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Contractual post‐closing purchase price adjustment mechanisms are found in purchase agreements that are structured as stock purchases as well as in those that are structured as asset purchases. Post‐closing purchase price adjustments can range from immaterial in the context of the transaction to large amounts that significantly impact the economics for the buyer and seller. There are three broad categories of potential contractual post‐closing adjustments to the purchase price:

1. Adjustments to the purchase price based on the financial position or performance of the target company as of or through the closing date

2. Adjustments to the purchase price based on the financial performance of the target company subsequent to the closing date

3. Adjustments to the purchase price based on the allocation of financial responsibility through representations, warranties, and indemnifications in the purchase agreement

Each of those categories of post‐closing adjustments can lead to disputes between the parties to the transaction. In addition to contractual purchase price adjustment disputes, there are also disputes related to the transaction and/or the purchase price that are based directly on the legal framework governing the transaction as opposed to the underlying contract. An example of a possible legal challenge that can lead to an adjustment to a share purchase price is a Delaware appraisal action. Another example of a legal challenge related to alleged under‐ or overpayment can be an action based on allegations of transaction fraud. Parties can also end up in dispute regarding a transaction that was never consummated based on, for example, allegations that one of the parties wrongfully failed to close. As this book focuses on accounting arbitrations, which generally find their basis in being preemptively agreed upon as a form of alternative dispute resolution, non‐contractual purchase price adjustment disputes are outside the scope of this book (although we discuss transaction fraud briefly in Chapter 22).

As it relates to contractual purchase price adjustments, agreements governing larger transactions generally contain at least a choice of law and forum selection clause. Many agreements, however, go much further and contain arbitration and/or expert determination clauses complete with prescribed procedures and an agreed‐upon timeline for dispute resolution. The agreed‐upon choices for alternative dispute resolution and the associated procedures can differ dependent on the nature of the potential dispute. In other words, one purchase agreement can contain multiple avenues for dispute resolution. For example, an agreement can simultaneously contain (i) an overall clause that prescribes New York law as the governing law and the federal court for the Southern District of New York as the venue of choice, (ii) an arbitration clause that arranges for an American Arbitration Association appointed arbitrator to decide any indemnification‐related disputes, and (iii) a clause that provides for an independent accountant to resolve any post‐closing net working capital disputes.

In general, the perceived benefits of alternative dispute resolution include the relative efficiency of the process, as it is often both faster and cheaper than traditional litigation, as well as the ability to tailor procedures and discovery. The limitations on discovery tend to be especially attractive to foreign transaction parties, for which the U.S. discovery process is often significantly more extensive than the obligations that are imposed by their home jurisdictions. In addition, especially in the event of a would‐be venue that is smaller and less used to foreign litigants, some foreign parties may fear that they would be at a disadvantage due to local biases. Of course, alternative dispute resolution also has downsides, including a commonly perceived tendency of arbitrators to arrive at split or compromise decisions as well as significant limitations on the ability to appeal an arbitration ruling. In the case of purchase price adjustment clauses, the efficiency benefits of alternative dispute resolution can be further increased by having, what are essentially, accounting disputes analyzed and decided by accountants.

The first category of purchase price adjustment disputes – adjustments based on the target company's financial position or performance as of or through the closing date – is as close as it gets to contract‐based pure accounting disputes. The underlying adjustment mechanisms include those based on the amounts of net working capital, debt (or net debt), and/or cash and cash equivalents that are transferred with the company at closing. The adjustment mechanisms can also incorporate performance measures such as EBITDA, earnings before interest and taxes (EBIT), or a variety of custom measures that cover a defined period prior to closing. For example, the contractual purchase price adjustment formula can incorporate the company's Adjusted EBITDA for the 12 months leading up to closing into the calculation of the ultimate purchase price. Not surprisingly, purchase agreements routinely arrange for purchase price disputes related to category 1 adjustment mechanisms to be brought before an independent accountant. Coates (2012) – in his analysis of a sample of M&A agreements for the period from 2007 through 2008 – found that “83 % of contracts containing price‐adjustment clauses also contained clauses mandating arbitration of disputes arising out of those price‐adjustment clauses.”1

Importantly, disputes related to category 1 adjustment mechanisms center on the quantification of an adjustment, if any. Generally, there is not the two‐step of actionable wrongful conduct and damages that is common in general civil litigation. Indeed, the need for some form of adjustment is generally not indicative of wrongful behavior. The existence of a dispute does not belie this; the parties may simply disagree on the appropriate accounting and need assistance in quantifying (part of) the adjustment.

Category 2 adjustments – adjustments based on post‐closing performance – are commonly referred to as earn‐out provisions and allow the seller of a company to retain some interest in the upside of the company's financial performance while protecting the buyer against paying upfront for expected performance that may never materialize. In a sense, disputes in the second category are often not about adjusting an estimated purchase price, but about quantifying what should be the ultimate purchase price based on post‐closing performance. Those disputes can encompass accounting issues and/or various legal and non‐accounting factual allegations about wrongful conduct. The accounting issues are frequently resolved by accounting arbitrators. The non‐accounting aspects of such disputes are typically brought before attorney arbitrators or judges, but can still involve accountants to provide consulting services and/or educate the trier of fact on the relevant accounting issues as a retained expert.

Disputes in the third category – adjustments based on representations, warranties, and indemnifications – are typically legal in nature. Moreover, although the related payments may be considered adjustments to the purchase price from an accounting perspective, the purchase agreements typically treat those items as payments between the parties and not explicitly as purchase price adjustments, unless for accounting or tax purposes. In our experience, it is highly uncommon for disputes in the third category to be brought before an independent accountant.

Notwithstanding, the findings of the independent accountant in relation to a dispute in the first category can indirectly impact the outcome of disputes in the second and third categories. By means of example, the accounting arbitrator can rule on the amount that should be included on the balance sheet as of the closing date for a partially performed contract, which would fall under the first category. That starting balance and the associated accounting can then have an impact on the amount of revenue that should be recognized in the year subsequent to closing. As a result, the accountant's ruling related to balance sheet work‐in‐progress accounting can impact the amount of the earn‐out owed to the seller for performance subsequent to closing. Similarly, by means of another example, the independent accountant could rule on the appropriate amount to be included on the balance sheet as a tax accrual. If the purchase agreement also contains a clause that arranges for indemnification of prior period taxes in excess of the applicable tax accrual, the ruling of the independent accountant in the context of a category 1 adjustment could very well impact a purchase price adjustment in relation to category 3.

As this book relates to accounting arbitrations as opposed to civil litigation, it focuses primarily on the conception, negotiation, and adjudication of the first category of post‐closing purchase price adjustments. The most prevalent adjustment mechanism in this category is for the amount of net working capital that exists on the target company's balance sheet as of the closing date. Post‐closing net working capital adjustments also form the bulk of post‐closing disputes that are brought before an accounting arbitrator.

Given their prevalence in practice as well as the analogous applicability of many of the identified issues to other adjustment mechanisms, the majority of this book will focus on net working capital–based adjustment mechanisms and disputes. Notwithstanding, we mention other purchase price adjustment mechanisms and disputes throughout this book where appropriate. We also specifically discuss certain other adjustment mechanisms, including EBITDA‐based adjustments and earn‐outs in Chapter 22.