Post-acquisition dispute resolution challenges

September 2018  |  COVER STORY  |  MERGERS & ACQUISITIONS

Financier Worldwide Magazine

September 2018 Issue

Once a merger has closed, acquirers could be forgiven for thinking that the hardest part of the process is over. In reality, however, it has only just begun. Given the complex nature of dealmaking, post-acquisition, expensive, time-consuming and contentious disputes can quickly arise over a variety of issues, including alleged breaches of representations and warranties, purchase price adjustments and others.

Negotiating M&A agreements requires parties to resolve a number of key business, legal, tax, intellectual property, employment and liability issues. Parties on both the sell- and buy-side must be able to successfully negotiate an amicable deal. They must also be aware of the pitfalls of pursuing a transaction and put in place a strategy to avoid issues. Companies must utilise this framework to ensure that disputes can be resolved and business interruption minimised. Failure to do so can create a range of problems.

According to Accuracy, most post-acquisition disputes can be attributed to four factors: volatility in the target company’s markets finding its way into the transaction, ambiguity in the wording of the sale and purchase agreement (SPA), pressure to acquire and the ‘thrill of the deal’, and fraud. For these and other reasons, dispute resolution can be expensive and time-consuming.

“Post-acquisition disputes broadly fall into a number of categories: breach of warranty claims, issues over the interpretation of earn-out provisions, arguments over escrow accounts, enforcement of restrictive covenants and post-completion issues such as share transfers, fulfilment of statutory duties and registration of properties,” says Laurence Winston, UK head of litigation at Squire Patton Boggs.

“The most common disputes arise from an ongoing economic or employment relationship between the buyer and seller,” says Jonathan Sablone, a partner at Nixon Peabody LLP. “For example, acquisitions that contain ‘earn-out’ provisions for departing executives or owners frequently result in future disputes. Such provisions, by definition, call for the application of accounting principles to economic indicators that are within the control of the buyer post-closing. Such calculations – which usually include the concept of EBITDA – are often open to differing interpretations and frequently result in the seller asserting claims of breach of contract, breach of the implied covenant of good faith and fair dealing, and misrepresentation or fraud. Of course, all cash or equity consideration without future earn-out opportunities would obviate such disputes, but are not always practicable given the economics and structure of the deal.”

For Marine Lallemand, a partner at Orrick, the most common type of post-acquisition dispute relates to claims under representations and warranties contained in SPAs, such as financial guarantees. “Vendors are more and more willing to guarantee buyers against events with strong hazard, such as third-party claims. This is quite a gamble as they are usually capped but imprecisely defined.

“In addition, the development of innovative startups brought about a new source of dispute linked to founders’ and managers’ exit clauses, especially in the framework of ventures. In this particular area, ventures may be quite touchy regarding funding rounds or the departure of a startup’s inventors, but also key players remaining in the company under an earn-out provision. As a matter of fact, contracts are rarely drafted with sufficient anticipation of tough situations,” she adds.

SPAs

Well drafted SPAs are key to a successful transaction. They represent the culmination of vital commercial and pricing negotiations. The parties to a merger aim to create an agreement that clarifies the responsibilities and duties of each side; however, these contracts are often imperfect, open to interpretation and exploitation.

Drafting a workable SPA can be challenging, but rewarding. Parties must ensure that the language included in the SPA is direct. “The easiest way to avoid disputes is to be as clear as possible in the language of the asset purchase agreement,” says Mr Sablone. “It may sound counterintuitive, but, during the negotiation of the agreement, both sides often have an incentive to use imprecise language that is open to their differing views. This is particularly true when negotiating over ongoing economic terms. As both sides just want to get to closing, and view the deal as ‘win/win’, the parties gloss over imprecise language in the hopes that an issue will not arise post-closing, and, if it does, then both sides take comfort in their ‘interpretation’ of the language. More precision, and conflict, during the negotiation phase would substantially decrease the risk of expensive and debilitating dispute resolution after closing.”

Regarding the allocation of risk, for example, reaching an agreement on who will be responsible for what risks at the time of closing can derail some negotiations, as the seller will want to allocate as much risk to the buyer as possible, and vice versa.

Any agreement will be informed by due diligence, which has serious implications for reps and warranties. “Drafting such a provision is truly helpful as it forces parties to adopt a proactive role and be well aware of each other’s duties and rights,” says Ms Lallemand. “Bringing back the contracting parties to the drafting process may reduce the likelihood of a dispute. Usually weak due diligence means either a cheap price or strong warranties; on the other hand, strong due diligence means a high price or limited warranties. Due diligence plays a prominent role if a contracting party is about to pay a hefty sum of money with no or limited warranties. For me, the key in SPAs is to write down whether due diligence excludes the contracting party’s liability. It is crucial that the contract is clear on this matter.” Companies can no longer rely on conventional in-house counsel and basic financial due diligence, and outside expertise may prove critical. Appointing the right advisers can limit the scope for future disputes.

It is also important for companies to include tailor-made dispute resolution provisions in their SPA. “Clarity in the SPA’s dispute resolution clauses will be key to ensuring that each type of dispute is addressed timely and appropriately,” says Mr Winston. “Often, the most appropriate resolution method is the initial negotiation for a finite period, then escalating to court proceedings or, frequently, expert determination. The courts are usually the default form of dispute resolution for domestic acquisitions, but arbitration is common for international acquisitions.”

Arbitration and other forms of alternative dispute resolution (ADR) are appearing more frequently in SPAs. The duration, flexibility and confidentiality of proceedings can lead companies to utilise arbitration. Most notably, however, the enforceability of arbitral awards among signatories to the New York Convention has made it an obvious choice for international dispute resolution. It also allows parties to choose a neutral forum and tribunal, thus avoiding one party being disadvantaged by unfamiliar language, courts, procedures or local counsel of a ‘third’ country.

However, there is an argument that the most effective means of resolving post-acquisition disputes is pre-emption. “In order to be fully efficient, dispute resolution must have been pre-empted and truly thought-through,” says Ms Lallemand. “Contracting parties’ advisers must balance the rights between the parties and give no room to divergent interpretations. In that case, the parties will have a clear and structured plan of action with detailed steps in order to quickly settle the dispute. I highly recommend companies invest time in drafting their agreements. “Provisions should be drafted under a litigation team’s supervision as they should be built as dispute resolution clauses with their specific procedural rules. Risk will be minimised as both drafting and resolution clauses will be thought-through for both the preamble and the provision.”

Identifying a potential arbiter in the event that a dispute does emerge should also be a priority. Certain claims may benefit from the support of a financial professional with expertise in business valuation, asset valuation, damage analysis, financial accounting and forensic accounting, for example. The parties may even enlist such an expert in the dealmaking process, to assist with due diligence, valuations and deal provisions, given that the majority of post-acquisition disputes typically involve financial investigation.

Cyber issues and liabilities in M&A

Acquirers must also be in a position to understand and evaluate the extent to which the target company is vulnerable to a cyber attack, or has already experienced an attack that compromised its high-value digital assets. Otherwise, the acquirer is at risk of buying the cyber vulnerability of the target company and assuming the damage and liability from incidents it has suffered. Neiman Marcus and Yahoo! both suffered breaches which impacted their purchase price.

Neglecting cyber security assessments in M&A due diligence, performing insufficient evaluations or limiting due diligence to just a company’s IT systems, can mean that serious cyber threats get ignored or passed over. “Due diligence has always been pivotal as the final terms of the deal are finalised and the true picture of what is actually being purchased emerges,” says Mr Winston. “It is the starting point when things do go wrong to evidence what has been purchased compared with the reality and to build a case to defend or pursue claims. The extent of its significance does largely depend on the nature of the claim. Well drafted warranties and indemnities are usually key in flushing out issues and it is also common to find hold-back monies to provide against claims.”

Price adjustment cases

Starbev GP Ltd v. Interbrew Central European Holdings BV was one of the most high-profile cases concerning price adjustment in recent years. The case centred on the question of whether the seller was entitled to a proportion of the profit realised by the buyer, when the business was sold on within a period of three years. The resolution of this dispute had serious financial consequences. The original sale price had been €1.475bn; the on-sale price was €2.65bn, with the seller claiming approximately €129m of the difference. In addition to a number of clauses providing how the seller’s ‘contingent value right’ was to be calculated, the SPA contained an anti-avoidance clause. The buyer structured €500m of the consideration due to the on-purchaser in the form of a convertible note, which it subsequently drew down on when the three-year period expired. The Court of Appeal confirmed that this transaction was consistent with the anti-avoidance clause, on the basis that it applied where the dominant purpose of the transaction was to reduce the seller’s contingent value right.

Team Y&R Holdings Hong Kong Ltd & Ors v. Ghossoub had similar implications. The dispute focused on an SPA provision which stated that post-completion, any seller whose employment with the target company was terminated for acts of gross misconduct, or who engaged in a competing business, would lose his right to deferred consideration and be required to sell his or her retained shares to the buyer at a substantial discount.

Calculating damages

Some of the most damaging and challenging disputes focus on whether the acquirer got what it paid for. But calculating damages can be challenging. Typically, the target company’s purchase price will be evaluated as a multiple of trailing 12 months reported earnings before interest, taxes, depreciation and amortisation (EBITDA), with an adjustment for any working capital excess or deficiency above or below a contractually agreed upon level. The target company’s required level of working capital at closing will typically be negotiated, agreed upon and specified in the purchase and sale agreement.

Parties will be required to employ a combination of business valuation, forensic accounting and economic analysis techniques in order to arrive at a decision. It may also be necessary to determine whether the target company has misled the acquirer through false financial statements, or other misrepresentations. Again, external experts may be required to provide technical insights and analysis.

Resolving disputes

ADR is often touted as the quickest way of resolving a dispute, and arguably, therefore, the cheapest. However, disputes can often rumble on, even when the parties utilise ADR. This can often be due to the ‘personalisation’ of the dispute. According to Mr Sablone, parties that act in a reasonable and business-like manner during the negotiation of an asset purchase agreement often make any subsequent disputes ‘personal’, adding emotion to what can seem intractable problems. Litigation and dispute resolution are business tools and should be used as such. The parties should approach the dispute in a dispassionate manner and apply cost/benefit analysis to the problem as they would any other business process. In this vein, hiring competent and experienced counsel is critical as parties need a trusted adviser who can put the client’s interest ahead of the lawyer’s short-term interest in fees.

Conclusion

According to Deloitte, M&A was on track to hit record highs in the first half of 2018. With activity showing no signs of slowing, disputes will continue to arise. Cyber incidents, in particular, are likely to become more frequent in the future.

Though most companies pursue deals with good intentions, post-acquisition disputes frequently emerge. They are often large, complex matters with heavy cost and time implications.

When considering and pursuing an acquisition, parties must be aware of common problems which may arise post-deal – and to adopt a strategy to avoid them. If companies are to be successful post-close, they must be able to isolate and understand the key business and financial issues that are likely to emerge, and find ways around them, ideally before the deal has closed. Prevention can be the best medicine.

© Financier Worldwide

BY

Richard Summerfield