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10675-341

Mergers and Acquisitions Disputes

A I C P A F o r e n s I C A n D V A l u A t I o n s e r V I C e s s e C t I o n P r A C t I C e A I D

Copyright © 2012 byAmerican Institute of Certified Public Accountants, Inc.New York, NY 10036-8775

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ISBN 978-1-93735-027-7


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Copyright © 2012, American Institute of Certified Public Accountants, Inc. All rights reserved.

Notice to ReadeRs

This publication is designed to provide illustrative information with respect to the subject matter covered. It does not establish standards or preferred practices. The material was prepared by the AICPA staff and volunteers and has not been considered or acted upon by AICPA senior technical committees or the AICPA board of directors and does not represent an official opinion or position of the AICPA. It is provided with the understanding that the AICPA staff and the publisher are not engaged in rendering any legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. The AICPA staff and this publisher make no representations, warranties, or guarantees about, and assume no responsibility for, the content or application of the material contained herein and expressly disclaim all liability for any damages arising out of the use of, reference to, or reliance on such material.

Acknowledgements

Mergers and Acquisitions Dispute Resolution Task Force

Robert Gray, Chair Jeff Litvak, Co-ChairJoe Arlinghaus Basil ImburgiaNeil Beaton Dr. William KennedyMatthew Bialecki Kevin KrebJames Brandt James NelsonMichael Cetrone Brian OngTroy Dahlberg Alan StoneEdward Dupke Gerry YarnallJennifer Heil

Task Force Alternates

Matthew Kipp Edward WestermanPaul Serritella

In addition, members of the 2010–2011 and 2011–2012 AICPA Forensic and Litigation Services Committee and Forensic and Valuation Services Executive Committee provided information and advice to the authors and AICPA staff for this practice aid.

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AICPA Staff

Jeannette Koger Elaine LeggettDirector Technical ManagerMember Specialization & Credentialing FVS Section

Barbara AndrewsProject ManagerFVS Section


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TAble ConTenTSnoTICe To ReADeRS 4

InTRoDuCTIon AnD SCoPe oF ThIS PRACTICe AID 8

Intent of This Practice Aid 8

ChAPTeR 1: oveRvIew oF MeRgeR AnD ACquISITIon TRAnSACTIonS AnD DISPuTeS 9

Mergers and Acquisitions 9Stages of M&A Transactions 11The Acquisition Agreement 15The Role of the Forensic Accountant in Preventing, Supporting, and Adjudicating

M&A Disputes 22

ChAPTeR 2: PoSTCloSIng PuRChASe PRICe ADjuSTMenTS 27

Overview 27Target Working Capital 28Preparation of the Closing Balance Sheet 29Objection Notice 30Access to Books and Records 30Basis of Accounting 31Adjustment to Target or Represent True Economic Change 33Subsequent Events 33Materiality 34Carve-Outs Not in Accordance With GAAP 35Common Areas of Working Capital Disputes 35Drafting Position Statements 37Roles for Accountants 37

ChAPTeR 3: eARnouT PRovISIonS AnD DISPuTeS 39

Introduction 39Mechanics of Earnout Adjustments 40Earnout Adjustments—Common Issues and Key Considerations 41Revenue Versus Net Earnings Stream 43Recordkeeping 45

ChAPTeR 4: MATeRIAl ADveRSe ChAnge ClAuSeS 47

Definition of a MAC 48Analyzing a MAC 49The Significance of the Event’s Impact on the Target Company 50Duration of the Event 51

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Disproportional Impact Relative to the Industry 51Unknown to the Party Seeking to Terminate the Deal 52Case Law Examples 52Valuation Issues to Consider in MAC Claims 54Summary of the Practitioner’s Role in Analyzing a MAC Claim 54

ChAPTeR 5: RePReSenTATIon AnD wARRAnTy DISPuTeS 55

Calculating Economic Damages—Indemnification Claims 55Indemnity Provisions in Acquisition Agreements 56Identification of Material Misrepresentations and Fraudulent

Misrepresentations 57Identifying Indications of How the Deal Was Done 58Measuring Damages: Dollar for Dollar Versus at the Multiple 60Key Considerations in Assessing Damage Amounts Under Indemnity

Claims 62Case Study: ABC Co. 65

ChAPTeR 6: Role oF The ACCounTIng neuTRAl 69

Introduction and Background 69Engagement Acceptance Issues 71Engagement Letter 74Arbitration Process 79Engagement Performance 84Fee Allocation 85General Guidelines and Professional Standards 85Enforceability of Awards 85

ChAPTeR 7: InTeRnATIonAl ConSIDeRATIonS 91

Introduction 91Overview 91Litigation Versus Arbitration 92Administration of the Dispute 92Procedural Rules of the Dispute 94Discovery 95The Role of Experts and the Presentation of Evidence 96Requirements for the Award 97Designation of Situs of Arbitration 98Choice of Substantive Law 98Interim or Conservatory Relief 99Damages in International Arbitration 99Punitive Damages 99


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Appeal and Enforcement 100Role of the Practitioner in International Arbitration Cases 100Conclusion 100

APPenDIx A: DeFInITIonS 101

Definitions for Merger and Acquisition Disputes 101


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iNtRoductioN aNd scope of this pRactice aid

Intent of This Practice Aid

The objective of this practice aid is to serve as a useful source of information for practitioners1 who provide merger and acquisition (M&A) dispute consulting services, whether as a neutral accountant, a consultant, or an expert witness. This practice aid will focus on the theoretical, legal, and accounting basis of M&A dispute consulting.

1 For purposes of this practice aid, the terms practitioners and forensic accountants are used throughout. Generally, these terms are used interchangeably. However, note that the term practitioner may be viewed more broadly as the CPA profession, whereas the term forensic accountant may be viewed in more narrow terms as those having requisite experience, training, and credentials, such as the AICPA’s Certified in Financial Forensics credential.


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Chapter 1: Overview Of Merger and aCquisitiOn transaCtiOns and disputes

Mergers and Acquisitions

The conjunctive term merger and acquisition (M&A) refers to transactions by which companies are combined through the purchase, sale, and combining of separate companies or assets thereof. M&A is typically consummated in an effort to accomplish financial objectives or help a company attain growth or market share within a particular industry or segment without having to organically create an additional business entity. During the first decade of the 2000s, over $14 trillion of M&A deals were completed globally, as described subsequently in chart 1.1.1

Chart 1.1: M&A Activity During the ’00s

—

2,000

4,000

6,000

8,000

10,000

12,000

14,000

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18,000

$ —

$500

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 #

of C

ompl

eted

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bal D

eals

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$ Volume # of Completed Global Deals

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Mergers and acquisitions are terms often used in conjunction with one another; however, the terms themselves are not synonymous. A merger is a legal term that refers to the absorption of one organization or corporation that ceases to exist into another that retains its own name and identity and that acquires the assets and liabilities of the former. 2 The term acquisition refers to gaining possession or control over a target company or its assets.

Business acquisitions may be accomplished by an asset purchase, a stock purchase, a merger, or some combination thereof.

Asset Purchases

An asset purchase is the acquisition of a company that is consummated by purchasing a portion or all of the assets directly from the target company itself, rather than by purchasing shares from the company shareholders. Only assets and liabilities specifically identified

1 Bloomberg.2 Black’s Law Dictionary.

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in the acquisition agreement of an asset purchase are transferred to the buyer, and any nonidentified assets and liabilities remain with the seller.3

Stock Purchases

A stock purchase is the acquisition of a company that is consummated by purchasing a controlling interest of its outstanding shares directly from the company shareholders. In a stock purchase, the seller will have no continuing interest in the assets and liabilities or operations of the target company, unless by seller minority interest or agreement of the parties.4

Merger

As previously discussed, a merger is the legal absorption of one organization or corporation that ceases to exist into another that retains its own name and identity and that acquires the assets and liabilities of the absorbed corporation. In a merger, companies contract directly with one another as opposed to contracting with their respective shareholders. Assets and liabilities are not exchanged between the parties to the merger. Instead, the transfer of assets and liabilities occurs by operation of law when a certificate of merger is filed.

Mergers may take on varying forms, including the following:

●● Forward merger. A forward merger is a merger in which the target merges into the buyer, and the target shareholders exchange their stock for the agreed-upon purchase price.

●● Reverse merger. A reverse merger is a merger in which the target corporation absorbs the buyer.

●● Subsidiary merger. A subsidiary merger (also known as a triangular merger or forward triangular merger) is a merger in which the target corporation is absorbed into the buyer’s subsidiary, with the target’s shareholders receiving stock in the parent corporation.5

●● Reverse subsidiary merger. A reverse subsidiary merger (also known as a reverse triangular merger) is a merger in which the buyer’s subsidiary is absorbed into the target corporation, which becomes a new subsidiary of the acquiring corporation.6

When one corporation is merged with another, and one of the two corporations operates as the combined corporation, that company is referred to as the surviving corporation. Conversely, when two corporations are merged, and the merged corporations cease to exist in favor of a newly established corporation, the new corporation is referred to as the successor corporation.

3 Modified Black’s Law Dictionary definition.4 See footnote 3. 5 See footnote 2. 6 See footnote 2.


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M&A transactions have two general categories of buyers: strategic buyers and financial buyers.

Strategic buyers acquire target assets or companies to enhance their existing business and operations. For example, strategic buyers may seek to acquire or purchase other companies in order to create a more competitive and cost-efficient company, diversify their product offerings, or gain market share within a particular industry or geographic location. The key motivation for combining two companies, from a strategic buyer’s perspective, is to create combined shareholder value greater than that of the sum of the stand-alone companies.

Among the driving forces for an M&A transaction for a strategic buyer are the anticipated synergies and the resulting perceived value enhancements of the combined entity. Synergies may include enhancements such as economies of scale derived from the transaction, overhead cost reductions, acquisition of new or improved technology or intellectual property, or improved market depth and visibility. Examples of some synergistic transaction strategies include the following:

●● Horizontal acquisition. A horizontal acquisition occurs when the two combining companies are in direct competition with one another, sharing similar product lines and product markets (that is, Beverage Co. A merges with Beverage Co. B).

●● Vertical acquisition. A vertical acquisition occurs when a company combines with a customer or supplier, forming an entity to create vertical integration (that is, Automobile Co. merges with Tire Co.).

●● Market-extension acquisition. A market-extension acquisition occurs when two companies selling the same products in different markets combine to form an entity (that is, Tire Co. East merges with West Coast Tires Co.).

●● Product-extension acquisition. A product-extension acquisition occurs when two companies selling different but related products in the same market combine to form an entity (that is, Screws & Nails, Inc., merges with Screwdriver & Hammers, Inc.).

Financial buyers acquire target assets or companies with the intent to realize value from an acquisition in excess of the purchase price. Typically, financial buyers seek to earn a return on their investment. They transact because they perceive opportunities to invest, enhance cash flow generation, and exit at a profit. Private equity firms are well-known examples of financial buyers.

Stages of M&A Transactions

The successful execution of an M&A transaction is an extensive exercise involving many stages. These stages range from the initial step of identifying or marketing potential transactions to the closing of the transaction and the resolution of any postclosing disputes that may arise. The following chart 1.2 illustrates the timing of the principal stages to an

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M&A transaction. Practitioners and forensic accountants may find these stages useful in their understanding of such transactions and of the potential disputes that may arise:

Chart 1.2: Timing of the Principal Stages to M&A Process

Throughout the preceding process, the transaction parties are responsible for ensuring that their interests are protected and served. Familiarity with the process that culminates in a completed acquisition is important to practitioners and forensic accountants who provide services in conjunction with M&A disputes. The following discussion is not intended to be an all-inclusive recitation of the M&A process. Rather, this discussion is an overview that highlights some of the key stages and issues that practitioners and forensic accountants may encounter when providing services in conjunction with M&A disputes.

Circulation of the Offering Memorandum and Confidentiality Agreement

A confidentiality agreement is a legally binding contract between the transaction parties. The confidentiality agreement details the confidentiality associated with the material and information provided to the prospective buyer, and it outlines the information provided and covered by the agreement, the term of the confidentiality period, the authorization of certain disclosures, employee solicitation restrictions, and other general restrictions regarding the prospective acquisition. A signed confidentiality agreement is ordinarily required to proceed with formalized financial due diligence, and it typically precedes or accompanies an offering memorandum.

The offering memorandum, sometimes referred to as the confidential information memorandum, is a summary document. This document is intended to provide fairly stated, concise, and relevant financial and operational information to prospective buyers that is necessary to evaluate a possible M&A transaction. The offering memorandum typically

12/31/X1and prior

4/30/X2 6/30/X2 9/30/X2 12/31/X2 2/28/X3 4/30/X3

NegotiationsPeriod

Pending Closing

Due DiligenceClosing Review (Buyer)

Seller’s Posclosing

Review

Closing Balance Sheet

Dispute Resolution (if needed)

InitiateNegotiations

Execution of Letter of

Intent

Execution of Acquisition Agreement

Closing Dateof Transaction

Presentation of Closing Balance Sheet to Seller(Prepared by

Buyer)

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Objection —Closing

Balance Sheet

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Due Diligence

Expiration of Period to Make

Claims for Indemnification

12/31/XX

Indemnity Claim

DisputeResolution (if needed)

Normal course assessment of postclosing purchase

price adjustmentsCirculation of historical

financial information about target via offering

memorandum or other means of interest solicitation


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contains an executive summary; an explanation of the offering; a listing of company risk factors; a discussion of the relevant industry and market; an overview of the company, its operations, and management; financial statements; an outline of the current ownership structure; and other pertinent company highlights.

The evaluation of the historical offering memorandum can often provide insight regarding the seller’s perspectives on the target’s business to forensic accountants who provide M&A dispute services. Information in the offering memorandum may also be relevant in an M&A dispute to the extent that it is a component that formed the basis of the purchase price.

Establishment of the Data Room

Prior to initiation of the due diligence process, the seller decides upon the documents and data to be provided to prospective buyers. Customarily, a data room is established to house the pertinent information that prospective buyers will evaluate during preliminary assessment of the proposed acquisition. Information in the data room often includes, but is not limited to, organization charts, management presentations, operational documents, financial statements, tax returns, accounting policies and manuals, legal documents, environmental documents, and other related documents pertinent to the transaction. The confidentiality of such information is typically governed by the confidentiality agreement executed by the seller and prospective buyer(s).

Due Diligence

In the lead-up to an M&A transaction, due diligence is conducted in order to assess the risks associated with the potential transaction. Due diligence is premised on inquiries made to understand the target’s business, its historical performance, and its future earnings potential. Legal, operational, financial, and environmental due diligence are all common types of due diligence, which may be undertaken in evaluating the deal. Typical due diligence activities include an evaluation of historical financial statements and management projections; an assessment of target management and operations; an evaluation of significant customers, contracts, and agreements; and an evaluation of contingencies, among other areas of financial and legal inquiry. Based on this due diligence, prospective buyers will conclude on a value of the target business and decide whether the acquisition aligns with their interests. Although due diligence continues subsequent to the execution of a letter of intent, the initial financial due diligence typically forms the basis of the initially agreed-upon purchase price memorialized in a letter of intent.

Evaluation of an inventory of the documents assessed during the due diligence process, due diligence reports prepared by financial advisors, and internal correspondence with respect to the due diligence process can often provide forensic accountants with valuable information about what was understood by the parties prior to close.

Negotiations Regarding the Purchase Price and Structure of the Transaction

After prospective buyers have had the opportunity to evaluate the merits of the acquisition, the seller will evaluate the proposals submitted. Upon evaluation of such proposals, the seller may select one particular proposal from a prospective buyer or negotiate further

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with select prospective buyers. At this stage in the process, negotiations often focus on the purchase price (that is, the consideration to be paid at closing, postclosing purchase price adjustments, and potential earnout provisions) and the transaction’s structure.

Signing a Letter of Intent

Eventually, negotiations may advance to the drafting and signing of a letter of intent. The letter of intent is a written statement detailing the preliminary understanding of parties who plan to enter into a contract or some other agreement.7 The letter of intent, which is typically nonbinding, ordinarily represents the starting point of contractual negotiations, outlining the agreement of the parties to that point regarding the purchase price, timing, structure, planned representations and warranties, and conditions for consummating or terminating the transaction.

Additional Due Diligence and Drafting of the Acquisition Agreement

After the parties have agreed in principle to the terms of the transaction, due diligence continues, and the drafting of the acquisition agreement proceeds. With respect to due diligence, the buyer will often expand its evaluation of financial and operational areas and conduct legal due diligence. Simultaneous with this effort, the buyer will begin drafting the acquisition agreement to reflect the terms described in the letter of intent and any negotiated modifications thereto.

Changes to the purchase price sought by the buyer, postclosing purchase price adjustment mechanisms, representations and warranties of the parties, conditions to closing the transaction, and indemnification terms are all areas that receive significant attention from both parties during the negotiation of the definitive acquisition agreement.

Closing the Transaction

At the closing date of the transaction, the parties cause the closing process described in the acquisition agreement to occur. In either an asset purchase or a stock purchase, this means that the seller causes the respective assets or stock to be delivered to the buyer in return for the consideration defined by the acquisition agreement. In a merger, this means that the parties cause the merger to be effected as a matter of law. Such activities necessary to close the transaction are commonly outlined in the “Conditions to Closing” section of the acquisition agreement, which is discussed later in this practice aid.

Postclosing Activities

Subsequent to the closing of the transaction, several activities remain open with respect to both parties, including postclosing due diligence, the calculation and settlement of postclosing purchase price adjustments and earnouts, and business integration. Following the close of the transaction, postclosing due diligence is conducted by the buyer. This phase of due diligence is to ensure that the buyer has acquired a business consistent with its understanding and the acquisition agreement. As part of this process, the buyer may

7 See footnote 2.


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learn of information important to its integration efforts, material information that was previously undisclosed, or information impacting the preparation of the closing balance sheet. When acquisition agreements incorporate postclosing purchase price adjustment or earnout clauses, both the buyer and seller may have contractual obligations postclose with respect to the preparation of materials necessary to calculate contractual adjustments to the purchase price. “The Purchase Price Adjustment” section addresses these elements of the acquisition agreement. For strategic buyers, integrating the acquired business with other operations may be among the most important and complicated postclosing activities.

Postacquisition disputes commonly arise regarding purchase price adjustments and earnouts or as a result of alleged breaches of representations, warranties, or covenants detected during the buyer’s postclosing due diligence. With respect to the latter, most acquisition agreements provide for indemnification of losses arising from such breaches.

The Acquisition Agreement

The acquisition agreement is the definitive contract detailing the terms of an agreed-upon transaction between parties to purchase, sell, or combine separate companies or the assets thereof. The form of the acquisition agreement depends on what is being acquired. Asset purchases and stock purchases are accomplished via an asset purchase agreement or a stock purchase agreement, respectively. Acquisition agreements commonly feature many of the same elements, although these elements invariably differ in exact contents from one transaction to the next. The following discussion does not purport to be a comprehensive itemization of the different components of acquisition agreements. Rather, the following discussion highlights relevant components of acquisition agreements that forensic accountants may encounter when providing services in conjunction with an M&A dispute.

Recitals

The “Recitals” section of the acquisition agreement enumerates the parties to the agreement and their desire to transact.

Definitions

Often, the acquisition agreement incorporates a “Definitions” section that defines terms appearing within various components of the contract. Forensic accountants encountering acquisition agreements should carefully examine the “Definitions” section. In agreements incorporating a “Definitions” section, key terms such as closing date, purchase price, working capital, GAAP, accounting policies and procedures, ordinary course of business, material adverse change, or material adverse effect may be defined. Even when a “Definitions” section exists, terms may also be defined within the body of the agreement.

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Sale and Transfer

Acquisition agreements typically follow “Recitals” and “Definitions” sections with a “Sale and Transfer” section that sets forth the terms and structure of the M&A transaction. Specifically, this section of the agreement is meant to

●● identify the business interest, assets, or shares to be exchanged and the structure of the transaction (that is, stock purchase, asset purchase, merger, and so on).

●● set forth the closing process and timing.

●● document the agreed-upon purchase price amount.

●● document any purchase price adjustment contemplated by the parties and define the related purchase price adjustment mechanism.

To the extent that the transaction is structured as an asset purchase subject to an asset purchase agreement, this section will identify the corresponding assets and liabilities subject to the agreement. If the acquisition is structured as a stock purchase governed by a stock purchase agreement, this section will identify the shares to be sold.

Closing Date

The “Closing Date” section identifies the specific time, date, and location of when the transaction is scheduled to close. In addition to identifying the logistics associated with the closing date, this section of the agreement typically identifies the obligations and deliverables of both parties at the time of the closing date, such as stock certificates, releases, employment agreements, noncompete agreements, and forms of payment (for example, wire transfer information, cashier’s check, promissory note, and so on).

Purchase Price

The scope of the “Purchase Price” section varies from agreement to agreement in terms of the depth of the discussion. However, this acquisition agreement section generally addresses (a) the consideration to be exchanged associated with the assets and liabilities to be acquired in the transaction and (b) the components to the purchase price (that is, the consideration to be paid at closing, postclosing purchase price adjustments, and any earnouts).

When disputes over M&A transactions arise, how the parties to the transaction arrived at the agreed-upon purchase price is frequently a relevant consideration for the forensic accountant.

Purchase Price Adjustment

Another feature common to acquisition agreements is the purchase price adjustment or adjustment amount provision. Depending on the negotiation of the parties and the structure of the transaction, the form and calculation of the purchase price adjustment mechanism may vary. However, in general, the purpose of the purchase price adjustment is to


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compensate the parties for variations in a balance sheet measure (for example, inventory, working capital, net assets, or some modified version thereof) at the closing date from a contractually defined target amount, commonly referred to as the peg.

The calculation of the purchase price adjustment is performed using information contained in a closing statement or closing schedule prepared as of the closing date. The initial estimated closing statement, which frequently takes the form of the balance sheet of the target company, is typically prepared by the seller, who possesses all the accounting records of the target until the close. Depending on the agreement, this estimated closing statement may affect the consideration exchanged at the closing. The seller typically prepares the estimated closing statement a few days prior to closing, and the payments at closing are based on the estimates set forth in the estimated closing statement.

Subsequent to closing, either the buyer or seller (depending on the terms of the agreement) will deliver to the transaction counterparty a “true-up” of the initially estimated closing statement. (The buyer typically provides this document because it usually has access to the target’s records subsequent to closing, and the seller does not have such access.) This document, the closing statement, may be audited or certified by an officer of the company. Acquisition agreements typically afford the preparer of the closing statement 15–90 days to complete its work and deliver its closing statement to the counterparty.

Upon receipt of the closing statement, the recipient is normally granted a period of access to the accounting records necessary to evaluate the closing statement and to identify any disputes related thereto. Disputed items are typically required to be identified in reasonable detail in an objection notice within a window of time after closing. Following an objection notice, the dispute resolution period ensues. During this period for dispute resolution, the buyer and seller will work to resolve disputed items. If such items cannot be resolved during this period, the acquisition agreement will likely address the procedures available to the parties for purposes of alternative dispute resolution (ADR). Often, the acquisition agreement identifies the role of a neutral accountant to participate in the resolution of disputed items.

Earnout Clauses

Earnout clauses are sometimes incorporated into acquisition agreements as a means to make a portion of the consideration to be paid to the seller contingent on the future performance of the target’s operations. Such clauses can be effective at bridging perceived value gaps between buyers and sellers. Typically, an earnout involves both accounting and financial reporting issues. As such, practitioners are commonly involved in the drafting of the earnout provision in the acquisition agreement, and subsequently, forensic accountants are often involved in determining the performance outcome and its related impact on the purchase price.

Representations and Warranties

The “Representations and Warranties” section of the acquisition agreement provides protection to both the buyer and the seller with respect to the transaction. Representations

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are statements of past or existing facts. Warranties are promises that existing or future facts are or will be true. The representations and warranties made by the seller are typically among the most lengthy and negotiated elements of an acquisition agreement.

The representations and warranties made by the seller serve three primary purposes. First, they are designed to be informational to the buyer with regard to the seller’s operations. Representations and warranties accompanied with the buyer’s due diligence enable the buyer to understand the seller’s operations prior to the execution of the acquisition agreement. Second, the representation and warranties may provide predicates for allowing the buyer to terminate the transaction subsequent to the execution of the acquisition agreement and prior to the closing date. Third, the representations and warranties serve as a framework for the seller’s indemnification obligations made to the buyer subsequent to the closing date.

Some examples of representations and warranties often made by the seller are that the organization is in good standing, the historical financial statements provided to the buyer are in accordance with generally accepted accounting principles (GAAP), the books and records of the target are fairly stated in all material respects, all known material liabilities have been disclosed, the assets are of a certain agreed-upon quality, and no material adverse change (MAC) or material adverse event has occurred.

Covenants

Preclosing covenants represent promises and agreement between the parties to do or not do something during the time period between the agreement execution and the transaction closing date. Such covenants are either made by the seller or buyer, and such covenants are either of the affirmative or negative nature.

Affirmative covenants obligate a particular party to perform certain actions during the period between the execution of the acquisition agreement and the closing date. Such affirmative covenants may include obtaining the necessary approvals from board members or regulatory agencies; providing access to the appropriate documents, including books and records; and filing all appropriate financial documents and forms of the target company.

Negative covenants are designed to protect the buyer by precluding the seller from taking certain actions that could impact the target company between the execution of the acquisition agreement and the closing date. Such negative covenants may include not altering accounting methodologies or tax-filing positions, not entering into contractual obligations outside the ordinary course of business, not declaring or distributing dividends or distributions to members, and not acquiring or divesting assets outside the ordinary course of business. Ultimately, the preclosing covenants are meant to ensure that the seller runs the operations of the target in the ordinary course of business until it is turned over to the buyer at the closing date.

Conditions to Closing

The acquisition agreement customarily outlines actions and obligations of both the buyer and seller that are necessary in order for the transaction to close. Absent the performance


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of such actions and obligations, a potential opportunity exists for a party to walk away from the transaction prior to the closing date. Customarily, the agreement will address conditions and obligations relating to the accuracy of the representations made by both parties, the attainment of appropriate consents and approvals, the process for due diligence and document access, and the ability to obtain financing for the transaction. In addition, the conditions to closing may be subject to a materiality qualification. This provision prohibits a party from attempting to terminate the transaction by relying upon an inconsequential breach of the representations.

Indemnity Clause

Most agreements include an indemnity clause that intends to protect the buyer from loss associated with the seller’s failure to perform in certain respects, as described in the Acquisition Agreement. For example, the indemnity clause typically protects the buyer against breaches by the seller of covenants, representations, or warranties (for example, the failure to operate the business in the normal course, the failure to disclose material information, or a misrepresentation of a material fact) that were undisclosed by the seller and discovered subsequent to the closing date by the buyer. The indemnity clause may also provide a mechanism for recovery related to matters for which the seller agrees to retain responsibility postclosing (for example, pending litigation or an environmental liability). The indemnity clause may include provisions protecting the seller from claims for indemnification regarding matters that were disclosed to the buyer pursuant to the acquisition agreement’s representations and warranties prior to the closing date.

Typically, the period for making certain claims under the indemnity clause will be for a defined time period negotiated and agreed upon by the parties. Exceptions to the time limit may exist related to certain matters, including environmental matters, fraud, and tax-related issues. In addition to a time period, the indemnification clause may include language for a cap, “basket,” or deductible. In the case of a cap, a maximum amount of liability to which seller can be exposed by entering the transaction is contractually established. This cap limits the potential amount that may be claimed by the buyer under the indemnity clause.

In acquisition agreements reflecting “basket” or deductible amounts, the buyer’s damage or losses claimed must meet or exceed a certain threshold before the seller is liable for any such items. In the case of a “basket,” the seller becomes liable for the total amount of losses claimed once the “basket” threshold amount is met or exceeded. Alternatively, when a deductible exists, the seller will become liable for indemnity losses only to the extent that such losses exceed an agreed-upon deductible amount.

Disclosure Schedule

The disclosure schedule is typically included as an appendix to the agreement and is used to specifically identify disclosed items pursuant to the representation and warranties. Commonly, the disclosure schedule will address such matters as excluded assets or liabilities, environmental matters, legal proceedings, material agreements or contracts, and tax matters. Items identified in the disclosure schedule are often intended only to qualify and limit the representations and warranties made by the seller in connection with the

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acquisition agreement. Typically, these items represent areas for the buyer to concentrate due diligence efforts in order to further understand the disclosed items.

M&A Disputes

Although M&A disputes are unique from one transaction to the next, they are not amorphous, and they commonly arise from one (or more) root causes of disagreement. Depending on whether the contemplated transaction has closed, M&A disputes may be classified as preacquisition or postacquisition. Preacquisition disputes occur when one party seeks to withdraw from a transaction (without the counterparty’s agreement) subsequent to the execution of an acquisition agreement but prior to the transaction’s close. Conversely, postacquisition disputes arise subsequent to the close of the transaction and will typically result from either (a) a disagreement over the execution of postacquisition terms of the agreements (for example, the calculation of postclose purchase price adjustments or earnouts) or (b) an alleged breach of contract by one of the parties.

Preacquisition Disputes

By their definition, preacquisition disputes are disputes that emerge prior to the close of a transaction. Preacquisition disputes occur when one party elects to withdraw (against the other party’s wishes) from an agreed-upon transaction prior to its close. Specific reasons for such withdrawal may vary significantly. However, the overall basis for withdrawal after a contract has been signed is commonly either the alleged occurrence of a MAC or an alleged fraud by the counterparty. When a party withdraws for either of these reasons, disputes about the basis of its withdrawal and resultant economic damages incurred often ensue.

Many agreements incorporate MAC clauses, which allow for either party to withdraw from the transaction before the close of the deal. Either party may withdraw in the event that a material adverse change, event, or effect occurs that damages the counterparty’s business. These provisions are included in agreements to protect the parties to a transaction during the interim period between the time that an agreement is executed and the time that a deal closes. When a party withdraws from a merger, an asset, or a stock purchase agreement, it is often because that party believes that a MAC, as defined by the agreement between the parties, has occurred.

When a party invokes a MAC clause, the forensic accountant may be called on to assist in an evaluation of the asserted MAC. This area of dispute is addressed in further detail in chapter 4, “Material Adverse Change Clauses,” of this practice aid.

Postacquisition Disputes

Postacquisition disputes arise subsequent to the close of the transaction. These disputes may involve disputes over contractually prescribed adjustments to, or components of, the purchase price, as well as claims for indemnification from alleged breaches of representations and warranties.


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Purchase Price Adjustment Disputes

Purchase price adjustments arise in transactions because the target continues to operate the business from the time of the agreement until the closing of the transaction. Due to the passage of time and the seasonality of some businesses, the assets and liabilities of the target company will fluctuate—at times significantly. To address this fluctuation and its potential impact on the value of the target at the time of the close, agreements often incorporate a purchase price adjustment (as previously discussed). The purchase price adjustment attempts to account for changes in the target’s financial position (for example, working capital, net assets, or some other financial metric) between the preclosing balance sheet available when the agreement was signed and the final closing-date balance sheet. The calculation of these adjustments frequently results in postacquisition disputes.

Many agreements require that the closing-date balance sheet be prepared in accordance with GAAP consistently applied for some historical period or point in time predating the transaction. This requirement often leads to disagreements regarding which accounting treatment constitutes GAAP, which accounting treatment complies with the requirement of consistent application, and which contractual requirement should be applied to calculate the closing balance sheet when compliance with both the GAAP and consistency provisions is not possible. Other commonly encountered disagreements include whether the closing balance sheet should be prepared using accounting procedures historically employed at interim dates or closing dates and whether the preclosing-dated balance sheet (that is, the working capital or net asset “peg”) should be adjusted. These areas of dispute are addressed in further detail in chapter 2, “Postclosing Purchase Price Adjustments,” of this practice aid.

Earnout Disputes

As previously discussed, earnout clauses are incorporated into agreements as a means to base some portion of the purchase price on the future performance of the target’s business. By the very nature of their structure, which compensates sellers based on some measure of future performance as operated and accounted for by the new owners, measurement of the purchase price adjustments from earnout provisions can be the source of contention. This area of dispute is addressed in further detail in chapter 3, “Earnout Provisions and Disputes,” of this practice aid.

Claims for Indemnification

Claims for indemnification typically arise as a result of alleged breaches of representations or warranties by the seller, whereby the buyer seeks indemnification for losses incurred as a result of the alleged breach. In a claim for indemnification, the buyer will seek recovery of economic losses adequate to return the buyer to the financial position it would have been in but for the alleged breach. Depending on the nature of the alleged breach, claims for indemnification may result in dollar-for-dollar damages to recover out-of-pocket losses or damages subject to a multiplier in situations when a buyer can demonstrate that it overpaid for the target based on the alleged breach. As previously discussed, recoveries from claims for indemnification may be subject to both contractual deductibles and contractual caps.

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This area of dispute is addressed in further detail in chapter 5, “Representation and Warranty Disputes,” of this practice aid.

The Role of the Forensic Accountant in Preventing, Supporting, and Adjudicating M&A Disputes

Practitioners provide a number of professional services to parties in M&A transactions, including assisting other business professionals and attorneys with valuing the target; assessing the general, tax, and accounting considerations; reviewing the transaction’s structure; evaluating financing; performing due diligence; and facilitating postmerger integration. In addition to providing these services, practitioners and forensic accountants are frequently retained by parties to M&A transactions to help prevent, support, and adjudicate M&A disputes. In doing so, practitioners and forensic accountants help the transaction parties avoid costly disputes or enhance and expedite dispute resolution when disputes arise.

Professional services in support of the prevention, support, and adjudication of M&A disputes are considered consulting services subject to Statement on Standards for Consulting Services No. 1, Consulting Services: Definitions and Standards (AICPA, Professional Standards, CS sec. 100), and the AICPA Code of Professional Conduct.

In general, forensic accountants are sought out in M&A dispute engagements to provide an objective analysis and accounting and consulting expertise. In addition to the general body of business valuation and forensic accounting knowledge for which CPAs are recognized, specialized training and experience in forensic accounting and business valuation may assist the CPA in M&A dispute engagements.

CPAs who are Certified in Financial Forensics (CFF) by the AICPA possess fundamental and specialized forensic accounting skills. These skills are developed through practice in service areas, including economic damages; fraud prevention, detection, and deterrence; financial statement misrepresentation; and valuation. These skills can be important when consulting on M&A disputes, which often involve several of these competencies.

Likewise, CPAs who are Accredited in Business Valuation (ABV) by the AICPA undergo rigorous training and examination to become credentialed. These CPAs possess skills and experience in business valuation. Because valuation of the subject or target company is often a significant area of contention in M&A disputes, the CPA who has obtained the ABV designation can be a valuable resource to the parties in an M&A dispute.

Practitioners and forensic accountants are asked to provide professional services in the prevention, support, and adjudication of M&A disputes, including the following:

●● Contract vetting

●● Dispute support

●● ADR arbitration and mediation


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Contract Vetting

Prior to executing an acquisition agreement, practitioners may be asked to evaluate the financial and economic components of the transaction either as part of the buyer’s due diligence process or as part of the seller’s deal evaluation. The practitioner’s role in such engagements is to provide consultation to assist the retaining party in its assessment of the transaction and to identify potential areas of disagreement requiring contract modification.

Buyers conduct due diligence to understand the potential risks associated with the transaction. This process includes, but is not limited to, an evaluation by finance and accounting professionals of the target company’s historical and current financial statements and an assessment of past, present, and projected performance of the target.

In an asset acquisition, the due diligence assessment incorporates procedures designed to confirm the quality, existence, and earnings potential of the target assets. In a stock acquisition, due diligence may be conducted to

●● confirm the existence of the assets and liabilities described in the financial statements.

●● identify and quantify unrecorded liabilities.

●● assess the reasonableness of significant management estimates (for example, reserves).

●● understand the quality of historical earnings.

●● identify significant nonrecurring or nonoperating events that have impacted historical earnings.

●● understand the consistency of the seller’s historical accounting.

Based on what information is gathered in the due diligence process, a prospective buyer may alter its bid; propose a contractual carve-out of certain assets, liabilities, and contingencies; request modifications to the postclosing purchase price adjustment mechanism; or negotiate additional contractual representations and warranties to be made by the seller.

Dispute Support

Forensic accountants are frequently engaged by one of the parties to the transaction to support the dispute process as financial advisors. Typically, forensic accountants engaged in such a role assist their client in the following areas:

●● Identification of dispute items

●● Discovery

●● Claims analysis

●● Presenting positions to support testimony

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Identification of Dispute Items

Forensic accountants may be engaged to perform an evaluation of the closing balance sheet as part of the postclosing purchase price adjustment mechanism, identify areas that may not comply with the contractual requirements for the preparation of the closing balance sheet, or assist in communicating a potential dispute item to the counterparty in the transaction.

Discovery

Discovery is a step in the dispute resolution process whereby each party requests relevant information and documents from one another in an effort to discover information relevant to the dispute. Forensic accountants may be asked to assist buyers or sellers (and their respective legal counsel) to identify the pertinent documents and financial records that should be requested from the opposing party during the discovery process. Such documents and records are requested in order to substantiate or defend against disputed items. Requesting the appropriate documentation during this phase can be important to successfully navigating the dispute resolution process. Often, the level of discovery afforded to the parties in dispute is hotly contested.

Claims Analysis

If an M&A dispute ensues, forensic accountants may be asked to perform analyses regarding the claims set forth. For instance, forensic accountants are often being asked to help assess whether a party’s specific claim conforms to the contract and to perform research and analyses to substantiate a party’s position. As part of such an analysis, forensic accountants may be asked to calculate the economic damages sustained and, if appropriate, assess the impact of such damages on the purchase price. They may further be asked to perform an analysis to help inform a client about the likelihood of prevailing if a claim is pursued. Forensic accountants may be asked to perform claims analysis as consulting experts or for purposes of testimony.

Presenting Positions to Support Testimony

In the event that a dispute cannot be resolved by the parties, forensic accountants may provide testimony at arbitration or trial. Depending on the nature of the dispute, this testimony might address topics including, but not limited to, the target’s adherence to GAAP; consistent practice; the calculation of postclosing purchase price adjustments, such as working capital or contractual earnouts; and the measurement of economic damages from alleged breaches of representations and warranties.

ADR Arbitration and Mediation

ADR may be used in M&A disputes as an alternative to litigation. ADR may be favored by parties as a more cost-effective, timely, and private manner to resolve disputes. Two forms of ADR are arbitration and mediation. Depending on whether arbitration or mediation is used, the parties will employ one or more neutral third-party arbitrators or a mediator to address the disputed items among the parties.


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In addition to the services previously discussed, forensic accountants engaged in matters employing ADR can provide insight and expertise to the client in the process of selecting the appropriate ADR forum, as well as the appropriate type of qualifications to seek in a third-party neutral arbitrator or mediator. For example, should the arbitrator or mediator be an accountant, an attorney, an industry expert, or a retired judge? Depending on whether the matter is being litigated, forensic accountants engaged in an ADR matter may have the ability to perform an analysis of the potential claims to support settlement negotiations. Unlike matters in litigation (in which the forensic accountant is unlikely to be involved in settlement discussions), professionals consulting in matters employing ADR may assist the client and legal counsel in seeking a mutually acceptable outcome for both parties through settlement negotiations.

Arbitration

In arbitration, one or more third-party neutral arbitrators are engaged to act in a similar capacity to a trier of fact. Parties to the dispute present the facts surrounding their dispute to a neutral arbitrator, or arbitrators, who considers the information presented and adjudicates the dispute. Typically, the ruling set forth by the neutral arbitrator is binding, unless a nonbinding arbitration is specifically set forth in the acquisition agreement.

As previously discussed, forensic accountants are engaged in M&A disputes to serve in a dispute support capacity, which may include a consulting or testifying role. In engagements that result in arbitration, the forensic accountant may be requested to testify to a neutral arbitrator at a hearing.

Practitioners may also be engaged by both parties to serve as neutral arbitrators and to ultimately adjudicate the M&A dispute. Often, M&A agreements between the parties specifically require a CPA to be retained as an arbitrator to adjudicate certain types of disputes. In these situations, M&A agreements may clearly define the arbitration process to be followed by the arbitrator, or they may provide little or no direction. It is not uncommon for forensic accountants engaged as arbitrators to outline the arbitration process, inclusive of identifying documentation to be exchanged by the parties, outlining a process for exchanging statements of position with respect to disputes, and to set hearing procedures and timing. Refer to chapter 6, “Role of the Accounting Neutral,” of this practice aid for additional information with respect to the role of the neutral arbitrator.

Mediation

In matters in mediation, the parties present their disputes before a mediator who does not adjudicate the disputes (as would be performed in arbitration). Rather, the mediator facilitates a discussion in an attempt to resolve the dispute among the parties. Mediation can be conducive to successful dispute resolution because the parties are brought together in a neutral environment where disputes can be freely and confidentially presented and evaluated before a neutral third-party mediator. The mediator then attempts to facilitate a resolution. In engagements that result in mediation, the forensic accountant may be asked to present to the mediator and opposing party the related facts and issues to a dispute on behalf of the client party.

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Forensic accountants are also commonly engaged in M&A disputes to serve as mediators because they have the necessary business and accounting expertise to assist parties in resolving their disputes and because they have experience in such disputes. In such engagements, the CPA mediator does not rule on the dispute but, rather, assists the parties in reaching a resolution. The goal of mediation is to allow the parties to resolve the disputes among themselves, rather than incur the time and cost of arbitration or litigation.

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