The vast majority of private company acquisitions contain some type of purchase price adjustment to account for any changes in certain financial metrics (including working capital) of the target between a specified reference date (or target) and the closing date. For a variety of reasons (including the inability to predict what might happen in the business between the signing and closing), disputes over these types of adjustments are common. In some cases, buyers view these adjustments as an opportunity to renegotiate the purchase price after the closing.
On June 27, 2017, the DE Supreme Court reviewed a net working capital adjustment and held that the buyer could not reopen the seller’s accounting methods by challenging the seller’s compliance with generally accepted accounting practices (GAAP) for purposes of the net working capital true-up. In so holding, the court reversed a controversial ruling last year in which the lower court allowed the buyer to submit GAAP challenges to a seller’s closing statement. In Chicago Bridge v. Westinghouse Electric, buyer Westinghouse alleged that it was entitled to a $2 billion working capital adjustment after buyer recalculated seller’s net working capital in compliance with GAAP – alleging that the seller had failed to comply with GAAP when it prepared the seller’s closing statement including the estimated net working capital as of the closing. In the reversal, the DE Supreme Court held that Westinghouse could not challenge Chicago Bridge’s estimate of the company’s closing statement for historical GAAP compliance and that any adjustments to the company’s net working capital for purposes of the true-up must instead be based only on facts and circumstances impacting working capital that occurred between signing and closing. The court explained that the purchase price adjustment language, which required the seller’s closing statement to be calculated “in accordance with [GAAP] applied on a consistent basis throughout the periods indicated and with the Agreed Principles” did not provide an independent means by which the buyer could assert that the seller’s closing statement was not GAAP compliant. The court looked at the plain language of the provision in light of the text and spirit of the entire contract, and concluded that any claims of GAAP non-compliance in the preparation of financial statements should have been addressed through the agreement’s representations and warranties regime. Since the representations and warranties did not survive the closing, the court explained that any attempt to challenge GAAP compliance through the net working capital adjustment would contradict the language and intent of the contract.
By limiting the independent auditor to a review of only changed facts and circumstances impacting changes to net working capital between the signing and the closing, the ruling appears to reset the court-stated “true purpose” of a net working capital adjustment as an important, but narrow, means to ensure that the value of the purchased business (normalized for anticipated working capital swings) at signing is essentially the same as its value on closing. The decision is a welcome development for sellers and provides helpful drafting advice that may serve to discourage a buyer from challenging a seller’s compliance with GAAP in the net working capital adjustment as a means to renegotiate the purchase price.
The facts in the case are complicated and summarized in detail in our prior blog post. Crucially to this decision, the court recast the facts in a manner that took into account the overall business deal and context of sale. The court found that leading up to the transaction, the parties had a joint venture that involved the construction of several nuclear power plants by a subsidiary of Chicago Bridge. As delays and cost overruns mounted, the parties agreed to sever their relationship by having Chicago Bridge sell its subsidiary to Westinghouse for $0. The court found that in exchange, Chicago Bridge would receive a clean break from future contribution obligations and liabilities related to the projects. Chicago Bridge made certain representations and warranties in the purchase agreement, including that its financial statements were prepared in accordance with GAAP. However, the representations and warranties did not survive the closing. Unusually, Westinghouse also agreed to indemnify Chicago Bridge for any post-signing and post-closing liabilities related to the projects. Closing was also contingent on Chicago Bridge receiving releases from the utility companies that would operate the plants when they were completed.
The agreement also had a fairly typical two-way purchase price adjustment that required a payment to the seller or the buyer based on whether the seller’s net working capital at closing was greater or less than target net working capital with a mechanism for a post-closing true-up for a final determination of net working capital as of the closing. Prior to closing, the seller delivered a closing statement that reflected a net working capital adjustment in its favor of about $428 million, largely due to the substantial construction costs Chicago Bridge had to incur in order to continue with the project as required in the ordinary course in the period between signing and closing. After closing, Westinghouse presented a closing statement that calculated a negative net working capital amount that would have required a payment to Westinghouse of about $2 billion, based largely on a change in the way Westinghouse calculated certain financial inputs, as described more thoroughly in our previous blog post.
The Court of Chancery held that the independent auditor was permitted to consider whether Chicago Bridge had complied with GAAP for purposes of the calculation of the final net working capital and the true-up. Chicago Bridge then appealed the decision to the Delaware Supreme Court.
DE Supreme Court reverses
The Supreme Court reversed. The court first noted that generally speaking, net working capital adjustments are meant to account for changes in a target’s business between the signing and the closing in order to: (i) compensate sellers for effectively running the business if the net working capital is greater than the target amount, and (ii) protect buyers against value depletion before they take over the business. The court found that the language in the purchase agreement was consistent with this general purpose. The court also found that the parties clearly recognized that GAAP allowed for a variety of treatments but that for purposes of the net working capital adjustment, the parties required consistent accounting treatment by both the buyer and the seller. The court noted that this conclusion was consistent not just with the specific language in the net working capital adjustment, but also the broader text and intent of the parties throughout the agreement (which essentially protected the seller from liability from the projects) and included language which limited the role of the independent auditor to that of an expert and not an arbitrator.
The facts of this case were highly unusual. However, the court appeared to restate the broader purpose of a net working capital adjustment as a tool for preserving value of the target between signing and closing, and not as a means to reopen purchase price negotiations following the closing.
The decision also helped to clarify the specific language that may be used to preclude a buyer from opening up the closing statement to GAAP compliance. In the purchase agreement, the closing statement was required to be prepared in accordance with GAAP “applied on a consistent basis throughout the periods indicated based on Agreed Principles” that the seller had historically used. Contrast this with the language in the agreement in Alliant Techsystems, Inc. v. MidOcean Bushnell Holdings in which the court found that the language permitted GAAP compliance challenges. In Alliant, the agreement required the net working capital adjustment to be 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].” In Alliant, the court found that the use of “and” created two separate tests which required the calculation to first comply with GAAP and second in a manner that was consistent with how the seller had prepared its financial statements. The holding, therefore, underscores the need for careful drafting.
Finally, as we previously noted, this decision highlights the need to consider the interplay between the net working capital adjustment and the other aspects of the purchase agreement, such as indemnification and, if relevant, the concept of “retained liabilities.” The court appeared to redirect claims for breaches of GAAP compliance to the agreement’s indemnification regime, and the caps, deductibles and other limitations of those provisions.