The New York City Bar Association recently presented a program titled “Why Purchase Price Adjustment Clauses Fail and How to Fix Them.” The program presented the ﬁndings of the Committee on International Commercial Disputes on purchase price adjustment clauses in private M&A transactions. The Committee’s report found that case law has exposed fundamental ﬂaws in the structure of purchase price adjustment clauses and substantial disagreement about the applicable legal standards for such clauses. The NYCBA panel distilled some of the main issues addressed in the Committee report, and we summarize and discuss some of these issues below.
Purchase Price Adjustment Clauses Generally
Purchase agreements in private M&A transactions often include a provision (commonly referred to as the “purchase price adjustment clause”) that sets forth a mechanism to conﬁrm the value of the target business as of closing and for an adjustment to the purchase price for any changes to the target’s value during the period between signing the purchase agreement and closing the transaction. The purchase price oﬀered by the buyer is typically determined, at least in part, based on the target company’s most recently prepared ﬁnancial statements (usually the most recent ﬁscal quarter or year end). Purchase price adjustments are typically based on changes to speciﬁc ﬁnancial metrics of the target company, and most commonly on changes to the target company’s working capital.
Dispute Resolution in Purchase Price Adjustment Clauses
Purchase price adjustment clauses commonly contain their own dispute resolution mechanism whereby the parties agree to submit any disputes regarding the adjustment to an independent accounting ﬁrm for a ﬁnal and binding determination. The Committee’s report found that there has been signiﬁcant confusion as to how to classify these dispute resolution mechanisms from a legal standpoint. They are often assumed to be arbitration provisions, and thus to be governed by the legal rules governing arbitration with the independent accountants acting as the arbitrators. However, the Committee’s report suggests that there is another viable option, called “appraisement” or “expert determination” that is less commonly known in the United States, but that has a developed legal history, especially in New York. The legal classiﬁcation is important because it will determine how the parties can challenge and enforce the accounting ﬁrm’s determination, so parties should carefully consider the available options when drafting purchase price adjustment clauses.
Arbitration vs. Expert Determination
The case law suggests that the best way to determine if the parties intend for a dispute resolution mechanism to be treated as an arbitration or an expert determination is to look at the type and scope of the authority granted to the decision maker. In an arbitration, the parties delegate broad authority to the decision maker to decide all legal and factual issues necessary to resolve a dispute (analogous to the authority of a judge to resolve a dispute). In an expert determination, the authority granted is limited to deciding a speciﬁc factual dispute, normally concerning a matter within the special expertise of the decision maker.
While expert determination is less well known in the United States than in other jurisdictions, New York actually has a statute (CPLR 7601) that explicitly recognizes this dispute resolution mechanism and provides that parties to an agreement providing for an expert determination of a dispute may seek a special proceeding to speciﬁcally enforce such a determination (similar to how a party would enforce an arbitration clause in New York). New York courts recognize the distinction between arbitration and expert determination and will speciﬁcally enforce expert determinations and, in appropriate cases, will provide judicial conﬁrmation and entry of judgment with respect to expert determinations, pursuant to the power granted them by CPLR 7601.
Standard of Review for Expert Determination
The distinction between arbitration and expert determination is also signiﬁcant because of the way that disputes regarding the arbitration award or expert determination are handled by the courts. It is important for the parties to correctly identify whether they prefer an arbitration or expert determination because the two proceedings may be subject to diﬀerent standards of review by a court.
The review of an arbitration award is set by the applicable rules of arbitration and cannot be contractually modiﬁed. Conversely, the review of expert determinations are governed by state law and in New York, for example, an expert determination is binding in the absence of “fraud, bad faith or palpable mistake.” The Committee notes that while this standard may be diﬃcult to meet, it may still give the court greater discretion than the parties intended by allowing the expert determination to be invalidated upon a ﬁnding that the expert lacked a “reasonable basis” for his determination, failed to follow customary practice or procedure or used a method deemed by the court to be unreliable.
Unlike the arbitrator’s role, which is to determine issues of both fact and law, an accounting ﬁrm’s role in reaching an expert determination is to determine factual issues relating strictly to the closing ﬁnancial statements. The Committee advises against giving courts the discretion to second-guess and therefore “re-arbitrate” the expert determination and recommends that the parties narrow the court’s review and provide that the expert determination will be ﬁnal and binding absent “fraud or manifest error.”
The Committee noted that parties usually do not clearly distinguish whether they intend the accounting ﬁrm’s purchase price adjustment resolution to constitute an arbitration award or expert determination. In some cases, parties may even use terms such as “arbitration” or “arbitrator” but describe a proceeding that shows their intent to provide for an expert determination. The Committee recommends that the parties expressly provide for either an arbitration or an expert determination. When providing for an arbitration, the Committee suggests (1) using the terms “arbitration,” “arbitrator” or “arbitration award,” (2) designating the applicable arbitration rules and (3) providing that judgment on the “arbitration award” may be entered in any court of competent jurisdiction. When providing for an expert determination, the parties should state that (1) the accounting ﬁrm is “acting as an expert and not as an arbitrator,” (2) the purchase price adjustment clause is not an arbitration provision and should be governed by the law of expert determination and appraisal, (3) the accounting ﬁrm’s authority is limited to resolving disputed issues of fact and not law, and (4) the expert determination will be ﬁnal and binding absent “fraud or manifest error.”
Reconciling a General Arbitration Clause with a Purchase Price Adjustment Clause
A few issues arise when a contract has both a general arbitration clause and a purchase price adjustment clause. First, will a dispute related to the purchase price adjustment clause be decided by the designated accounting ﬁrm or by an arbitrator under the general arbitration clause? Second, what is the relationship and hierarchy between the purchase price adjustment clause and the general arbitration clause? For example, if a party seeks an injunction in connection with, or to enforce or set aside a decision made by, an expert acting under a purchase price adjustment clause, should that party go to court or ﬁle a claim with an arbitrator under the contract’s general arbitration clause?
The sparse case law on these issues has generally found that disputes relating to the expert determination fall outside the scope of the agreement’s general arbitration provision unless expressly included. Under this theory, only a court will have jurisdiction to mediate any disputes regarding the expert determination. The logic behind these rulings may be that an expert determination is treated as an alternative or speciﬁc carve out to the general arbitration clause. On the other hand, courts have also found that the opposite is true, particularly in disputes involving cross-border transactions where generally parties intend to avoid the national courts of the other party. To avoid potentially unexpected results in the event of such a dispute, the Committee recommends that the parties expressly carve out or include the expert determination within the scope of the general arbitration provision.
Procedural Problems in Purchase Price Adjustment Clauses: Access to Books and Records
Purchase agreements often grant one party the right to access the books, records and personnel of the party that has prepared the closing ﬁnancial statements. Access to this ﬁnancial information is usually necessary for a party to be able to fully understand the closing ﬁnancial statements and prepare its required objections with the “reasonable detail” often required by the agreement. Denial of access to the preparing party’s books, records and personnel may have signiﬁcant consequences for the objecting party. Failure to identify a speciﬁc issue or otherwise comply with the “reasonable detail” requirement in the objection notice may result in a waiver or invalidation of a party’s objection to the closing statements.
As most purchase price adjustment clauses are currently structured, the independent accounting ﬁrm is retained only after a dispute has arisen and the parties have failed to negotiate a resolution. Typically, ﬁrst the closing ﬁnancial statements are prepared by one party, then the other party is given a limited period of time to prepare its objections, and then the parties attempt to negotiate a resolution to the dispute. It is only if the parties cannot reach a resolution that an accounting ﬁrm is retained and even then, the accounting ﬁrm’s role is limited to resolving only the disputed items (even if undisputed items are later found to be incorrect).
The result is that there is no practical ability for a party to seek the early intervention of an accounting ﬁrm to force a party to provide information the other party needs to prepare its objection notice. Without such a clause, a party seeking to require the other party to comply with its obligation to provide access to books, records and personnel has no option but to turn to the court. Compounding this problem are the very short time limits — typically 30 to 45 days — imposed on a party to prepare its notice of objections.
The Committee recommends that parties modify their purchase price adjustment clauses so that a party may seek the early intervention of the designated accounting ﬁrm to resolve disputes about access to books, records and personnel. The Committee also recommends that the accounting ﬁrm be given the authority to stay and extend any relevant deadlines, and, if a party demonstrates that it has been prejudiced by a denial of access to information, then also to allow the party the opportunity to amend its notice of objections and any other applicable documents.