United States: Contract Language Is Key To Mitigating M&A Disputes

Over the past year, acquisitive companies have increasingly seen the mergers and acquisitions market become stronger and more competitive. While this is good news on many fronts, it also can signal heightened opportunity for disputes to arise in the wake of a deal. In our estimation, about a third of all transactions end up with a dispute between the parties. Many of those are resolved through negotiation and never reach an arbitrator. However, many of those involved in a case that must be arbitrated find that even one may feel like too many.

Any business transaction between two independent entities can potentially result in a dispute. However, acquisitions have unique qualities that create even more opportunities for discord in the aftermath. Post-transaction disputes tend to arise in many of the same areas time after time; parties can substantially mitigate this risk by explicitly outlining the process through which they will determine the final purchase price.

When an acquisition is made across borders, the same issues usually arise, but they can become more complex. For instance, accounting and other business practices often differ between the buyer’s country and the country in which the seller is located. If the purchase agreement does not spell out how those differences will be considered, a dispute is significantly more likely.

Transaction disputes most often arise in a few common areas. Such disputes often are driven by post-closing purchase-price adjustment mechanisms, such as closing balance sheet calculations and earn-outs. Other areas of contention may include inadequate or inaccurate projections on the part of the seller, implementation of material adverse change provisions and determining the reasons for any deterioration of the business after the deal. Additionally, as a reflection of the times, transaction fraud allegations increasingly have come into play.

We will take a closer look at some of the most common types of disputes, starting with the closing balance sheet calculations. A purchase agreement typically will outline the mechanics to accommodate changes in the subject company’s historical working capital items between the purchase agreement date and the closing date. These mechanisms serve to finalize the purchase price and substantiate any necessary adjustments.

The closing balance sheet adjustments or changes can prompt discord if the mechanisms in the agreement for addressing them are vague or subject to interpretation. The nature of "normal operations" during the period between the closing date and the finalization of the accounting records can be somewhat unclear. This is a consideration for the seller during negotiations regarding who will be responsible for preparing the closing statement.The new owner is now in control, but many – and often most – of the employees are those who worked for the previous owner. If the seller is responsible for preparing the closing statement, but has to rely on employees now working for the buyer, conflicts could arise.

In a recent dispute, the seller was responsible for creating the closing balance sheet. However, because the employees doing the work were under the buyer’s oversight and the seller had minimal access to the detailed accounting records, the seller did not fully agree with the way the balance sheet was prepared. Once the buyer had a chance to review and respond to the balance sheet as prepared, it came up with more objections, putting the seller in a position where it had to hire experts and defend a balance sheet that it did not fully support in the first place.

Differences also can arise over earn-out calculations, which often are used to settle differences at the time of purchase between the values that the buyer and seller place on the business. Earn-out provisions often result in dispute, particularly if the earn-out is over a relatively long period or if the structure of the purchased company changes under the new owner.

Earn-outs can be extremely technical and complicated calculations. In a recent instance, a large conglomerate bought a much smaller company and built a multi-year earn-out into the deal, with a target of $50 million in revenue. If the company realized that target, the sellers were owed about $15 million. If it fell short, then they were owed nothing. When the earn-out period had passed, the selling shareholders claimed they were owed millions, but the buyer claimed that revenue missed by approximately a hundred thousand dollars), resulting in no payment due under the terms of the earn-out. In fact, subsequent to the transaction’s closing, the buyer had changed the revenue recognition policies. Additional entities also were rolled into the purchased company. As a result, determining the actual revenue of the purchased company on a stand-alone basis consistent with historical accounting practices was quite complex.

An emerging area of risk related to post-acquisition disputes is the allegation of transactional fraud. Such claims center on the concept that the seller intentionally misled the buyer into paying an artificially inflated purchase price. While such allegations are very serious, they may not always be made in good faith. Our experience in the US indicates that a fraud claim is sometimes an attempt to skirt the arbitration process called for within the purchase agreement, leveraging a threat to take a dispute to the courts instead. Such claims have become increasingly common and at times have resulted in the unwinding of the original transaction. Additionally, transactions in some situations and involving parties in certain markets can be unusually subject to actual fraud. With increasing levels of investment in emerging markets like those in Eastern Europe, Asia, and Latin America, where business practices may not be as well established or are different from those in the Western world the perception may exist that disputes are the result of fraud..

Most transaction disputes boil down to differing interpretations of the terms of the purchase agreement. However, if the purchase agreement is well crafted from the start and explicitly spells out in detail how post-closing calculations will be performed – and how any disputes will be resolved – the process is likely to be much smoother.

One repeat culprit that drives post-acquisition disputes is the use of generic language in a purchase agreement. Companies invest a tremendous amount of time, effort, and money to conduct extensive due diligence in advance of an acquisition. Why, then, would they use contract language that does not fully and accurately reflect their findings?

Outside counsel drafting the purchase agreement should work directly with those negotiating the deal and outside due diligence advisors when drafting those clauses related to working capital adjustments, earn-out calculations, or other closing balance sheet matters. Likewise, those working on the seller’s side should pay attention to such clauses and consider how the calculations will work based on their historical accounting practices. A fully detailed calculation should be agreed to and included in the purchase agreement. Any conflicts between the parties should be resolved before both sides sign on the dotted line.

One such generic clause that shows up frequently is that all calculations will be done in accordance with generally accepted accounting principles (GAAP). However, not all target companies are necessarily in full compliance with GAAP. In addition, GAAP, by its very definition, recognizes that there may be more than one acceptable accounting methodology in a given area. If the seller already is aware that certain items in the financial statements are not presented in accordance with GAAP, then they should not agree to generic provisions to create a closing balance sheet using GAAP, or they could be at a significant disadvantage. Indeed, many agreements exclude certain assets and liabilities, so it is impossible from the outset to prepare a GAAP statement.

Another question that may arise with a GAAP provision in cross-border transactions is which country’s GAAP is to be used. While the parties to a transaction are often quick to agree as to which GAAP they will use, the implications of the selection of GAAP on post-closing mechanisms are not always fully thought through. The accounting principles that are generally accepted vary from country to country, and even within a country, depending on industry.

A best practice is to explicitly state the GAAP or other accounting methodology to be used, on an item-by-item basis if necessary, and detail any exceptions based on the due diligence findings. If the due diligence findings indicate that a particular area of the company’s accounting may prove problematic, the buyer may want to reflect specific agreements on how they will be treated in the contract language. The seller, meanwhile, will want to consider the buyer’s underlying motives in adding specific language and consider the implications of those clauses to the final purchase price.

Finally, the purchase agreement must include provisions on how to settle disputes in the event they arise. While most purchase agreements include an arbitration clause, they may not be specific enough. We often have witnessed disputes over who the arbitrator will be, what his or her qualifications should be, and where he or she is geographically located. Contracts that specify, for example, that the arbitrator will be an accountant with certain specific qualifications tend to provide less room for dispute. Contracts that spell out exactly who the arbitrator will be by firm or even by name are that much more straightforward. Just as important, the arbitration process to be used should be agreed upon and reflected in the agreement. Key questions arise around discovery, hearings, rebuttal, and timing.

In cross-border acquisitions, venue is a further consideration that deserves attention in the contract. A deal between a US buyer and an Eastern European seller did not address where the arbitration would take place. When a dispute came up, it was clear from the contract that they would go through arbitration, but each party had a different idea of where that should take place. After much legal deliberation, the sides finally agreed on Paris, but the parties likely would have reached an agreement more easily before discord had become a factor.

By taking care to define the terms of the purchase agreement and by tailoring them to the parties and facts involved, much of the risk for dispute after the fact can be eased. Conflict may arise nonetheless, but the more specific the agreement, the fewer the topics to be decided through post-closing negotiations or arbitration.

This article was originally published in Financier Worldwide magazine’s 2006 Cross-Border M&A Review.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.