Adjustment or Breach: Two Very Different Products
Purchase price adjustment dispute resolution clauses are included in business acquisition agreements as a way to streamline the resolution of disputes regarding certain elements of the final purchase price. Often the value of the purchase price changes daily or there may not be sufficient accurate information prior to closing to fully determine the final purchase price. Thus, the parties may agree to a post-closing process to identify the correct number. Typically, the clause detailing the post-closing process (referred to here as a "purchase price adjustment clause") provides deadlines for the parties to exchange information and agree on a final purchase price. If the parties cannot agree, their dispute is subject to a special resolution procedure, often before an independent accountant. The concept is a good one: By appointing an arbiter familiar with accounting standards and the intricacies of the merger and acquisition process, the parties seek to avoid the discovery process and leave the accounting in the hands of the experts. Although agreements do not always call this process "arbitration," the independent accountant often has final authority to resolve the dispute, rendering the process a binding arbitration.
However, just because the parties have agreed to arbitrate one brand of post-closing dispute does not mean they agree to arbitrate all such disputes. The same acquisition agreement will often contain an exclusive remedies provision, specifying that claims for indemnification (including claims for breach of representations and warranties) be litigated in a designated forum. The representations and warranties most often invoked in a fight about whether a particular claim is one for adjustment or indemnification are those regarding the pre-closing financial condition of the target entity, including the seller's representation that the financial information provided to the buyer as part of the due diligence process fairly represents the company's financial condition and was prepared in accordance with specified accounting standards, consistently applied.
In this context, the distinction between arbitrable disputes and those that must be litigated is not confined to forum and procedure, but can have major economic consequences for the parties. Typically, a heavily negotiated indemnification clause will provide that any action based on breach of representations and warranties is subject to monetary limitations, such as a threshold that must be reached before the indemnification provision kicks in, and a damages cap. These provisions provide the parties with some certainty, by setting limits on how much a party may recover (or suffer) in damages post-closing. But if a breach of representation claim is presented as a purchase price dispute, the arbitration provision may swallow the indemnification clause and circumvent its protections and limitations. This isn't a matter of Old Gold versus Lucky Strike: Whether you seek to arbitrate or litigate a post-closing dispute can make a significant difference in the outcome for your client.
Don't Forget the Research Department: Placing a Claim in Context
Once you know whether your client wants to avoid or avail itself of a purchase price adjustment dispute resolution clause, you will have to make your case to a court (unless you invoke the purchase price adjustment procedure and the opposing party agrees to arbitrate). In reviewing such a clause—unlike a broad arbitration clause, where a dispute about arbitrability will be referred to the arbitrator—the court must first consider whether the dispute, on its face, falls within the clause. McDonnell Douglas Fin. Corp. v. Pa. Power & Light Co., 858 F.2d 825 (2d Cir. 1998).This is especially true when the same contract contains a broader dispute resolution clause, specifying litigation for other disputes, as acquisition agreements often do. It's a matter of intent: Parties can only be compelled to arbitrate that which they have agreed to arbitrate.
In the same way the creatives at Sterling Cooper consult their researchers before making a pitch, in framing a dispute, a litigator should consult a transactional attorney familiar with the acquisition agreement and the due-diligence process. The importance of a full understanding of the transaction is illustrated by the decision in Westmoreland Coal Co. v. Entech, Inc., 100 N.Y.2d 352 (N.Y. 2003). There, the buyer objected to asset values contained in the seller's closing date certificate, which listed the seller's calculation of the aggregate value of the company's assets as of the closing date. The buyer claimed it was entitled to a purchase price adjustment because many of the values in the seller's closing date certificate did not comply with generally accepted accounting principles (GAAP), and demanded arbitration. The seller objected, arguing that the buyer's alleged claims for purchase price adjustments were actually claims for breaches of a representation or warranty, subject to the stock purchase agreement's indemnification clause and resolvable only in a court of law.
In reaching its opinion that the dispute must be litigated, the court construed the contract in the context of the dispute itself, noting that the transaction was the result of an auction or a competitive bidding process. This fact—external to the dispute resolution clauses but central to the equities of the case—led the court to acknowledge the unfairness of allowing the winning bidder to achieve a major reduction in purchase price on the basis of the transaction's underlying "accounting fundamentals," which the buyer had the opportunity to review and consider prior to closing. The court also reasoned that allowing arbitration of the claims would subvert the contract's indemnification clause and allow the buyer to circumvent the indemnification damages cap. In making this determination, the court noted that the purchase price adjustment provision must be read not in isolation, but in the context of the entire agreement. Construing together the indemnification provisions and the dispute resolution clause, the court reasoned that two sophisticated parties would "never intend to consign a significant portion of the purchase price to ADR" before an independent accountant—particularly where a "complete, comprehensive remedy for any and all claims for breach of representation or warranty" was provided by the indemnification provisions. Westmoreland, 100 N.Y.2d at 360.
This same focus on fairness, and on giving effect to bargained-for indemnification provisions, can be perceived in many reported cases regarding purchase price disputes. In OSI Systems, Inc. v. Instrumentarium Corp., 892 A.2d 1086 (Del. Ch. 2006), the Delaware Court of Chancery considered a buyer's claim that it was entitled to a downward closing adjustment of approximately 54 percent of the purchase price. The buyer, which sought to refer the dispute to arbitration before an independent accountant, reached its number by applying different accounting principles than the seller had used in preparing its interim financial statements, citing flaws in those statements. The court found that the buyer's claim rested fundamentally on an assertion that the seller had violated its representation that its interim statements complied with U.S. GAAP. In ordering the parties to utilize the dispute resolution procedure specified in the contractual indemnity provisions, rather than the purchase price clause, the court noted that the indemnification provisions limited the buyer to receiving damages of no more than 25 percent of the purchase price for a breach of representation and warranty claim. The court declined to allow the buyer "to end-run the contractual indemnification process" by funneling its claim into the narrower closing adjustment arbitration process. OSI, 892 A.2d at 1094.
These cases, and others like them, provide useful sound bites when posturing a claim as one for indemnity. The fairness-based pitch has appeal. However, if you are seeking to invoke the purchase price adjustment resolution procedure, consider whether your claim has any link to a contractual representation or warranty. If it proceeds from a financial statement that was the subject of representations and warranties, it is more likely to be viewed as an indemnity claim. If, however, a claim challenges accounting principles utilized in a financial statement that was not the subject of any representations or warranties, then arbitration may be compelled. See, e.g.,Severstal U.S. Holdings, LLC v. RG Steel, LLC, 865 F. Supp. 2d 430 (S.D.N.Y. 2012).This linkage may be the best identifying feature of an indemnity claim: If you don't want the indemnification provisions to apply, consider whether you can sever your claim from represented financials.
Everyone's an Ad Man: Beware the Two-Faced Claim
Draper calls cigarettes "the greatest advertising opportunity since the invention of cereal." If you've ever felt overwhelmed in the cereal aisle, you know what he means: One product can be marketed effectively by multiple brands. Likewise, the same issue can sometimes be twice-branded. On the one hand, every post-closing dispute can be framed as a purchase price dispute— the seller wants more money; the buyer wants a discount. But given the breadth of some contractual representations and warranties, it may be impossible to sever them entirely from a dispute about the value of one component of the final purchase price.
One court has declared that in the case of dual-nature claims—claims that may be viewed as purchase price adjustments or indemnity claims—the presumption for arbitrability applies. See, e.g., Severstal, 865 F. Supp. 2d at 443. But this approach would fail in the context of an acquisition agreement calling for different forms of arbitration, with an independent accountant resolving purchase price adjustment disputes and legal arbitration for indemnity claims. See, e.g., OSI, 892 A.2d at 1087.
Other courts have acknowledged that some acquisition agreements allow—and sometimes specifically contemplate—the same claim to be resolved by two different mechanisms. For example, in Lincoln Snacks Holding Co., Inc. v. Brynwood Partners III, L.P., 803 N.Y.S.2d 19 (N.Y. Sup. Ct. 2005), a court refused to dismiss indemnity claims that had also been submitted as adjustment claims to a purchase price arbitrator. Because litigation was the contract's exclusive remedy for indemnity claims, the court found it was required to entertain them, even though they were the same or part of the same claims under way before the independent accountant. The court stayed the litigation pending the outcome of the adjustment arbitration.
More recently, the U.S. District Court for the District of Delaware found the principles of collateral estoppel inapplicable to indemnity claims already subjected to purchase price arbitration. By the time the court rendered its opinion in Compucom Systems, Inc. v. Getronics Finance Holdings, B.V., 2012 WL 4963314 (D. Del. 2012), an independent accountant had already arbitrated the purchase price dispute and concluded that the seller's use of a particular accounting convention was not unreasonable as a matter of accounting. The Delaware district court found that notwithstanding this conclusion, the seller could proceed with indemnity claims based on the use of this accounting convention because the seller claimed its use constituted a breach of the representations concerning the accuracy of the financial statement in which it was reflected.
These cases underscore an important point in assessing a post-closing dispute: Whether the dispute is branded a purchase price adjustment or an indemnity claim (or both), how much is the difference really worth? Some disputes are large enough to justify dual proceedings; others may not warrant two tracks. In an unpublished memorandum order issued after its collateral estoppel ruling, the Compucom court expressed frustration that the purchase price proceedings before the arbitrator had not moved the parties toward a consensual settlement: "[I]t strikes me that the parties at bar are being unreasonable in their approach to this case, and are spending more money on lawyers than on an acceptable business solution." Compucom v. Getronics Fin. Holdings B.V., No. 09-173-SLR, mem. at 2 (D. Del. Nov. 19, 2012).
In that same first Mad Men episode, Draper tells his Lucky Strike clients, "Advertising is based on one thing: happiness." And maybe it's a little different when you're peddling some form of dispute resolution. But in these cases, your post-acquisition clients have just finished an exhaustive period of negotiations, due diligence, and transition. It doesn't hurt to assign some value to the satisfaction of returning to business, and factor that into your strategy.
Keywords: litigation, commercial, business, post-closing dispute, purchase price adjustment, contractual indemnity claim, dual-nature claims, presumption of arbitrability