Navigating Litigation Disputes in Mergers and Acquisition
Mergers and acquisitions (M&A) witnessed significant activity from 2021 to early 2023, fueled by a variety of factors including; low-interest rates, an excess of dry powder sitting with private equity sponsors, a rebound in deal activity from the lows of the initial covid uncertainty and return to, if not an overshoot of pre covid economic conditions. As a result, valuations soared to unprecedented levels. As the euphoria of deal activity has passed, business forecasts and economic conditions have normalized, in some instances the expected post-closing cash flows have not materialized as anticipated. This has often led to buyer (and in some cases seller) remorse, leading to disputes over post-closing adjustments and representations made during the transaction process. This article explores the factors contributing to the rise in post purchase disputes and some strategies to minimize them from occurring.
Common Areas of Disputes in M&A Transactions
Post-purchase price disputes arise when there is disagreement between the buyer and seller on the payments to be made after the closing of the transaction. Common areas of post-closing disputes are:
Working capital adjustments: Disputes often arise due to differences and inconsistencies in the calculation of working capital at the closing date and in setting the target working capital. The seller is required to deliver a “normal level” of working capital at the time of close to the buyer to ensure adequate liquidity post-closing. During negotiations, the parties will agree on a mutually acceptable methodology to calculate the target working capital. While not an exact science, this process often involves analyzing historical trends, prospective financial results and seasonality of the business. Any differences between the actual working capital at close and the target working capital will result in a corresponding adjustment, dollar-for-dollar, to the final purchase price. For the purposes of the Sale and Purchase Agreement (SPA), the target working capital must be set; however, it is often determined at the last minute without both parties fully understanding the implications of not agreeing on the methodology / details. The SPA often includes language that states working capital is to be calculated “in accordance with Generally Accepted Accounting Principles (GAAP), based on historical past practice”. GAAP is a set of accounting standards that generally describe the methodologies that are permissible given a set of facts, it is not, nor is it meant to be prescriptive in its use. For example, different parties may treat provisions regarding inventory obsolescence using alternative methodologies that may result in very different conclusions. The alternative methodologies may both be permissible under GAAP. Therefore, relying solely on GAAP is not sufficient to address the issue. GAAP in the context with past practices must be reviewed. Issues often arise when the matter has never been addressed before or when past practice did not conform to GAAP. Admittedly, new issues may not be addressed in the target calculation or between the parties; however, such issues should be minimal after a through due diligence has been completed. In instances where past practices do not confirm with GAAP, it is best practice to identify these issues and agree on their treatment when setting the target working capital at closing.
Payment of Contingent Considerations: Often a portion of the purchase price depends on the acquired business’s future performance, known as an earn-out or contingent consideration. Contingent payments are typically measured against some financial benchmark such as revenues, Earnings Before Interest, Depreciation and Amortization (EBITDA), expected growth or a budget. Misalignment or misinterpretation of the underlying calculation relative to the benchmark is often the root cause of any dispute. Once the business is sold, the buyer usually has full control of the operations of the business. Any short-term operational change within the contingent consideration period, could be averse to the contingent payment, yet benefit the long-term strategy of the business. Any operational changes should be discussed before closing and can be carved out of the calculation, if required. The seller should protect themselves by clearly defining, explaining (what is included and what is not included) and illustrating the calculations of any contingent consideration.
Breach of Representations and Warranties: Representations and warranties are contractual statements made by the seller regarding the condition, performance, and legal compliance of the business being sold. If these statements are found to be inaccurate after the sale, disputes can arise over whether the seller was responsible for providing accurate information during the evaluation process. Common areas where disputes occur include undisclosed liabilities, inaccuracies in financial statements, misrepresentation of customer / supplier contracts and relationships, and the physical state of facilities and machinery. The rise in rep and warranty insurance in transactions has played a critical role in addressing some of these issues.
Breach of Non-Compete and Confidentiality Agreements: Non-compete and confidentiality agreements are covenants that restrict the seller’s ability to compete with the purchased business for a certain period, solicit former employees and customers and disclose confidential information. Disputes may arise over the breach of the prohibited activities and use of confidential information.
Strategies to Minimize Disputes in M&A Transactions
To minimize disputes in M&A transactions, it is crucial for parties to adopt a proactive and collaborative approach that focuses on thorough due diligence, clear and detailed purchase agreements, effective communication, and the utilization of expert advisors.
- Thorough Due Diligence
Conducting comprehensive due diligence is essential to identify potential risks, liabilities, and areas of contention early in the transaction process. Thorough due diligence enables parties to assess the accuracy of financial statements, evaluate the quality of assets and liabilities, and uncover any undisclosed issues that may impact the transaction. Parties should engage experienced professionals, including legal advisors, financial advisors, accountants, industry experts and equipment experts to conduct due diligence reviews and identify potential red flags.
- Clear and Detailed Purchase Agreements
Drafting clear and detailed purchase agreements is crucial for minimizing ambiguity and reducing the likelihood of disputes. Purchase agreements should address key issues such as purchase price adjustments, representations and warranties, indemnification provisions, dispute resolution mechanisms, and post-closing obligations in detail. Parties should engage experienced legal counsel to draft purchase agreements that accurately reflect the parties’ intentions and protect their interests.
- Clear Definitions
The SPA should explicitly state which accounting framework will govern the preparation of the financial statements and any post-closure adjustments. This includes specifying whether GAAP, a specific version of GAAP, or historical accounting policies will be used. Where there is a departure from GAAP, the issue should be raised during the due diligence process and mutually agreeable solutions should be negotiated prior to the closing of the transaction.
- Reconciliation and Adjustment
If historical accounting policies are to be used, the SPA can require a reconciliation to GAAP for due diligence purposes. This allows the buyer to understand the differences and make informed decisions.
- Illustrative Examples
It would be best practice to include schedules as part of the SPA detailing the calculation of the working capital and calculation of any contingent consideration.
- Effective Communication and Collaboration
Open communication and collaboration between the buyer and seller can help mitigate misunderstandings and build trust. Parties should engage in transparent discussions, disclose relevant information, and address concerns promptly to prevent disputes from escalating. Establishing clear lines of communication and setting realistic expectations from the outset can help foster a positive working relationship between the parties and minimize the likelihood of disputes.
Role of Advisors and Independent Experts in Resolving Disputes
Despite best efforts, post purchase disputes do arise. Often, with some guidance with legal / financial advisors, they can be settled by discussing the issues between the parties. In some cases, items cannot be resolved amicably and the provisions of the settlement mechanism in the SPA must be followed. Advisors and independent experts can play a crucial role in facilitating dispute resolution and ensuring a fair outcome for all parties involved. Key responsibilities include:
- Get a second opinion. It would be highly recommended to obtain a second opinion from an independent expert. Often the parties that argued about the issue in the first instance have an entrenched position that they will not move from. Often a fresh perspective can add value to the discussion and may be able to add a different perspective to the matter. Independent experts with specialized knowledge in accounting, auditing, valuation, and transactions can provide impartial analysis and assessment of disputed issues. An independent party may only play a consultant role in the entire dispute process or may be more involved as an expert or arbitrator determination.
- Clearly identify the areas in dispute. This is not the time to re-open the entire negotiation process and reevaluate the transaction value. Often there are times when the parties have remorse or ill feelings built up during the process and use this process to reset the transaction price. Vague, overly broad arguments are not helpful. Clear, concise, supportable arguments will assist in narrowing the issues.
- Mediation and Arbitration. Advisors can facilitate mediation or arbitration proceedings to resolve disputes efficiently and cost-effectively. Mediation involves a neutral third party assisting the parties in reaching a mutually acceptable resolution through facilitated negotiation and dialogue. Arbitration involves submitting the dispute to a neutral arbitrator or panel of arbitrators for binding resolution based on the evidence and arguments presented by the parties. The SPA will clearly set out the terms of the settlement process. When selecting a mediator or arbitrator, ensure they have considerable knowledge in accounting, valuation, transaction and dispute resolution.
About the authors:
Vimal Kotecha CA, CBV Partner in Richter’s Valuation Litigation and Transaction (VLT) group, has acted as consultant, expert and arbitrator on various post purchase price disputes. His experience on accounting, valuation and transaction assignments plays a key role in quickly identifying issues and providing clear, concise courses of action.
Danish Khan , CPA, CBV is Vice President in Richter’s Transaction Advisory group. With a versatile background in public accounting, business valuations and transaction advisory, Danish plays a pivotal role in sale transactions.
