The global impact of Covid-19, or coronavirus, is one that no business can ignore. The outbreak is an international issue that touches all aspects of business, including M&A.
Before the outbreak, middle market M&A transactions were on the rise and were predicted to steadily increase over the upcoming years. However, against this new backdrop, the outlook for M&A activity is—understandably—highly uncertain. Nevertheless, for various reasons, including strategy, corporate opportunity and necessity, companies will continue to consider—and, where appropriate, pursue—M&A transactions, but with deal terms carefully crafted under the Covid-19 lens as parties seek to allocate the risks associated with the effects of the coronavirus on the target company. Buyers will likely push to structure the purchase price with post-closing working capital adjustments and deferred consideration payments (collectively, “post-closing adjustments”) that are contingent on the performance of the business post-closing in line with agreed financial targets.
With this projected trend toward increasingly complex post-closing adjustments, the legal and business communities will witness an increase in post-closing disputes. The subject of such disputes will likely concern the interplay between the post-closing purchase price provisions of the purchase agreement and the detailed and heavily negotiated indemnification provisions therein. However, before the substance of these types of disputes can be addressed, the parties will need to agree on the proper characterization and mechanism for resolving such disputes, as the outcome could have material financial consequences (or conversely, financial benefits) to the parties. Thus, the express language of the purchase agreement is critical to securing the most favorable financial outcomes for buyers and sellers in M&A transactions.
Indemnification provisions are primarily designed to allocate risk among the parties to a transaction, and the disputes involving indemnification claims are typically resolved through the courts or binding arbitration. Sellers generally prefer disputes to be resolved through the indemnification procedures set forth in the purchase agreement, as their potential post-closing liability under the transaction documents is limited by the cap and basket. Post-closing adjustments, on the other hand, are aimed at protecting buyers against decreases in the value of the target company. Generally, buyers prefer these disputes to be resolved through post-closing adjustments procedures, as they are afforded the possibility of greater recovery without the monetary limitations generally imposed by indemnification provisions.
With the advent of post-closing disputes, courts will increasingly be presented with the issue of properly classifying post-closing disputes over accounting treatments and methodologies used by a target company as either governed by an agreement’s indemnification provisions or post-closing adjustment provisions. When financial statements used in the calculation of working capital are challenged as not being prepared in accordance with GAAP, a decision must be reached about whether a buyer’s claim should be resolved through working capital adjustment or be limited to resolution for breach of the financial representation under the indemnification provisions. Recognizing that indemnification claims often are subject to specific cap and basket limitations, courts have historically been careful not to allow disputes concerning purchase price adjustments to be used as a back door to resolve disputes that are technically embodied in seller’s financial statements representation.
There are two essential cases in this area that offer key guidance for professionals: Alliant Techsystems, Inc. v. MidOcean Bushnell Holdings, L.P, 2015 WL 1897659 (Del. Ch. Apr. 27, 2015) and Westmoreland Coal Company v. Entech, Inc., 100 N.Y.2d 352 (1st Dept. 2003). Interestingly, these cases yielded very different results. In Alliant, the court held that based upon the plain terms of the agreement, the dispute fell within the ambit of a post-closing purchase price adjustment and not, as seller contended, the indemnification provisions. In all, buyer was awarded a $22,000,000.00 working capital adjustment in its favor, which was not subject to any baskets, caps or other limitations on recovery. In contrast, the court in Westmoreland held that because the purchase agreement expressly provided that the remedies set forth in the indemnification provisions were the exclusive remedies available to the parties, and that working capital would be determined in accordance only with past practices of seller, the dispute over GAAP was clearly contemplated to be resolved through the indemnification provisions of the agreement. As a result, seller’s liability was capped at the monetary threshold specified in the purchase agreement.
Consequently, there are a number of crucial items that should be considered by M&A professionals when drafting a purchase agreement:
- If a deal involves post-closing adjustments, sellers should insist on adequate audit and information rights and post-closing covenants from buyer to ensure that the new owners conduct the target business optimally post-closing.
- Clearly define accounting terms used in the definition of working capital or calculating financial targets and establish a clear understanding of the historical component of each line item, including in the calculation of working capital, and confirm the applicability of each line item to the target’s business.
- Attach a detailed exhibit to the purchase agreement making reference to each line item in the calculation of working capital to the line item in the target’s financial statements.
- Buyers typically favor calculating working capital or other financial targets on a GAAP basis, while sellers typically favor calculating in a manner consistent with historical practice. The purchase agreement should avoid multi-part definitions that leave room for interpretation and establish which objective—GAAP or consistency—takes priority.
- Specify the intended treatment of GAAP (such as GAAP applied on a consistent basis with earlier financials) throughout the purchase agreement. Simply referring to GAAP alone may leave its application open for interpretation, as GAAP encompasses a wide range of acceptable accounting practices.
- Limit provisions about compliance with GAAP to the exclusive remedy provisions of indemnification and resolution by the judicial system or, alternatively, expressly provide for carve-outs to those provisions which permit controversies to be resolved by accounting specialists through purchase price adjustments.
- Consider a provision in the purchase agreement which instructs accountants on how to effectively handle errors in the financial statements.
- Address specific issues which arise in diligence by creating a separate indemnity reserve (and exclusion from working capital) as an exclusive remedy so that buyer does not seek further collection from seller, in contrast to resolving the matter through a working capital adjustment.
- Consider placing a cap on the post-closing working capital adjustment to eliminate controversy over classification of the dispute as one involving a working capital claim or indemnity claim.
- The Covid-19 crisis will likely cause an increase in the use of post-closing adjustments. Sellers may want to seek floors or collars in their purchase price adjustment mechanisms to avoid being unduly penalized during the crisis. Conversely, buyers will want to ensure that they will be acquiring a business with levels of working capital and profitability that are within defined parameters. Ultimately, the goal for M&A professionals involved in the process should be to best ensure that the intentions of the parties are clearly reflected in the purchase agreement. This will serve to minimize the potential for disagreements post-closing and even hopefully remove the risk altogether.