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The following is a review of significant Delaware and other key state court decisions relating to private mergers and acquisitions and disputes. The eight decisions discussed in this three-part series were issued in 2017 and provide important guidance on several aspects of the M&A process. Some of the decisions concern drafting points, such as working capital adjustments and fraud carveouts, while others address the fiduciary duty implications of action by controlling stockholders and governance matters. The final decision, from a Texas court and to be discussed in part 3, is a reminder of the risks of being deemed to have formed a contract through the exchange of emails.

Chicago Bridge & Iron Co. NV v. Westinghouse Electric Co. LLC (June 27, 2017)

Parties should make express in their purchase agreements whether a dispute over whether the closing balance sheet complies with GAAP must be resolved as part of the purchase-price-adjustment process, or under the indemnities for breach of the financial statements representation.

Chicago Bridge involved a working capital true-up dispute in connection with the sale by Chicago Bridge & Iron Co. NV (the seller) of its nuclear power plant construction company, CB&I Stone & Webster Inc. (the company), to Westinghouse Electric Co. (the buyer). In presenting its closing statement as part of a two-step true-up process, the buyer maintained that the net working capital amount was more than $2 billion lower than the target amount, due mainly to alleged failures of the seller's calculations to be based on a proper application of generally accepted accounting principles, or GAAP. In reversing the Delaware Chancery Court decision for the buyer, the Delaware Supreme Court held that the purchase agreement required that the true-up process be limited to determining changes in working capital between signing and closing, determined consistently with past practices. Any challenges on the basis of GAAP compliance constituted claims for breach of the financial representations and warranties, which were precluded under a bar for post-closing damages.

The Language of the Purchase Agreement

The purchase agreement defined "net working capital amount" as the company's current assets less current liabilities "solely to the extent such assets and liabilities are described and set forth on Schedule 1.4[f])." That schedule was the company's June 30, 2015, balance sheet, which was also included in the financial statements covered by the financial statements representation. Prior to closing, the seller had to deliver a "closing payment statement" to the buyer setting forth its good-faith estimate of the net working capital amount. In the second stage of the true-up, the buyer had to deliver a "closing statement" to the seller within 90 days after closing, including the net working capital amount and its estimate of the "final purchase price." Both the closing payment statement and the closing statement had to be "prepared and determined from the books and records of the Company and its Subsidiaries and in accordance with [GAAP] applied on a consistent basis throughout the periods indicated and with the Agreed Principles."

The "agreed principles" provided as follows:

Working Capital ... will be determined in a manner consistent with GAAP, consistently applied by [the Company] in preparation of the financial statements of the Business, as in effect on the Closing Date. To the extent not inconsistent with the foregoing, Working Capital ... shall be based on the past practices and accounting principles, methodologies and policies applied by [the Company] and its subsidiaries and the Business (a) in the Ordinary Course of Business and (b) in the preparation of: (i) the balance sheet of the Company and its Subsidiaries for the year ended December 31, 2014 (adjusted to reflect the Business); and (ii) the Sample Calculation set forth on Schedule 1.4(f).

In the closing statement, the buyer reflected the net working capital amount as negative $976.5 million, which was over $2 billion less than the targeted amount of $1.174 billion (the target). Most of the deviations from the target were due to changes in accounting methodology as opposed to changes in the company's business between signing and closing. When the parties were unable to resolve their disagreement over the net working capital amount, the seller filed a court action seeking an order declaring the buyer's claims over the net working capital amount were claims for breaches of representations and warranties, which were barred under the purchase agreement. Disputes over the “final purchase price” were to be determined by an independent auditor, acting as an expert and not an arbitrator, whose determinations were to be final, binding and nonappealable. The seller argued that the buyer could not circumvent a bar on post-closing damages under the purchase agreement (the liability bar) by running the issues through the independent auditor. The buyer maintained, in contrast, that the true-up was a process for resolving any disagreement over the calculation of the final purchase price.

The Context of the Dispute

The court first looked to the context of the dispute and the terms of the entire contract. The acquisition of the company was an attempt by the buyer and the seller to resolve ongoing cost overrun disputes in a collaboration to build nuclear reactors. The seller viewed the transaction as a "quitclaim," where it would hand over the company for free, subject to post-closing adjustments with respect to the net working capital amount and other items, and potential upside payments. In light of a covenant requiring the seller to continue to run the company in the ordinary course prior to closing, it was likely that required cash infusions to the business would result in a higher net working capital at closing. The court noted that the purchase agreement contained the unusual provision that the buyer's sole remedy for a breach by the seller of its representations and warranties was to refuse to close, and that the liability bar precluded the buyer from making any claims for monetary damages. Also unusually, the buyer had broad indemnification obligations. The purchase agreement also contemplated that various liability releases in favor of the buyer would be in full force and effect at closing. The court noted that "the crux of this deal was that [the seller] was done with the nuclear projects. It would get no profit for selling [the company] — as of closing — the Liability Bar, indemnity and releases meant [the seller] would at least be rid of liability for the still-spiraling costs of the projects ...."

A Review of the Language in Light of the Purpose of Purchase Price Adjustments

The court then described the general purpose of purchase prices adjustments as accounting "for changes in a target's business between the signing and closing ..." and that the most common interpretation of this change in working capital is that "the business being sold is run for the seller's benefit" until closing. The court noted that when the definition of "net working capital" under the purchase agreement at issue was read in conjunction with the rest of the agreement, it required that the company's historical accounting practices be used, and not a new assessment of whether these accounting practices complied with GAAP. The court noted that the closing payment statement and the closing statement had to "be prepared and determined from the books and records of the Company and its Subsidiaries and in accordance with [GAAP] applied on a consistent basis throughout the periods indicated and with the Agreed Principles." The accounting principles required working capital calculations to be "determined in a manner consistent with GAAP, consistently applied by [the company] in preparation of the financial statements of the Business, as in effect on the Closing Date ... [and] based on the past practices and accounting principles, methodologies and policies applied by [the company]." From this, the court distilled two conditions with which the closing payment statement and the closing statement had to comply: "i) they must be prepared from [the company's] books and records; and ii) they must use the same accounting approach as had been used in the past."

The court noted that its interpretation was reinforced by the way the representations and warranties and the true-up fit together. The seller represented that the financial statements it provided to the buyer were prepared in accordance with GAAP, and that working capital was defined as being determined on the basis of GAAP consistently applied in preparation of the company's financial statements. It therefore made sense that the accounting approach for working capital be the same as the historical approach taken for the company's financial statements. It would be difficult to measure changes in the business between signing and closing if the accounting approach were not the same. The court also noted that the role of the independent auditor provided further support for this conclusion. Its role, as an expert and not an arbitrator, was limited, and did not extend to resolution of whether the seller had breached its representations and warranties. The court further noted that the buyer's interpretation "renders the Liability Bar meaningless and eviscerates the basic bargain between these two sophisticated parties."

An Analysis of Precedent

The court analogized its decision to the decision in OSI Systems Inc. v. Instrumentarium Corp.,1 and distinguished it from the decision on Alliant Techsystems Inc. v. MidOcean Bushnell Holdings LP.2 In OSI, the buyer's closing statement had to be "prepared in accordance with the Transaction Accounting Principles applied consistently with their application in connection with the preparation of the Reference Statement of Working Capital and the Statement of Estimated Closing Modified Working Capital ...." "Transaction accounting principles" was defined as "U.S. GAAP; provided, however, that (i) with respect to any matter as to which there is more than one principle of U.S. GAAP, Transaction Accounting Principles means the principles of U.S. GAAP applied in the preparation of the Financial Statements ...." The Chicago Bridge court noted that in OSI, as in Chicago Bridge, there was a representation that the historical financials complied with GAAP, and the language for the working capital adjustment "did not establish a separate GAAP compliance test, but instead a consistency test: the adjustment was to be 'in accordance with the Transaction Accounting Principles applied consistently with their application in connection with the preparation of the [statements based on historical financials].'"

The Chicago Bridge court distinguished Alliant on the basis that in that case, "the definition of Net Working Capital was that it was a relevant set of assets less liabilities on a consolidated basis 'and calculated in accordance with GAAP and otherwise in a manner consistent with the practices and methodologies used in the preparation of the [benchmark financial statements] ..." the chancellor found that the use of two separate 'and's created two separate tests. The first test was if the calculation complied with GAAP. The second test was if the calculations were 'otherwise' consistent with how the seller had prepared its financial statements."

Takeaways

Whether GAAP-compliance arguments can be raised in the purchase price adjustment process, versus being solely a matter for post-closing indemnities, can have material importance. In Chicago Bridge, there was no cap on the purchase price adjustment, and there were zero post-closing indemnities. Thus, the ability to raise a GAAP-compliance issue meant having an approximately $2 billion claim that would not otherwise have existed.

The court in Chicago Bridge identified two approaches: one, which can be called the "consistency test," was present in Chicago Bridge and OSI, and the other, which can be called the "bifurcated test," was present in Alliant. Under the consistency test, the working capital calculation uses an accounting approach that is consistent with that used by the acquired company. A GAAP-compliance test is not undertaken in connection with the purchase price adjustment because it would not achieve the goal of measuring changes in the business between signing and closing. A GAAP-compliance test can only be raised as a claim for breach of representations and warranties.

The bifurcated test, on the other hand, involves an initial GAAP-compliance inquiry followed by a consistency inquiry. An initial inquiry is made into whether the seller's historical accounting approach (on which the net working capital calculation is based) is in accordance with GAAP. If it is not, then the buyer can reject the historical approach and calculate net working capital in accordance with GAAP. If it is in accordance with GAAP, then the accounting approach for the net working capital calculations should be otherwise consistent with the seller's historical accounting approach.

Acquirers will typically want the bifurcated test because it gives them the option of introducing a GAAP-compliance challenge into the purchase price adjustment process if it is in their interest to do so. What sort of road map to obtaining the bifurcated test do the three cases provide? In Chicago Bridge, the closing payment statement and the closing statement had to "be prepared and determined from the books and records of the Company and its Subsidiaries and in accordance with [GAAP] applied on a consistent basis throughout the periods indicated and with the Agreed Principles." But this expressly references GAAP. The court appears to have been heavily influenced by the factual context, and by the other provisions in the purchase agreement, such as the liability bar and the releases, and de-emphasized the words "in accordance with GAAP." In OSI, the transaction accounting principles were defined as "U.S. GAAP; provided, however, that (i) with respect to any matter as to which there is more than one principle of U.S. GAAP, Transaction Accounting Principles means the principles of U.S. GAAP applied in the preparation of the Financial Statements .... " The words "U.S. GAAP" seem to have been similarly de-emphasized in light of the overall structure of the purchase agreement. So acquirers would be advised to assume that unless the language clearly specifies a bifurcated test, it is likely to be interpreted as a consistency test. The language in Alliant worked, although that may have been a close call.

Sellers, on the other hand, may wish to include an express statement that the parties understand and agree that the working capital adjustment provisions cannot be used to resolve any claims regarding whether the historical financial statements comply with GAAP, and that any such claims can only be made as part of a claim for breach of representations and warranties.

EMSI Acquisition Inc. v. Contrarian Funds LLC (May 3, 2017)

When drafting fraud carveouts, parties should specify whether the fraud to be covered is intended to be contractual or extracontractual, and whose fraud is covered.

EMSI involved a motion to dismiss a claim for post-closing indemnification based on a target company's alleged fraudulent financial statement misrepresentations under a stock purchase agreement. The plaintiff's right of recovery turned on whether the fraud carveout language in the SPA exempted claims for fraudulent misrepresentations in the SPA made by company management from the limits on recovery for indemnification under the SPA. The Delaware Chancery Court held that the SPA was ambiguous, and refused to grant the motion to dismiss. The decision builds on the analytical framework for fraud carveout provisions set forth in Abry Partners V LP v. F&W Acquisition LLC,3 and provides further guidance on drafting pitfalls to avoid.

The EMSI decision involved the sale of a company by several institutional investors and two company officers (collectively, the sellers) to a private equity fund (the buyer). A forensic investigation conducted after closing revealed that the company had manipulated its work-in-progress model, inflating volume and prices, accelerating revenue recognition and falsifying progress on ongoing projects, which led the buyer initially to bring a claim through the working capital adjustment process. The aggregate purchase price adjustment determined by a settlement auditor exceeded the amount placed in escrow. The buyer then brought a legal action to recover the shortfall in the purchase price adjustment, and to recover damages for the inflated price it paid as a result of the company's alleged fraud.

The SPA Language

The court noted that the SPA contained straightforward nonreliance language pursuant to which the buyer acknowledged that it was relying only on representations and warranties made under the SPA. The SPA, however, contained ambiguous and potentially contradictory language in the indemnification section, Article X. Section 10.2 set forth the sellers' indemnification obligations, including for breaches of representations and warranties such as the representations about the company's financial statements in Article IV made by the company (and not the sellers). Section 10.4 set forth various limitations, including the following language in Section 10.4(d):

Notwithstanding anything to the contrary in this Agreement ... [t]he Buyer Indemnified Parties shall only be entitled to indemnification (i) with respect to Losses in respect of the representations and warranties (other than the Excluded Representations and the Specific Indemnity Items) to the extent of, and exclusively from, any then-remaining Escrow Funds ....

Section 10.10(a) contained the following exclusive remedy language regarding breaches of representations, warranties and covenants:

From and after Closing (except ... in the case of claims for fraud or willful or intentional misrepresentation), the sole and exclusive remedy of the Seller Indemnified Parties and the Buyer Indemnified Parties for any breach or inaccuracy, or alleged breach or inaccuracy, of any representation, warranty or covenant under, or for any other claims arising in connection with, any of the Transaction Documents ... shall be indemnification in accordance with this Article X, subject to the limitation set forth herein ....

Section 10.10(b) then carved out any claim based on fraud from this limitation:

Notwithstanding anything in this Agreement to the contrary (including ... any limitations on remedies or recoveries ...) nothing in this Agreement (or elsewhere) shall limit or restrict (i) any Indemnified Party's rights or ability to maintain or recover any amounts in connection with any action or claim based upon fraud in connection with the transactions contemplated hereby ....

The buyer argued that Section 10.10(b) carved out fraudulent misrepresentations of company management under Article IV of the SPA from the contractual limits on recovery. The defendants argued that the carveout in Section 10.10(b) only applied to extracontractual fraud, and that any claims for contractual fraud remained subject to the limitations under Article X.

The Abry Framework

In evaluating the parties' arguments, the court first reviewed the legal framework established for fraud carveouts by the Chancery Court's decision in Abry. The Abry decision analyzed the type of fraud claims that could be waived, in light of Delaware's public policy against fraud. Abry involved the sale of shares of a company by one private equity fund to another. The stock purchase agreement at issue contained a broad nonreliance clause. The Abry court held that Delaware's public policy against fraud did not prevent buyers from contracting away their rights to bring claims based on extracontractual representations through a clear nonreliance clause. With respect to representations and warranties under the stock purchase agreement, the Abry court held that parties could allocate the risk with respect to unintentional false statements of fact, but not intentional misrepresentations, because to do so would violate Delaware's public policy against fraud. A key point in both Abry and EMSI is that, as is typically the case in a stock purchase agreement, the allegedly fraudulent representations and warranties in both cases were made under the stock purchase agreement by the target company and not by the sellers. According to the Abry court, for a buyer to avoid the bargained-for limits on its remedies, the sellers must have either known that the company's representations and warranties were false, or themselves lied to the buyer about a contractual representation and warranty. In other words, the sellers must have had an "illicit state of mind".

The Abry Framework Applied to EMSI

So how did the EMSI parties deal with the Abry framework? The EMSI court noted that the SPA contained both a specific nonreliance clause and a separation of the representations and warranties between the sellers and the company, with the financial representation and warranty having been made only by the company.

The sellers maintained that Section 10.10(a) preserved claims for "fraud or willful or intentional misrepresentation" within and subject to the contractual indemnification framework, and that Section 10.10(b) provided for a fraud exception with respect to extracontractual representations. The sellers' interpretation of Section 10.10(a) was consistent with Abry because it addressed fraudulent misrepresentation made by officers of the company, and not by the sellers. According to the sellers, given that the buyer's claims were based on fraudulent misrepresentation made by officers of the company, they remained subject to the indemnification limits, including the cap, under the SPA.

The buyer rejected this argument, and maintained instead that Section 10.10(b) provided for a contractual exclusion from the indemnification limitations that was not present in Abry. The buyer argued that Section 10.10(b) expressly excluded from the indemnification limits any action or claim "based on fraud," regardless of whether the fraud was that of the sellers or that of the company's officers. Thus, since the buyer's indemnification claim was based on the fraudulent misrepresentation of the company's officers under the financial statements representation in the SPA, it was excluded from the indemnification limits.

The EMSI court noted that the SPA was ambiguous because the SPA contained "notwithstanding anything in this Agreement to the contrary" clauses in Sections 10.10(b) and 10.4(d) that appeared to override each other. The court found that it was at least reasonable to view the clause in Section 10.10(b) as overriding the clause in Section 10.4(d), as maintained by the buyer. Moreover, the very broad exclusion in Section 10.10(b) for "any action or claim based upon fraud" did not delineate between contractual fraud and extracontractual fraud. The court found that both interpretations were plausible, and denied the sellers' motion to dismiss.

The Takeaways

This case serves as a warning against liberal usage of "notwithstanding anything herein to the contrary" clauses, which can end up creating interpretive ambiguities, as it did in this case. One such ambiguity was whether the fraud carveout could be interpreted as only carving out fraud for extracontractual representations and warranties. Such an interpretation in EMSI seemed counterintuitive, given that the SPA also contained a nonreliance provision. But such ambiguities can still create leverage in litigation settlement discussions. A second ambiguity was whether the broad fraud carveout for "any action or claim based on fraud" should be interpreted as applying to fraud by the company's management in addition to fraud by the sellers.

The lesson for both buyers and sellers is to proactively address these issues in drafting, and avoid use of competing "notwithstanding anything herein to the contrary" clauses. Sellers should try to limit the fraud carveout so that it is as narrow as possible. One way of doing that would be to argue against including any fraud carveout language in the stock purchase agreement, and simply have the buyer rely on the courts to apply Delaware's public policy exception should the requisite type of fraud occur. If that is not possible, sellers should try to ensure that fraud carveout language applies to fraud of the sellers only, and not intentional misrepresentations by company management.

Buyers, on the other hand, will want to make the fraud carveout as expansive as possible, so that it covers both contractual and extracontractual fraud, and covers fraud of both the sellers and company management. As a related matter, it is now quite common for parties to include a definition of "fraud" in the acquisition agreement. Sellers will want a definition that tracks the elements of intentional, common-law fraud as opposed to more expansive types of fraud, such as equitable fraud (which does not require proof of scienter) or negligent fraud. Buyers will want a broad definition of fraud that does not require scienter.

  1. 892 A.2d 1086 (Del. Ch. 2006).

  2. 2015 WL 1897659 (Del. Ch. Apr. 24, 2015).

  3. 891 A.2d 1032 (Del. Ch. 2006).

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