United States: Accounting True-Up vs. Valuation Dispute

Chicago Bridge Decision from Delaware Chancery says Accounting Expert Has Exclusive Jurisdiction over $2.5 Billion Contract Dispute

On December 2, 2016, a Delaware Chancery Court held that the courts had no role in considering a purchase price adjustment dispute based on "plain language of the purchase agreement" that made arbitration by an independent accounting firm the "mandatory path" for resolving disputes over a closing date adjustment.1 As discussed in our prior Jones Day Commentary, purchase price adjustment provisions are common, and disputes over the amount and bases of the resulting calculations occur frequently. Clients, therefore, should take note of the substantive assertions and contract clauses in Chicago Bridge that led to the dispute so as to avoid potential disputes and unintended consequences in their transactions.


In Chicago Bridge, a dispute arose under a textbook post-closing purchase price adjustment provision.2 Under the Chicago Bridge agreement, the purchase price was to beadjusted based upon a comparison of closing net working capital to a specified target net working capital amount ($1.174 billion). The seller (Chicago Bridge) calculated an estimated closing net working capital amount of approximately $1.601 billion, which would have resulted in a $428 million payment from Westinghouse, the buyer. Following the closing, the buyer recalculated closing net working capital as negative $976 million, which would have resulted in a $2.15 billion payment from the seller to the buyer.

Of particular importance were the bases on which the buyer proposed adjustments to the seller's calculation. The buyer went beyond challenging the underlying calculation and, instead, used its proposed adjustments to challenge whether the seller's calculations were GAAP (generally accepted accounting principles) compliant. Specifically, based on the facts described in the opinion and pleadings, in three of the four adjustments, the buyer appeared to apply its own, different accounting estimates and judgments to project costs for nuclear plant construction.3 These adjustments consisted of the following:

  • A 30 percent reduction to an outstanding receivable on the target's balance sheet called "claim costs." "Claim costs" represented costs incurred by the target for items that would be recovered from either the project owners or the buyer—either as a matter of contractual entitlement or as claims for overruns for which the target was not responsible. The buyer asserted that the seller's estimate of "100% collectability" violated GAAP.4
  • An adjustment of the same claim costs receivable to reflect costs of design changes allegedly mandated during a regulatory review, resulting in a reserve for these costs (ostensibly under GAAP) and thus a further reduction to net working capital.
  • An increase of the cost estimates to complete the projects by 30 percent, which created an additional liability on the balance sheet. This adjustment reflected the buyer's view that it would cost $3.2 billion more to complete the projects than the seller had initially predicted.

In its fourth adjustment, the buyer separately claimed that the seller had violated GAAP by omitting a non-cash, purchase accounting liability of $432 million that related to the seller's 2013 acquisition of the target.5

The Chicago Bridge purchase agreement stated that the representations and warranties, including those covering historical financial statements, would not survive the closing. Accordingly, the crux of the seller's argument was that the buyer's recharacterization of net working capital line items was an attempt to circumvent the limit on indemnities for breaches of representations and warranties by challenging target's historical GAAP compliance through the post-closing purchase price adjustment. In contrast, buyer took the position that it did not waive its right to raise issues of GAAP compliance in respect of balance sheet accounts through the closing date adjustment.

The Chicago Bridge adjustment provisions referred to calculation according to both the "illustrative calculation and Agreed Principles" (commonly referred to as a "sample statement") as well as GAAP consistently applied by the seller. This dual standard created an opportunity for the parties to assert competing and conflicting accounting treatments. Based on the court's reading of this contract language and existing Delaware case law, the chancery court held that the buyer's challenges to the calculation methodology were properly within the scope of the adjustment provision itself.

Challenging a Seller's Working Capital Calculation as Not GAAP Compliant

The source of the dispute in the Chicago Bridge case and in the line of Delaware cases cited by the Chicago Bridge court is the inconsistent and potentially erroneous application of accounting principles. Purchase agreement provisions covering financial statements have two sometimes competing objectives: (i) to ensure that all financials are GAAP-compliant, and (ii) to use an apples-to-apples comparison of the target's financial condition to measure changes in assets, liabilities, and other financial metrics between a specified measurement ("balance sheet") date and the closing. In order to properly measure changes in financial attributes, the agreement should require consistency in methodology between the pre-closing reference balance sheet and closing calculations. Under this construct, parties need to analyze the accounting policies used to set the target at the outset to ensure proper application of GAAP and to carry through this application in the true-up.6 If the agreement does not require consistency, the buyer's adjustment can potentially reflect a change in accounting treatment.

The Chicago Bridge case brings home the importance of the specific contract language used in the purchase price adjustment provision. If the contract is silent or unclear, or makes GAAP an overriding consideration, a buyer's accountants may adjust the balance sheet prepared by a seller for GAAP inconsistencies. In contrast, if consistency of application of accounting principles is emphasized in the contract, any challenges to GAAP compliance must generally be raised in an indemnity claim and subject to the caps and baskets typically included in these contracts to limit such claims.

The contract in Chicago Bridge did not contain language clarifying that the intent of the parties was solely to measure changes in net working capital, or that the processes were not intended to permit the application of judgments or estimation methodologies that differed from those used in the initial calculation. Such language would have strengthened the seller's argument that the buyer's recalculation of net working capital under its own accounting estimates was simply a back door indemnity claim.

Importance of Scope of Representations and Warranties on Financial Statements

The Chicago Bridge court emphasized that the scope of accounting adjustment proceedings is a function of the governing contract terms. The court discussed Delaware precedent in which the terms of a GAAP compliance representation expressly covered the reference statement (the sample statement by which a target's working capital is determined). This contractual language required that a challenge to the GAAP compliance of a seller's "reference statement" only be brought as an indemnity claim.7

In other Delaware cases, however, different governing contract terms allowed a buyer to contest the GAAP compliance of values in the seller's reference statement in an accounting adjustment procedure. Specifically, in Alliant Tech Systems v. Mid-Ocean Bushnell Holdings,8 the court concluded that if the seller had not followed GAAP in its initial calculation (by which the target was set), then the buyer could assert its own GAAP-compliant calculation in an accounting procedure. The court relied on the purchase agreement's requirement that closing net working capital be "calculated in accordance with GAAP" to conclude that the contract anticipated that GAAP issues could be raised in a post-closing price adjustment procedure as well as in an indemnity claim.

Pros and Cons of Accounting Arbitration

An underlying rationale behind post-closing purchase adjustments is that fluctuations in financial metrics (such as working capital) should fall within a range of past, normalized working capital levels. Deviations that materially exceed these parameters may be an indication that something has gone awry or of a larger or different dispute between the parties relating to valuation of the business or the integrity of the financial statements. Accordingly, it may be prudent to limit mandatory accounting arbitration to adjustments that do not exceed some percentage of the target amount or to some appropriate fixed amount, or to include language limiting the scope of the accountants' work to an "apples-to-apples" comparison intended to capture only changes over time to working capital.

Sellers, especially, should be wary of drafting contracts that allow complex questions of contract interpretation or high-dollar issues of seller compliance with GAAP to be decided through the (appropriately) abbreviated process typical of accountant price adjustment determinations.9 The "quick and dirty" process used in accountant determinations can make them less than suitable for complex, high-value cases involving contract interpretation or complicated application of accounting principles. Accountants typically do not have the experience and background to assess legal issues concerning contract construction. There is no opportunity for discovery, testimony, or cross-examination. Accounting dispute resolution also normally involves a single neutral, which may increase the risk of a poorly reasoned award. And, as with any arbitration, judicial review is tightly circumscribed.

Material disputes involving contract interpretations and claims of noncompliance with applicable accounting standards may be better decided in full-scale "legal" (as contrast to accountant-led) arbitrations or in lawsuits. Each of these alternatives allows for some degree of discovery and requires decision according to governing legal standards. Arbitration is typically quicker and less expensive than full-scale litigation.

In addition, should the parties wish to have decision-makers with specialized expertise, arbitration allows the parties to make contractual provisions for that. For example, the International Center for Conflict Prevention and Resolution ("CPR") has established a specialty banking, accounting, and financial services panel comprising attorneys with financial background and expertise in resolving disputes which arise in the context of mergers and acquisitions and other corporate deals.

Further, arbitrations can be confidential if the parties so desire. If the parties are committing material disputes over accounting adjustments to a full arbitration proceeding, then specialized arbitrators, such as those in the Certified Public Accountant Panels available from CPR can have advantages. Typically, post-closing accounting adjustment provisions call for the parties to choose an accounting firm to make the final determinations regarding adjustments. Finding an experienced accounting neutral without a relationship with one or more of the parties is often difficult and time consuming, especially in light of the consolidation and dissolution of what used to be the "Big Eight" into the "Big Four" firms.

Broadening dispute resolution to CPR and similar proceedings would also: (i) deepen the bench of available neutrals to include experienced and well-regarded commercial arbitrators in multiple jurisdictions, and (ii) avoid the conflicts of interest associated with accounting firms that regularly provide audit, tax, and other services to the parties.

Reasons for rejecting arbitration of a legal dispute associated with a price adjustment include: (i) many arbitrators have the tendency to do some sort of "baby split" award as opposed to a reasoned analysis of the merits; (ii) there are extremely limited appeal rights unless the parties write an appeal provision into the arbitration provision into the contract;10 (iii) since court decisions are subject to review and appeal, the prospect of being overturned often results in judicial decisions being grounded more firmly in law governing contract interpretation; and (iv) many U.S. clients prefer litigation as the "devil they know"—at least in the United States—as compared with a less-certain process in arbitration.

Arbitration can be cheaper and faster than litigation, and it is private (or at least it can be if the parties so specify). But if the main concern is getting the right decision, these considerations may well be less compelling. Litigating a dispute in court allows the opportunity for challenging a plaintiff's claims as a matter of law through summary judgment and, more important, allows for appellate review. If the claims present mixed questions of law and accounting under the agreement, or implicate bad faith, fraud, or breach, a court proceeding or a formal arbitration under AAA or CPR rules may be the better option.

Lessons Learned and Practice Tips

As illustrated by Chicago Bridge and prior cases, attempts to clarify the parties' intentions regarding net working capital adjustments through arbitration before an accounting expert are poor substitutes for a detailed and specific set of accounting provisions prepared with the benefit of expert financial accounting advice, thorough due diligence, and precise drafting. Accordingly, contract drafters and business development professionals should take into account the following:

Pre-closing Accounting Due Diligence. The parties should highlight and assess treatment prior to the sale of potential areas of dispute, including:

  • Reserves and accruals for liabilities that would typically be covered by seller indemnity, such as taxes, litigation, environmental, or off-balance-sheet amounts.
  • "Debt-like" items, such as equipment leases.
  • Contingent liabilities, such as litigation and claim reserves.
  • Industry-specific accounting methodologies and business attributes (such as seasonality, deferred revenue, or installment accounting) that could distort closing calculations artificially, depending on when the closing occurs.
  • Accounts receivable and inventory values and reserves (including excess and obsolete reserves), processes for closing date physical inventories and the potential for revaluations.

Precise Formula. Any accounting, including working capital, formula should list the specific components of the formula, and refer to line items on a referenced balance sheet, or general ledger. Referring simply to "net working capital," "current assets," "current liabilities," or similar broad categories creates ambiguity as to what's in and what's out of the calculation.

Intent to Measure Changes. If applicable (and particularly in sell-side representations), the adjustment provision should state that the calculation is intended to measure changes from the target working capital to the closing working capital, thereby countering any inference that a de novo calculation of historic, booked amounts is permissible.

Consistency of Accounting Policies and Estimates. The purchase agreement should clarify that a target's past accounting practices, and the same accounting principles, estimates, judgments, methodologies, policies, and the like—including judgments as to loss and gain contingencies and materiality determinations—used to prepare the target should be respected in calculating the closing statement.11 Conversely, if representing a buyer, consider permitting use of prior principles only if in compliance with GAAP, and enabling the buyer to correct errors and omissions and to take into account all accounting entries regardless of their amount.

Hierarchy if Accounting Principles Conflict. The purchase agreement should be clear as to which principles—GAAP, "modified"-GAAP, or seller's non-GAAP/sample statement principles—take precedence in the event of a conflict.12

Operation of Exclusive Remedy Provisions. Parties, particularly sellers, should be wary of language contained in indemnity exclusive remedy provisions that exclude purchase price adjustment provisions. Courts have looked to such language as supporting the buyer's right to apply GAAP to correct a seller's working capital calculations through an accounting arbitration even though such claims could also be asserted as a breach of rep claim.

Additional Protective Provisions. Sell-side adjustment provisions should include standards that would limit a buyer's right to assert its own, sometimes novel adjustments. Such provisions could include:

  • Excluding the effect of the operation of the business of the target after closing.
  • Consideration only of information available to the parties up to the closing date or the date seller delivers the notice of disagreement.
  • Preparation of the calculation on the basis that the target is a going concern.
  • Exclusion of purchase accounting adjustments, the effects of any post-closing reorganizations, or the post-closing intentions or obligations of the buyer.
  • Exclusion of any provision with respect to any matter that could form the basis of an indemnity in favor of the buyer under the agreement.
  • Exclusion of any item to the extent the buyer is financially responsible for such item under the agreement.
  • Exclusion of amounts to the extent such amounts are subject to, and included as, a separate adjustment to the purchase price under the agreement (e.g., net debt calculation).

Timelines for Closing Statement Calculations. According to Chicago Bridge's complaint, Westinghouse requested and Chicago Bridge granted a 30-day extension to permit Westinghouse to prepare its closing statement, which may have given Westinghouse more time to develop creative accounting positions to rebut the seller's initial calculation. Absent special circumstances, the parties should be held to the contract timetable to minimize such risks.

Express Limitations on an Accounting Arbitrator's Authority. Express limitations on post-closing accounting arbitration and the arbitrator's authority can remove uncertainty about the purpose and scope of the proceedings. Such limits could include restricting the accounting expert's determinations to the application of accounting principles, as defined in the agreement, and limiting determinations of contract interpretation or law. An arbitration decision that exceeds the express limits of an arbitrator's authority represents one of the few avenues for appeal of an arbitration award. Thus, express limitations can provide certainty and protection to the parties in connection with post-closing adjustments.13


1. Chicago Bridge & Iron Company, N.V. v. Westinghouse Electric Company, LLC, et al., C.A. No. 12585-VCL 2016 (Del. Ch. Dec. 2, 2016). On December 5, 2016, the Court issued a corrected Memorandum Opinion and Chicago Bridge filed its notice of appeal to the Delaware Supreme Court.

2. Post-closing purchase price adjustments are almost universally present in definitive agreements for the sale of privately held businesses. These provisions—which include earn-out clauses, working capital adjustments, and debt/net debt true-ups—require an adjustment to the purchase price paid at closing, based on calculations relative to pre-closing targets, standards, or formulas. Such provisions set forth not only the methodology for determining the amount of the adjustment, but also a resolution process in the event the parties disagree on the amounts to be paid. These processes typically include (i) an exchange of the relevant financial calculations and access to work papers and supporting documentation, (ii) submission by the recipient party of objections to the calculation, (iii) a period of time within which the parties will attempt to resolve the dispute in good faith, and (iv) submission of the unresolved issues to a neutral accounting firm for ultimate resolution.

3. Chicago Bridge's complaint intimates that prior to closing, Westinghouse (in its role as project consortium partner) settled and released claims with the project owners for less than what Chicago Bridge had been carrying on its books, thereby supporting Westinghouse's post-closing assertion that GAAP required a write down of claim costs. Such write down had the effect under the net working capital adjustment of artificially shifting such released costs foregone through such settlements back to Chicago Bridge.

4. According to Chicago Bridge's complaint, on the closing date, Westinghouse announced that it had named a new subcontractor to take over management of a significant portion of the construction at the nuclear facilities designed by Westinghouse at which Chicago Bridge had been principal contractor. Chicago Bridge asserted that Westinghouse, the subcontractor, and the project owners developed their own new timelines and cost estimates for the projects as a result of the performance commitments negotiated by Westinghouse in its claims settlement with the project owners, which in turn would have resulted in new cost and recovery estimates. According to Chicago Bridge's complaint, during the negotiations on the working capital adjustment and the Delaware case proceedings, Westinghouse refused to provide the seller with copies of the settlement agreements with the project owners.

5. According to Chicago Bridge's complaint, not only did this purchase accounting entry not represent future cash outflow liability, but it also was not included in the calculation of the working capital target.

6. In 2014, 62 percent of post-closing adjustments were to be determined in accordance with GAAP, or GAAP applied consistent with past practice. 33 percent—roughly half as many—were to be determined by another standard, such as modified GAAP, or principles set forth in a schedule to the purchase agreement. Source: 2015 ABA Business Law Section Private Target M&A Deal Points Study.

7. See OSI Systems, Inc. v Instrumentarium Corp., 892 A.2d. 1086 (Del. Ch. 2006).

8. Alliant Techsystems, Inc. v. MidOcean Bushnell Holdings, L.P., C.A. No. 9813-CB (Del. Ch. Apr. 24, 2015).

9. Under Delaware law, such proceedings presided over by accountants are treated and reviewed by courts as arbitrations. Viacom Int'l v. Winshall, 72 A.2d 78 (Del. 2013). It should be noted that certain other states, most relevantly, New York, have separate provisions and proceedings associated with expert accountant determinations. See New York Civil Practice Law and Rules 7601.

10. CPR (International Institute for Conflict Prevention & Resolution) has an appeal protocol, for example, that provides for another arbitrator or set of arbitrators to provide appellate review of an arbitration award.

11. Compare the Chicago Bridge equivalent provision: "[T]here shall be no changes to accounts receivable reserve accounts or inventory reserve accounts that are not in accordance with GAAP as in effect on the Closing Date and the accounting principles, practices, methodologies and policies described under "General" above [past accounting practices of the Company and sample calculation, and supported by the Company books and records] or that are not supported by a change in facts, the underlying criteria or a change in the related account balance." (emphasis added)

12. See note 6 supra.

13. Current practice is to permit accounting arbitrators to hire counsel to assist with legal determinations along the following lines:

Arbitrator may seek and consider the views of legal counsel not associated with the parties if he deems such to be necessary in resolving the dispute submitted hereunder and if the parties both consent. Arbitrator will not consult outside counsel until he has presented the issue to the parties for their input. Arbitrator will either utilize counsel jointly selected by the parties or will secure the approval of the parties of the choice of counsel made by him. In either event, counsel shall submit an estimate for its work to be approved by the parties and [accounting firm] shall be reimbursed for the cost of such counsel. Even if Arbitrator consults with outside counsel, Arbitrator retains full decision-making power related to items in dispute.

Consider whether a better option would be to include an AAA or similar arbitrator provision governing disputes with mixed issues of accounting and law that allows a single "legal" arbitrator to retain an independent expert to assist with accounting issues but leaves ultimate authority with the arbitrator.

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.

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