The seller’s first argument was that the dispute was not ripe for the neutral accounting firm because the buyer breached the merger agreement by failing to provide access to the requested financial information.

The court disagreed, ruling the seller’s delivery of the dispute notice shifted the focus from “ascertaining” the existence of a dispute to “resolving” the dispute, with the neutral accounting firm having exclusive authority to resolve.

In the court’s analysis, it acknowledged that, under certain circumstances, a CPLR 7601 petition can be dismissed in the event of a breach of “warranties, representations and the like, which must be litigated in a plenary action.” [Citing Matter of Westmoreland Coal Co. v. Entech, Inc., 100 NY2d 352 (2003)]. In Westmoreland, the New York Court of Appeals reversed the grant of a CPLR 7601 petition on the grounds the dispute needed to be adjudicated via indemnification in a court of competent jurisdiction (not by the neutral accountant).

The court in Decree-Crane noted the seller did “not contend that the issues raised by the [d]ispute [n]otice fall within the indemnity provisions of the [m]erger [a]greement, and in any event those provisions explicitly carve out disputes to be resolved under [the purchase price adjustment provision].” The court cited Spectris Inc. v. 1997 Milton B. Hollander Family Trust, 44 Misc 3d 1215 (Sup. Ct. NY County 2014), aff’d 138 AD3d 626 (1st Dep’t 2016), where, like Decree-Crane (but unlike Westmoreland), the indemnification provisions expressly excepted the purchase price adjustment dispute resolution mechanism.⁴

As for the seller’s second argument, the court pointed out the neutral accounting firm needed to be acceptable to both parties, and neither side was willing to accept the other’s recommendations (i.e., there was no breach by either party exercising its discretion to reject the other’s suggestions).

The court gave the parties two new accounting firms to choose from, with the court preserving the authority to make the ultimate determination if the parties could not agree. Also, evidently the subject merger agreement contained a fee shifting provision, so the court awarded the buyer its reasonable attorneys’ fees as the “substantially prevailing party.”

Lessons and reminders from Decree-Crane

Identifying the neutral accounting firm

Buyers and sellers go to extreme lengths to craft the purchase price adjustment with precision and narrow the scope of matters that can be decided by a neutral accountant in the event of a dispute.

Decree-Crane is a good example of what can happen when the neutral accountant is the proverbial “player to be named later.” While true the buyer was awarded its attorneys’ fees, the same facts without a fee shifting provision would have forced the buyer to incur attorneys’ fees just to get the dispute into the hands of the neutral accountant. The lesson is to eliminate this risk by specifically identifying the neutral accountant in the acquisition agreement.

The review period and the dispute notice

Dispute notices are typically “you snooze you lose,” meaning any objections not raised will be deemed waived, and there is usually a short deadline (in Decree-Crane the review period was 30 days).⁵ Interestingly, the merger agreement at issue in Decree-Crane provided that if access to requested information was denied by the buyer, the seller could extend the review period for each day access was denied. However, the utility of this seller-friendly language was compromised when the seller sent the dispute notice to the buyer because the court ruled that doing so was a “binding election to terminate the review period and move to the dispute resolution phase.”

Three lessons here, all for sellers.

First, consider adding language to extend the review period if access to financial information is not provided.⁶

Second, sellers should seek to obtain access to as much financial information at the earliest possible stage during the review period. This will be especially important when there is no extension language because there will be a clock ticking on the deadline for delivering a dispute notice.

Third, understanding the dispute notice needs to be timely, sellers should obtain all information needed to submit a comprehensive objection before delivering the dispute notice. Most purchase price adjustment provisions limit the scope of the neutral accountant’s review to matters objected to. If (i) a seller is faced with a looming deadline on delivering a dispute notice; (ii) the buyer is denying access to information requested; and (iii) there is no extension language, one possible course of action for the seller would be to timely deliver the dispute notice but expressly (x) reference the denial of information; (y) preserve the right to modify the objection(s) once access is provided; and (z) assert that the information withheld should be provided to the neutral accountant for consideration in resolving the dispute.⁷ It’s unclear if this hedging would be upheld by a court or the neutral accountant, but it is better than letting the deadline pass and risking a conclusion the seller waived the right to object to the buyer’s calculation altogether.

Carve-out language from indemnification

The court in Decree-Crane took note of the merger agreement language excepting purchase price adjustment disputes from the indemnification provisions. In the absence of such language, the defendant seller in Decree-Crane would have been armed with an argument to support dismissal of the CPLR 7601 petition on the grounds that the claims were subject to the indemnification procedures (or, as the court phrased it, would have required “litigat[ion] in a plenary action”.⁸

This should serve as a reminder of the significance of having carve-out language to clarify that purchase price adjustment disputes are not subject to the restrictions and limitations of the indemnification provisions. This is critical when there is an exclusive remedy provision (i.e., a provision that states indemnification is the exclusive post-closing remedy for breaches of representations, warranties and covenants).⁹ Assuming the application of New York law, the absence of this carve-out language will give the opponent of a CPLR 7601 petition support from Westmoreland.

On the other side of the coin, however, excepting the purchase price adjustment from the indemnification can be a double-edged sword because the indemnification cap will not apply, which can be painful for a seller. Case in point is the Delaware Court of Chancery’s decision in Northern Data AG v. Riot Platforms, Inc.

Delaware—Northern Data AG

In Northern Data, the seller sought to vacate an accounting expert’s determinations in two dispute categories in favor of the buyer under the subject stock purchase agreement (SPA).

First, the seller challenged the accounting expert’s treatment of approximately $22 million of up-front customer payments as deferred revenue, rendering this amount “indebtedness” for purposes of the closing statement. That determination took a huge chunk (approximately 41.6%) out of the $52,812,202 in cash paid to the seller at closing.

Second, the seller challenged the accounting expert’s determinations (a) disallowing a $1.2 million account receivable as a current asset in the net working capital calculation (on the grounds of double billing) and (b) including an account payable of almost $3 million for an outstanding electricity invoice as “indebtedness” for purposes of the closing statement.

The basis for the challenge on the $22 million of deferred revenue was an assertion that the accounting expert ignored the seller’s historical accounting treatment in contravention of the purchase price adjustment provision. That language required the accounting expert to resolve the dispute “in accordance with GAAP, in a manner in accordance and consistent with the [i]llustrative [c]losing [s]tatement and pursuant to the terms of the [SPA].” Evidently the illustrative closing statement reflected the seller’s historical accounting treatment, which did not record the $22 million as deferred revenue.

The seller (Northern Data) argued the language required the accounting expert to consistently apply GAAP, the Illustrative Closing Statement and the SPA, while the buyer (Riot) argued there was a hierarchy in the sense that GAAP was a constant requirement and the accounting expert need only consider the illustrative closing statement to the extent it was consistent with GAAP. The court concluded the language was “unambiguous” because the buyer’s interpretation was reasonable and the seller’s was not.

Citing Archkey Intermediate Holdings Inc. v. Mona, the court framed the issue as follows:

Similar to this dispute, Archkey involved an agreement that an accounting expert would resolve a [purchase price adjustment] dispute ‘in accordance with GAAP and consistent with the past practices of the [c]ompany and a [specified historical balance sheet].’ Relying on a professional guide to accounting arbitrations in mergers and acquisition disputes, the [Archkey] court explained that GAAP compliance was the ‘floor’ and the requirement of consistency with the historical balance sheet ‘narrow[ed]’ the expert’s ‘available choices under GAAP’ [citation omitted]. If the Company’s historical balance sheet complied with GAAP, the same method would be applied in the [purchase price adjustment] process. But if the historical practice was noncompliant with GAAP, it could not be used in the [purchase price adjustment] process.

The Northern Data court defended this reading as “a feature, not a bug”, relying an excerpt from the accounting treatise relied on in Archkey (Biemans & Hansen).

Although the court analyzed and determined the contractual language de novo, it applied a “manifest error” standard¹⁰ to uphold the accounting expert’s determination that $22 million of upfront customer payments constituted deferred revenue that should have counted as indebtedness for purposes of the purchase price adjustment. This was the case even though the buyer’s due diligence evidently uncovered the seller’s accounting treatment and the “illustrative closing statement” that was attached to the underlying SPA did not account for the payments as deferred revenue.

Given the magnitude of the $22 million reversal, Northern Data bears a striking resemblance to Chicago Bridge & Iron v. Westinghouse Electric, where the Delaware Supreme Court rejected a buyer’s arguments that “it could seek monetary payments by alleging that [seller’s] historical accounting treatment wasn’t GAAP-complaint” despite a “liability bar” where representations and warranties expired at closing (i.e., no post-closing indemnification). In Chicago Bridge & Iron, Delaware’s high court ruled the buyer could not accept non-GAAP compliant financial statements pre-closing and wait until the post-closing adjustment process to dispute the seller’s historical accounting methodology when there was no post-closing indemnification. Although the acquisition agreement in Chicago Bridge & Iron had no post-closing indemnification for breaches of representations and warranties, its decision relied on OSI Systems, Inc. v. Instrumentarium Corp., 892 A.2d 1086 (Del. Ch. 2006) and Westmoreland (the New York Court of Appeals case referenced above), cases that did have post-closing indemnification with defined caps. The Chicago Bridge & Iron court declined to follow the Court of Chancery’s decision in Alliant Techsystems, Inc. v. Midocean Bushnell Holdings, L.P., where a buyer prevailed in convincing the court that GAAP noncompliance was within the ambit of the neutral accountant’s authority even though there was an overlapping indemnification claim.

In Northern Data, there was an indemnification cap of $2.7 million, so the determination that $22 million of up-front customer payments was “closing indebtedness” under GAAP exceeded the cap by almost $20 million! The only apparent way to reconcile Chicago Bridge & Iron and OSI, on the one hand, with Northern Data and Alliant Techsystems, on the other hand, is that, in the former cases, the definition of “Net Working Capital” did not expressly reference compliance with GAAP as a requirement. However, there is an argument this is a distinction without a difference because (a) the purchase price adjustment provision at issue in Chicago Bridge & Iron expressly required preparation and determination in accordance with GAAP; and (b) the definition of “Transaction Accounting Principles,” which was embedded in the purchase price adjustment in OSI, also required compliance with GAAP.

Both OSI and Chicago Bridge & Iron concluded a buyer could not circumvent the limitations on post-closing indemnification by accepting non-GAAP compliance at closing and then seeking recourse through the purchase price adjustment mechanism. That seems to be precisely what occurred in Northern Data.

Curiously, the court in Northern Data cited Chicago Bridge & Iron later in the opinion in support of its conclusion vacating the accounting expert’s determinations on the accounts receivable and accounts payables issues (on the grounds these were matters addressed by specific representations and warranties and not appropriate for the purchase price adjustment).

The court concluded the accounting expert lacked authority to determine that $1.2 million of accounts receivable should not have been included as a current asset in the Net Working Capital on the grounds that it “directly implicate[ed]” the accounts receivable representation in the SPA and was subject to the exclusive remedy provision governing indemnification claims, including the $2.7 million cap.

Similarly, the court concluded the accounting expert did not have authority to rule on the issue of whether a $3 million overdue electricity bill should have been included as “closing indebtedness” because it “directly implicat[ed]” the representation on outstanding indebtedness, falling into the indemnification / exclusive remedy bucket and outside of the purchase price adjustment process.¹¹

On these two issues, the court ruled:

Neither [item] involves a ‘change in [Target’s] business between the signing and the closing’ of the SPA.¹² Accounting Methodologies, or their application, have no bearing on resolving either issue. These are indemnity claims that involve legal issues: whether the [seller and target] complied with the representations [governing accounts receivable and indebtedness] in the SPA.

The Accounting Expert lacked the authority to resolve such matters. He was permitted by the SPA to [act] as an ‘expert, not an arbitrator’ ...

Instead, [these disputed items] implicate the exclusive remedy clause [] in the SPA ...

The Accounting Expert’s decision on [these disputed items] is therefore vacated.

Ironically, the court cited Chicago Bridge & Iron as support for its assertion “if every indemnification claim related to an accounting matter could be resolved through the [purchase price adjustment] process, the SPA’s cap on indemnity damages would be meaningless.” However, as stated above, it seems the same could be said for the accounting expert’s determination that $22 million of deferred revenue was closing indebtedness subject to the purchase price adjustment and not subject to the indemnification cap.

Lessons and reminders from Northern Data

GAAP

Sellers need to carefully examine whether all items within the ambit of the purchase price adjustment are compliant with GAAP. The stumbling block for the seller in Northern Data was the SPA language governing the purchase price adjustment expressly referenced “compliance with GAAP.” Even though the accounting expert’s determination was inconsistent with the historical accounting treatment of the target (and even though this historical accounting treatment was evidently reflected in an illustrative closing statement attached to the SPA), the deviation from GAAP resulted in a $22 million claw back for the buyer.

Sellers with historical accounting methodologies that are not GAAP compliant should reject a purchase price adjustment provision that requires a calculation in accordance with GAAP. Such sellers should instead require that the calculations be in accordance with the target’s historical financial statements, attaching an illustrative closing statement. This will increase the likelihood that post-closing complaints about non-GAAP accounting methodologies will stay in the exclusive remedy / indemnification bucket and will not leak into the uncapped territory of the purchase price adjustment provisions. With the provisions drafted this way, GAAP disputes are more likely to be treated like Chicago Bridge & Iron and OSI and less likely to be treated like Northern Data and Archkey.

Consider a cap

Another way to mitigate the risk of an unpleasant surprise (i.e., a whopping post-closing adjustment far in excess of the indemnification cap) is to place a specific cap on the amount of any post-closing adjustment. Although these are less common than indemnification caps, they are sometimes negotiated and may help sellers sleep better at night knowing that even in a doomsday scenario the pain of a post-closing adjustment will be capped.