In a well-reasoned memorandum opinion, the Delaware Chancery Court in Alliant Techsystems, Inc. v. MidOcean Bushnell Holdings, L.P.[1] provided to M&A practitioners a stark reminder to take extra care in crafting purchase price adjustment provisions, particularly in respect of their interplay with contractual indemnification clauses.
It is common for agreements for the sale of privately held businesses to provide for post-closing purchase price adjustments. Typically, such adjustments call for payments to be made by ATK to MidOcean, or by MidOcean to ATK, to the extent the amount of a financial account – such as net working capital or tangible net worth – at closing is above or below an agreed “peg” value specified in the contract and extrapolated from the historical financial statements of the business.
Such purchase price adjustments are customarily made from the first dollar, without being subject to deductibles, caps or other limitations. Disputes regarding such adjustments are submitted to an accounting firm for resolution. In contrast, seller indemnities for breaches of representations and warranties – de rigueur in purchase agreements – typically are limited by deductibles, baskets, caps and minimum claim size requirements, with claims being adjudicated conventionally by an arbitrator or judge. As a result, whether an amount in dispute is properly characterized as a purchase price adjustment or an indemnity claim can have meaningful consequences.
The Alliant Techsystems case arose from the 2013 acquisition by Alliant Techsystems (“ATK”) of Bushnell Group Holdings, Inc. from MidOcean Bushnell Holdings, L.P. (“MidOcean”) for a purchase price of $985 million. The purchase agreement provided that the price would be increased or decreased by the amount of any excess or deficiency, respectively, in Bushnell Group’s closing net working capital relative to the agreed target amount of $188.1 million. For purposes of this adjustment, “net working capital” was defined as the sum of all current assets minus the sum of all current liabilities “calculated in accordance with GAAP [generally accepted accounting principles] and otherwise in a manner consistent with the practice and methodologies used in the preparation of” the historical financial statements of the company. Any dispute concerning the calculation of the closing net working capital amount and any related adjustment would be submitted to a mutually agreed independent accounting firm as the sole and exclusive means of resolution.
The purchase agreement also contained customary representations and warranties for a sale of a business. Among other things, the company represented and warranted to ATK that its audited year-end financial statements for 2010, 2011 and 2012, as well as its unaudited financial statements for the period ended April 30, 2013, were “prepared in accordance with GAAP applied on a consistent basis throughout the periods covered thereby”. MidOcean agreed to indemnify ATK for any breach of the company’s representations or warranties contained in the agreement, but only to the extent that they exceeded, in the aggregate, a deductible of up to $4,925,000. This indemnity would serve as the sole and exclusive remedy for any such breaches of representations and warranties, except to the extent that it would “interfere with or impede the operation” of the net working capital/purchase price adjustment provisions.
Two separate escrow accounts were established – an Adjustment Escrow Account ($5,000,000) and an Indemnity Escrow Account ($7,387,500) to secure MidOcean’s obligations in respect of any purchase price adjustment or indemnity claim, with both escrow accounts being available for the former and only the Indemnity Escrow Account being available for the latter. Accordingly, a claim properly styled as a purchase price adjustment would be recoverable from the first dollar (without any deductible) with a cap of $12,387,500, while an indemnity claim would be subject to the deductible of up to $4,925,000 and a cap of $7,387,500.[2]
At the closing of the transaction, MidOcean furnished to ATK an estimate of the net working capital of the company, purportedly calculated in a manner consistent with the methods and principles underlying the company’s historical financial statements. This estimate resulted in a purchase price increase of $4,307,000. But following the closing, ATK delivered to MidOcean a “true-up” closing net working capital statement which showed a deficiency in the closing date net working capital of over $25 million relative to MidOcean’s closing date estimate – not the small difference that is more typical of a “true-up” adjustment.
MidOcean objected to the adjudication of the deficiency claim through the purchase price adjustment process, since it was based on an assertion that certain items reflected in net working capital had not been accounted for in accordance with GAAP and in accordance with the inventory representation contained in the purchase agreement. In MidOcean’s view, the closing date net working capital should be determined consistently with the manner in which the target amount was established – whether or not it was compliant with the purchase agreement’s representations and warranties. Accordingly, MidOcean posited, ATK’s claims should have been made under the indemnification provisions of the agreement, since the crux of its complaint was that the historical accounting treatment of the disputed items did not comply with the representations and warranties concerning financial statements. Put differently, MidOcean claimed that ATK was seeking to shoehorn an indemnification claim into the purchase price adjustment in violation of the exclusive remedy clause of the indemnification provision, thereby circumventing the deductible and smaller escrow amount applicable to indemnification claims. ATK disagreed, arguing that the dispute focused on whether the net working capital had been computed in accordance with GAAP, a fundamental requirement of the purchase price adjustment. ATK also pointed out that where a dispute falls within both of the purchase price adjustment and indemnification provisions, the exclusive remedy clause expressly accords precedence to the exclusivity of the purchase price adjustment.
ATK brought suit in Delaware Chancery Court, seeking an order to send the dispute to an accounting firm for adjudication in accordance with the purchase price adjustment procedures. The Court agreed with ATK. First, the Court noted the purchase agreement’s requirement that net working capital be “[i] calculated in accordance with GAAP and [ii] otherwise in a manner consistent with the practices and methodologies used in the preparation of the Financial Statements….” In the Court’s opinion, the two prongs of the standard were separate and independent and would not be satisfied by a net working capital computation not in accordance with GAAP, even if it is fully consistent with the historical practices and principles on which the target amount was established.
MidOcean argued that the failure to read the prongs together as a unitary standard would undermine the holistic purpose of the net working capital adjustment, namely to “account for changes in the Seller’s financial position between the pre-closing balance sheet date and the closing date balance.” The Court stated that this “would be a commercially sensible and logical way for a buyer and seller to structure a stock purchase transaction,” but that the parties had done otherwise in this case. Rather, the Court held, the purchase agreement clearly provides that net working capital must be determined in accordance with GAAP irrespective of whether the target amount was established on such basis, and that any disputes with respect to the net working capital adjustment must be referred to an accounting firm for resolution.
The Court distinguished the facts of the case from those of another Chancery Court decision involving a purchase price adjustment dispute, OSI Systems, Inc. v. Instrumentarium Corp.[3] and a similar New York case, Westmoreland Coal Co. v. Entech, Inc. In those cases, the purchase agreement required the application of the same accounting principles to the purchase price adjustment as those used by the seller historically – rather than the two-pronged requirement agreed to by ATK and MidOcean.
In the course of purchase agreement negotiations, it is common for the buyer’s counsel to insist that the closing net worth or net working capital statement expressly be prepared in accordance with GAAP, whether as part of the historical standard and other times as an independent requirement. This case serves as a reminder that doing so, rather than simply requiring consistency with the historical methods and principles on which the target amount is based, can have unintended consequences indeed.
[1] C.A. No. 9813-CB (Del. Ch. April 24, 2015, rev. April 27, 2015).
[2] The purchase agreement also suggested that ATK procured a third party insurance policy as an additional source of recovery for a breach of MidOcean’s representations and warranties.
[3] 892 A.2d 1086 (Del. Ch. 2006).