Update: Purchase Price Adjustment Disputes: Drafters Continue to Beware

In the Spring 2017 edition of Dechert’s Global Private Equity Newsletter, we reviewed the Delaware Court of Chancery’s decision in Chicago Bridge & Iron Company N.V. v. Westinghouse Electric Company LLC and WSW Acquisition Co., LLC (Del. Ch. December 5, 2016) (“Chicago”). The article, “Purchase Price Adjustment Disputes: Drafters Beware,” highlighted the need for practitioners to consider carefully the effects that post-closing purchase price adjustment provisions can have on seller’s representations and warranties and related remedies, as well as the effects such representations and warranties and related indemnification provisions can have on purchase price adjustments.

Although the Delaware Supreme Court reversed the Court of Chancery in Chicago Bridge & Iron Co. N.V. v. Westinghouse Electric Co. LLC and WSW Acquisition Co., LLC (Del. June 27, 2017) (“Westinghouse”), holding that the Court of Chancery’s decision was too broad, practitioners should still continue to consider carefully the potential effects noted above.

The Delaware Supreme Court’s decision in Westinghouse is also rather instructive. In Westinghouse, the Court took a holistic view of the purchase agreement when considering purchase price adjustment provisions. The Court focused its analysis on reading the purchase price adjustment provisions and the post-closing liability bar in terms of the function of these provisions together with seller’s representations and warranties, as a whole. The Court emphasized that (x) the net working capital adjustment was intended to measure changes in working capital between signing and closing and (y) in exchange for a purchase price of zero, Westinghouse agreed that its sole remedy if Chicago Bridge breached its representations and warranties was to refuse to close, i.e. Chicago Bridge would not be subject to post-closing monetary liability (the “Liability Bar”). 

Highlights 

• Practitioners should not lose sight of the Court’s emphasis that the “basic business relationship between the parties must be understood to give sensible life to any contract.” 
• Buyers and sellers should consider carefully the function of GAAP in net working capital adjustments and how that relates to indemnification limitations applied to breaches of financial statement representations and warranties. 
• Buyers and sellers should clearly delineate the role of the independent auditor, arbitrator or expert (the “Independent Reviewer”) in connection with purchase price adjustment disputes, including specifying items that are not in the purview of the Independent Reviewer’s authority. 

The Delaware Supreme Court’s Analysis and Holding 

Focusing on the need to read and interpret purchase agreements holistically, the Court reversed the Court of Chancery’s decision. The Court held that Westinghouse’s GAAP compliance allegations were not within the scope of the Independent Reviewer’s authority as the post-closing purchase price procedure (“true-up”) was a “narrow, subordinate, and cabined remedy available to address developments affecting [seller’s] working capital … between signing and closing.” 

Chief Justice Strine emphasized that the role of a purchase price adjustment is informed by its function in the purchase agreement. The outcome in this case turned on the specific language of the true-up, the scope of the Independent Reviewer’s authority and the role of the Liability Bar. 

In its decision to apply the Liability Bar to Westinghouse’s effort to raise GAAP compliance claims through the true-up procedures, the Court noted that: 

• The true-up was not meant to aid Westinghouse’s investigation of the target business or provide a historical picture of the purchased business’s operations. 
• Purchase price adjustments account for the normal variations in businesses between signing and closing. As such, the carve-outs to the non-survival provisions of the merger agreement did not serve to carve GAAP compliance out of the Liability Bar but rather to clarify that Chicago Bridge could owe Westinghouse money after closing only as a function of changes in working capital.¹ 
• Based on its findings, the Court rejected Westinghouse’s allegation that it “gave up nothing in the Liability Bar because, through the [true-up], it could seek monetary payments by alleging that Chicago Bridge’s historical accounting treatment wasn’t GAAP compliant.” 

The Court also noted that the specific language of the merger agreement had clearly circumscribed the role of the Independent Reviewer. The Independent Reviewer did not have a mandate to address any dispute that might arise from the merger agreement, as parties had already specified a set of disputes that the Independent Reviewer could resolve. The merger agreement stated in several places that the auditor was to act as an expert and not an arbitrator, thus limiting the scope of the Independent Reviewer’s domain. The Independent Reviewer did not have wide-ranging authority but was confined to a discrete set of narrow disputes. Importantly, these disputes did not include assessing if the seller breached its financial statement representations and warranties. 

Given the limited role of the Independent Reviewer and the fact that the non-survival provisions did not carve GAAP compliance out of the Liability Bar, the outcome of the case turned on the precise language used with respect to net working capital (specifically, what role GAAP compliance played in determining net working capital). The Court noted that the true-up in this case was similar to the true-up in OSI Systems, Inc., v. Instrumentarium Corporation (Del. Ch. March 14, 2006), a case in which the Court determined that only a single test applied — whether the seller consistently applied GAAP principles — and that the net working capital adjustment did not establish a separate GAAP compliance test. The Court held that to be the case in Westinghouse as well. For these reasons, the Court held that Westinghouse’s assertion that Chicago Bridge’s financial statements were not GAAP compliant should not be presented to the Independent Reviewer for its determination. 

Closing Thoughts 

Both Chicago and Westinghouse should serve as important reminders to drafters that they need to focus on the purchase price adjustment provisions and the various other provisions contained in a purchase agreement and evaluate the interplay between all such provisions as a whole. In Westinghouse, Westinghouse attempted to circumvent the Liability Bar by arguing that Chicago Bridge’s financial statements were not in accordance with GAAP, but the Court determined that the zero purchase price, coupled with the Liability Bar, only made sense if both parties agreed that the transaction would enable Chicago Bridge to have a clean break from its subsidiary’s projects. To interpret the true-up broadly as the Court of Chancery did in Chicago would thus undermine the primary business deal. 

Additionally, both parties should consider the role that they would like the Independent Reviewer to play in resolving disputes, and the kinds of disputes an Independent Reviewer should determine. It is important to ensure that language relating to such review process is unambiguous. 

Footnotes 

_{1) The Court emphasized that buyers typically use working capital adjustments to protect against value depletion, citing an article co-authored by Dechert and Alvarez & Marsal: Working Capital Adjustments: At the Crossroads of Law and Accounting, N.Y.L.J. Oct. 26, 2015), which can be found in the Winter 2016 edition of Dechert’s Global Private Equity Newsletter.}