Resolution of Purchase Price Disputes in M&A Transactions
Arbitration issues in M&A transactions most typically arise in the context of purchase price adjustments (PPAs) and indemnification claims in transactions involving target companies whose common stock is not publicly traded. This chapter focuses on the issues that PPAs present in M&A transactions, specifically, with the intention that practitioners keep these issues in mind as they review the relevant procedural and substantive rules of arbitration in the jurisdictions covered in this volume.
The purchase and sale of a business or its assets involving a non-publicly traded target company almost universally requires the buyer and seller to agree upon a final adjustment of the purchase price following the closing of the transaction. M&A arbitration often stems from disputes that arise during the PPA. Purchase agreements often have built-in mechanisms to address these disputes, which are typically distinct processes from those governing post-closing indemnification claims. However, a well-drafted purchase agreement may take various forms with respect to purchase price disputes, and the ultimate resolution of such disputes may vary depending on the governing law and jurisdiction. This chapter looks at how alternative dispute resolutions can address PPA disputes, specifically focusing on expert determination versus arbitration.
This chapter is divided into three sections. The first section details common dispute resolution terms in the context of PPA provisions and how the PPA provision is often tailored to address the likelihood of such disputes. This mainly draws on US law and practices. The second section touches on some differences between jurisdictions with respect to arbitration of purchase price disputes. The final section provides a checklist for M&A and dispute resolution practitioners to utilise in negotiating and drafting purchase agreements and attempting to prepare for disputes if they arise.
Preparing for purchase price disputes
As M&A attorneys know, the purpose of PPA provisions is to protect both parties against any change in value of the target company or business between the period of when the initial calculation occurred and the closing date of the transaction, usually attributable to working capital, debt or similar variable measures of a target’s financial condition. The provision protects the interests of both parties. Specifically when the adjustment relies on changes to working capital, the adjustment compensates the seller for managing the business between signing and closing, and for the buyer, it protects against value depletion if the seller ignores the business’ ongoing operations. Given the protection this provision provides, its inclusion in US purchase agreements has grown from 68 per cent of M&A deals in 2006 to 95 per cent of deals in 2019. A 2020 survey showed that 85 per cent of US agreements contained completion accounts or PPA provisions. In addition, in many transactions, the adjustment to the purchase price for purposes of determining the amount paid at closing is based on a calculation made by the seller, which the buyer cannot challenge. The price paid at closing is usually further adjusted after closing, based on a calculation initially done by the buyer, with a right by the seller to object and invoke a dispute resolution mechanism. And of course, where there is modification to a term as integral to a transaction as purchase price, especially outside of the pre-signing negotiation period, there is bound to be disagreement.
Sources of disagreement
The most common source of disagreement from PPAs relates to the choice of accounting principles that apply and how they apply. Many US agreements state that the US Generally Accepted Accounting Principles (GAAP) should apply. Unfortunately, it is common for parties to agree to apply US GAAP without appreciating how it may affect the purchase price calculation. For example, within US GAAP there are different valid methods to account for the same item. Some disputed items include revenue recognition policies, cash on books versus cash in bank, treatment of cash on the closing day, accounts receivable and bad debt policies, and accruals for accounts payable. Cross-border transactions may be complicated even further by mandates, or lack thereof, to follow the International Financial Reporting Standards (IFRS), issued by the International Accounting Standards Board, or other local accounting standards. The United States, Japan and China are a few major markets that have yet to issue an IFRS mandate, leading to inconsistencies across countries. The following two cases illustrate issues that arise with applying US GAAP.
In Twin City Monorail, Inc v. Robbins & Myers, Inc, the parties disagreed on the proper inventory valuation method for the PPA. The buyer argued that inventory should be valued using the ‘last in, first out’ method because this was the method used in the seller’s reports on corporate earnings. Conversely, the seller advocated for the ‘first in, first out’ method because that was the method used on the target’s balance sheet. Both methods complied with US GAAP, but they resulted in a difference of US$700,000 on the purchase price calculation.
In Mehiel v. Solo Cup Co, the purchase price dispute between the parties turned on an asset that the target owned. In the pre-closing balance sheet, the seller classified the asset as an asset held for sale due to the intention to sell the asset. Such categorisation would have increased the working capital that the PPA relied on. The buyer had convinced the seller to keep the asset and that it would not affect the purchase price. Relying on the buyer’s persuasion to keep the asset, the seller was disadvantaged after closing when the buyer reclassified the asset as a long-term asset and, thus, was not included in working capital. The accountant hired to arbitrate the dispute sided with the buyer because the target company no longer planned to sell the asset. However, both methods of categorisation were valid. Also important to note in this case, when the seller filed a lawsuit in the Delaware Court of Chancery, the Court refused to hear the claim stating that the dispute was resolved by the accountant and that the resolution was final, binding and conclusive.
While issues in applying US GAAP methodologies are by far the most common source of PPA disputes, another source of dispute stems from the inclusion or exclusion of items in the calculation. While time-consuming, enumerating items for the calculation can clear up the categorisation of assets and prevent disputes. However, due to time and cost, it is more likely that catch-all phrases are used for certain categories of assets. For example, Accel International Corporation v. Lyndon Life Insurance Co involved a dispute between the parties on whether deferred tax liabilities should be calculated under liabilities in the balance sheet; the seller had taken a tax election that relieved the target of the liability at closing and the parties had not discussed how the deferred tax liability was to be treated.
An additional source of dispute includes use of pre-closing balance sheets, and consistency issues with how pre-closing balance sheets and the closing date balance sheet are calculated. This can include inconsistencies in how US GAAP methodologies are applied, as aforementioned, or even doubts as to whether US GAAP was applied properly between the two balance sheets. While addressing these sources of dispute, US agreements with PPA and dispute provisions across different deals tend to look very similar.
Addressing disputes: US trends in provision language
Across the US legal market, the structure of the dispute sub-provision to the PPA provision can vary in some respects. However, the provision generally lays out: (1) the period for communicating or submitting a dispute; (2) the third party that will determine the final purchase price; (3) whether there is a limit to the third party’s calculation; and (4) how to allocate the fee of the third party’s services. This is assuming that the parties cannot resolve the purchase price themselves within the period designated in the agreement. While most transactions with PPA provisions have dispute sub-provisions, there are still agreements that choose to do without the protection. Based on our experience, and looking at some of the published M&A transaction documents and studies of M&A deals in the US, there are some patterns to note.
Those companies that integrated PPA provisions with dispute sub-provisions generally chose accountants as the independent third party responsible for calculating the final purchase price. This is likely due to time and cost concerns of dispute resolution and accountants’ familiarity with working capital calculations or other accounting concepts involved in the dispute. The question of who is responsible for the final price calculation is further discussed in ‘Expert determination or arbitration? That is the question’, below. Most transactions also chose to limit the third party’s calculation in some way, such as requiring that the third party’s determination of a specific amount not be more or less than the calculations made by the disputing parties. In a 2012 study, only 27 per cent of surveyed US agreements did not place any limitation on the third party’s final calculation, and 71 per cent of agreements limited the calculation between the parties’ proposed calculations. Finally, regarding costs, transactions can either use the proportional approach, the fees split evenly approach or the loser pays all approach. The proportional approach and the fees split evenly approach are the most common in the US. The 2012 study found that 43 per cent of US agreements used the proportional approach, 42 per cent used the fees-split-evenly approach and only 12 per cent used the loser-pays-all approach.
Under the proportional approach, the parties split the costs proportionally based roughly on the proportion that the final calculation bears to each party’s calculation. As an example of the proportional approach, the agreement and plan of merger between Sun Communities, Inc and Safe Harbor Marinas, LLC states the following:
The fees and expenses of the Accountants shall be allocated between the Surviving Company and Seller Representative (on behalf of the Security Holders, severally, and not jointly, in accordance with each Security Holder’s Pro Rata Share), so that each such party’s share of such fees and expenses shall be equal to the product of (A) the aggregate amount of such fees and expenses and (B) a fraction, the numerator of which is the amount in dispute that is ultimately resolved in the other party’s favor pursuant to this Section 2.15 (as finally determined by the Accountants) and the denominator of which is the total amount of the disputed items submitted to the Accountants.
The proportional approach is generally favoured because it incentivises parties to calculate price with good faith. The fees-split-evenly approach is generally more costly due to the even split of costs sheltering the parties and allowing for more dispute in calculations. The loser-pays-all approach forces the party whose calculation is furthest from the final valuation to pay the full cost, and is disfavoured for that reason.
In one study of US M&A agreements, one agreement did not use any of the three aforementioned approaches. Instead, the fee was agreed to be split evenly unless one of the party’s calculation was more than twice the difference between the third party’s calculation and the other party’s calculation. In such case, the more erroneous party would pay the fee. This is another middle ground between the fees-split-evenly approach and the loser-pays-all approach.
It is worth noting that, based on the authors’ experience, many M&A agreements do not address the parties’ respective responsibilities for indemnifying the expert or arbitrator and, perhaps, more importantly, do not require the parties to negotiate and execute an engagement letter with the expert or arbitrator.
Expert determination or arbitration? That is the question
Many countries recognise both expert determination and arbitration as binding alternatives to litigation. Countries may differ in the rules that govern these methods, but many countries follow the practice that arbitration rules do not apply to expert determinations. As previously discussed, US agreements favour expert determinations, specifically accountants, over arbitration. In a recent study, 86 per cent of US M&A agreements included PPA provisions, up from the 82 per cent approximately five years earlier. In addition, 97 per cent of US agreements in M&A transactions with PPA provisions selected an independent accountant for the expert determination. However, the best alternative dispute resolution for an agreement can vary with the facts and circumstances of the deal. While the number of deals with accountant expert determinations is high, arbitration is not irrelevant. Arbitration provides for more protection for deals where a party believes there is much to be gained from the more formal, judicial-like process of arbitration.
In the US, arbitrators have broader authority to interpret an agreement’s language or address legal arguments. Experts are more limited to a specific factual question. However, with the arbitrator’s broader authority comes more regulation; the US Federal Arbitration Act (FAA) only applies to arbitrations and not expert determinations. Parties cannot compel an expert determination or enforce an expert’s decision under the FAA. However, the FAA does serve as a beneficial safeguard in arbitrations for both parties through more onerous standards of review. The Act allows a court to vacate an arbitration award in the following circumstances:
- ‘where the award was procured by corruption, fraud, or undue means’;
- ‘where there was evident partiality or corruption in the arbitrators, or either of them’;
- ‘where the arbitrators were guilty of misconduct in refusing to postpone the hearing, upon sufficient cause shown, or in refusing to hear evidence pertinent and material to the controversy; or of any other misbehavior by which the rights of any party have been prejudiced’; or
- ‘where the arbitrators exceeded their powers, or so imperfectly executed them that a mutual, final, and definite award upon the subject matter submitted was not made’.
Some courts have also held that an arbitration award can be vacated for a manifest disregard of the law. While there are some safeguards for expert determinations, a court will generally only step in for cases of ‘fraud, bad faith, or palpable mistake’ (e.g., lack of reasonable basis for decisions, failure to follow agreement instructions or incorrectly deciding legal issues).
In addition to the FAA’s governance, arbitration allows parties to negotiate aspects of the arbitration such as the number of arbitrators, how the arbitrators should be appointed, whether a particular set of laws or industry regulations should be applied by the arbitrators, and whether the arbitration is final and binding or simply advisory. Because of the larger scope of arbitration, compared to expert determination there is much more to negotiate prior to finalising an arbitration PPA dispute sub-provision. Furthermore, drafting for arbitration does not end at settlement of the initial procedure; parties must also consider an appeals process if the dispute continues past the initial arbitration.
Expert determinations are not without their downfalls. While, the drafting and negotiation may be simpler, there are still concerns revolving the less extensive procedure. Specifically when the expert is an independent accountant, common concerns are that (1) accountants may be overly inclined to use US GAAP and not apply specific rules negotiated between the parties, and (2) the purchase price dispute may involve compliance issues in the agreement outside of the specific purchase price calculation provision, which is outside the accountant’s skill set. When an expert is selected, the parties rely on the expert to use his or her knowledge and experience, the accountant is not there only to perform mathematical calculations.
When drafting a PPA provision dispute sub-provision, note that in the US any provision that specifically identifies an alternative dispute resolution stands, even if the agreement has a general provision governing the entire agreement stating otherwise. Furthermore, there have been a handful of cases that complicate the drafting of the PPA dispute sub-provision once the contracting parties have agreed and made a determination on whether to resolve through expert determination or arbitration. Specifically, courts have held that the nomenclature used in the dispute provision is not integral to finding whether the third party is acting as an arbitrator or an expert. The substance of the scope of powers given to the third party is determinative over the form. Arbitration provides for a complete resolution of the dispute, whereas in an expert determination the decision maker’s authority is limited to a specific factual dispute within his or her area of expertise. Thus, the broader the scope that the third party is given in the subsection, the more likely US courts will find that the third party is an arbitrator. Careless drafting of powers of the third party can lead to undesirable consequences, such as inadvertently subjecting the third party to the FAA regulations.
Regardless of the method chosen (expert determination or arbitration), both methods are documentation-heavy in the US. The process requires ledgers, contracts, invoices and journal entries to support each party’s proposition of purchase price. It is not uncommon for the whole process to be done through paperwork, foregoing in-person meetings, although on-site inspections or interviews are sometimes necessary. Note that the US places a heavy emphasis on reasonable access for both parties of information needed for calculations. This difference is evident when looking at other jurisdictions and their less onerous production requirements. For example, arbitration in the US is likely to look similar to litigation when it comes to evidence-gathering, and witness testimony is likely to have broader scope than in other jurisdictions.
This chapter has so far focused primarily on PPA provisions in the US. While not all countries follow the US’s practice in implementing price adjustment provisions – especially in jurisdictions where a locked box mechanism is often used – a 2020 study has shown a general trend of around 45 per cent of deals outside the US using PPA provisions. A survey of the 2020 M&A market shows that 51 per cent of UK agreements, 29 per cent of Asian agreements, 33 per cent of European agreements and 61 per cent of Middle Eastern agreements contain PPA provisions. When broken down by deal value, we see that larger European transactions are more likely to have PPA provisions.
We look to English and German law as non-US examples of expert determinations and arbitrations for PPA.
English law governing arbitration has a structure similar to that of the US, as set forth in the UK Arbitration Act of 1996. However, similar to US law, English law agreements generally choose to use expert determination to resolve PPA disputes. Similar to the US, these determinations are final and generally only reviewed by courts for a manifest error. Both the arbitration and expert determination methods are document-heavy, and in-person meetings may not be necessary, similar to the US. On-site inspections and interviews may occur if needed.
In the UK, if expert determination is chosen as the dispute resolution method, the expert may be limited in what documents it can uncover. Experts in this jurisdiction do not have the subpoena power that is present in the US due to the contractual nature of the process.
In Germany, arbitration is governed by the Tenth Book of the German Code of Civil Procedure. Like the US and the UK, arbitration is a formal, quasi-jurisdictional proceeding. However, unlike the US and the UK, an expert determination looks more like an independent investigation, and the expert is less likely to see himself or herself as a trier of disputes. While in the US and the UK an expert report may simply contain a final calculation and brief indication of the basis of the value, in Germany such a brief report would not suffice. Expert reports will be a more robust report, likely due to the previously mentioned independent investigator role that the expert sees himself or herself in. Without a fully seasoned report, there is a danger that the determination will not be upheld if a competent person in the field cannot determine how the final value was reached. Similar to the UK, experts in Germany do not have any subpoena powers.
These small differences between jurisdictions can make negotiations tricky in cross-border deals. To further complicate matters, drafters must be cognisant of the political environment in and between the negotiating parties’ countries. As arbitration provisions in agreements increase, negotiations regarding the arbitration forum will likely become more heavily negotiated given the increased fracturing of relationships between a number of major nations and assertions of national rights. For example, looking at the strained political relationship between the US and China, would Hong Kong be a sufficiently independent forum? What about London or New York? The same question can be asked for the relationships between the countries within the European Union and Russia, as well as the UK and Russia. This question is particularly relevant where a business entity involved in the deal is effectively backed by the nation-state or seen as a ‘flag bearer’.
Based on the foregoing, the checklist below should provide helpful guidelines to help ensure careful drafting of PPA provisions and dispute sub-provisions in any jurisdiction.
- Prepare a well-drafted purchase agreement to avoid PPA disputes.
- Pay special attention to the standards or methodology that are applied to the purchase price calculation.
- Do the standards or methodology applied allow for some flexibility in the purchase price calculation? If so, ensure that the flexibility has been mitigated by tightly defining accounting definitions and standards, giving careful consideration to all possible disputes (see ‘Sources of disagreement’, above).
- In working capital PPAs, are adjustments to be made to current assets and current liabilities? If so, they should be specifically identified including, if possible, by reference to specific accounts in the business’s balance sheet.
- Are the business’s past practices to be used in calculating working capital? The past practices of a business can be more specific than the requirements of GAAP and, in some cases, conflict with GAAP.
- If the parties wish to calculate a PPA in accordance with a historical financial statement of the business, is that financial statement audited or unaudited? Is a copy of the historical financial statement readily available (e.g., an exhibit or schedule to the M&A agreement)?
- To limit the risk of disputes, consider attaching an illustrative schedule or example to the purchase agreement, including as much detail as possible. Consider limiting all adjustments to the calculation to the specific line items set forth in the schedule or example.
- Ensure clients are properly counselled with respect to resolutions of purchase price disputes.
- Sellers will likely prefer arbitration, purchasers are more likely to prefer expert determination.
- From a business standpoint, parties occasionally like to either limit the magnitude of the potential adjustment (for example, to amounts contained in an escrow account) or, conversely, provide that there will be no adjustment payment if the adjustment payment is below a certain amount (i.e., a ‘collar’).
- When drafting the PPA dispute sub-provision, pay careful attention to the meanings of terms and scope of the third party’s role, and include ‘magic language’; while the nomenclature is not dispositive, careful use of terms is still helpful if litigation arises.
- Example language for selecting expert determination in the US: ‘The expert is not an arbitrator of the dispute and shall not be deemed to be acting in an arbitral capacity’.
- Example language for selecting arbitration in the US: ‘If the purchaser and the sellers, notwithstanding such good faith effort, fail to resolve such disputes within 30 days after the purchaser’s receipt of a dispute notice delivered in accordance with Section 2.4(a), the sellers and the purchaser shall jointly engage the arbitrating accountant as arbitrator to resolve the remaining disputed items’.
- Note that in cross-border drafting, the above examples may not result in the same selection in other countries as it would in the US; parties may need to be more expressive in documents to ensure that there are no surprises when disputes arise.
- Ensure there is no conflict between the PPA mechanism and indemnification mechanism.
- Carve-out purchase price disputes under the ‘sole remedy’ section on indemnification to prevent indemnification processes or limitations from applying to a PPA claim inadvertently.
- Ensure that the language in the PPA mechanism, analysed within the context of the full agreement, is as narrow or as broad as intended; watch out for any language relating to the mechanism’s purpose that may limit what an expert or arbitrator can review.
- Other issues to be considered in drafting the dispute resolution provision include the following.
- Whether the expert should be required to have experience in the specific industry (e.g., big four accounting firms versus industry-specific firm).
- If selecting arbitration as the method of dispute resolution, what arbitration rules should apply to the process (the arbitration-mediation-arbitration protocol, Judicial Arbitration and Mediation Services or an international organisation)?
- Who pays the costs of the dispute – buyer, seller or 50-50?
- Whether the dispute resolution process will include discovery and written submissions, and be final and binding.
- What time frame allowing for negotiations should precede the dispute resolution process, if any?
- Will interest accrue during the dispute period?
- Where will the venue be located? This is especially important for cross-border deals.
- Is there a cap on costs?
- What is the contractual extent to which the parties will need to share information with each other and the expert or arbitrator in connection with the PPA process?
The US favours PPA provisions to finalise the purchase price in M&A transactions. An overwhelming majority of these provisions choose expert determination over arbitration, specifically expert determination by an accountant. Regardless of the method chosen, drafters must be careful to avoid common pitfalls such as applying accounting methodologies without appreciating the flexibility within the methodology that may cause disputes or inadvertently drafting an expert’s role too broadly to essentially be appointing an arbitrator in the eyes of courts. European deals are split between PPA provisions and the locked box mechanism. Much of the determination of what governs purchase price disputes in Europe will come down to the size of the deal as well as the buyer’s preference.
 William S Dudzinsky and Lance J Phillips are partners, and Amy Chen and Michael Mannino are associates, at Eversheds Sutherland (US) LLP.
 Chi. Bridge & Iron Co. N.V. v. Westinghouse Elec. Co. LLC, 166 A.3d 912 (Del. 2017).
 American Bar Association, ‘2019 Private Target M&A Deal Points Study’ (2019).
 Eversheds Sutherland 2020 survey.
 PWC, ‘IFRS and US GAAP: Similarities and Differences’, (2019), pp. 4–5.
 728 F.2d 1069 (8th Cir. 1984).
 No. 06C-01-169-JEB, 2007 WL 901637 (Del. Super. Ct. 26 March 2007).
 2002 WL 193697 (S.D. Ohio 2002).
 Jorge L Freeland, Jonathan L Mann and Jonathan R Picard, ‘2012 Survey of Private Company Purchase Price Adjustments’, Practical Law Connect (1 April 2013) (The percentage of purchase agreements in the US that selected an independent accountant to resolve disputes over the purchase price adjustment was 98 per cent, 94 per cent and 97 per cent in the 2011 Survey, 2009 Survey and 2008 Survey, respectively.).
 American Bar Association, Private Target Mergers and Acquisitions Deal Point Studies (2017).
 ‘2012 Survey of Private Company Purchase Price Adjustments’, footnote 10.
 9 U.S.C. Section 10(a).
 See Halligan v. Piper Jaffray Inc., 148 F.3d 197, 202 (2d Cir. 1998).
 New York City Bar Committee on International Commercial Disputes, ‘Purchase Price Adjustment Clauses and Expert Determinations: Legal Issues, Practical Problems and Suggested Improvements’, No. 69 (2013), p. 20.
 id., pp. 21–22.
 See Penton Bus. Media Holdings, LLC v. Informa PLC, No. 2017-0847-JTL, 2018 WL 3343495, *34–35 (Del. Ch. 9 July 2018).
 CMS, CMS European M&A Study 2019 (11th ed. 2019).
 Eversheds Sutherland 2020 survey.
 CMS, CMS European M&A Study 2017 (9th ed. 2016), p. 16.
 Richard Kreindler, George Zuber, Timothy Kautz and Will Inglis, ‘Cross-Border Purchase Price Adjustment Provisions’, 8 J. Private Equity (Fall 2005), p. 82, 84.
 id., pp. 82, 86.
 id., pp. 82, 87.
 id., pp. 82, 86.
 See Chicago Bridge & Iron Co. N.V. v. Westinghouse Electric Co. LLC, 166 A.3d 912 (Del. 2017).