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August 16, 2012

Forum Alternatives for Purchase Price Adjustment Disputes

Jeffrey S. Torosian and Kimberly M. DeShano – August 16, 2012

Purchase and sale agreements for operating businesses, as well as merger agreements, commonly include procedures for adjusting the purchase price based on changes in the working capital of the target business from the time the contract is executed to the closing date. Even when this procedure is detailed, conflicting means of resolving the disputes over the purchase price adjustment can arise. This is particularly true when the purchase price dispute centers on issues that involve Generally Accepted Accounting Principles (GAAP) and that also implicate the agreement's indemnification provisions for GAAP-related representations. As a result, the parties' agreement may contain competing provisions for how to resolve these disputes and in what forum. Whether drafting or litigating these provisions, attorneys need to be aware of how courts may resolve these conflicts.

A Typical Purchase Price Adjustment Provision
Although each acquisition agreement is unique, many contain common elements for a post-closing purchase price adjustment process. In this process, the parties establish some type of reference figure for working capital—either a target figure is agreed upon in the acquisition agreement or a balance sheet is prepared during the due diligence period, usually by the seller (the reference balance sheet). Then a balance sheet is prepared as of the closing date, typically by the purchaser (the final balance sheet). The two balance sheets are compared and—assuming there is no dispute—the purchase price is adjusted up or down based on the difference, according to the terms of the parties' agreement. The agreement will typically require that both the reference balance sheet and the final balance sheet be prepared in accordance with GAAP or consistently with the seller's historical accounting practices, or both.

The parties will frequently disagree on the final balance sheet and must then follow the procedures set forth in their agreement to resolve this dispute. Typically, these procedures will require the party receiving the final balance sheet to object to the calculation and the opposing party to then respond to each objection. If those disputes cannot be resolved, the agreement will often provide for the submission of the remaining disputes to an agreed-upon accountant (an accountant arbitrator), who will then issue a final and binding determination of the final balance sheet and the resulting adjustment to the purchase price.

This process can be relatively straightforward, but often the agreements will also contain a separate dispute resolution procedure for indemnification claims relating to the breach of a representation or warranty. These dispute resolution procedures may require indemnification claims to be heard by a specific court or by a legal arbitration association separate from the accountant arbitrator.

Conflicts arise when disputes can be characterized as purchase price adjustments or indemnification claims or both. For instance, common in these agreements is the seller's representation that the company's financials were prepared in accordance with GAAP. Suing on that claim under an indemnification provision, rather than claiming a change in the working capital (for the difference between a non-GAAP-compliant reference balance sheet versus a GAAP-compliant final balance sheet) under the purchase price adjustment provision, may have significant ramifications. That is because the indemnification provision usually has a minimum damages floor and a maximum damages cap limiting the buyer's possible recovery. Accordingly, buyers may try to characterize the indemnification dispute as a working capital dispute to avoid limitations to their recovery of damages.

Few courts have wrestled with the issue of whether a dispute constitutes a purchase price adjustment dispute or an indemnification claim, and the ones that have dealt with it have approached the issue differently. However, all of the courts have placed a special focus on the language of the acquisition agreement as a whole.

The Courts' Tools of Interpretation
Courts routinely state that they favor arbitration as a matter of statute and public policy. Although courts interpret arbitration provisions like any other contract provision, that is, according to the parties' intent, they construe the parties' intentions regarding arbitrability generously. Nonetheless, courts generally give effect to every provision in an agreement in a way that reconciles them in the context of the agreement as a whole. This concept is especially critical where questions over GAAP compliance are raised with respect to preparation of the reference balance sheet or the final balance sheet, because compliance with GAAP may have implications under the indemnification provision as well.

Disputes Deemed to Be Outside the Purchase Price Adjustment Process
At first blush, it would appear that any disputes over the preparation of the reference or final balance sheet will always be subject to dispute resolution under the purchase price adjustment provision. Typically, the parties agreed to submit such disputes to the accountant arbitrator because it is expected to be a private, quick way to resolve any disagreement over the parties' calculations. But when issues arise over how the balance sheets are prepared, specifically whether they are GAAP-compliant or consistent with the company's past accounting practices, some courts have found that determination to be beyond the scope of a purchase price adjustment arbitration process and subject to the agreement's separate indemnification provisions.

For instance, in OSI Systems, Inc. v. Instrumentarium Corp., the seller of a medical services business prepared a final balance sheet that, upon being compared with the reference balance sheet, would have lowered the purchase price by $7 million. 892 A.2d 1086, 1088 (Del. Ch. 2006). The acquisition agreement permitted the buyer to prepare its own version of the final balance sheet, which resulted in a purchase price reduction of $24 million, over half of the entire purchase price. The buyer claimed that the seller did not apply GAAP in preparing either the reference balance sheet or its version of the final balance sheet. Although the agreement provided for disputes regarding the final balance sheet to be submitted to an independent accounting firm for final resolution, the seller refused, claiming that the alleged failure to comply with GAAP constituted instead a breach of the GAAP representation, which would make the claim subject to separate legal arbitration and limited to 25 percent of the purchase price. The Delaware Chancery Court agreed, concerned that the buyer was trying to make an end run around the damages limitation cap for indemnification claims by "funneling" them into the purchase price adjustment process. As a result, the court found that the dispute was subject to legal arbitration under the indemnification provision and not subject to the purchase price adjustment process. Specifically, the court found that the purchase price adjustment process required the accountant arbitrator to apply the accounting principles used in the reference balance sheet to the final balance sheet, meaning that the buyer could not ask the accountant arbitrator to apply inconsistent principles even if those inconsistent principles were GAAP-compliant.

Similarly, in In re Westmoreland, the purchaser objected to the seller's final balance sheet, claiming a purchase price adjustment of over $74 million (50 percent of the purchase price) because it did not comply with GAAP. 100 N.Y.2d 352, 356 (N.Y. Ct. App. 2003). The parties' acquisition agreement also contained a separate representation that the financial statements complied with GAAP and an indemnification provision with a damages cap of $1.75 million. The seller refused to submit to arbitration, as required for purchase price adjustment disputes, and insisted that the issue be litigated as a breach of representation under the indemnification provision. The New York Court of Appeals agreed that any question regarding GAAP compliance should be litigated as a breach of representation. It noted that the purchaser had the opportunity during due diligence to review the accounting methodologies used by the seller and could not now use an independent accountant in a streamlined alternative dispute resolution proceeding to object to "the transaction's underlying accounting fundamentals."

Other courts that have refused to allow the purchase price adjustment process to apply to issues of GAAP compliance have focused on the placement of the seller's GAAP representation in the acquisition agreement's separate representation and warranties provision. See E*Trade Fin. Corp. v. Deutsche Bank AG, No. 09-3029-Civ., 2010 WL 1196814, at *1 (2d Cir. 2010) (noting that indemnification provision provided for sole and exclusive remedy for breaches of representation); Holt Co. of Ohio v. Ohio Mach. Co., No. 05AP-1280, 2007 WL 1674023, at * 11 (Ohio Ct. App. 10th Dist. June 12, 2007) (focusing on placement of GAAP representation as separate from purchase price adjustment provision).

Disputes Kept Within the Purchase Price Adjustment Process
Courts that have found the opposite—that disputes over GAAP compliance of the reference and final balance sheets should be resolved under the purchase price adjustment provision—have also focused on the interpretation of the acquisition agreement as a whole. For example, in Advanstar Communications, Inc. v. Beckley-Cardy, Inc., the court noted that the provision requiring the final balance sheet to comply with GAAP was found within the same provision that required any purchase price adjustment disputes to be arbitrated by an independent auditor. 1994 WL 176981, at *2 (S.D.N.Y. May 6, 1994). This placement made it clear to the court that the parties "intended to have an independent auditor determine whether or not the party departed from . . . past accounting policies and procedures."

In two other cases, courts found that the language of the acquisition agreement was even more explicit. In Matria Healthcare, Inc. v. Coral SR, LLC, the agreement included both a purchase price adjustment process that required submission to an accountant arbitrator and a separate arbitration provision for other claims (including claims for breaches of representations and warranties). No. 2531-10, 2007 WL 763303, at *2 (Del. Ch. Mar. 1, 2007). Any recovery for representation claims were limited to the parties' $20 million escrow fund and specifically excluded any matters that could pertain to the purchase price adjustment. The Delaware Chancery Court found that this exclusion required that the parties' dispute over the accounting treatment of a settlement with the seller's customer be resolved by the accountant arbitrator pursuant to the purchase price adjustment provision, even if it could also be considered a breach of representation.

The indemnification provision in Violin Entertainment Acquisition Co. v. Virgin Enterprise Holdings, Inc., similarly excluded issues related to the final balance sheet. 871 N.Y.S.2d 613, 613 (N.Y. App. Div. 2009). The New York appellate court in that case held that this language required the purchaser's claim that the final balance sheet was not GAAP compliant to be submitted to the accountant arbitrator, rather than have it resolved as an indemnification claim.

In yet another case, a federal district court noted that the seller had repeatedly indicated to the buyer during the purchase price adjustment process that it believed the dispute should be submitted to the accountant arbitrator. Gestetner Holdings, PLC v. Nashua Corp., 784 F. Supp. 78, 83 (S.D.N.Y. 1992). That conduct, combined with the court's finding that "where claims may be understood to raise an arbitrative issue, arbitration must be compelled, even if the claims can be characterized another way," required resolution of the issue by the accountant arbitrator.

In short, courts are initially inclined to order arbitration or other alternative dispute resolution of purchase price adjustments where the parties clearly agreed to it in their contract. But courts will look to the overall intent of the acquisition agreement as well as to the parties' post-closing conduct to assess the scope of that process. Courts may be concerned when it appears that the parties clearly intended a limited and narrow purchase price adjustment process but then raise broader issues. Courts are likewise suspicious of attempts to obtain significant discounts through this process when caps are provided elsewhere in the agreement. Finally, courts may be reluctant to permit major adjustments to be imposed by a limited non-judicial arbitrator. Transactional attorneys would be wise to consult with litigation counsel both when negotiating purchase price adjustment provisions and when engaged in the initial exchange of dispute notices to ensure that disputes are resolved through the intended process and forum.

Keywords: litigation, commercial, business, forum alternatives, purchase price adjustment

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