Role of the Litigation Consultant in Post-Closing Purchase Price Adjustments

By Dennis S. Neier

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The purchase price may ultimately be based, in whole or in part, on the financial statements of the seller as of the closing date. Because the transaction is structured, negotiated, and finalized well before the closing date financials are available, however, the parties will use previously issued (reference) financial statements as the basis for the transaction. Because of this, the parties will generally provide for a post-closing purchase price adjustment, once the closing date financials are available, that will reflect any changes from the reference financials.

A Complex Process

While post-closing purchase price adjustments seem uncomplicated, they often result in significant post-closing disputes. Most post-closing purchase price adjustments are based on balance sheet items, but some are based on earnings or cash flow criteria. For example, a transaction might include a provision that the seller deliver to the buyer, as of the closing date, a specific amount of net assets, net worth, stockholders’ equity, retained earnings, working capital, inventories, and sales volumes based upon the amounts reported on the reference financials. The post-closing purchase price adjustment provision is designed to adjust the purchase price for the difference in one or more of such items between the amounts reported on the reference financials and the amounts reproted on the closing date financials.

The parties often disagree on the amount of the post-closing purchase price adjustment because the provision is not clear or circumstances arose that were not contemplated when the provision was drafted. Accordingly, the issue of the amount of the post-closing purchase price adjustment often becomes the subject of negotiation, mediation, arbitration, or litigation.

The Role of the Litigation Consultant

Most post-closing purchase price adjustments involve financial calculations, the interpretation of generally accepted accounting principles (GAAP), financial statement analysis, the analysis of financial concepts, or the analysis of changes between the reference financials and the closing date financials. Therefore, most attorneys that represent the purchaser or the seller in a dispute should engage a CPA litigation consultant who can perform these tasks.

The litigation consultant can be engaged as a consultant, a testifying expert, or both. A consultant can do the following:

• Help the attorney understand the accounting and financial jargon used in the post-closing purchase price adjustment provision.
• Help the attorney understand the various accounting, auditing, economic, financial, tax, valuation, and analytical issues involved.
• Perform the calculation of the post-closing purchase price adjustment in accordance with the provision.
• Analyze the reference financials and the closing date financials.
• Rebut the other parties’ calculations of the post-closing purchase price adjustment.
• Construct or evaluate settlement offers.

A testifying expert can assist the trier of fact by doing the following:

• Interpreting the accounting and financial jargon used in the post-closing purchase price provision.
• Explaining the purchaser’s or the seller’s position regarding the calculation of the post-closing purchase price adjustment.
• Analyzing the difference between the two sides’ positions.
• Demonstrating why one calculation more accurately conforms to the terms of the post-closing purchase price adjustment provision and the intent of the parties.

Accordingly, if the post-closing purchase price adjustment dispute results in litigation or is to be submitted to mediation or arbitration (pursuant to the original purchase and sale agreement, a court order, or an agreement between the parties), the attorney representing each party should retain a litigation consultant to assist in the preparation of the case, issue an expert report, and offer expert testimony.

Knowledge and Know-how

If the matter is to be submitted to mediation or arbitration, the parties will be best served if the mediator, arbitrator, or members of the arbitration panel are CPAs with litigation consulting experience. The litigation consultant can resolve the post-closing purchase price dispute, which, almost always, involves accounting and financial issues and concepts. The litigation consultant also has the experience of working in the dispute resolution process and can conduct and administer the mediation or arbitration. Many attorneys now advise that the post-closing purchase price adjustment provision should require a mediator or arbitrator to be a CPA with litigation consulting experience.

The Language of the Post-Closing Purchase Price Adjustment Provision

A CPA litigation consultant can also be useful in drafting the language of post-closing purchase price adjustment provisions. A litigation consultant can help the parties interpret the language, help the parties defend their positions regarding the amount of the post-closing purchase price adjustment, or be the mediator or trier of fact in a post-closing purchase price mediation or arbitration.

Many post-closing purchase price adjustment disputes arise because the parties have different interpretations of the language contained in the provision. Of necessity, most provisions use technical accounting terminology that the drafting attorneys might not fully understand. If not properly drafted, the technical language and terms can lead to different interpretations when calculating the post-closing purchase price adjustment. Lack of input by a litigation consultant can result in contracts that call for computations that cannot be made or that produce unintended results.

There are ways of drafting the accounting and financial aspects of the post-closing purchase price adjustment provision so that they are more favorable to the buyer or to the seller. A litigation consultant is best equipped to help the drafting attorneys develop the language and terms so that they benefit the attorney’s client. A litigation consultant can also help identify language that the other party is attempting to use to the same effect.

Accounting and Auditing Issues

Many accounting and auditing issues must be addressed in the drafting of a post-closing purchase price adjustment provision. There are several in particular in which engaging a CPA litigation consultant can prove extremely useful.

Materiality. Materiality is often defined as an amount that would influence the user of the financial statements. Financial statements may contain immaterial departures from GAAP and yet the financial statements, taken as a whole, can still be in conformity with GAAP. These immaterial departures, however, can be a source of a major dispute when they are elements of post-closing purchase price adjustments and will require cash outlays by the buyer or the seller. Arbitrators are likely to use a much lower threshold of materiality when considering the calculation of the post-closing purchase price adjustment. Accordingly, the post-closing purchase price provision should be specific regarding standards for materiality.

Judgment in applying GAAP. Many agreements provide that the post-closing purchase price adjustment must be calculated in accordance with GAAP. Even though GAAP provides a reasonably clear framework for how financial transactions and items are to be accounted for and reported, the actual calculations made pursuant to GAAP can be highly subjective because they can involve estimates, particularly when determining the various types and amounts of reserves. Accordingly, the purchase and sale agreement should address the methods of computing the items that are the basis for post-closing purchase price adjustments. The agreement should provide the following:

• The methods used to calculate estimates in the reference financials should also be used to calculate estimates in the closing financials.
• The practices, estimates, and assumptions to be used when calculating the post-closing purchase price adjustment should be clearly stated and defined.
• The dollar amount of items requiring a significant amount of judgment should be quantified in advance.

Consistency. Most post-closing purchase price adjustment provisions provide that the adjustment will be computed in accordance with GAAP applied on a consistent basis. This straightforward language can be the foundation for significant post-closing purchase price adjustment disputes. But what happens if, at the time of computing the adjustment, the seller did not account for a particular item in the reference financials in accordance using GAAP? Should the post-closing purchase price adjustment be calculated in the same manner, to be consistent with the company’s past practices even though those practices were not in accordance with GAAP? Or should the adjustment be computed using GAAP, which would not be consistent with the company’s past practices? If the adjustment should be computed in accordance with GAAP, should the reference financials be adjusted to a GAAP basis?

Most arbitrators will find that where GAAP conflicts with past practice, GAAP trumps consistency and the reference financials should not be adjusted so that they are in accordance with GAAP. Accordingly, the parties could find themselves in a position where an item on the closing financials computed in conformity with GAAP is being compared with an item on the reference financials that was not recorded in conformity with GAAP. This can produce results that were not originally contemplated by the parties.

If, upon entering into the purchase and sale agreement, the parties want certain items not to be in accordance with GAAP when the post-closing purchase price adjustment is calculated, the agreement can set specific exceptions from GAAP and require that the adjustment be calculated using these exceptions.

Audited or unaudited financial statements. Questions arise as to whether or not the closing financial statements need to be audited and, if so, by whom. Regardless of whether the reference financials are audited, it is almost certain that the closing financials should be audited. The seller’s auditor will have experience with the company’s financials, an advantage in efficiency and economy. If the buyer’s reporting requirements require audited financial statements, however, having the buyer’s auditors perform the audit might be more appropriate.