Purchase price adjustments are common features (2015 SRS study: 77% of deals) of private merger agreements that are generally intended to ensure that the acquired company will have the same level of cash or working capital to operate the business post closing that it had at signing. However, if not carefully considered, purchase price adjustment disputes may result in an unintended renegotiation of the purchase price after the closing in a way that significantly changes the economics of the transaction. A recent decision in Chicago Bridge v. Westinghouse Electric (Del. Ch. December 5, 2016) illustrates the potentially significant consequences – to the tune of about $2 billion – of a disputed net working capital adjustment where the parties disagreed over whether the closing statements were prepared in accordance with generally accepted accounting principles, or GAAP. The court held, as a preliminary matter, that the dispute had to be resolved through the agreement’s dispute resolution mechanism and not adjudicated by the court. It then found, over the seller’s objections, that the independent auditor tasked with resolving the dispute could review issues of GAAP compliance in connection with the parties’ preparation of the closing statements because the specific provisions in the contract gave the auditor broad authority to do so.
The ruling draws attention to the specific drafting that may or may not give a party the ability to open the closing statement to GAAP review, which is generally disfavored due to the vast discrepancy in which companies apply GAAP to financial statements. Regardless of how the dispute is ultimately resolved, the ruling provides guidance on how courts may interpret these provisions going forward, which should result in deal parties focusing on the words more carefully. Moreover, because GAAP compliance is often also addressed in the representations and warranties of an agreement, as was the case here, the decision also highlights the need for parties to consider the interplay between the purchase price adjustment and the representations/indemnification provisions, in order to ensure that the drafting is aligned with each party’s understanding of its post-closing risks.
At the time of the acquisition, Chicago Bridge & Iron Company N.V. (the seller), was working with Westinghouse Electric Company LLC (the buyer) on a project to design and build two nuclear power plants through the seller’s subsidiary, CB&I Stone & Webster (the company). The project suffered severe cost overruns and delays and resulted in disagreements over who bore responsibility. To resolve these disputes, the buyer agreed to buy the company and assume all its project costs and liabilities for an aggregate purchase price of $0 in cash, subject to a purchase price adjustment based on the company’s net working capital at the closing, plus potential deferred payments in the form of earnouts. The agreement contemplated a large net working capital target of $1.174 billion at signing, subject to a typical two-way adjustment if the company’s cash at closing was either more than or less than the target amount. Days before the closing, the seller delivered an estimated closing statement reflecting net working capital in excess of the target, which would have required a payment to the seller of $428 million. After closing, the buyer delivered a final closing statement reflecting a negative net working capital amount that would have required a payment to the buyer of $2.15 billion.
The wide gap stemmed from four changes made by the buyer to the seller’s calculations that demonstrated how calculations, derived from GAAP, may diverge significantly. In its closing statement, the buyer challenged the following inputs: (1) a “claim cost” receivable that the buyer decreased because it did not believe it was 100% collectible due in part to the fact that a significant portion of the receivable was owed by the buyer and the buyer disputed the charges, (2) a claim receivable that the buyer adjusted downward to reflect the cost of design changes that were mandated to be implemented by regulators that the seller had not accounted for, (3) cost estimates that the buyer believed should be increased for certain projects and (4) a liability of $432 million that the buyer believed was not accounted for that was related to the seller’s original acquisition of the company. The parties then agreed to invoke the agreement’s dispute resolution mechanism, but shortly before the objections period ended, the seller filed this lawsuit.
The court dismissed the case, noting that the plain language of the agreement established that the parties were required to resolve disputes through the independent auditor. It then found that the agreement contained express provisions permitting the buyer to challenge GAAP compliance in the preparation of the closing statements. In particular, the court cited to:
- a provision in the purchase price adjustment (Section 1.4(f)) that required the closing statements to be “prepared and determined from the books and records of the Company . . . in accordance with . . . GAAP” that was separate from the “compliance with GAAP” representation in the financial statements representation, which the court said established an independent reason why the seller’s GAAP compliance could be reviewed,
- a provision giving the independent auditor the authority to resolve “any and all matters that remain in dispute” and that gave the auditor the ability to act as an “expert” and not just as an “arbitrator” in resolving disputes, which allowed the auditor to go beyond pure mathematics and review the underlying accounting methodologies, and
- a carve-out in the “sole remedy” provision of the indemnity for disputes under the purchase price adjustment, which indicated that even if the representations in the agreement did not survive the closing, the separate representations in the purchase price adjustment gave the buyer a separate avenue to pursue remedies for GAAP non-compliance.
In reviewing the case, the court compared the facts to other precedents that addressed purchase price disputes over GAAP compliance. The court distinguished the contractual language from the contract at issue in OSI Systems v. Instrumentarioum (Del. Ch. 2006), in which the court construed the terms of the dispute resolution mechanism narrowly and held that alleged breaches of GAAP compliance in the closing statement were required to be pursued through the contract’s representations (and indemnity) regime. The court held that, unlike here, the OSI contract did not contain a separate representation in the purchase price adjustment that the closing statements would be prepared in accordance with GAAP. The court also found that the OSI contract did not expressly carve-out purchase price adjustment disputes from the agreement’s sole and exclusive remedy provision. The court then analogized the case to Alliant Techsystems v. MidOcean (Del. Ch. 2015), in which the court held that issues of GAAP compliance in the purchase price adjustment should be resolved by the independent accountant charged with addressing working capital disputes, and concluded that the Alliant case controlled. The court noted that in Alliant, there was a similar carve-out in the “sole remedy” provision of the indemnification and a separate provision that required the working capital calculation to be GAAP compliant.
The decision offers some key observations:
The facts here were unusual in light of the parties’ historical business relationship and interrelated dealings, which may explain the unusually large discrepancy in the purchase price adjustment. Typically, purchase price adjustments are not intended to be used as a means to renegotiate the purchase price after closing. Therefore, parties tend to price deals assuming that there will be no working capital adjustment, with sellers, in particular, more often concerned about the potential for a negative adjustment than they are hopeful for a positive adjustment.
However, despite this common premise, GAAP compliance disputes often arise due to the inconsistency in which parties apply GAAP to line items (e.g., accounts receivable or deferred revenue) on financial statements. To help minimize disputes, if a seller is requested to provide an estimate of working capital that is “in compliance with GAAP,” it may wish to qualify that statement with, “as applied in a manner that is consistent with the acquired company’s past practices and methodologies.” A seller may also wish to qualify GAAP compliance with an illustrative calculation set forth in an exhibit that the parties agree will guide the calculation of the final net working capital adjustment after closing (and not just serve as the basis for “the format” of the closing statement, as was required in Chicago Bridge).
In many deals, the net working capital target, itself, is agreed upon based on an average of net working capital over time. Implicit in the calculation of the target amount is the assumption that accounting methodologies will not differ. Seller-favorable language may therefore require an adjustment to the target amount if differing methodologies or principles are used in the final calculation so that the true-up will allow for an apples-to-apples comparison. From a buyer’s perspective, it should review the illustrative calculation and closing statement carefully, and ensure that the methodology used is logical and understandable so that the final closing statement will reflect the company’s true net working capital, or other chosen metric, for the acquired business.
Parties should also be mindful of the way in which the purchase price adjustment interacts with the indemnification remedy or escrow. Sellers should be cautious when carving out purchase price disputes from the “sole and exclusive remedy” provision of the indemnity because the court has construed such carve-outs broadly, even if the substance of the dispute may well relate to matters (e.g., litigation, financial statements) intended to be addressed in the representations and remedied solely through an indemnification escrow.
See a copy of Chicago Bridge & Iron Company N.V., v. Westinghouse Electric Company LLC, C.A. No. 12585-VCL (December 5, 2016)