert to be included in the working capital computation at the time of closing and the payment thereof was not required to be held in abeyance pending the buyer's receipt of the refund from IRS.
Many purchase agreements are silent on when tax refunds shall be payable, or leave it to the parties to mutually agree. If sellers wish to expedite matters, they should negotiate for the independent expert to award such refunds as part of its mandate in the absence and in advance of remittance from IRS. This will allow the seller to expeditiously receive these refunds absent being subject to intentional or other delays caused by tardy filing by the buyer of amended tax returns seeking such refunds. Including this item in the appropriate column of Attachment “A” to the engagement letter should be helpful in conferring such authority upon the independent expert even if the purchase agreement is silent or permissive (but not mandatory) with respect to the scope of authority so granted to the accounting firm so engaged. An interesting question arises as to what the disposition should be if, when the ultimate IRS refund is received years later, such refund is in an amount significantly different than the "reasonable" estimate upon which the independent expert rendered its working capital decision. That discussion is beyond the scope of this article.
As noted above, Attachment “B” to the independent expert engagement letter usually sets forth a schedule of events and time frames which the parties are required to adhere to. The first meaningful event is the submission of each party’s “Statement of Position” to the independent expert. When each side has submitted its Statement of Position, the independent expert provides copies thereof to the opponent and time is then provided for each party to reply to the other party's “Statement of Position.” The independent expert typically reserves the right, during specified time periods, to send interrogatories to one or both parties requesting a written response thereto within additional time frames. A frequently asked question from the independent expert might be: "If there is a conflict between GAAP and the Purchase Agreement, which shall govern?" Answering that question is not always simple when the purchase agreement says its accounting terms are governed by US GAAP, consistently applied. Failing to receive responsive, satisfactory or clarifying answers, the independent expert may issue supplemental interrogatories or, in some cases, request a telephone conference or, rarely, in-person meetings with both sides. Depending upon the wishes of the parties as reflected in the content of the engagement letter itself, the independent expert may be asked to render a long form reasoned decision or a short form conclusion-oriented decision. In either case the engagement letter generally provides that either party may only contest arithmetical calculations, and all additional substantive arguments and materials received after the initial decision letter is issued will be disregarded or discarded. Note that the decision of the independent expert will not generally award interest, attorney fees or other costs unless specifically articulated in the purchase agreement. Given the paucity of precedent in this area, the best practice is probably to also provide for recovery of such items in the engagement letter if that is what is intended.
How is the independent expert's determination enforced? Once the engagement letter is executed, the independent expert should be the final authority as to matters within its purview. Courts and arbitration panels such as the American Arbitration Association appear to have given deference to the decisions of these independent experts absent fraud or conflicts of interest, the latter of which is usually initially addressed in the engagement letter. However, even though the decision letter is "final, binding and conclusive," the quoted language by itself may or may not be sufficient to confirm the working capital decision of the independent expert so as to have a judgment entered thereon similar to the confirmation and entering of a judgment based upon a commercial arbitrator’s award. Litigators generally recommend that the parties add language to the purchase agreement and the independent expert's engagement letter to the effect that such award may be entered and reduced to judgment in a court of competent jurisdiction so as to enable the prevailing party to enforce the terms thereof if payment is not made when required. The terms of the typical independent expert's engagement letter are required by the independent expert to be "confidential," so any public disclosure thereof, even converting the award to a judgment which is publicly filed, may require a carve-out to the terms of such letter.
What strategic considerations should parties to working capital disputes be mindful? Given the above process, which is the modus operandi of the Big 4 accounting firms, several questions arise in how to strategically position the arguments on both sides. First, will the independent expert review the true-up and the “Notice of Objection” or only the Statements of Position and replies? If so, how detailed should those documents be? Do the parties want to state their full positions in the true-up and Notice of Objection documents, or, should they save some ammunition for the Statements of Position in the event no resolution can be achieved before having to utilize the services of the independent expert?
Other issues related to the net working capital adjustment may also arise that are outside the purview of the independent expert. For example, what happens if the buyer delivers its true-up significantly later than required under the terms of the purchase agreement? Or, what happens if one party refuses to agree to the terms of the engagement letter? The independent expert cannot resolve these issues because it has not been engaged to do so, and thus the parties will be relegated to the other dispute mechanisms set forth in the purchase agreement.
One thing is for certain. No careful lawyer or private equity executive should go down this dispute resolution path (or sign a purchase agreement) absent guidance from an expert well versed in GAAP and the nuances of such a potential dispute, especially if large sums are involved.