Using Arbitration to Settle Post-Closing Tussles: It’s quicker and cheaper to settle M&A disputes outside of the courts

In virtually every M&A deal of significance, buyers and sellers negotiate and document a mechanism for resolving post-closing disputes, which often center on accounting and financial statement issues. A well-accepted method for settling these sometimes-painful controversies is arbitration, which can get to a resolution with much less time and expense than going to court. Even if the two sides never have a post-acquisition dispute, they can negotiate the agreement more effectively knowing that a fallback process is in place. However, it’s important that there is upfront agreement on major details ranging from identification of the issues that are ripe for arbitrating to determining the arbitration process. Before exploring the arbitration process, it’s helpful to identify issues most likely to put a buyer and seller at loggerheads after the deal is completed and the two sides presumably have gone their separate ways. A sampling includes: GAAP Negotiators should incorporate in the sale agreement how Generally Accepted Accounting Principles (GAAP) might affect post-acquisition payments, e.g., purchase price adjustments, earn-outs, etc. Many agreements provide that the financial statements and post-acquisition calculations will be prepared in accordance with GAAP, applied on a basis consistent with past practice. That, however, is often insufficient to avoid disputes because it does not address how to handle financial statement items that require judgments and estimates, and it does not specify what to do if past practice differs from GAAP. Clarifying the accounting treatment for certain financial statement items can minimize post-acquisition disputes, as will be described later. Accounting estimates and judgments Applying GAAP to financial statements often is said to be more art than science because the statements contain judgments and estimates. Since buyers and sellers often have different views of what judgments and estimates should be, they may prepare financial statements that contain different amounts for the same company, even though both are prepared in accordance with GAAP. Merely designating in an agreement that financial statements and post-acquisition calculations are to be prepared in accordance with GAAP consistent with past practice does not prevent the parties from disagreeing on accounting items that affect the purchase price. Deal advisers can help by suggesting language that provides some specifics for financial statement items that require judgments and estimates. For example, GAAP provides that in determining a company’s income, gross revenues are to be reduced by the amount of estimated future sales returns. Nobody can quantify those returns with certainty so management must use judgment in calculating an estimate. In a post-acquisition dispute, seller and buyer managements may have differing views of the estimate, and the differences could affect such payments as the amount owed under an earn-out. To help avoid these clashes, the acquisition agreement can specify that the estimate should be determined through the policies and practices of either the seller or the buyer, which may include some specificity on the actual methodology to be used. Alternatively, the two parties could produce an objective formula, such as a specified percentage of sales. The aim is to limit the subjective nature of the estimate. Excess and obsolete inventory Another estimate that commonly touches off post-acquisition disputes is the provision for excess and obsolete inventory, which arises from the GAAP requirement that inventory be reported at its cost or market value, depending on which is lower. Again, the two managements might use different methods for this estimate. For example, the seller may have calculated the estimate based on its company policy while the buyer might look to its actual experience, such as the amount of inventory it did not sell, after the closing to determine the amount of the provision that was required at closing. To prevent or minimize such disputes, the sale agreement can provide a formula requiring the estimate to be based on an objective measure, such as how long the inventory has remained in stock or how many inventory units are in stock that are in excess of some prior level of sales. Alternatively, the buyer and seller can provide that the buyer will be compensated for any inventory acquired in the deal that is not sold by a specified date after closing. If an alternative is used, it can inflame the controversy because the buyer is operating the business and the seller has little or no say in the operations. Contingent liabilities Differing views on the operation of the business can create disputes over contingent liabilities, such as pending lawsuits. In general, GAAP requires a liability to be recorded if it is probable that a liability has been incurred and the amount can be reasonably estimated. Sometimes, the seller may not have recorded a liability because it believed that it would prevail in the litigation. After acquiring the business, the buyer might have a different, less favorable view of the litigation and might choose to settle. When such an uncertainty exists, the parties may want to clarify in the acquisition agreement whether the buyer or the seller will be responsible for any settlement. They also could also place a cap on the amount the seller will pay if the lawsuit is lost, or stipulate that the seller is not responsible for litigation at all and any payments are the responsibility of the buyer. Past accounting practices To reiterate, sale agreements often specify that financial statements be prepared in accordance with GAAP, consistent with past practice. This phrase, however, is not clear because it does not specify whether it is more important for the financial statements to be prepared in accordance with GAAP or consistent with past practice. Post-acquisition disputes commonly arise in this area when past practice may not have been in accordance with GAAP for individual financial statement items, even though the financial statements as a whole were consistent with GAAP. Unrecorded liabilities Unrecorded liabilities are liabilities that were incurred prior to the closing date of the deal but were not recognized on the balance sheet when the deal was completed. Buyers often receive invoices after the purchase of a business for services that were rendered prior to the acquisition. The buyer typically claims that if the closing balance sheet is to be prepared in accordance with GAAP, those invoices should have been recognized as liabilities. A common response from the seller is that its practice was to include only those invoices that were received before the balance sheet was prepared. Thus, the seller may argue, on a year-over-year basis, that there is no significant difference. Avoiding disputes over unrecorded liabilities could involve language that specifies whether it’s more important for the financial statements to be prepared in accordance with GAAP or to be consistent with the seller’s past practice. Non-Accounting Disputes There also are disputes that do not specifically involve accounting issues, such as whether the buyer has used “reasonable efforts” in running the business after closing the deal. The language to minimize the potential for disputes, much like GAAP estimates and judgments, is subjective. One issue that is prone to post-deal argument in this category arises when the buyer pays part of the purchase price based on the future performance of the target – an earn-out. Disputes often erupt when the seller alleges that the buyer did not meet earnings targets because the buyer changed the business. For example, the buyer may have fired members of the sales team, which, the seller claims, impeded attainment of earnings targets. To try to minimize such disputes, the parties can agree that the buyer is to operate the business using “reasonable efforts” or that the buyer cannot “substantially change” the business for a specified period of time. However, the parties will need to agree on the definition of these terms. Arbitration Machinery Notification of dispute Purchase agreements typically provide a mechanism for notification that disputes have arisen. Usually, one party details the areas of disagreement with the other party’s calculations, e.g., purchase price adjustments, earn-outs. The form and terms of the notification are important because it may be the basis for ultimately submitting a dispute to an arbitrator if it cannot be resolved through negotiation by the two sides. For example, the M&A agreement may not have given the party filing the notice sufficient time to respond. This short time frame may limit the ability of the party disputing the calculations to fully identify all areas of disagreement because there may not be adequate time to review records and obtain discovery that could reveal additional areas of dispute. It’s common for the objecting party to become aware of additional areas of dispute as the parties exchange more information in an attempt to resolve their differences. A frequent question submitted to the arbitrator in such situations is whether areas of dispute that were not in the original notification can be arbitrated. Framers of the sale contract could determine whether items that were not in the notification of dispute can be submitted to the arbitrator. This position can be written into the agreement but if not, it can be an agenda item when the two sides determine the topics on which the arbitrator will be allowed to rule. Alternatively, the parties could provide for an adequate period of time before a notification of dispute in which they can exchange information. Arbitration Approaches Post-acquisition disputes can be handled by various arbitration approaches. One process includes an initial submission by each party detailing the areas of dispute and the arguments for its position. The initial submission also should provide evidence to assist the arbitrator, such as schedules showing calculations, sworn statements from individuals with relevant knowledge, copies of relevant accounting literature, and detailed listings of financial statement items like accounts receivable ledgers and inventory schedules. The initial submissions can be simultaneously exchanged and provided to the arbitrator, or the party seeking relief may file first and the respondent provides its initial submission later, typically 30 days after the first filing. In my experience, if both parties are familiar with all arguments, simultaneous exchanges work well. If both sides don’t understand all positions, staggered filings can be more productive. After the initial submissions, the parties usually want the opportunity to rebut the other side’s arguments and submit replies. Evidence to rebut the opposing party’s arguments typically is provided in the replies. If only a small number of issues are in dispute and the parties are familiar with each other’s arguments, they may agree that there is no need for replies, which expedites the process and reduces costs. Buyers and sellers also may seek hearings in front of an accounting arbitrator who will hear fact and expert witness testimony. A court reporter should be hired to prepare transcripts of the hearings, which will allow the arbitrator to refer to precise testimony in writing a decision. The arbitrator’s decision can be as simple as providing a monetary figure to a claimant or writing an in-depth, reasoned opinion with rulings on each of the issues presented. A reasoned opinion affords each side an opportunity to understand the basis for the arbitrator’s decision. In addition, M&A agreements, as well as the arbitrator’s retention agreement, should specify that the decision is final and binding. Otherwise, the losing side has the ability to argue that the arbitrator’s decision is not enforceable. Participating in the Process As the parties submit their claims and provide fact and expert testimony at hearings, they can best present the merits of their positions effectively by: * Clearly identifying the issues in dispute; * Addressing whether legal issues should be decided by the arbitrator; and * Researching the specific provisions in accounting literature that supports their position. Before filing with the arbitrator, it’s helpful for both parties to agree which issues are in dispute. For example, I’ve been involved in cases where the two sides clash, with one claiming that both parties have agreed to the areas in dispute and the other responding that additional issues are to be decided. Such disagreements result in procedural delay and add to the cost of arbitration. The U.S. Supreme Court has held that arbitrators may interpret the meaning of contracts, even though their construction is a question of law. Parties often differ over the meaning of the underlying M&A contract and, if there are complex legal issues to be addressed, they may find it helpful to allow the arbitrator to retain legal counsel to consult on questions of law, subject to approval of the retained lawyer by both sides. In presenting evidence to an accounting arbitrator, both parties can strengthen their positions that financial statement items were prepared in accordance with GAAP by specifically citing the technical accounting literature. Both GAAP and Generally Accepted Auditing Standards provide guidance, including factors for auditors and accountants to consider when evaluating the reasonableness of accounting items. In a post-acquisition dispute involving accounting issues, referencing the guidelines and factors provides a reasonable basis for an arbitrator to evaluate whether financial statements are prepared in accordance with both GAAP and the terms of the M&A agreement. Understanding the issues commonly disputed after closing and the way arbitration works can allow buyers and sellers to agree on many of these items in the sale agreement and perhaps minimize the possibility that they will flare following consummation of the deal. Disputes often erupt when the seller alleges that the buyer did not meet earnings targets because the buyer changed the business. Jeffrey Katz, CPA/ABV, CFE, is the Practice Leader for Post-Acquisition Dispute Resolution Services in the Litigation & Fraud Investigation Practice at BDO Seidman. He is based in New York. (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com