On January 29, 2021, the Delaware Court of Chancery determined that the final purchase price payable pursuant to a post-closing purchase price adjustment provision in an M&A transaction must be determined by the unambiguous provisions of the merger agreement that required the application of a three-tier hierarchy of accounting principles, even if it results in different application of accounting principles in determining the tangible net worth minimum at signing and the tangible net worth at closing.
In Golden Rule Financial Corp. v. Shareholder Representative Services LLC, the merger agreement provided that the buyer would acquire the target for a base purchase price of $750 million. The merger agreement included a purchase price adjustment provision based on, among other matters, whether tangible net worth at closing exceeded or fell short of the tangible net worth minimum established at signing. Prior to closing, the target prepared an estimate of its tangible net worth as of closing and delivered an estimated balance sheet and the related estimated tangible net worth calculation to the buyer.
The accounting principles in the merger agreement set forth a three-tiered hierarchy to be used to determine the target’s tangible net worth. At the top of the hierarchy was a specific policy that “Tangible Net Worth will reflect the impact of the requirements of GAAP accounting standard ASU 2014-09, ‘Revenue from Contracts with Customers (Topic 606),’” which we refer to as “ASC 606,” without reference to how it was applied in setting the tangible net worth minimum or in the target’s past financial statements. As a private company, the target was not required to implement ASC 606 in its financial statements for pre-closing periods.
Post-closing, the buyer prepared a calculation of the actual tangible net worth of the target at closing, but discovered that the target incorrectly implemented ASC 606 in its pre-closing interim financial statements, which the buyer relied upon at signing in establishing the tangible net worth minimum, and that such error was also in the target’s calculation of its estimated tangible net worth as of closing. Post-closing, the buyer delivered to the seller a balance sheet and the buyer’s calculation of tangible net worth of the target at closing, using the same approach to ASC 606 that was used in the target’s interim financial statements, but it also included a reconciliation statement informing the seller that the tangible net worth would have been approximately $38 million higher if the buyer used an approach to ASC 606 consistent with the specific terms of the merger agreement instead of the “consistent with prior application” approach. Not surprisingly, the seller disputed the final adjustment statement and triggered the dispute resolution procedures in the merger agreement. The buyer then sought an injunction prohibiting the independent accounting firm from determining the final purchase price adjustment amount using an application of ASC 606 that was different from or inconsistent with the application of ASC 606 that the target used in its estimated balance sheet and unaudited interim financial statements.
The Delaware Court of Chancery concluded that the unambiguous language of the merger agreement required the tangible net worth of the target to reflect the application of ASC 606 as the first item in the hierarchy. The fact that (1) the merger agreement provided that the final balance sheet be prepared in accordance with the accounting principles, consistently applied, and (2) the second priority in the hierarchy was that the final balance sheet be prepared, to the extent not covered by the first priority in the hierarchy and not inconsistent with GAAP, in accordance with the accounting policies used in the target’s pre-closing audited GAAP balance sheet, did not negate the specific hierarchy of the accounting principles that required ASC 606 to be correctly applied and did not require application of ASC 606 to be consistent with the target’s past financial statements or the estimated balance sheet. The court noted that the buyer was advocating an approach to ASC 606 that was inconsistent with GAAP. The court did note, however, that the buyer could resort to indemnification and sue for a breach of representations and warranties in the merger agreement as an alternative to seeking a favorable accounting determination from the independent accounting firm, although a deductible would apply.
The court in Golden Rule distinguished its holding from the Delaware Supreme Court’s 2017 decision in Chicago Bridge & Iron v. Westinghouse Elec. Co. LLC. In Chicago Bridge, the Delaware Supreme Court concluded that the contractual provisions relating to the pre-closing financial statement, the post-closing financial statement, and the applicable accounting principles plainly required working capital calculations to be consistent with past practices. In Golden Rule, the court noted that while the agreement in Chicago Bridge lent itself to being interpreted as demanding consistency across the relevant time frame, the merger agreement in Golden Rule did not. The court also noted that the merger agreement in Golden Rule did not require the application of accounting principles relating to the first priority to be consistent with the application in the target’s past financial statements or its estimated balance sheet.
Some lessons can be gleaned from the Golden Rule decision:
First, parties should fully understand how target metrics and purchase price adjustments relate to the historical financial information from which they are derived. In Golden Rule, the buyer apparently failed to realize that the target’s financial statements and tangible net worth minimum were calculated in a manner inconsistent with how the final purchase price true-up was to be determined.
Second, parties should carefully review the accounting principles to be used to calculate target metrics and purchase price adjustments to ensure the same accounting standards are used to calculate those items at signing and at closing. In Golden Rule, the inclusion of the phrase “consistently applied” in one, subordinate accounting principle in the merger agreement did not override the specific, first priority accounting principle, namely that ASC 606 be applied as GAAP requires in the post-closing purchase price true-up.
Third, a buyer should ensure that the target’s representations and warranties provide consistent application of any specific accounting principles used in the final purchase price true-up, the target’s historical financial statements, and the calculation of the target’s estimated metrics at closing and that any indemnity provides buyer with dollar-one recovery for breach of any such representations and warranties.