Gregory Wolski is a partner at Ernst & Young
This article originally appeared in the November/December issue of Business Law Today
As companies continue to expand their presence around the globe, the number of completed cross-border mergers and acquisitions has soared. Any merger or acquisition activity presents the possibility of a post-transaction dispute. In transactions between companies in different countries with different accounting systems, cultures, and languages complicating an already thorny process, disputes may be more likely––and most are more complex.
Language and cultural differences can be apparent from the outset of a cross-border deal, and the parties can address them by including people in the negotiations who are fluent in the language and well versed in the cultural norms of the other party. More subtle concerns—especially to the lawyers and other dealmakers involved—may arise from the disparate generally accepted accounting principles (GAAP) used by entities in different jurisdictions. GAAP may vary widely from country to country, and even within a country, depending on the industry and the rigor of the country's financial regulators with regard to financial reporting matters.
Accordingly, post-closing accounting mechanisms can lead to very different interpretations of the final purchase price, and that in turn can lead to complicated post-transaction disputes. While the adoption of international financial reporting standards (IFRS) in more countries may reduce the instances of inconsistency in the definition or implementation of accounting standards, those standards are not likely to become globally uniform, at least in the near term. Therefore, IFRS alone will not eliminate the need to provide for detailed accounting mechanisms within a purchase agreement.
Judging from our M&A transaction and dispute experience, in our estimation, about one-third of all closed transactions end up in a dispute between the parties. While cross-border deals present some unique issues in a dispute, they also may simply complicate common dispute factors. Many disputes are resolved through negotiation and never reach an arbitrator, but the dispute-resolution process can be a trying experience for all involved. This article explores common causes for post-transaction disputes and ways that the participants and counsel involved in the transaction can mitigate those risks before problems have a chance to develop. Foremost among the mitigation efforts is specificity regarding commonly disputed matters in the terms of the purchase agreement.
Cross-Border Accounting
Transaction disputes most often arise over a few common issues. Dominating these issues are post-closing purchase-price adjustment mechanisms such as closing balance sheet calculations and earn-outs. In international transactions, these issues can become more complicated by the differing accounting standards used in each country where the parties operate.
A purchase agreement typically will outline the mechanisms for constructing a closing balance sheet. Such tools should be detailed and flexible enough to accommodate changes in the subject company's historical working capital items between the purchase agreement date and the closing date. In an international deal, the agreement also should specify the accounting standards or methodology that will apply. These mechanisms serve to finalize the purchase price and define or substantiate any necessary adjustments under the terms of the agreement.
Disputes arise when each party is expecting the calculations to be made in a different way or when they disagree on the accounting practices used pre- or post-transaction. While such disagreements can occur in transactions in the same country, they are both more likely and more complex when the deal is cross-border. The more countries involved, the more complex the issues and the more opportunity for disputes to arise.
One generic clause that shows up frequently is that all calculations will be done in accordance with GAAP. However, not all target companies are necessarily in full compliance with their own country's GAAP. For instance, a small privately held company may not have fully or adequately adopted GAAP. In addition, a division of a large company may not always have all necessary accruals and adjustments for a standalone presentation. If the seller already is aware that it has not presented certain parts of its financial statements in accordance with GAAP, then it should not agree to generic provisions to create a closing balance sheet using GAAP, or it could be at a significant disadvantage. Indeed, many agreements exclude certain assets and liabilities, making it impossible from the outset to prepare a GAAP statement––and making it even more important to customize provisions to the parties involved. To the extent that a GAAP-based statement is not used as the basis for the purchase agreement accounting mechanisms, then each and every area of contention or known departure from GAAP should be clearly identified and dealt with in the agreement.
With the ever-increasing size of transactions, many involve operations in several countries within the same transaction. Each country may have its own version of GAAP. However, as the term "principles" implies, more than one approach may be acceptable in a given situation. For example, in accounting for pensions and other employee benefits, unintended disputes often arise from differences in practices and the range in acceptable underlying actuarial and other assumptions within each country's operations. In a recent transaction dispute, our client, a U.S.- based seller, had always accounted for its international operating locations under U.S. GAAP. In connection with the sale of one of the U.S. company's significant operating subsidiaries, the international-based buyer attempted to apply various local country-based GAAP to the various pension and employee benefit obligations on a country- by-country basis, wherever it resulted in a favorable adjustment to itself. Discount rates were tweaked, salary scale assumptions were changed, and census data and mortality assumptions were adjusted. While any single country impact was somewhat insignificant, the total impact of the adjustments claimed by the buyer exceeded $10 million.
A best practice is to explicitly state which GAAP or other accounting methodology will be used, as well as whether any departures from GAAP will be allowed, on an item-by-item basis if necessary. Otherwise, the closing balance sheet adjustments or changes can prompt discord if the mechanisms in the agreement for addressing them are vague or subject to interpretation.
While the parties to a transaction are often quick to agree on which GAAP they will use, they do not necessarily fully think through the implications of that decision. For example, if the company based in the country whose GAAP is to be used does not fully implement GAAP itself, it will have to refigure its own books for the closing statements to be constructed in accordance with the purchase agreement. Provisions to accommodate for that fact could be a valuable addition to the purchase agreement.
Another issue to consider is which party is responsible for preparing the balance sheet and the implications of that decision, especially for the seller. The nature of "normal operations" during the period between the closing date and the finalization of the accounting records can be somewhat unclear. The new owner is now in control, but many—and often most—of the employees are those who worked for the previous owner. If the seller is responsible for preparing the closing statement but has to rely on employees now working for the buyer, conflicting interests could arise together with some surprising results.
In a recent dispute between a U.S.- based seller and a German buyer, the seller was nominally responsible for creating the closing balance sheet. Because the employees doing the work were under the buyer's oversight and the seller's representatives had minimal access to the detailed accounting records, the seller did not fully agree with the way the balance sheet was prepared by its former employees. Once the buyer had a chance to review and respond to the balance sheet as prepared, it came up with objections and additional changes, putting the seller in a position of having to hire experts and defend a balance sheet that it did not fully support in the first place. Again, while this was an international transaction, it bears repeating that this issue can arise for any seller, regardless of where the buyer is based. The agreement could have been drafted in a manner that contemplated this known situation and shifted responsibility as appropriate.
Issues in Transaction Disputes
In addition to the closing balance sheet, another accounting mechanism that can cause disputes in the wake of a transaction is the calculation of earn-outs, a tool often used to negotiate differences at the time of purchase between the values that the buyer and seller place on the business. Earn-out provisions often result in disputes, particularly if the earn-out is over a relatively long period or if the structure of the purchased company changes under the new owner.
In concept, earn-outs may be simple, but they can be extremely technical and complicated calculations, especially when the sold business was a carve-out, unincorporated division, or other entity without a stand-alone set of financial statements. In a recent instance, a large conglomerate bought a much smaller company and built a multiyear earn-out into the deal, with a $50 million revenue target. If the company realized that target, the sellers were due about $15 million. If it fell short, then the buyer owed nothing further. When the earn-out period had passed, the selling shareholders claimed they were owed millions, but the buyer asserted that the revenue target was missed by approximately $100,000 (less than half a percent of the target amount), resulting in no payment due under the terms of the earn-out. In fact, subsequent to the transaction's closing, the buyer had changed the company's revenue recognition policies. Additional entities also were rolled into the purchased company. As a result, determining the actual revenue of the purchased company on a stand-alone basis consistent with historical accounting practices was quite complex. The fact that this transaction took place within one country only begins to illustrate the complications involved if the divergent accounting practices characteristic of international transactions are in the mix as well.
Earn-outs can become problematic down the road because few people consider at the time of the transaction how the company may change over the term of the earn-out. These provisions can go on for three, five, even 10 years, and most companies evolve substantially over that period. The buyer may acquire more entities and consolidate them with the entity bought in the transaction at issue. Product mix changes may affect the intended results. Accounting systems may change. The company's mission may become different, making it impossible to compare revenues generated to what would have come in under the original business plan. Therefore, both parties should seriously consider these factors and provide for them or reconsider constructing an earn-out at all.
Other issues that commonly cause post-transaction disputes include inadequate or inaccurate projections on the part of the seller, implementation of material adverse change provisions, and determination of the reasons for any deterioration of the business after the deal. Additionally, as a reflection of the times, transaction fraud allegations increasingly have come into play.
Transactional fraud claims focus on the concept that the seller intentionally misled the buyer into paying an artificially inflated purchase price. While such allegations are very serious, accusers may not always lodge them in good faith. A fraud claim is sometimes an attempt to skirt the arbitration process called for within the purchase agreement, leveraging a threat to take a dispute to the courts instead. Such claims have become increasingly common and at times have resulted in the unwinding of the original transaction––a particularly significant concern when the transaction participants are competitors. On the other hand, transactions in some situations and involving parties in certain markets can be unusually subject to actual fraud. Results of Ernst & Young's 9th Global Fraud Survey show that executives in both developed and emerging markets believe fraud is most likely to occur in operations within emerging markets. Therefore, with increasing levels of investment in Eastern Europe, Asia, and Latin America, where business practices may not be as well established or are different from those in the Western world, dealmakers may perceive (correctly or otherwise) that transaction fraud has occurred.
Strategies to Mitigate Risk
As noted above, most transaction disputes boil down to differing interpretations of the terms of the purchase agreement. However, if the purchase agreement is well crafted from the start and explicitly spells out in detail how post-closing calculations will be performed–– and how any disputes will be resolved––the process is likely to be much smoother.
Lawyers can help prevent disputes by eliminating a common culprit–– generic language––from the purchase agreement. Companies invest a tremendous amount of time, effort, and money to conduct extensive due diligence in advance of an acquisition. Why, then, would they use contract language that does not fully and accurately reflect their findings?
If the due diligence findings indicate that a particular area of the company's accounting may prove problematic, the buyer may want to add specific agreements into the contract on how those matters will be treated. The seller, meanwhile, will want to consider the buyer's underlying motives in adding specific language, as well as the implications of those clauses with respect to the final purchase price.
Outside counsel drafting the purchase agreement (typically done by the buyer) should work directly with those negotiating the deal and outside due diligence advisors when drafting those clauses related to working capital adjustments, earn-out calculations, or other closing balance sheet matters. Likewise, those working on the seller's side should pay attention to such clauses and consider how the calculations will work based on the target company's historical accounting practices. The parties should agree to a fully detailed calculation that is included in the purchase agreement. Further, any disagreements on these matters between the parties should be resolved before both sides sign on the dotted line.
Finally, the purchase agreement must include provisions on how to settle disputes in the event they arise. While many purchase agreements include an arbitration clause, such a clause may not be specific enough. Disputes over who the arbitrator will be, what his or her qualifications should be, and where he or she should be geographically located often arise where these matters are not specified in the agreement. Contracts that specify, for example, that the arbitrator will be an accountant with certain specific qualifications tend to provide less room for dispute. Contracts that spell out exactly who the arbitrator will be, by firm or even by name, are that much more straightforward. Just as important, the parties should agree up-front regarding the arbitration process and document that understanding in the purchase agreement, addressing key questions about discovery, hearings, rebuttal, and timing.
In cross-border acquisitions, the arbitration venue is a further consideration that deserves attention in the contract. One deal between a U.S. buyer and an Eastern European seller did not address where the arbitration would take place. When a dispute came up, it was clear from the contract that they would go through arbitration, but each party had a different idea of where that should take place. After much legal deliberation, the sides finally agreed on Paris, but the parties likely would have reached an agreement more easily before discord had become a factor.
By taking care to define the terms of the purchase agreement and by tailoring them to the parties and facts involved, much of the risk for dispute after the fact can be eased. Conflict may arise nonetheless, but the more specific the agreement, the fewer the topics to be decided through post-closing negotiations or arbitration.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.