M & A - Equity Rollover and Section 197(f)(9) Antichurning

Enactment of the Revenue Reconciliation Act of 1993 (the RRA),1  which added section 197.

Section 197 was enacted to reduce controversy between taxpayers and the IRS in connection with the amortization of certain intangible assets, including goodwill and going concern value. Although section 197 has largely served its purpose, the antichurning rules contained in section 197(f)(9) remain a source of much consternation for tax practitioners.

The intangible assets of a business, such as goodwill, going concern value, patents, and customer lists, often constitute a significant portion, if not most, of the value of an enterprise, as compared with its tangible assets such as property, plant, and equipment. When a purchaser acquires the assets of a business, the purchaser’s ability to offset future taxable income generated by the business with depreciation or amortization deductions for U.S. federal income tax purposes can significantly affect the economics of the transaction; in other words, it can affect the price the purchaser is willing to pay for the business.

Before the enactment of the Revenue Reconciliation Act of 1993 (the RRA) (part  of  the  Omnibus  Budget Reconciliation Act of 1993) which added section 197, goodwill and going concern value were generally treated as nonamortizable intangible assets (Reg. section 1.167(a)-3, before amendment by T.D. 8865, 65 Fed. Reg. 3820 (Jan. 25, 2000), Doc 2000-2456, 2000 TNT 14-4). As a result, the portion of the purchase price of a business allocated to those assets could be used only to offset gain recognized on a future sale of the assets of the business.

Because of the less-than-optimal tax treatment of those intangibles, purchasers of businesses were often tempted to assign a proportionately greater amount of the purchase price of a business to depreciable tangible and amortizable intangible assets than to goodwill or going concern value. This often gave rise to conflicts between taxpayers, who attempted to allocate significant value to short-lived  intangible  assets  similar  to  goodwill  for which a useful life had been assigned and, accordingly, could be amortized, and the IRS, which claimed that a greater portion of the value should have been allocated to nonamortizable  intangibles, such as going concern value. It  also resulted  in  protracted  negotiations between  purchasers of businesses, who wanted to allocate as large a portion of the purchase price of a business as reasonably possible to a seller covenant not to compete, which portion could be amortized over the term of the covenant, and sellers, who wanted to
allocate as small a portion of the purchase price of a business to the covenant, because the portion of the purchase price allocable to a covenant not to compete was treated as ordinary income rather than capital gain.

The frequent litigation between taxpayers and the IRS, as amplified by the subjective nature of the valuation process generally and the significant amount of money at stake, was called one of the oldest controversies between taxpayers and the IRS by the General Accounting Office in its 1991 report to Congress on the taxation of intangibles. Also, because depreciation deductions were allowed for the cost or other basis of intangible property used in a trade or business or held for the production of income only if the intangible property had a limited useful life that could be determined with reasonable accuracy, questions about what constituted a limited useful life and reasonable accuracy abounded.

In  1992  the  Supreme  Court granted certiorari in Newark Morning Ledger Co. v. United States, a case involving some of the relevant issues, and it issued its decision on April 20, 1993. A divided Supreme Court held 5 to 4 that if a taxpayer is able to prove with reasonable accuracy that an intangible asset that the taxpayer uses in a trade or business or holds for the production of income has a value that wastes over an ascertainable period of time, the taxpayer may depreciate the value of the asset over the asset’s useful life regardless of how much the asset appears to reflect the expectancy of continued patronage. The Supreme Court cautioned that the taxpayer’s burden of proof was substantial and would often prove too great to bear.

In response, Congress enacted section 197, in part because the ‘‘severe backlog of cases in audit and litigation’’ was ‘‘a matter of great concern." Tax practitioners generally greeted the new section 197 with enthusiasm.What practitioners may not have realized was that many years after enactment, they would still be spending significant time and energy grappling with the antiabuse provisions in section 197(f)(9) (the "antichurning rules"), which were intended to prevent taxpayers from converting a nonamortizable intangible into an amortizable section 197 intangible.

Section 197 and Regulations

Although section 197 was enacted in 1993, proposed regulations were not issued until early 1997   and were not finalized until January 2000. The final regulations issued in January 2000 included proposed regulations that elaborated on specific issues related to partnerships, and those proposed regulations were finalized in November 2000.

Section 197 permits taxpayers to amortize the adjusted basis of those intangible assets that constitute amortizable section 197 intangibles ratably over 15 years, beginning with the month in which they are acquired.

Section 197 Intangibles

Section 197 intangibles comprise the following: (1) goodwill; (2) going concern value; (3) workforce in place, including its composition and terms and conditions of its employment; (4) business books and records, operating systems, or any other information base (including lists or other information regarding current or prospective customers); (5) any patent, copyright, formula, process, design, pattern, know-how, format, or other similar item; (6) any customer-based intangible, meaning composition of market, market share, and any other value resulting from the future provision of goods or services pursuant to relationships (contractual or otherwise) in the ordinary course of business with customers, and, in the case of a financial institution, deposit base and similar items; (7) any supplier-based intangible, meaning any value resulting from future acquisitions of goods or services pursuant to relationships (contractual or otherwise) in the ordinary course of business with suppliers of goods or services to be used or sold by the taxpayer; (8) any item similar to those listed in (3) through (7) above; (9) any license, permit, or other right granted by a governmental unit or an agency or instrumentality thereof; (10) any covenant not to compete (or other arrangement to the extent it has substantially the same effect) entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof; and (11) any franchise, trademark, or trade name.

Excluded Intangibles

Intangibles specifically excluded from the definition of section 197 intangibles are: (1) any interest in a corporation, partnership, trust, or estate, or under an existing futures contract, foreign currency contract, notional principal contract, or other similar financial contract; (2) any interest in land; (3) any computer software that is readily available for purchase by the public, is subject to a nonexclusive license, and has not been substantially modified, and other computer software that is not acquired in a transaction (or series of related transactions) involving the acquisition of assets constituting a trade or business or substantial portion thereof; (4) any of the following items if not acquired in a transaction or series of related transactions involving the acquisition of assets constituting a trade or business or a substantial portion thereof: (a) any interest in a film, sound recording, videotape, book, or similar property; (b) any right to receive tangible property or services under a contract or granted by a governmental unit or agency or instrumentality thereof; (c) any interest in a patent or copyright; and (d) to the extent provided in reg. section 1.197-2(c)(13), any right under a contract (or granted by a governmental unit or an agency or instrumentality thereof) if the right has a fixed duration of less than 15 years or is fixed as to amount and would otherwise be recoverable under a method similar to the unit-of-production method; (5) any interest under an existing lease or tangible property or any existing indebtedness (except as provided regarding financial institutions); (6) any right to service indebtedness that is secured by residential real property unless the right is acquired in a transaction (or series of related transactions) involving the acquisition of assets (other than those rights) constituting a trade or business or substantial portion thereof; and (7) any fees for profes

sional services and any other transaction costs incurred by parties to a transaction regarding which any portion of the gain or loss is not recognized under sections 351 through 368.

"Acquired" "After" "August 10, 1993" 

To constitute an amortizable section 197 intangible, a section 197 intangible must have been acquired after August 10, 1993, the date of enactment of section 197, and must be held in connection with the conduct of a trade or business or an activity engaged in for the production of income. Intangibles, other than (1) franchises, trademarks, or trade names; (2) covenants not to compete entered into in connection with an acquisition of an interest in a trade or business or a substantial portion thereof; and (3) licenses, permits, or other rights granted by a governmental unit or an agency or instrumentality thereof that are self-created rather than acquired will not constitute amortizable section 197 intangibles unless they are created in connection with a transaction (or series of related transactions) involving the acquisition of assets constituting a trade or business or a substantial portion thereof.

No Other Depreciation or Amortization Deduction Allowed

If an asset constitutes an amortizable section 197 intangible, no other depreciation or amortization deduction is allowed with respect to it.26  Thus, if a covenant not to compete constitutes an amortizable section 197 intangible, a taxpayer must amortize any portion of the purchase price of a business allocated to the covenant over 15 years, even if, under prior law, that amount would have been amortizable over the term of the covenant.

Special Rules

Section 197(f) contains special rules that affect the applicability and operation of section 197. Among them is a rule that provides that if a section 197 intangible is acquired in a nonrecognition transaction under section 332 (complete liquidations of subsidiaries), section 351 (transfers to controlled corporations), section 361 (non- recognition of gain or loss to corporations), section 721 (contributions to partnerships), section 731 (distributions from partnerships), section 1031 (like-kind exchanges), section 1033 (involuntary conversions), or in a transaction between members of an affiliated group that files a consolidated income tax return, the transferee steps into the shoes of the transferor for purposes of applying section 197 regarding the amount of the transferee’s adjusted basis that does not exceed the transferor’s adjusted basis in the section 197 intangible.

The Antichurning Rules of Section 197(f)(9)

Section 197(f)(9) contains antichurning rules that exclude from the definition of amortizable section

197 intangible certain intangibles acquired in certain transactions. The conference report on section 197 states that those rules were enacted to ‘‘prevent taxpayers from converting existing goodwill, going concern value, or any other section 197 intangible for which a depreciation or amortization deduction would not have been allowable under [prior] law into amortizable property.’’

The antichurning rules apply to except from the definition of amortizable section 197 intangible any otherwise amortizable section 197 intangible for which depreciation and amortization deductions would not have been allowed under prior law, including specifically goodwill and going concern value if (1) the intangible was held or used at any time on or after July 25, 1991, and on or before August 10, 1993 (the transition period), by the taxpayer or a related person; (2) the taxpayer acquired the intangible from a person who held it during the transition period, and the user of the intangible does not change as part of the transaction; or (3) the taxpayer grants the right to use the intangible to a person (or a person related to that person) who held or used the intangible at any time during the transition period, but only if the transaction in which the taxpayer grants the right and the transaction in which the taxpayer acquired the intangible are part of a series of related transactions.

The antichurning rules define ‘‘related persons’’ as any persons that are related under sections 267(b) or 707(b)(1), in each case applied by substituting 20  percent for 50 percent, and any persons  that are engaged in trades or businesses under common control, within the meaning of section 41(f)(1)(A) and (B).

a. Section 267(b). Section 267(b) defines ‘‘related persons’’ to include the following:

• members of a family, including only brothers and sisters (by whole or half blood), spouse, ancestors, and lineal descendants;

• an  individual  and  a  corporation, more than 20 percent of the value of the outstanding stock  of

which is owned directly or indirectly by or for that individual; 

• two  corporations  that  are  members  of  the  same controlled group under section 1563(a), with modifications;

• a grantor and a fiduciary of any trust;

• fiduciaries of different trusts, if the same person is the grantor of both trusts;

• a fiduciary of a trust and a beneficiary of such trust;

• a fiduciary of a trust and a beneficiary of another trust, if the same person is the grantor of both trusts;

• a fiduciary of a trust and a corporation, more than 20 percent of the value of the outstanding stock of

which is owned directly or indirectly by or for that trust or the grantor of that trust;

• a person and an organization to which section 501 applies, and that is controlled, directly or indirectly,by that person or, if the person is an individual, by members of the person’s family;

• a corporation and a partnership if the same persons own  more  than  20  percent of the value of the outstanding stock of the corporation and more than 20 percent of the capital or profits interests in the partnership;

• an S corporation and another S corporation, or an S corporation and a C corporation, if the same persons own  more than 20 percent of the value of the outstanding stock of each corporation; and

• with some exceptions, an executor of an estate and a beneficiary of the estate.

Also, the following constructive ownership rules apply: (1) stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries; (2) an individual is considered as owning the stock owned, directly or indirectly, by or for the individual’s family (which includes, for this purpose, only brothers and sisters, spouse, ancestors, and lineal descendants); and (3) an individual owning (otherwise than by the application of (2)) any stock of a corporation is considered as owning the stock owned, directly or indirectly, by or for the individual’s partner (the partner stock attribution rule). Stock constructively owned by reason of clause (1) of the preceding sentence is treated as actually owned by that person for purposes of applying the constructive ownership rules to treat another as the owner of the stock.

b. Section 707(b)(1). Section 707(b)(1) defines ‘‘related persons’’ to include the following:

• a  partnership  and  a  person  owning,  directly  or indirectly, more than 20 percent of the capital or profits interest in the partnership; or

• two partnerships in which the same persons own, directly or indirectly, more than 20 percent of the capital or profits interests.

The constructive ownership rules that apply for purposes of section 267(b), other than the partner stock attribution  rule,  also  apply  for  purposes  of  section 707(b)(1).

Timing of determination. The determination of whether persons are related is made both immediately before and immediately after the acquisition of the section 197 intangible. In the case of a series of related transactions, or a series of transactions that together comprise a qualified stock purchase under section 338(d)(3), the determination is made immediately before the earliest transaction in the series of transactions and immediately after the last transaction in the series of transactions. 

Partnership rules. If there is an increase in the basis of partnership property under section 732, 734, or 743, for purposes of applying the ‘‘related person’’ rules, each partner is treated as having owned and used its proportionate share of the partnership’s assets. In those cases, the partnership is treated as an aggregate, rather than as an entity, for purposes of applying the antichurning rules. In all other partnership situations, the antichurning rules are generally applied at the partnership level, rather than at the partner level.

a. Section 743(b). If a partnership interest is sold or transferred on death and the partnership has in effect an election under section 754 (a section 754 election) or one is made for the tax year in which the transfer occurs or the partnership has a substantial built-in loss immediately after the transfer, the basis of partnership property is adjusted with respect to the transferee. The antichurning rules apply to those basis adjustments only if the transferee is related to the transferor, and they do not apply based on the transferee’s relationship to the partnership or other partners.

Example: Drop Down LLC Structure



It should be noted that the above referenced LLC structures may not avoid the anti-churning rules of Section 197 if the business of the S corporation was in existence prior to August 1993 and the existing shareholders roll over more than 20 percent. The application of this rule would, in general, result in any portion of the step-up allocated to goodwill being non-amortizable for tax purposes. These rules can be avoided by limiting the historical shareholders’ rollover into the acquiring entity to 20 percent.

In the case where anti-churning is an issue and there is expected to be greater than 20 percent rollover, the transaction should be structured as an “over-the-top” sale of partnership interests, so the step-up comes from a Section 754 election. Under these facts, the new LLC will need to have at least two partners and be formed some period prior to the closing of the transaction.

Example: Over-the-Top Sale of LLC Interest

In this transaction, the acquisition is a purchase of a partnership interest from the target. As mentioned, to ensure the step-up, a valid Section 754 election must be in place. The over-the-top purchase will result in the acquirer’s proportionate share of the inside basis of the partnership’s assets being stepped-up to reflect the purchase price paid and entitle the purchaser to tax deductions and amortization of goodwill reflective of such stepped-up inside basis.


Also, in accordance with the exception to the anti- churning rules for transfers on death in which basis is determined under section 1014 (discussed further below), the antichurning rules do not apply when a section 743(b) basis adjustment is made by reason of the death of a partner, with the new partner’s basis determined under section 1014(a). In that situation, the new partner is treated for purposes of the antichurning rules as acquiring the interest from an unrelated person.

"Subject to the provisions of Purchase Price Allocation (filing tax return provisions), if requested by the Acquirer in writing and subject to the provisions of Purchase Price Allocation (filing tax return provisions), New LLC shall make a timely, effective and irrevocable election under Section 754 (the “Section 754 Election”) of the Code with regard to the sale and the purchase of the Acquired Units as contemplated herein and shall file such election in accordance with applicable federal regulations.  Subject to the provisions of Purchase Price Allocation (filing tax return provisions), the Acquirer and Target shall complete, execute and deliver to the federal and applicable state Tax authorities such forms or documents as may be required to make the Section 754 Election binding and effective.  Such parties agree to act in accordance with all applicable laws and regulations relating to the Section 754 Election in the preparation and filing of any federal or state Tax Return."

Sandbagging PLC Summary 2016 - Reliance, Reliance, Reliance! Intentional or Negligence Misrepresentation!

One of the most overwrought issues in private M&A deal negotiations is the question of whether to allow the buyer to bring a post-closing claim against the seller for indemnification due to a breach of a representation, when the buyer knew before closing that the representation had been breached.

Negotiations over issues like the precise language of the seller's representations and warranties or the definition of Material Adverse Effect can be contentious enough. But for many, the idea that the buyer can sit on a claim and bring it after the closing smacks of a certain unfairness. Even the term for bringing such a claim—"sandbagging"—nods at a vague sense that the buyer is doing something untoward. In the seller's view, sandbagging amounts to lying in wait solely for the sake of bringing a claim and effectively adjusting the purchase price unilaterally. A more appropriate course of action, in the seller's opinion, is to bring up any problems before closing and work out a solution. Failing that, the buyer should be deemed to have waived its claim once it proceeds to closing.

The buyer takes a different view. In its opinion, it purchases the seller's representations and warranties as part of the overall transaction, which allocates to the seller the risk that one of its representations or warranties is false. That the buyer obtains its own knowledge about the business is to its own credit and should not be held against it, particularly because the seller is in a better position to know about the business and stand behind its own representations and warranties.

With the two views in stark opposition and a drafting compromise not readily available, many agreements stay silent on the issue altogether rather than choose one approach or another. There are different possible explanations for how counsel can justify that outcome in spite of the uncertainty it creates:

• Counsel may assume that the governing law on default rules for sandbagging is clear, leaving little to lose if the agreement stays silent. In some jurisdictions, this assumption is justified, though if this were the main driver of the decision, different market practices in different jurisdictions should be observed. In any event, the governing law is not always as unambiguous as counsel may assume.
• The issue is both fraught and zero-sum. Sellers sometimes resist sandbagging provisions by complaining that the buyer is asking for a right to ambush it, to which buyers respond by asking caustically if the seller is not prepared to stand behind its representations and warranties. In this situation, counsel may decide that the best course of action is to leave the agreement silent rather than choose between these arguments.
• In pro-sandbagging jurisdictions (and jurisdictions that counsel assume to be pro-sandbagging), it is hard for a seller to ask for an anti-sandbagging provision without having to give up something of value to the buyer in return.
• The decision to stay silent may be strategic. The inclusion by the buyer of an express pro-sandbagging clause in its draft or the inclusion by the seller of an express anti-sandbagging clause in its draft inevitably draws the counterparty's attention and likely result in the striking of the original clause and the insertion of the opposite provision in its place. The thinking may be that if that is the case, better to remain silent and rely on the governing law.

With this background in mind, this Article has two goals:

• To describe the common law on sandbagging in Delaware, New York, and Texas (along with other anti-sandbagging jurisdictions).
• To ascertain market practice in those jurisdictions and determine if counsel and M&A parties are adjusting their approach to sandbagging depending on the default rules of the particular jurisdiction.

For examples of express pro-sandbagging and anti-sandbagging provisions, see Standard Clause, Purchase Agreement: Sandbagging and Anti-Sandbagging. Throughout this Article, references to pro-sandbagging and anti-sandbagging provisions can be taken to mean provisions similar to those.

Sandbagging under Delaware Law

The prevailing assumption among M&A practitioners is that the default rule in Delaware is in favor of a sandbagging right in the absence of a contractual provision to the contrary. This assumption is well-founded, though based on surprisingly few decisions that explicitly address the issue.

The underlying principle that reliance is not a necessary element for a claim of contractual indemnification has been expressed by the Delaware courts several times (for example, see Gloucester Holding Corp. v. U.S. Tape and Sticky Products, LLC, 832 A.2d 116, 127 (Del. Ch. 2003), addressing breach of a representation in an asset purchase agreement; Interim Healthcare, Inc. v. Spherion Corp., 884 A.2d 513, 548 (Del. Super. 2005), addressing breach of a representation in a stock purchase agreement). However, the Delaware judiciary has had few occasions to apply that principle to a typical sandbagging scenario. One such occasion arose in a 2007 decision, in which the Delaware Court of Chancery specifically allowed a buyer to bring a claim for indemnification in spite of the fact that its due diligence investigation would likely have uncovered the breach giving rise to the claim (Cobalt Operating, LLC v. James Crystal Enters., LLC, 2007 WL 2142926, at *28 (Del. Ch. July 20, 2007), aff'd without op., 945 A.2d 594 (Del. 2008)). In Cobalt, the Chancery Court detailed the rationale that buyers make when negotiating for a sandbagging right:

"Due diligence is expensive and parties to contracts in the mergers and acquisitions arena often negotiate for contractual representations that minimize a buyer's need to verify every minute aspect of a seller's business. In other words, representations like the ones made in the Asset Purchase Agreement serve an important risk allocation function. By obtaining the representations it did, Cobalt placed the risk that WRMF's financial statements were false and that WRMF was operating in an illegal manner on Crystal. Its need then, as a practical business matter, to independently verify those things was lessened because it had the assurance of legal recourse against Crystal in the event the representations turned out to be false."

This is a clear statement by the Chancery Court, upheld by the Delaware Supreme Court, that a buyer can rely on the seller's explicit representations and warranties in spite of the buyer's own due diligence investigation and knowledge. Interestingly, though, the Chancery Court's decision does not stop there, but adds that the asset purchase agreement contained a pro-sandbagging provision:

"[H]aving given the representations it gave, Crystal cannot now be heard to claim that it need not be held to them because Cobalt's due diligence did not uncover their falsity. This point is, in fact, made clear in the Asset Purchase Agreement itself, which provides that 'no inspection or investigation made by or on behalf of [Cobalt] or [Cobalt's] failure to make any inspection or investigation shall affect [Crystal's] representations, warranties, and covenants hereunder or be deemed to constitute a waiver of any of those representations, warranties, or covenants.' Having contractually promised Cobalt that it could rely on certain representations, Crystal is in no position to contend that Cobalt was unreasonable in relying on Crystal's own binding words."

In this portion of its decision, the Chancery Court apparently bases its ruling in part on the fact that the seller agreed to a pro-sandbagging provision. Although the better reading of the decision is that the court was likely to have upheld the buyer's indemnification claim even without the provision, the issue is less than Crystal clear.

Market Practice in Delaware

To determine market practice in Delaware on the issue of sandbagging, Practical Law surveyed every publicly filed private acquisition agreement entered into in 2016 that contemplates post-closing indemnification and is summarized in the What's Market database as of publication of this Article. The scope of the private acquisitions database includes all publicly filed acquisition agreements (whether a stock purchase, asset purchase or merger agreement) with a signing value of at least $25 million that documents the acquisition of either:

• All or substantially all of the assets of a private US company.
• At least a majority of the outstanding stock of a private US company.
• A complete business unit of a US company.

The database excludes bankruptcy sales and certain outlier transactions. Based on these parameters, the survey sample consisted of 119 acquisition agreements with Delaware governing law. All 119 surveyed agreements are detailed here. The results are summarized in Figure A.

​

As shown, a substantial portion of agreements with Delaware governing law stayed silent on the issue of sandbagging. This makes sense for buyers if they are willing to rely on the assumption that Delaware allows sandbagging by default in the absence of contracting to the contrary. Of the 51 agreements that remained silent, two of them—both with the same buyer—spelled out that the seller has no sandbagging right with respect to the buyer's tax representation. This can be read to imply that the parties intend to retain sandbagging rights with respect to all other representations and warranties.

The next most common approach in the survey sample was to explicitly contract for sandbagging, using language that makes clear that the buyer can bring a post-closing claim in spite of any knowledge it had before closing. The fact that as many as 39 percent of agreements with Delaware governing law explicitly contracted for sandbagging rights might reflect the Cobalt decision's slight ambiguity on the question of sandbagging by default, or might simply reflect that counsel to buyers tend to negotiate for a pro-sandbagging provision regardless of the particular transaction's governing law.

The What's Market database distinguishes, and the survey distinguished, provisions that state that the buyer retains its contractual rights despite its investigation or that the seller's representations and warranties survive closing despite the buyer's investigation, if the provision does not make clear that the buyer can bring a post-closing claim despite the knowledge it had before closing concerning the representation or warranty. The survey found 12 agreements, or 10 percent of the Delaware survey sample, with this type of murky provision. As shown in Figure B and Figure C below, this percentage is substantially higher in Delaware than in other jurisdictions, which may reflect (assuming statistical significance) a more relaxed approach to negotiating sandbagging provisions in Delaware, given the assumption that sandbagging is permitted in Delaware by default.

Of the 119 surveyed agreements, only seven included an explicit anti-sandbagging provision. This low number—in a jurisdiction in which remaining silent likely means allowing sandbagging—provides powerful evidence that the pro-seller position that buyers should not be permitted to lie in wait until the closing is not a winning argument. In particular where, as in Delaware, a buyer has a right to sandbag and therefore surrenders something of value if it agrees to an anti-sandbagging provision, the more common resolution that sellers acquiesce to is to stay silent on the issue altogether. However, as discussed, sellers should realize that staying silent on sandbagging under Delaware law is likely tantamount to agreeing to a sandbagging right for the buyer.

Two of the agreements with anti-sandbagging provisions are worth highlighting for their definition of the buyer's knowledge:

• In one agreement, the buyer is deemed to have knowledge if its CFO has actual knowledge of the breach because of information communicated to the CFO at a meeting of the board of the target business, as reflected by a written agenda for the meeting or given to the CFO in writing.
• In another agreement, the buyer must be aware not only of the underlying facts of the breach, but that those facts constitute a breach of the agreement.

Figure A also makes reference to an agreement with a mix of pro- and anti-sandbagging provisions. In that agreement, the buyer can sandbag, even if it had the knowledge in question before signing, if its claims concern the seller's representations and warranties pertaining to equipment and inventory and FCPA compliance. Regarding all other claims, the agreement provides that the buyer cannot sandbag if it had actual knowledge through information disclosed by the seller in the electronic data room at least two business days before the signing.

Finally, one agreement provided that the buyer can sandbag, yet the buyer also represented that none of its officers has actual knowledge that the sellers' representation and warranties are inaccurate or untrue in any material respect or that the sellers are in breach of any covenant. The combined effect of these provisions is that while the buyer can make a post-closing claim in spite of its pre-closing knowledge, it will be found in breach of its own representation when it is revealed how it came to know that the seller was in breach.

Cure Rights

Related to the issue of sandbagging is the matter of whether the seller can (or must) update the disclosure schedules to account for any event that arises after the signing (or that existed at signing but were unknown at the time) and which constitutes a breach to the acquisition agreement if not carved out of the relevant representation or warranty by including it on the disclosure schedule. Like sandbagging provisions, a covenant to update the disclosure schedules can be a contentious issue, as, depending on its wording, it can shift the risk for potential breaches away from the seller and on to the buyer. For a sample of a covenant to update the disclosure schedules and a discussion of the different pro-buyer and pro-seller permutations, see Standard Clause, Purchase Agreement: Covenant to Update the Disclosure Schedules.

For purposes of this survey, the focus is on those agreements that are silent on the issue of sandbagging. If the schedule-update covenant explicitly provides that scheduling the event or discovery that constitutes a breach does not cure that breach, the covenant effectively acts as a backdoor pro-sandbagging provision. This is because the buyer will have pre-closing knowledge of a breach, will be able to choose to close on that breach, and yet will continue to have a post-closing claim for indemnification. This is not exactly the same as providing that the buyer can bring a post-closing claim in spite of any pre-closing knowledge it gleaned from its own investigation, and counsel should not leave to logical argumentation that which can be spelled out in the contract. Nevertheless, the buyer can have an argument that if it can close and retain its post-closing remedies in spite of knowledge it receives directly from the seller, it should certainly retain its post-closing remedies if it obtained that knowledge on its own.

The table of Delaware transactions indicates which agreements that are silent on sandbagging provide that the seller's updates to the disclosure schedule do not cure the underlying breach. The survey found a total of 14 such agreements, or 27 percent of the 51 agreements that were silent on the issue of sandbagging.

Sandbagging under New York Law

New York law on sandbagging defies simple categorization. In CBS, Inc. v. Ziff-Davis Publishing Co., the Court of Appeals overturned the lower court's decision and allowed the buyer to bring a claim in spite of its knowledge that the seller's financial-statements representation was inaccurate. The appellate court explained that "the critical question is not whether the buyer believed in the truth of the warranted information," but whether the buyer "believed that it was purchasing the seller's promise as to its truth" (553 N.E.2d 997, 1000-01 (N.Y. 1990)).

On its own, this language seemingly constitutes a robust statement in favor of a default sandbagging right. However, the court also relied in part on the fact that the buyer, in correspondence with the seller before closing, had expressly reserved its rights regarding the alleged breach. This aspect of the decision received significant attention in New York case law in subsequent years. In Galli v. Metz, the Second Circuit Court of Appeals, interpreting CBS, held that parties cannot sandbag by default without expressly reserving their rights before closing. The court stated:

"Where a buyer closes on a contract in the full knowledge and acceptance of facts disclosed by the seller which would constitute a breach of warranty under the terms of the contract, the buyer should be foreclosed from later asserting the breach. In that situation, unless the buyer expressly preserves his rights under the warranties (as CBS did in Ziff–Davis), we think the buyer has waived the breach."

(973 F.2d 145, 151 (2d Cir. 1992).)

A later decision of the Second Circuit emphasized the phrase "disclosed by the seller" from the Galli v. Metz opinion. In Rogath v. Siebenmann, the court held that if the seller is not the source of the buyer's knowledge, but that the buyer has obtained knowledge either from a third party or simply because it is "common knowledge" that the seller's warranties are false, then the buyer can still prevail on its post-closing claim (129 F.3d 261, 265 (2d Cir. 1997)). In that situation, the Rogath court explained, it is "not unrealistic to assume" that the buyer purchased the seller's warranty "as insurance against any future claims," which fulfills the requirement described in CBS. This understanding has been followed in more recent cases, such as in Gusmao v. GMT Group, Inc., 2008 WL 2980039, at *5 (S.D.N.Y. Aug. 1, 2008).

In a recent decision, the district court explained that a pro-sandbagging provision also fulfills the requirement of demonstrating that the buyer believed itself to be purchasing the seller's promise as to the representations' truth. In Powers v. Stanley Black & Decker Inc., the court held that a "knowledge savings clause" in the transaction document at issue allowed the buyer to bring a post-closing indemnification claim (137 F.Supp.3d 358, 375 (S.D.N.Y. Sept. 28, 2015)).

What emerges from the case law is that a buyer can bring a post-closing claim in spite of its pre-closing knowledge if it expressly reserves its right to do so. This can be accomplished in one of two ways:

• Through an express pro-sandbagging provision, as highlighted in Powers.
• By explicitly doing so in separate correspondence with the seller before closing, as in CBS.

Less clear is whether the buyer can sandbag without having contracted for that right and without having reserved its rights separately before closing if its knowledge was not obtained directly from the seller. The Rogath and Gusmao decisions seemingly support that conclusion, but the Powers decision does not offer that alternative, instead emphasizing only the contract's pro-sandbagging provision.

Market Practice in New York

A key takeaway from the case law in New York is that a buyer leaving an acquisition agreement with New York governing law silent on the issue of sandbagging and that does not reserve its rights before closing essentially relies on two events that are out of its control:

• That the seller will not obtain the relevant information concerning the breach and notify the buyer of that information.
• That the court eventually deciding the litigation will accept the argument that under New York law, the buyer does not need to expressly reserve its rights in a written notification to the seller if the buyer's information came from a third party or from common knowledge.

Given this inherent uncertainty, parties to private acquisition agreements with New York governing law would be expected to contract explicitly either for or against a sandbagging right. To ascertain whether this is market practice in New York, Practical Law surveyed all private acquisition agreements in the What's Market database entered into in 2016 as of publication of this Article that contemplate post-closing indemnification. The survey parameters yielded a sample of 41 acquisition agreements, all of which are detailed here. The results are summarized in Figure B.

​

The survey results may fairly be described as perplexing. Nearly half of all New York agreements remained silent on the matter of sandbagging, despite all the uncertainty that this portends. These are agreements for transactions valued at $25 million or more and for which the parties contracted for indemnification rights. The sandbagging question is hardly peripheral to the buyer's post-closing remedies, yet many parties, presumably sophisticated, left this issue to chance. If this is a result of counsel using forms in New York that work for Delaware, then counsel must make itself aware of the significant distinction between Delaware and New York law on this point.

The percentage of agreements that included clear pro-sandbagging provisions was roughly the same in the Delaware and New York survey samples. In New York, however, 12 percent of the surveyed agreements contracted explicitly against a sandbagging right, compared to six percent in Delaware. One of these agreements specified that the buyer cannot sandbag specifically if the seller provides notice of the breach, the seller acknowledges that the breach represents a failure of a closing condition, and the buyer proceeds with the closing regardless.

Cure Rights

Of the 19 agreements with New York governing law that were silent on sandbagging, three provided that the seller's notification of a breach and update to the disclosure schedule does not cure the breach or affect the seller's representation. In the Delaware-law context, this could be taken as a backdoor sandbagging provision. However, its effect in New York can be the opposite—if the seller is the source of the buyer's knowledge, the buyer cannot sandbag unless it has explicitly reserved its rights.

Anti-Sandbagging Jurisdictions

Certain jurisdictions maintain that reliance is a necessary element for a breach-of-contract claim, not just a fraud claim. In these jurisdictions, the default rule is that the buyer cannot sandbag, because if it has knowledge that the seller's representation or warranty is untrue, then it cannot be said to have relied on the truth of the representation or warranty in deciding whether to close. Consequently, silence on the issue of sandbagging in the acquisition agreement has the opposite effect as it does in Delaware—the buyer will be assumed to have waived its right to sandbag.

California, Colorado, Kansas, Maryland, Minnesota, and Texas all require reliance for a contract claim (see Charles K. Whitehead, Sandbagging: Default Rules and Acquisition Agreements, 36 Del. J. Corp. L. 1081 (2011), for a summary of the relevant case law in these jurisdictions). The Practical Law survey aggregated all acquisition agreements entered into in 2016 from these jurisdictions with post-closing indemnification and collected in the What's Market database. The survey found 31 qualifying agreements, as follows:

• Twenty-one with Texas governing law.
• Six with California governing law.
• Three with Colorado governing law.
• One with Maryland governing law.
• None with Kansas or Minnesota governing law.

​

As illustrated, a significant percentage of agreements stayed silent on the question of sandbagging, despite that approach's implications for the buyer. Indeed, given the similar percentages for both pro-sandbagging and silence in Delaware, New York, and these anti-sandbagging jurisdictions, it is hard to escape the conclusion that many parties and their counsel are not tailoring their approach to this issue in recognition of the acquisition agreement's governing law.

Two agreements provided for a hybrid approach to sandbagging.

• In one agreement, the buyer negotiated a sandbagging right with respect to the seller's representations and warranties pertaining to: organization and authority; the target company's organization, authority and qualification; capitalization; subsidiaries; environmental matters; taxes; and brokers. For all other representations and warranties, the buyer may not sandbag.
• In the other agreement, the buyer obtained a sandbagging right except regarding environmental defects, liabilities, and conditions and title defects of which the buyer had knowledge before the one-month anniversary of the agreement and for which they did not provide notice to the sellers as required under the purchase agreement.

None of the 12 agreements that were silent on sandbagging provided that the seller's update to the disclosure schedule does not cure the underlying breach.

Fiduciary Duties of Board and Investment Bankers - Delaware

Under Delaware law, corporate directors owe fiduciary duties to stockholders, which consist of the duty of care and the duty of loyalty. The duty of care requires directors to act on an informed basis, with the level of care that an ordinary prudent person would exercise in similar circumstances. The duty of care requires each director to acquire sufficient knowledge of the material facts related to a proposed transaction, thoroughly examine all information available to such director with a critical eye, and actively participate in the decision-making process. The duty of loyalty requires that disinterested and independent directors act in good faith and in a manner believed to be in the interests of the corporation and its stockholders, rather than in the director's own self-interest or in the interests of other persons. Directors are required to consider a transaction on its merits, free from any extraneous influences or conflicts.

In the "change of control context," which arises where the merger consideration is predominantly cash, Delaware courts have held that a board of directors has an obligation to exercise its fiduciary duties for the purpose of obtaining the highest value reasonably available for the stockholders. This is often referred to as a board's Revlon duties, after the case in which it was established. There is a "change in control" for purposes of the Revlon duties in an all-cash merger, in a merger where there is an acquirer with a controlling stockholder, and in a merger where the cash consideration is 50% or more of total consideration.

When a board of directors' decision is challenged by stockholders alleging breach of fiduciary duty, Delaware courts can apply one of three standards of review: the business judgment rule, entire fairness, or enhanced scrutiny.

The business judgment rule states that a court should not substitute its own business judgment for that of a corporation's board of directors. Under business judgment rule review, in a lawsuit alleging breach of fiduciary duty, the court will presume that directors satisfied their duties of care and loyalty by acting on a fully informed, good faith basis and in a manner believed to be in the best interests of the stockholders. The court will defer to the business judgment of a corporation's directors and grant a motion to dismiss the lawsuit, unless the plaintiff can allege facts that demonstrate that there is a reasonable basis for questioning whether the board satisfied either the duty of loyalty or the duty of care.

Entire fairness review applies in cases where a board's actual conflicts tainted its decision making-e.g., a majority of directors were either on both sides of the transaction or were not independent of directors who were on both sides of the transaction. If the entire fairness standard of review is applied, the burden is on the directors to demonstrate that both the decision-making process and transaction price were fair to the stockholders.

When the Revlon duties apply in a change-of-control merger transaction, enhanced scrutiny is the legal standard of review (unless the entire fairness standard is applicable). Rather than deferring to the board under the business judgment rule, a court will examine whether the board's actions were reasonable under the circumstances as a good faith attempt to secure the highest value reasonable attainable. The standard is whether the board made a reasonable decision, not whether it was a perfect one, and board liability requires bad faith or a knowing violation of its fiduciary duties. Importantly, under Revlon the fiduciary duties of a board do not change, but the board's duties of care and loyalty have to be exercised for the purpose of obtaining the highest value reasonable available for the stockholders.

In  re Rural/Metro Corp. stockholders litigation, RBC Capital Markets LLC engaged to represent Rural/Metro Corp. in a merger transaction, was also lobbying to provide financing to the acquirer, Warburg Pincus LLC for the transaction, and was trying to leverage its role with Rural/Metro to gain advantage in providing financing in connection with another acquisition within the industry. RBC was found to have manipulated the negotiations process in Warburg's favor. Rural/Metro's board was not provided with valuation analysis until three hours before its meeting to approve the deal, and the valuation metrics provided were found to have been manipulated to make Warburg's offer look more favorable. It was also determined that RBC provided the acquirer with information about the internal dynamics of Rural/Metro board's deliberations. The investment banking firm's undisclosed conflicts and conduct in this cash-merger transaction caused the board to be uninformed as to the actual value of the company and to provide misleading disclosure to its stockholders, in violation of the board's fiduciary duty of care. As a consequence, RBC was held liable for aiding and abetting the board's breach of fiduciary duties and ordered to pay stockholders $76 million in damages. The Delaware Supreme Court ruled that third parties, such as RBC, can be liable for damages if their actions caused a board to breach its duty of care, even if directors are not directly liable for the breach. The court stated that simple negligence on the part of the directors can be the basis for third party liability, even though director gross negligence is the standard of care when director personal liability is at issue. In this regard, the laws of Delaware and most other states allow a company's charter to include an exculpation provision that shields directors from personal liability even where they are found to be grossly negligent in breach of their duty of care. The court also ruled that RBC's conduct resulted in a faulty sales process and as a consequence the board failed to obtain the best value reasonably available, in violation of its Revlon duties. The court stated that directors need to be active and reasonably informed when overseeing the sales process, including identifying and responding to actual or potential conflicts of interest.

In re PLX Technology Inc. stockholders litigation, the stockholders alleged that the board breached its duty of care by failing to identify and tax adequate measures to understand and address a financial advisor's conflicts, that the lead investment banker on the fairness opinion committee was working simultaneously on a purchase for the acquirer, from which one could reasonably infer that certain information was improperly shared and contributed to a potentially unreasonable sale process, that the banker had possibly skewed financial projections, as it presented lower than historical growth rates, and that the banker only disclosed the extent of its extensive relationship with the acquirer on a simultaneous deal on day before rendering its fairness opinion. The court declined a motion to dismiss the suit, noting that the target's board had failed to identify conflicts early in the sales process and had compounded the failure by failing to continuously and diligently oversee the banker's actions. The court noted that generic disclosure that had been made to the disinterested stockholders who approved the transaction was not sufficient to overcome the significant conflicts. The court suggested that the company's sale committee could have hired a second investment advisor to recommend corrective action, released other bidders from their standstills, recalibrated deal protection measures, sought new bidders or fired the banker and restarted the process.

Once the business judgment standard of review is determined to apply to the board's decision because of a fully informed, uncoerced vote of the disinterested stockholders, dismissal of claims of failure to perform duties of care and loyalty in the context of Revlon duties is warranted. However, A financial advisor whose bad faith actions cause its client boards to breach their fiduciary duties can nevertheless be held liable for aiding and abetting even if the board itself cannot be held liable for the breach. The financial advisor liability requires plaintiff to prove scienter and therefore protects financial advisors from due-care violation.

To do list:

• Identify potential deal partners first and do the research and ask questions and document recent deals that may be considered conflicts before engaging advisors regarding potential conflicts;
• Include in the engagement letter that the advisor may not perform deal advisory services to the potential deal partners during the engagement;
• Include in the engagement letter that should the board determine in its reasonable judgment that a conflict has developed or been discovered, the advisor will reduce its fee so an independent advisor can be brought in to confirm the first advisor's work.

Representations and Warranties Insurance

1. Purposes and Functions

• Protects against seller's breaches of representations and warranties and losses that may arise therefrom post-closing.
• Reduces or eliminates seller's indemnify obligations 
• May provide additional protection over specified indemnities

2. Not intended to provide protection against:

• "Knowledge" of a breach (no sandbagging to be allowed from insurer's perspective) - insured prefers to limit knowledge to actual knowledge (no constructive knowledge) and limit "Knowledge Persons" to as small a group of management employees as possible.
• "Fraud" - definition of fraud as a carve-out from the coverage needs to be reviewed with caution; ensure that definition in the purchase agreement is identical to the definition in the insurance policy; the broader the definition of fraud, the greater the risk of buyer; seller (e.g., PF funds in platform sales) needs to ensure that (i) buyer does not amend or modify the policy in a manner that is adverse to seller (attache the policy as an exhibit) and (ii) buyer does not enter into any agreement with any person (insurer) that is broader than or inconsistent or conflicts with buyer's rights, interests or obligations under the purchase agreement (e.g., scope of subrogation rights in the policy) and any such broader, inconsistent or conflicting right, obligation, covenant or agreement will not be effective or binding against seller.
• Working Capital Adjustment - purchase price issue
• Adequacy of specific reserves on a balance sheet
• Underfunded pension obligations
• Covenants of a seller (state of matters v. actions)
• Absence of due diligence (moral hazard)
• Forward looking statements

3. Buyer's perspective

• Increase or augment indemnity
• Extension of survival period of reps and warranties (24 m - 36 m up to 6y; 6y for fundamentals)
• Ease of collection
• Backstop in public deals or seller bankruptcy
• Sweeten bid in auction
• Manage post-closing relationships with customers, suppliers and management of target

4. Seller's perspective

• Reduce contingent post-closing liabilities 
• Enable distribution of all sale proceeds upon closing
• Protect passive sellers (LPs)
• Attract best bids by maximizing indemnity
• May offer separate indemnity package for tax, employment, environment or real property

5. Usage

• More frequently used in stock deals, PIPES, mergers and Section 338(h)(10) transactions where buyer assumes pre-closing liabilities
• Less frequently used in asset transactions where seller is retaining pre-closing liabilities

6. Terms

• Coverage: 100% plus of purchase price or may bifurcate (fundamental v. regular reps)
• Retention (Deductible): seller's skin in the game; 1-2% of purchase price; esp. insisted regarding fundamental reps and warranties; step-down retention after a certain period post-closing
• Premium: as of 2016 2-4% of coverage
• Underwriting fee: $15,000-$50,000

Purchase Price Adjustment Provisions - Jones Day Article

Accounting True-Up vs. Valuation Dispute

January 2017

Chicago Bridge Decision from Delaware Chancery says Accounting Expert Has Exclusive Jurisdiction over $2.5 Billion Contract Dispute

On December 2, 2016, a Delaware Chancery Court held that the courts had no role in considering a purchase price adjustment dispute based on "plain language of the purchase agreement" that made arbitration by an independent accounting firm the "mandatory path" for resolving disputes over a closing date adjustment.[1] As discussed in our prior Jones Day Commentary, purchase price adjustment provisions are common, and disputes over the amount and bases of the resulting calculations occur frequently. Clients, therefore, should take note of the substantive assertions and contract clauses in Chicago Bridge that led to the dispute so as to avoid potential disputes and unintended consequences in their transactions.

Background

In Chicago Bridge, a dispute arose under a textbook post-closing purchase price adjustment provision.[2] Under the Chicago Bridge agreement, the purchase price was to beadjusted based upon a comparison of closing net working capital to a specified target net working capital amount ($1.174 billion). The seller (Chicago Bridge) calculated an estimated closing net working capital amount of approximately $1.601 billion, which would have resulted in a $428 million payment from Westinghouse, the buyer. Following the closing, the buyer recalculated closing net working capital as negative $976 million, which would have resulted in a $2.15 billion payment from the seller to the buyer.

Of particular importance were the bases on which the buyer proposed adjustments to the seller's calculation. The buyer went beyond challenging the underlying calculation and, instead, used its proposed adjustments to challenge whether the seller's calculations were GAAP (generally accepted accounting principles) compliant. Specifically, based on the facts described in the opinion and pleadings, in three of the four adjustments, the buyer appeared to apply its own, different accounting estimates and judgments to project costs for nuclear plant construction.[3] These adjustments consisted of the following:

• A 30 percent reduction to an outstanding receivable on the target's balance sheet called "claim costs." "Claim costs" represented costs incurred by the target for items that would be recovered from either the project owners or the buyer—either as a matter of contractual entitlement or as claims for overruns for which the target was not responsible. The buyer asserted that the seller's estimate of "100% collectability" violated GAAP.[4]
• An adjustment of the same claim costs receivable to reflect costs of design changes allegedly mandated during a regulatory review, resulting in a reserve for these costs (ostensibly under GAAP) and thus a further reduction to net working capital.
• An increase of the cost estimates to complete the projects by 30 percent, which created an additional liability on the balance sheet. This adjustment reflected the buyer's view that it would cost $3.2 billion more to complete the projects than the seller had initially predicted.

In its fourth adjustment, the buyer separately claimed that the seller had violated GAAP by omitting a non-cash, purchase accounting liability of $432 million that related to the seller's 2013 acquisition of the target.[5]

The Chicago Bridge purchase agreement stated that the representations and warranties, including those covering historical financial statements, would not survive the closing. Accordingly, the crux of the seller's argument was that the buyer's recharacterization of net working capital line items was an attempt to circumvent the limit on indemnities for breaches of representations and warranties by challenging target's historical GAAP compliance through the post-closing purchase price adjustment. In contrast, buyer took the position that it did not waive its right to raise issues of GAAP compliance in respect of balance sheet accounts through the closing date adjustment.

The Chicago Bridge adjustment provisions referred to calculation according to both the "illustrative calculation and Agreed Principles" (commonly referred to as a "sample statement") as well as GAAP consistently applied by the seller. This dual standard created an opportunity for the parties to assert competing and conflicting accounting treatments. Based on the court's reading of this contract language and existing Delaware case law, the chancery court held that the buyer's challenges to the calculation methodology were properly within the scope of the adjustment provision itself.

Challenging a Seller's Working Capital Calculation as Not GAAP Compliant

The source of the dispute in the Chicago Bridge case and in the line of Delaware cases cited by the Chicago Bridge court is the inconsistent and potentially erroneous application of accounting principles. Purchase agreement provisions covering financial statements have two sometimes competing objectives: (i) to ensure that all financials are GAAP-compliant, and (ii) to use an apples-to-apples comparison of the target's financial condition to measure changes in assets, liabilities, and other financial metrics between a specified measurement ("balance sheet") date and the closing. In order to properly measure changes in financial attributes, the agreement should require consistency in methodology between the pre-closing reference balance sheet and closing calculations. Under this construct, parties need to analyze the accounting policies used to set the target at the outset to ensure proper application of GAAP and to carry through this application in the true-up.[6] If the agreement does not require consistency, the buyer's adjustment can potentially reflect a change in accounting treatment.

The Chicago Bridge case brings home the importance of the specific contract language used in the purchase price adjustment provision. If the contract is silent or unclear, or makes GAAP an overriding consideration, a buyer's accountants may adjust the balance sheet prepared by a seller for GAAP inconsistencies. In contrast, if consistency of application of accounting principles is emphasized in the contract, any challenges to GAAP compliance must generally be raised in an indemnity claim and subject to the caps and baskets typically included in these contracts to limit such claims.

The contract in Chicago Bridge did not contain language clarifying that the intent of the parties was solely to measure changes in net working capital, or that the processes were not intended to permit the application of judgments or estimation methodologies that differed from those used in the initial calculation. Such language would have strengthened the seller's argument that the buyer's recalculation of net working capital under its own accounting estimates was simply a back door indemnity claim.

Importance of Scope of Representations and Warranties on Financial Statements

The Chicago Bridge court emphasized that the scope of accounting adjustment proceedings is a function of the governing contract terms. The court discussed Delaware precedent in which the terms of a GAAP compliance representation expressly covered the reference statement (the sample statement by which a target's working capital is determined). This contractual language required that a challenge to the GAAP compliance of a seller's "reference statement" only be brought as an indemnity claim.[7]

In other Delaware cases, however, different governing contract terms allowed a buyer to contest the GAAP compliance of values in the seller's reference statement in an accounting adjustment procedure. Specifically, in Alliant Tech Systems v. Mid-Ocean Bushnell Holdings,[8] the court concluded that if the seller had not followed GAAP in its initial calculation (by which the target was set), then the buyer could assert its own GAAP-compliant calculation in an accounting procedure. The court relied on the purchase agreement's requirement that closing net working capital be "calculated in accordance with GAAP" to conclude that the contract anticipated that GAAP issues could be raised in a post-closing price adjustment procedure as well as in an indemnity claim.

Pros and Cons of Accounting Arbitration

An underlying rationale behind post-closing purchase adjustments is that fluctuations in financial metrics (such as working capital) should fall within a range of past, normalized working capital levels. Deviations that materially exceed these parameters may be an indication that something has gone awry or of a larger or different dispute between the parties relating to valuation of the business or the integrity of the financial statements. Accordingly, it may be prudent to limit mandatory accounting arbitration to adjustments that do not exceed some percentage of the target amount or to some appropriate fixed amount, or to include language limiting the scope of the accountants' work to an "apples-to-apples" comparison intended to capture only changes over time to working capital.

Sellers, especially, should be wary of drafting contracts that allow complex questions of contract interpretation or high-dollar issues of seller compliance with GAAP to be decided through the (appropriately) abbreviated process typical of accountant price adjustment determinations.[9] The "quick and dirty" process used in accountant determinations can make them less than suitable for complex, high-value cases involving contract interpretation or complicated application of accounting principles. Accountants typically do not have the experience and background to assess legal issues concerning contract construction. There is no opportunity for discovery, testimony, or cross-examination. Accounting dispute resolution also normally involves a single neutral, which may increase the risk of a poorly reasoned award. And, as with any arbitration, judicial review is tightly circumscribed.

Material disputes involving contract interpretations and claims of noncompliance with applicable accounting standards may be better decided in full-scale "legal" (as contrast to accountant-led) arbitrations or in lawsuits. Each of these alternatives allows for some degree of discovery and requires decision according to governing legal standards. Arbitration is typically quicker and less expensive than full-scale litigation.

In addition, should the parties wish to have decision-makers with specialized expertise, arbitration allows the parties to make contractual provisions for that. For example, the International Center for Conflict Prevention and Resolution ("CPR") has established a specialty banking, accounting, and financial services panel comprising attorneys with financial background and expertise in resolving disputes which arise in the context of mergers and acquisitions and other corporate deals.

Further, arbitrations can be confidential if the parties so desire. If the parties are committing material disputes over accounting adjustments to a full arbitration proceeding, then specialized arbitrators, such as those in the Certified Public Accountant Panels available from CPR can have advantages. Typically, post-closing accounting adjustment provisions call for the parties to choose an accounting firm to make the final determinations regarding adjustments. Finding an experienced accounting neutral without a relationship with one or more of the parties is often difficult and time consuming, especially in light of the consolidation and dissolution of what used to be the "Big Eight" into the "Big Four" firms.

Broadening dispute resolution to CPR and similar proceedings would also: (i) deepen the bench of available neutrals to include experienced and well-regarded commercial arbitrators in multiple jurisdictions, and (ii) avoid the conflicts of interest associated with accounting firms that regularly provide audit, tax, and other services to the parties.

Reasons for rejecting arbitration of a legal dispute associated with a price adjustment include: (i) many arbitrators have the tendency to do some sort of "baby split" award as opposed to a reasoned analysis of the merits; (ii) there are extremely limited appeal rights unless the parties write an appeal provision into the arbitration provision into the contract;[10] (iii) since court decisions are subject to review and appeal, the prospect of being overturned often results in judicial decisions being grounded more firmly in law governing contract interpretation; and (iv) many U.S. clients prefer litigation as the "devil they know"—at least in the United States—as compared with a less-certain process in arbitration.

Arbitration can be cheaper and faster than litigation, and it is private (or at least it can be if the parties so specify). But if the main concern is getting the right decision, these considerations may well be less compelling. Litigating a dispute in court allows the opportunity for challenging a plaintiff's claims as a matter of law through summary judgment and, more important, allows for appellate review. If the claims present mixed questions of law and accounting under the agreement, or implicate bad faith, fraud, or breach, a court proceeding or a formal arbitration under AAA or CPR rules may be the better option.

Lessons Learned and Practice Tips

As illustrated by Chicago Bridge and prior cases, attempts to clarify the parties' intentions regarding net working capital adjustments through arbitration before an accounting expert are poor substitutes for a detailed and specific set of accounting provisions prepared with the benefit of expert financial accounting advice, thorough due diligence, and precise drafting. Accordingly, contract drafters and business development professionals should take into account the following:

Pre-closing Accounting Due Diligence. The parties should highlight and assess treatment prior to the sale of potential areas of dispute, including:

• Reserves and accruals for liabilities that would typically be covered by seller indemnity, such as taxes, litigation, environmental, or off-balance-sheet amounts.
• "Debt-like" items, such as equipment leases.
• Contingent liabilities, such as litigation and claim reserves.
• Industry-specific accounting methodologies and business attributes (such as seasonality, deferred revenue, or installment accounting) that could distort closing calculations artificially, depending on when the closing occurs.
• Accounts receivable and inventory values and reserves (including excess and obsolete reserves), processes for closing date physical inventories and the potential for revaluations.

Precise Formula. Any accounting, including working capital, formula should list the specific components of the formula, and refer to line items on a referenced balance sheet, or general ledger. Referring simply to "net working capital," "current assets," "current liabilities," or similar broad categories creates ambiguity as to what's in and what's out of the calculation.

Intent to Measure Changes. If applicable (and particularly in sell-side representations), the adjustment provision should state that the calculation is intended to measure changes from the target working capital to the closing working capital, thereby countering any inference that a de novo calculation of historic, booked amounts is permissible.

Consistency of Accounting Policies and Estimates. The purchase agreement should clarify that a target's past accounting practices, and the same accounting principles, estimates, judgments, methodologies, policies, and the like—including judgments as to loss and gain contingencies and materiality determinations—used to prepare the target should be respected in calculating the closing statement.[11] Conversely, if representing a buyer, consider permitting use of prior principles only if in compliance with GAAP, and enabling the buyer to correct errors and omissions and to take into account all accounting entries regardless of their amount.

Hierarchy if Accounting Principles Conflict. The purchase agreement should be clear as to which principles—GAAP, "modified"-GAAP, or seller's non-GAAP/sample statement principles—take precedence in the event of a conflict.[12]

Operation of Exclusive Remedy Provisions. Parties, particularly sellers, should be wary of language contained in indemnity exclusive remedy provisions that exclude purchase price adjustment provisions. Courts have looked to such language as supporting the buyer's right to apply GAAP to correct a seller's working capital calculations through an accounting arbitration even though such claims could also be asserted as a breach of rep claim.

Additional Protective Provisions. Sell-side adjustment provisions should include standards that would limit a buyer's right to assert its own, sometimes novel adjustments. Such provisions could include:

• Excluding the effect of the operation of the business of the target after closing.
• Consideration only of information available to the parties up to the closing date or the date seller delivers the notice of disagreement.
• Preparation of the calculation on the basis that the target is a going concern.
• Exclusion of purchase accounting adjustments, the effects of any post-closing reorganizations, or the post-closing intentions or obligations of the buyer.
• Exclusion of any provision with respect to any matter that could form the basis of an indemnity in favor of the buyer under the agreement.
• Exclusion of any item to the extent the buyer is financially responsible for such item under the agreement.
• Exclusion of amounts to the extent such amounts are subject to, and included as, a separate adjustment to the purchase price under the agreement (e.g., net debt calculation).

Timelines for Closing Statement Calculations. According to Chicago Bridge's complaint, Westinghouse requested and Chicago Bridge granted a 30-day extension to permit Westinghouse to prepare its closing statement, which may have given Westinghouse more time to develop creative accounting positions to rebut the seller's initial calculation. Absent special circumstances, the parties should be held to the contract timetable to minimize such risks.

Express Limitations on an Accounting Arbitrator's Authority. Express limitations on post-closing accounting arbitration and the arbitrator's authority can remove uncertainty about the purpose and scope of the proceedings. Such limits could include restricting the accounting expert's determinations to the application of accounting principles, as defined in the agreement, and limiting determinations of contract interpretation or law. An arbitration decision that exceeds the express limits of an arbitrator's authority represents one of the few avenues for appeal of an arbitration award. Thus, express limitations can provide certainty and protection to the parties in connection with post-closing adjustments.[13]

Lawyer Contacts

For further information, including sample contract provisions and guidance on alternative dispute resolution procedures, please contact your principal Firm representative or one of the lawyers listed below. General email messages may be sent using our "Contact Us" form, which can be found at www.jonesday.com/contactus/. 

Michael P. Conway 
Chicago 
+1.312.269.4145 
mconway@jonesday.com  

Bryan E. Davis 
Atlanta 
+1.404.581.8631 
bedavis@jonesday.com  

Elizabeth C. Kitslaar 
Chicago 
+1.312.269.4114 
ekitslaar@jonesday.com  

James A. White 
Chicago 
+1.312.269.4161 
jawhite@jonesday.com  

Jones Day publications should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general information purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at our discretion. To request reprint permission for any of our publications, please use our "Contact Us" form, which can be found on our website at www.jonesday.com. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. The views set forth herein are the personal views of the authors and do not necessarily reflect those of the Firm. 

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[1] Chicago Bridge & Iron Company, N.V. v. Westinghouse Electric Company, LLC, et al., C.A. No. 12585-VCL 2016 (Del. Ch. Dec. 2, 2016). On December 5, 2016, the Court issued a corrected Memorandum Opinion and Chicago Bridge filed its notice of appeal to the Delaware Supreme Court.

[2] Post-closing purchase price adjustments are almost universally present in definitive agreements for the sale of privately held businesses. These provisions—which include earn-out clauses, working capital adjustments, and debt/net debt true-ups—require an adjustment to the purchase price paid at closing, based on calculations relative to pre-closing targets, standards, or formulas. Such provisions set forth not only the methodology for determining the amount of the adjustment, but also a resolution process in the event the parties disagree on the amounts to be paid. These processes typically include (i) an exchange of the relevant financial calculations and access to work papers and supporting documentation, (ii) submission by the recipient party of objections to the calculation, (iii) a period of time within which the parties will attempt to resolve the dispute in good faith, and (iv) submission of the unresolved issues to a neutral accounting firm for ultimate resolution.

[3] Chicago Bridge's complaint intimates that prior to closing, Westinghouse (in its role as project consortium partner) settled and released claims with the project owners for less than what Chicago Bridge had been carrying on its books, thereby supporting Westinghouse's post-closing assertion that GAAP required a write down of claim costs. Such write down had the effect under the net working capital adjustment of artificially shifting such released costs foregone through such settlements back to Chicago Bridge.

[4] According to Chicago Bridge's complaint, on the closing date, Westinghouse announced that it had named a new subcontractor to take over management of a significant portion of the construction at the nuclear facilities designed by Westinghouse at which Chicago Bridge had been principal contractor. Chicago Bridge asserted that Westinghouse, the subcontractor, and the project owners developed their own new timelines and cost estimates for the projects as a result of the performance commitments negotiated by Westinghouse in its claims settlement with the project owners, which in turn would have resulted in new cost and recovery estimates. According to Chicago Bridge's complaint, during the negotiations on the working capital adjustment and the Delaware case proceedings, Westinghouse refused to provide the seller with copies of the settlement agreements with the project owners.

[5] According to Chicago Bridge's complaint, not only did this purchase accounting entry not represent future cash outflow liability, but it also was not included in the calculation of the working capital target.

[6] In 2014, 62 percent of post-closing adjustments were to be determined in accordance with GAAP, or GAAP applied consistent with past practice. 33 percent—roughly half as many—were to be determined by another standard, such as modified GAAP, or principles set forth in a schedule to the purchase agreement. Source: 2015 ABA Business Law Section Private Target M&A Deal Points Study.

[7] See OSI Systems, Inc. v Instrumentarium Corp., 892 A.2d. 1086 (Del. Ch. 2006).

[8] Alliant Techsystems, Inc. v. MidOcean Bushnell Holdings, L.P., C.A. No. 9813-CB (Del. Ch. Apr. 24, 2015).

[9] Under Delaware law, such proceedings presided over by accountants are treated and reviewed by courts as arbitrations. Viacom Int'l v. Winshall, 72 A.2d 78 (Del. 2013). It should be noted that certain other states, most relevantly, New York, have separate provisions and proceedings associated with expert accountant determinations. See New York Civil Practice Law and Rules 7601.

[10] CPR (International Institute for Conflict Prevention & Resolution) has an appeal protocol, for example, that provides for another arbitrator or set of arbitrators to provide appellate review of an arbitration award.

[11] Compare the Chicago Bridge equivalent provision: "[T]here shall be no changes to accounts receivable reserve accounts or inventory reserve accounts that are not in accordance with GAAP as in effect on the Closing Date and the accounting principles, practices, methodologies and policies described under "General" above [past accounting practices of the Company and sample calculation, and supported by the Company books and records] or that are not supported by a change in facts, the underlying criteria or a change in the related account balance." (emphasis added)

[12] See note 6 supra.

[13] Current practice is to permit accounting arbitrators to hire counsel to assist with legal determinations along the following lines:

Arbitrator may seek and consider the views of legal counsel not associated with the parties if he deems such to be necessary in resolving the dispute submitted hereunder and if the parties both consent. Arbitrator will not consult outside counsel until he has presented the issue to the parties for their input. Arbitrator will either utilize counsel jointly selected by the parties or will secure the approval of the parties of the choice of counsel made by him. In either event, counsel shall submit an estimate for its work to be approved by the parties and [accounting firm] shall be reimbursed for the cost of such counsel. Even if Arbitrator consults with outside counsel, Arbitrator retains full decision-making power related to items in dispute.

Consider whether a better option would be to include an AAA or similar arbitrator provision governing disputes with mixed issues of accounting and law that allows a single "legal" arbitrator to retain an independent expert to assist with accounting issues but leaves ultimate authority with the arbitrator.