NBA-CLS Newsletter Online: Post-Acquisition Disputes: A Financial Perspective

Post-Acquisition Disputes: A Financial Perspective

By Marc B. Sherman, CPA, Esq. and Laura Connor, MBA[1]

The execution and closing of every purchase agreement has a reasonable risk of ending in a future post-acquisition dispute. These disputes commonly relate to failures of representations and warranties, questions about the existence of purchased assets or liabilities and, most commonly, post-contract “financial true up.” Given these potential disputes, during contract negotiation and due diligence, buyers and sellers unfortunately pay too little attention to the contract provisions relating to the contract’s dispute resolution provisions and pre- and post-closing responsibilities.

PURCHASE AGREEMENT PROVISIONS & AREAS THAT AID IN AVOIDING DISPUTES

Every purchase agreement should contain provisions to provide for a potential post-acquisition dispute. In addition, when entering into a purchase agreement, both parties should take steps to avoid potential disputes by (1) providing for (and ultimately performing) adequate due diligence[1] and (2) carefully considering certain aspects of other contract provisions.

Due Diligence

Pre-acquisition “due diligence” commonly entails a somewhat detailed but relatively simple verification of the seller’s accounting balances. The buyer, through its own accounting department or a third-party firm, generally performs a “numbers verification” of the account balances in the accounting ledgers to verify that the numbers on the financial statements are supported. However, should the buyer perform a more in-depth, non-accounting due diligence? Should a buyer’s due diligence probe what the seller’s business is about? Should a buyer engage in continuing due diligence after the purchase agreement’s execution, or even have a continuing responsibility to do so? Do the reps and warranties attach responsibility for post-execution changes in the business, its customer base, market conditions or other factors that degrade historical performance? Further to the last question, an important issue for consideration is the effect of a heightened form of pre-acquisition due diligence? Should the seller’s representations be impacted by the scope and adequacy of the due diligence? Should the buyer’s ability to detect issues and problems supersede the seller’s reps and warranties and absolve the seller of responsibility for the rep and warranty failures?

In Great Lakes Chemical Corporation v. Pharmacia Corporation,[2] the Delaware Court of Chancery found that the availability of experts and advisers to perform due diligence weighed heavily in the conclusion that the seller was not responsible for acquisition-related misrepresentations. In Great Lakes, after the buyer decided to negotiate for the purchase of the seller’s business, the business was impacted by price cutting and the entry of new competitors into the market, both of which permanently affected the seller’s customer base and revenue stream. The seller’s management had detailed knowledge of these developments and the related performance impact. In addition, the seller held patents that they allegedly knew were being infringed by a competitor. One of the buyer’s due diligence experts received unverified information of the infringement. When the buyer’s expert asked the seller’s representatives if they knew of the alleged interference, the buyer was told “no.” During its due diligence, the buyer made several inquiries to the seller about the business, intellectual property, product markets, and its actual sales and sales forecasts. However, having very little experience in the industry, the buyer claimed to have relied on the seller’s experience in that business and, particularly, on the seller’s representations concerning the events that affected revenue. As a result, the buyer alleged fraud and misrepresentation on the part of the seller.

The court found that the buyer was put on notice of impending problems through the seller’s revisions of the forecasts, negating the buyer’s claim of reliance on the seller’s representations. The court also found its conclusion to be strengthened by the buyer’s retaining industry experts and legal advisors. According to the court, the buyer knew that price-cutting was occurring in the market, and the buyer “had available as resources, experts capable of understanding and communicating how that fact was significant to [the business’s] future sales prospects.” (emphasis added). In essence, the court found that the seller was not obligated to correct misrepresentations or omissions when the due diligence should have discovered the issues.

Situations like those in cases like Great Lakes and others raise obvious questions about who should take the responsibility for the future performance of the business, the buyer or seller? Because full due diligence possibly shifts an acquisition’s risks to the buyer, whether such a due diligence should be conducted needs to be carefully considered. Whether mandated by the seller, or considered prudent by the buyer, substantive due diligence, and the contractual provisions mandating and defining it, could avert many post acquisition disputes.

In arranging for adequate due diligence, a buyer needs the purchase agreement to specifically set out the documents and personnel that will be available to it during due diligence as well as the timing of their availability. The due diligence process should include the buyer’s meeting with the seller’s personnel. However, this can present problems to the seller because, for various business reasons, a seller often will not notify employees of a potential or intended sale.

Closing Price & Closing Procedures

The preliminary selling price in most purchase and sale agreements is based on the facts and financial data available at the time of contract execution. The price is then finalized (or “trued up”) on the closing date once the final financial data and other relevant information is known. This purchase price “true up” is usually determined by reference to some balance sheet items,[3] which are typically measured using Generally Accepted Accounting Principles (GAAP), consistently applied. The contract provision relating to the “closing date balance sheet adjustment” usually sets out the procedures for determining the adjustment, including which party will be responsible for the preparation of the closing balance sheet (“CBS”). Key items important to this post-closing true up and the contract provisions leading up to the process are whether the CBS will be audited, whether the CBS will be prepared in accordance with GAAP or in accordance with past practices, and the relevance of consistent application of accounting treatment and the timing of the delivery of the CBS. The decisions made and outlined in this provision can help prevent some types of potential disputes by providing a clear true up process.

Unfortunately, not all disputes can be so easily avoided. Often disputes arise despite carefully drafted contract provisions, particularly concerning the use of GAAP (which is often judgmental and subject to estimates) and its consistent application. A buyer and seller even though each method is acceptable under GAAP. The “Purchase Price Adjustment” clause usually provides for the post-closing adjustments. These adjustments frequently include a working capital adjustment or an earn-out calculation, both of which often require analysis of post-closing results. When drafting and executing this clause of a purchase agreement, both parties should consider some key items, including the time period allowed for objections, access to records and people, the right to take copies of records, limits on objections (e.g. materiality), and the existence of a holdback or escrow arrangement.

Dispute Resolution

The preferred dispute resolution provision used today in purchase and sale agreements is some form of alternative dispute resolution (“ADR”). When drafting the ADR clause, it is extremely important to clearly define the dispute resolution terms and conditions. One important factor to define is the claims over which the arbitrator will have authority. Other details to consider in ADR clauses include the decision of binding v. non-binding arbitration, the structure of the arbitration (single arbitrator v. arbitration panel), the arbitrator selection process, the responsibility for payment of expenses of the arbitration, the time period allowed for notice of filing for arbitration, discovery procedures, and the timing and form of arbitrator’s decision.[4]

CONCLUSION

When entering into a purchase agreement, a party is wise to consider the possibility that the agreement will result in a post-acquisition dispute. Given this possibility, both buyers and sellers should enter into the agreement fully aware of the type of provisions that often result in disputes and what steps can be taken to help protect their interests. Be aware of what level of due diligence you perform and whether you are open to risks in a potential dispute if it is not thorough enough or even too thorough. When drafting and executing the purchase agreement, carefully consider the purchase price “true up” provisions and the representations and warranties and the method for resolving post-acquisition disputes.

References

[1] Marc B. Sherman is the Office Managing Director of Huron Consulting Group’s Washington, DC office. Laura Connor is a Manager in Huron Consulting Group’s Washington, DC office. Marc and Laura actively help clients with due diligence as well as post-acquisition dispute matters. Marc has also served as an arbitrator on dozens of matters.

[1] The meaning of “due diligence” is subject to interpretation. The extent and scope of due diligence could have a significant impact on a party’s success in a dispute and more importantly understanding what they are buying.
[2] Great Lakes Chem. Corp. v. Pharmacia Corp., 788 A.2d 544, 555- 556 (Del. Ch. 2001).
[3] Common measures for the true up are “working capital” and “tangible net worth” and are often referred to as the closing date balance sheet adjustment.
[4] See, e.g., “Model Asset Purchase Agreement with Commentary”, American Bar Association, pp. 257-258.