It is common practice for purchase agreements in private company M&A transactions to contain one set of rules to determine and resolve disputes regarding a post-closing purchase price adjustment and a separate, often vastly different, regime for dealing with breaches of representations and warranties. The recent Delaware Court of Chancery decision in Chicago Bridge & Iron Company N.V. v. Westinghouse Electric Company LLC and WSW Acquisition Co., LLC (Del. Ch. December 5, 2016) highlights the need to carefully consider how these separate regimes interrelate when it comes to overlapping subject matter, particularly GAAP compliance, to avoid unintended consequences. In the Westinghouse case, the seller thought it had eliminated its exposure for non-compliance with GAAP by having the GAAP financial statement representation expire at the closing. That effort failed, however, because the court ruled that the purchase price net working capital adjustment provision allowed the buyer to make adjustments to the purchase price to correct for any non-compliance with GAAP.
Buyers and sellers should consider what effect the post-closing purchase price adjustment provisions should have on the representation and indemnity provisions and vice versa and draft carefully to achieve that effect
Buyers might lose the opportunity to challenge post-closing purchase price adjustment calculations on the basis of GAAP compliance or other grounds unless the issue is addressed in the purchase agreement with specific language, which may need to:
negate typical survival/sole remedy carve outs
enlarge the authority customarily granted to independent accountants adjudicating disputes
distinguish the financial statements representation from the standard for calculating the purchase price adjustment
Sellers might lose their insulation against exposure for GAAP compliance or other representation issues, despite any survival/sole remedy clause, if the clause contains carve outs for the purchase price adjustment provisions
Buyers and sellers should consider whether an issue, such as GAAP compliance, decided in a purchase price adjustment dispute resolution proceeding should be considered finally determined for purposes of any subsequent breach of representation claim that might have the same issue at its root
In Westinghouse, the buyer, a designer of nuclear power plants, agreed to purchase the seller’s subsidiary that built nuclear power plants. The purchase price consisted of a closing payment, in part determined by the amount of closing date net working capital of the target business, and an earnout. Based on the seller’s estimate of closing net working capital, the closing payment was US$428 million. After closing, as part of the post-closing purchase price adjustment procedure, the buyer calculated that the closing payment should have been negative US$2.15 billion (meaning that, in addition to returning the US$428 million closing payment, the seller owed the buyer US$2.15 billion). Part of the reason for the US$2.578 billion swing in the purchase price calculation was that the buyer claimed that the seller’s calculation had failed to calculate closing date net working capital in accordance with GAAP because the seller had omitted a US$423 million liability.
The purchase agreement provided that the seller could either accept the buyer’s calculations, in which case they would become “final, conclusive, binding and non-appealable” or submit the dispute to an independent accountant for review, with the independent accountant’s determinations being “final, conclusive, binding, non-appealable and incontestable.” Instead, the seller filed suit.
The seller claimed that the purchase agreement prohibited the buyer from making adjustments to the purchase price based on alleged non-compliance with GAAP. The seller pointed to an article of the agreement containing a clause stating that the representations and warranties, “including any rights arising out of any breach of such representations [and] warranties [,]” would not survive the closing. The seller argued that, because there was a financial statements representation from the seller that spoke to compliance with GAAP, the survival clause eliminated any right the buyer might otherwise have, whether in the form of a suit for breach or the post-closing purchase price adjustment procedure, to challenge the GAAP compliance of any of the figures in the financial statements. However, the buyer cited another provision in the same article of the agreement that stated that the article would not “operate to interfere with or impede the operation of [the purchase price adjustment dispute resolution provision].”
The Court’s Analysis and Holding
The court sided with the buyer and granted the buyer’s motion for judgment on the pleadings, finding that the purchase agreement was not ambiguous. In doing so, the court relied on Alliant Techsystems, Inc. v. MidOcean Bushnell Holdings, L.P. (Del. Ch. Apr. 24, 2015) and distinguished the case from OSI Systems, Inc., v. Instrumentarium Corporation (Del. Ch. Mar. 14, 2006). The court noted that the purchase agreement in both Westinghouse and Alliant (but not in OSI) contained (1) a provision stating that the sole remedy or non-survival provision would not operate to interfere with or impede the operation of the post-closing working capital adjustment provisions, (2) a provision separate from the representations and warranties requiring the working capital calculation to be calculated in accordance with GAAP, and (3) a representation regarding the target company’s financial statements that did not encompass the closing date working capital calculations. The court also noted that the grant of authority to the independent accountant in both Westinghouse and Alliant provided that the independent accountant would act “as an expert and not as an arbitrator” and the court in Alliant had found that this grant, absent any limiting language to the contrary noted by the court, “encompassed assessments of accounting methodology[,]” including GAAP compliance. By contrast, the court in OSI had found that the grant in that case (to determine “the appropriate amount of each of the line items” in the working capital statement) did not encompass determining GAAP compliance. The court in Westinghouse also rejected the seller’s argument that the potential size of the adjustment was a reason to take the issue away from the independent accountant, even though that was a factor cited by the court in OSI. On this point, the Westinghouse court distinguished OSI on the grounds that the parties recognized that size could be an issue as evidenced by a cap provision included in the purchase agreement.
Westinghouse should serve as an important reminder to pay close attention to the interplay between purchase price adjustment provisions and other purchase agreement provisions, particularly the survival, sole remedy and indemnification clauses. If buyers would like to calculate, and ensure that the independent accountant is authorized to calculate, the purchase price adjustment items in accordance with GAAP, they should take care to carve out the purchase price adjustment provisions from any survival or sole remedy provision and to vest the independent accountant with the authority to make such decisions. In this case, the authority clause should also expressly state that it includes authority to determine whether the purchase price adjustment items have been calculated in accordance with the agreed upon accounting principles/GAAP, regardless of the potential size of the adjustment. Buyers should also consider the interplay between survival limitations and any potential need for additional language if the seller’s financial statements representation encompasses the working capital. Sellers, on the other hand, that would like to achieve the opposite result, should negotiate to exclude GAAP from the agreed upon accounting principles (which the parties should consider clearly delineating) and should consider expressly excluding GAAP compliance from any carve out to any survival/sole remedy provisions.
Additionally, both parties should consider whether the “final and binding” language of the typical purchase price adjustment dispute resolution provision might produce an unintended result. In resolving a purchase price adjustment dispute, unless outside the scope of review, the independent accountant/expert might rule on an issue, such as GAAP compliance. If the same underlying issue is relevant to a breach of representation, such as a representation regarding financial statements, inventory, accounts receivable, undisclosed liabilities or other accounting matters, one party or the other might argue that the independent accountant’s determination is final and binding and forecloses reconsideration of the issue under the dispute resolution provisions governing breaches of representations. Whether this result would favor the buyer or the seller is challenging to predict when the agreement is being drafted, before knowing what issues will arise in the purchase price adjustment dispute. And whether the parties should aim for this result is open for debate. On the one hand, an accounting expert is especially qualified to weigh in on accounting issues like GAAP compliance. On the other hand, the typical purchase price adjustment dispute resolution process is abbreviated and accounting experts are not necessarily expert adjudicators. In any event, parties on both sides should enter into deals with their eyes as wide open as possible and pay close attention to the drafting to avoid surprises.