February 6, 2017

Post-Closing Adjustments: Lessons From “Chicago Bridge” Decision

This Jones Day memo addresses the implications of the Chancery Court’s recent decision in Chicago Bridge & Iron v. Westinghouse, (Del. Ch.; 12/16), in which the Court held that under the plain language of a purchase agreement, post-closing purchase price adjustment disputes were subject to mandatory arbitration by an independent accountant.

While parties generally consider post-closing working capital adjustments to be a process for “truing up” the purchase price after the deal, in Chicago Bridge, the stakes were much higher. The “textbook” purchase price adjustment provision in the Chicago Bridge agreement said that the purchase price was to be adjusted based upon a comparison of closing net working capital to a specified target net working capital amount ($1.174 billion). The seller calculated an estimated closing net working capital amount of approximately $1.601 billion, which would have resulted in a $428 million payment from 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.

How did the gap between the parties become so wide? Here’s an excerpt with the explanation:

The buyer went beyond challenging the underlying calculation and, instead, used its proposed adjustments to challenge whether the seller’s calculations were GAAP 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.

The memo uses the Chicago Bridge case as the starting point for a wide-ranging discussion of purchase price adjustment provisions in acquisition agreements, and offers up a number of tips to keep in mind when drafting & negotiating them.  Here’s an excerpt on language in the agreement about the consistent application of accounting principles:

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’s financial statements should be respected in calculating the closing statement. 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.

Any accounting formula contained in the purchase agreement should also list its specific components, & refer to line items on a referenced balance sheet or general ledger. The memo points out that 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.

John Jenkins