Volatility, disruption and fraud: the making of a modern M&A dispute

A RESEARCH PAPER BY BRGBerkeley Research Group

About BRG Berkeley Research Group is a leading global strategic advisory and expert consulting firm that provides independent advice, data analytics, authoritative studies, expert testimony, investigations, and regulatory and dispute consulting to Fortune 500 corporations, financial institutions, government agencies, major law firms and regulatory bodies around the world.

Our experts combine intellectual rigour with practical experience and an in-depth understanding of industries and markets. Their expertise spans economics and finance, data analytics and statistics, and public policy in many of the major sectors of our economy, including healthcare, banking, information technology, energy, construction, and real estate.

Named by Forbes as one of America’s Best Management Consulting Firms in 2016, BRG is headquartered in Emeryville, California, with offices across the United States and in Asia, Australia, Canada, Latin America, the Middle East, and the United Kingdom.

Litigation and arbitration services Our litigation and arbitration experts provide independent and objective analyses, litigation support, and expert testimony on damages issues in prominent litigation cases in court proceedings, arbitrations, and mediations, and before governmental agencies. Our commercial litigation and damages services are primarily focused on allegations and issues relating to disputes in antitrust, intellectual property, securities, healthcare and pharmaceuticals, financial reporting, labour and employment, contract, business interruption, and mergers and acquisitions.

Post transaction and shareholder disputes servicesOur experts have helped resolve hundredsof post transaction and shareholderdisputes. We have a deep and up-to-dateunderstanding of transactions and theaccounting and financial aspects of closingmechanisms. This knowledge is necessaryto identify key issues in disputes and to linkthem into the quantification of damages orinvestigations of fraud.

In essence, most private M&A disputes relate to disagreement over “value” transferred from seller to buyer at closing. The target may be worth less than what the buyer paid for (for example because it becomes clear that the target’s future earnings will be lower than expected, or liabilities were concealed). This could be either by accident or design.

Cross-border M&A and LBO transactionsthat end up in disputes are often resolvedthrough international arbitration. BRG experts often work on the quantification of damages and forensic accounting matters in arbitrations, including matters related toclosing accounts, breach of warranty, fraud,and earn-out disputes. We work as advisorsor expert witnesses. Where appropriate, wework closely with other experts, for examplein construction, investigations, or forensictechnology.

Copyright ©2016 by Berkeley Research Group, LLC. Except as may be expressly provided elsewhere in this publication, permission is hereby granted to produce and distribute copies of individual works from this publication for non-profit educational purposes, provided that the author, source, and copyright notice are included on each copy. This permission is in addition to rights of reproduction granted under Sections 107, 108, and other provisions of the U.S. Copyright Act and its amendments.

Disclaimer: The opinions expressed in this publication are those of the individual authors and do not represent the opinions of BRG or its other employees and affiliates. The information provided in the publication is not intended to and does not render legal, accounting, tax, or other professional advice or services, and no client relationship is established with BRG by making any information available in this publication, or from you transmitting an email or other message to us. None of the information contained herein should be used as a substitute for consultation with competent advisors.

A few weeks after closing, the target’s

management requests additional cash

to cover unexpected operating losses

$

18 months after the deal closes, the owner manager of the target sues over his earn-out

Long-term contracts initially valued

at millions of euros discovered to be

worth a fraction of that amount

European country near the target

elects ultra right wing leader. Bond

yields move sharply

What could possibly go wrong?

Purchaser discovers that the target

has been the victim of industrial

espionage

A whistleblower calls the purchaser

shortly after closing and mentions

social security fraud

100,000 of the target’s customer accounts get hacked

C H A N C E

A forensic analysis of the target’s

accounts uncovers fabricated invoices

Purchaser accountants become suspicious about the level of the

target’s provisions

Political uncertainty causes the buyer’s

home currency to crash. Earn-out

payments become more expensive

After the transaction is signed, but before it is closed, the largest

customer of the target decides to take its business elsewhere

?

$

ForewordAt BRG we have seen more than our fair share of disputes arising from mergers and acquisitions. These disputes are time consuming, costly and best avoided. This paper focuses on post M&A disputes, how they come about and some of the ways dealmakers can avoid them.

If we had to give just one bit of advice about how to avoid a dispute it would be this: make sure everyone on your team works together and communicates effectively.

This may seem banal, but we have seen hundreds of disputes that took place because a lawyer forgot to share a clause in a document with an accountant, or because a risk expert didn’t look over an accountant’s assumptions.

This risk of avoidable error is multipliedin cross border disputes where localpractices differ. For example, in Europemost deals now close using a mechanismcalled a “locked box”, a practice that isvery rare in the US. Conversely,representations and warranties insurancehas long been a common feature of USdeals, but has only recently caught on incontinental Europe.

As a result, this paper includes the perspectives and views of many different BRG experts from across our global practice. We hope you find it interesting and would welcome your feedback.

Volatility. Disruption. Fraud. Dispute.

Author: Heiko Ziehms

Edited by James Lumley

Thank you for the helpful comments from: Anna Baird, Matthew Caselli, Ron Evans, Ben Johnson, Amy Kingdon, Eric Miller, James Rusden, Alice Sheridan and the experts interviewed for this paper.

Interest rate environment and the valuation of liabilitiesDebt, both on and off balance sheet, plays an important role in M&A disputes and fraud cases. Real interest rates have been exceptionally low for a significant period of time, and even negative in some large economies. Low interest rates are causing long-term liabilities on company balance sheets to increase. They are creating record pension deficits which in turn weigh on deals. And extremely low interest rates also affect long held practices in valuation, both when valuing a transaction or quantifying damages.We focus on this in the section on debt PAGE 16 to 18

Completion mechanismsAll of the factors listed above have led todisputes that BRG experts have worked on.But where are these mistakes made andwhere is the smoking gun?

For dealmakers, the deal’s blueprint is the SPA. In M&A disputes the SPA is mostoften – though by no means always – the battleground. A key part of the SPA is the completion mechanism. The following article explains more.

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Elements of a dispute Disruption and volatility One frequent element of an M&A disputeis disruption – the unexpected creeping into a deal.

Curve-ball events often lead to breaches of representations and warranties or alleged material adverse effects. Surprised buyers tend to look for reasons for their surprise, and, because humans make mistakes, lawyers and accountants who get paid to uncover inconsistencies and errors, tend to find them.

Unsurprised buyers tend not to question the deal they have just done, and so sleeping dogs are allowed to lie. It is safe to assume that many breaches of warranties and even frauds go unnoticed.

Unexpected events can impact final pricesin unexpected ways, and the world in which we are living at the moment appears to be one where the unexpected is increasingly becoming a factor. The markets, as we all know, were wrong-footed by the UK electorate’s decision to leave the European Union. The market volatility that followed the Brexit vote is a testament to that.

Companies with large exposure to foreign exchange rate movements have been affected considerably. This type of market volatility has found its way into valuations of companies and measurements at closing.

Add to that technology-induced volatility,such as flash-crashes and hackedcustomer data and it is plain to seethat there are an increasing number ofvariables that can cause nasty surprises,leading to disagreement over accountingmeasurements when setting the finalprice or so-called material adversechange (MAC) events, which often lead torenegotiations of prices after signing theSale and Purchase Agreement (SPA).We discuss these on PAGE 10

OverconfidenceHuman frailty and fallibility is a constant.There have always been, and will always be, sellers who get “deal fever” and ignore due diligence red flags, only to regret it later. Overconfidence in decision-making is a major contributor to post deal disputes. In our experience, buyers systematically overestimate their knowledge and ability to make a transaction a success.

Buyers who overestimate how well they understand the target and its marketsare likely to make technical errors. They are also likely to underestimate the challenges they may face when integrating their acquisition. This is why many deals fail, disappointment may well set in after closing, and dispute could be the result.We highlight the perspective of abehavioural economist on PAGE 9

AmbiguityEven level headed sellers are likely to takean optimistic viewpoint when preparingtheir accounts pre M&A. This is to beexpected as accounting, after all, allows agreat deal of scope for judgment. Disputesoften arise where judgment goes beyondoptimism into bias and outside of acceptable ranges of estimates.

Nowhere is ambiguity or subjectivity intransactions more relevant than in thetarget’s projections and in the accountingfor working capital and provisions.We discuss this theme on PAGES 16 to 18

Fraud Sometimes bias can cross into intentional misrepresentation, and intent is what often suggests fraud.

Fraud is particularly difficult to detectbefore signing. We, however, highlight a number of red flags. Overly complicated documentation might suggest a fraud is taking place. Earnings that don’t convert into cash is another hallmark. Also, if a seller is restricting the information it disclosed to the buyer, it might be a sign that they have something to hide.

Fraud most often affects revenue recognition and the recognition of earningswhich are the basis of price. We discuss this on PAGE 11

Learning to love completion mechanisms

6

Whether a dispute is caused by fraud,ambiguous wording in the SPA, or just changed circumstances, the battleground is often the SPA, and the devil really is in the detail.

Anybody who has ever been involved in thenitty-gritty of an M&A transaction knows that they can be fraught and pressure-fuelled processes. Principals and their advisors (accountants, lawyers, bankers, consultants), under the pressure of extremely tight deadlines, must deal with complicated technical issues that span disciplines and workstreams. At thebest of times, the atmosphere is collegiate,at the worst: outright adversarial.

Once the SPA is signed, closing conditions need to be met. The closing period is a time in which target, purchaser and vendor continue to trade. Or maybe one of them goes bankrupt. Management might change. Legal disputes that the target is engaged in may be resolved. New ones may start. Markets might fall. Or rise. Regulators will scrutinise the deal. Key managers or customers may leave. Large construction projects that the target is engaged in may be delayed or cancelled. The target may even be the victim of a cyber attack. All these things can, and do, happen.

Much can happen in weeks, months or ayear.

And then, when the closing conditions are met, the lawyers and accountants who

worked on the SPA spring back into action and interpret the SPA as they draw up thecompletion accounts. What has changed? What does the SPA say must be done in the event of such a change? These are among the reasons why completion of an M&A deal can be extremely complex.

The transaction timelineThere are many reasons why complex M&Atransactions do not sign and close on thesame day. Transactions are often subjectto antitrust and other regulatory approvals.Increased vigilance from regulatoryand antitrust authorities takes time. Closing conditions are set out in the SPA. And so, after signing, an M&A deal will usually go into a closing period before all the conditions are met and the transaction closes.

The closing period is often weeks or a few months, but can be significantly longer, especially in highly regulated industries.This time lag means that there isuncertainty at signing as to the precisebalance sheet at closing. The longer theclosing period, the greater the uncertainty. It is also difficult to predict the exact length of the closing period at signing. This introduces an additional source of uncertainty.

Daily changes in the balance sheetmean that more, or less, value could betransferred at closing than the partiesbargained for. The parties, therefore, needa mechanism in place to ensure that the

Signing

Closing period Post-closing period

ClosingIntent to do

the deal

Final purchase

price

Diagram: Transaction timeline

7

value transferred at closing corresponds towhat the parties bargained for when theysigned the SPA.

As well as protecting the purchaser fromuncertainty, without safeguards it would be possible for the seller, who controls the business until closing, to “extract value”, or for value to leak.

There are many different ways to extract value between signing and closing, including dividend payments, adjusting transfer prices in transactions with related parties or changing management compensation. Each of these may reduce the commercial value of the equity to be transferred to the buyer at closing. Even in the absence of the seller’s manipulation, there is a rationale for protecting either party from possible disadvantages due to changes in the balance sheet up to closing. A good completion mechanism means a fair and “clean” transaction, and therefore fewer problems down the line.

Marry in haste, repent at leisure

There are two principal ways to deal with the uncertainty that this causes: the purchase price adjustment and the locked box. There is also a hybrid approach, which combines elements of both.

While locked boxes tend to be generally seller friendly and straightforward in many cases, there are good reasons to use purchase price adjustments on many deals. Purchase price adjustments have more moving parts than locked boxes in which the purchase price is fixed.

Both locked boxes and purchase priceadjustments have been used in thousandsof transactions, most of which never wentinto a dispute. However, at BRG we dealwith the fallout caused in the atypicalcases where mistakes are made orcircumstances change and disputes takeplace. Maybe that makes us Cassandralike,but we prefer not to repent at leisure.

We have noticed similar patterns of mistakes replicated in many post M&A disputes. The following article presupposes a level of knowledge about transactions, and doesn’t offer generic solutions: every M&A transaction is different. However, there is a benefit to understanding disputes and their typical causes.

The makings of a modern M&A dispute

“A firm’s decisions, including those related to M&A transactions, are made by individuals, and their behavioural traits influence outcomes. Research indicates that chief executives tend to be more optimistic and more open to risk than the general population.

It is also a natural tendency for people to surround themselves with likeminded people. But in doing so, they risk making themselves vulnerable. One important way to improve decision-making and avoid overconfidence is diversity. The more diverse the pool of individuals involved, the better the decision-making probably is.

That is because diversity combats group-think. If you have a large pool of people working on a deal, but they all think in the same way, they all may make the same mistaken assumptions, and validate them to each other.”

Dr Shireen Meer

Commerce, on the whole, likes certainty, not volatility, disruption and unforeseen circumstances. Yet disruption and the unforeseen have become a disturbingly recurring theme recently.

A year ago, the probability that 2016 would see the dual outcomes of the Brexit referendum and the US presidential elections as they were, would have been considered remote by serious market commentators. Similarly, predicting the UK stock market bull run, or the volatility in exchange rates that accompanied these political events, would have been exceptionally difficult. Such major movements will certainly have handed some businesses unforeseen opportunities, and provided others with unexpected hurdles. They will also have made some pending cross-border M&A transactions, for example those into the UK, more attractive and others less so.

Besides political events, technological developments have introduced new sources of disruption that would have been almost unheard of even a decade ago. Take cyber security. Revelations that the Yahoo/Verizon deal is facing problems following news that Yahoo was the victim of a massive cyber attack is another example of a wild card event.

More generally, there haven’t been many M&A disputes over cyber security, so there isn’t a market in ideas yet. There is what we call “craft ignorance” and a lack of recognised standards. But it is fair to assume there will be many disputes in precisely this area in the future, and the stakes are high.

So, what should be the response of people like us, people who work in M&A disputes and transaction services?

M&A disputes tend to be complicated, time-wasting and expensive. In the context of an M&A transaction, although we have a good idea about where the usual hot spots for disputes lie, we know that we can’t truly predict what disruptive event might run a coach and horses through our carefully, or not-so-carefully worded drafting. This means that we know we can’t cut corners.

In putting together this paper, we have analysed a large number of M&A disputes and have spoken to BRG experts across

the firm’s practice areas and geographies. We hope that you find that each expert interviewed for this paper brings an interesting perspective to M&A disputes.

This paper summarises our findings and discusses the various ways in which a poorly worded SPA combined with the unexpected can lead to a purchaser or seller getting less than what they had bargained for, leading them to seek redress. Although we may not be able to predict them, we are able to consider the potential effects of “long tail” events.

First, we discuss fraud, where one party sets out to deceive another party for financial gain. Or, more subtly, when a seller goes beyond “gilding the lily” and makes fraudulent misrepresentations. We then discuss revenue recognition, the most common area of financial statement fraud. Our next topic is debt, both hidden and apparent. We then look at working capital, an area of the balance sheet that can be used to double-dip a buyer, either by accident or design, and an area where volatile real world events find their way into balance sheets and cause surprises that often lead to disputes. Our next topic is earn-outs. They are a great way to incentivise the former managers of a target company, but equally a way to widen the window for litigation. We then consider transactions with a fixed purchase price, the so-called “locked box”. Although it reduces the risk of disputes, it has its own quirks. Our final topic is the assessment of damages in M&A disputes.

While this publication has a technical focus on corporate finance and accounting aspects of transactions, M&A disputes have taught us the importance of “softer” factors, including culture, overconfidence and other cognitive biases. More generally, the limitations of human beings to process information play a significant role in disputes. When volatility and disruption in markets find their way into a transaction, the behavioural view becomes even more relevant. Behavioural economics has much to say about this. We bring this perspective into the analysis throughout the paper. But before we go any further, we must clearly set down what we mean by an “M&A -related dispute”.

Introduction:the makings of an M&A dispute

9

What is an M&A-related dispute?

10

It may seem obvious, but for the purpose of this paper it is important to define what is meant by an M&A-related dispute. An M&A-related dispute is any dispute, whether litigated, arbitrated, mediated or prosecuted, arising from the sale of one business, or part of one business, to another, or a merger of two businesses.

Most M&A-related disputes arise during the period after closing. However, this is not always the case. Disputes can also arise before the deal is signed, and during the period in between signing and closing, known as the closing period. This is shown below.

1

1/ At the time of writing, the deal is still in its closing period. Recent revelations that half a billion of Yahoo’s customers had their accounts hacked have, according to newspaper reports, led to Verizon seeking a discount or even considering pulling out of the deal based on MAC. Adam Samson, James Fontanella-Khan, and Hannah Kuchler, “Yahoo email hacking may have ‘material’ impact on Verizon deal,” Financial Times (13 October 2016), available at: https://www.ft.com/content/458c2bf4-917b-11e6-8df8-d3778b55a923. In this deal, the MAC event was one that would “reasonably be expected to have a material adverse effect on the business, assets, properties, results of operation or financial condition of the Business, taken as a whole.” Vipal Monga and Ryan Knutson, “Will Yahoo’s Data Breach Derail Verizon Deal?”, Wall Street Journal (23 September 2016), available at: http://www.wsj.com/articles/will-yahoos-data-breach-derail-verizon-deal-1474588172.

Pre-signing Closing period Post-closing period

Pre-signing disputes typically relate to letters of intent, heads of terms, exclusivity or confidentiality agreements. Disputes arise, for example when the parties fail to agree whether a letter of intent is binding, or when one party alleges breach of an exclusivity agreement. Pre-signing disputes can also relate to pre-contractual duties, in particular disclosure obligations.

There is scope for the parties to fall out over whether closing conditions have been met if these are subject to interpretation. For example, disputes arise over MAC clauses which allow a buyer to withdraw from the deal if the value of a target has been adversely affected by a significant adverse development before closing. The acquisition of Yahoo by Verizon may be a case in point. 1

While an obvious source of potential closing period disputes, in reality, even when purchasers do threaten to exercise MAC clauses, MAC events are rare. Instead, it is more common that the buyer uses a potential MAC event in order to renegotiate the price.

Most M&A-related disputes, fall into this category. These disputes usually relate to purchase price adjustments, or alleged breaches of representations and warranties. They may also relate to seller’s obligations, indemnifications, or earn-outs.

A frequent trigger of post-closing disputes is unforeseen liquidity needs of the target soon after closing. As a result, many post M&A disputes happen in the months after closing. However, mechanisms such as earn-outs mean that the buyer might have to continue to pay the seller for years after closing. As long as that is happening, a dispute is always on the cards.

SIGNING CLOSING

Most disputes occur because of mistakes and oversights in the negotiating process and while drafting the SPA. But this is not always the case. Sometimes one party deliberately attempts to deceive the other party. And that is fraud.

While there are different categories of fraud, this paper will focus on those that are most relevant in a transaction context: financial statement fraud and corruption.

Financial statement fraud is the deliberate misrepresentation or omission of financial statement data for the purpose of misleading the reader and creating a false impression of an organisation’s financial strength. It typically relates to misrepresentations by the target entity or the seller about the target entity. However, we at BRG have also seen disputes where misrepresentations were made by the buyer or by financial institutions.

A useful framework for analysing fraud is what has become known as the fraud triangle. The fraud triangle was first introduced by the American sociologist Donald R. Cressey who hypothesised that three factors must be present in order for someone to commit fraud: pressure, opportunity and rationalisation. 3

Fraud

11

2

2/ Association of Certified Fraud Examiners, What is Fraud?, available at: http://www.acfe.com/fraud-101.aspx.3/ Donald Ray Cressey, Other People’s Money: A Study in the Social Psychology of Embezzlement, Glencoe (Ill.): The Free Press, originally published in 1953.4/ See, for example, Erlson Precision Holdings Ltd –v- Hampson Industries plc [2011] EWHC (Comm), 20 April 2011.

Fraud includes any intentional or deliberate act to deprive another of property or money by guile, deception, or other unfair means. 2

Pressure

Opportunity Rationalisation

The fraud triangle can be a tool to understand fraud in a transaction context because M&A processes often give rise to circumstances in which some or all of the elements of the fraud triangle are particularly relevant.

So, what is the source of pressure, in a transactional context? There are many potential sources: the seller may come under pressure to avoid disclosing bad news during the negotiations. It may present inflated projections and maintain them when things deteriorate and against better knowledge, which can lead to inflated assumptions on which the purchase price is agreed. Similarly, the seller may feel under pressure to conceal debt that the buyer would have otherwise deducted from the purchase price (if it would not keep it from buying the business altogether). Pressure often intensifies as the transaction progresses and, especially towards the end of long negotiations, some sellers feel a need to avoid disclosing bad news, or to “soften” its impact, at almost any cost.

As pressure builds, the downward spiral begins. If, in such a situation, the seller presents misleading forecasts and decides to stay silent about recent adverse developments (for example, the loss of a key customer), this may be considered a fraudulent misrepresentation if the buyer relies on the sellers’ forecasts. 4

“A client in the extractives sector who decided not to do rigorous pre and post-M&A due diligence on a deal in sub-Saharan Africa, led to Department of Justice scrutiny. A catalogue of FCPA infringements which breached a Deferred Prosecution Agreement, led to punitive fines, negative press coverage, activist and environmentalist scrutiny, a sharp decrease in share price, dire investor relations and, finally, the demise of the company. At the risk of being a Cassandra, conducting deep reputational due diligence in opaque and challenging jurisdictions really does pay dividends.”

Sarah Keeling

Identifying fraud before signing can be particularly difficult as one party is intentionally attempting to conceal it from the other party. A seller who is committing fraud will typically also attempt to restrict access as much as possible during the due diligence phase.

Given the multitude of schemes, identifying fraud often requires expert knowledge. It can therefore be important to include forensic accountants or fraud examiners in the financial due diligence team, at least when the risk of fraud appears significant. It is also a good idea to keep an open mind and healthy scepticism throughout the transaction process, even amid infectious enthusiasm. “Deal fever” can lead to a buyer feeling pressurised into signing a transaction, and regretting it later. It is, therefore, important to listen to impartial advice.

The last element of the fraud triangle, rationalisation, is the ability of the person who commits the fraud to convince him or herself that their actions are acceptable or justifiable. In a transaction context, there is often an (tacit) understanding that sellers are expected to “dress up the bride”. It is generally true that sellers present the target company in the best possible light. In most M&A situations, the purchaser will accept that the lily is often gilded. But if a seller crosses a line and makes intentional misstatements, instead of simply treating the glass as half full, a fraud has taken place.

Fraud continued

12

The second element of the fraud triangle, opportunity, is due in part to the information asymmetry between the buyer and seller in a transaction. Unsurprisingly, the seller normally knows far more about the target business than the buyer, and the seller can typically influence accounting choices or disclosures. Buyers attempt to level the playing field by conducting comprehensive due diligence, but access may be limited, in particular in competitive auction processes. Importantly, detecting fraud is not typically the focus or even the scope of standard buy-side financial due diligence. However, if there are concerns over the numbers or “red flags” that are starting to emerge during the negotiations, an effective response can be to incorporate forensic expertise and fraud examination tools in the financial due diligence. See some common“red flags” to look out for on the diagram on this page.

Red flags for fraudWhen analysing

organisational structure look out for:

Unnecessarily complicated

corporate structure or financing

arrangements

Dominant CEO/

chairman

Impending/recent

flotation or buy-out

Consistent adoption of “racy”

but acceptable accounting

policies

Involvement of non financial

management in accounting

Weak finance function

High level of

related party transactions

When analysing profitability and cash flow, look out for:

Sales that do not turn into cash — red flags

include deteriorating collection ratios, receivables ageing, inventory turnover, and sustained cash outflow

from operations despite profit growth

Pressures on profitability as evidenced by

declining profit margins

Straight line or “hockey stick” earnings/profit

growth

High financing costs

compared to debt levels

That fraud may be found out, or may lie undetected on (or off) the company’s books. Once the transaction closes, the new owner takes control and has the opportunity to find out more about the target’s financial statements and disclosures. Somewhat surprisingly, many buyers do not take advantage of the opportunity. It is therefore safe to assume that many frauds remain undetected.

“We did a cybersecurity check on a company that was an M&A target. We found so many problems, all of them unrelated to the deal itself, that the transaction was pulled and the target needed to spend a considerable amount on network upgrades. Parties on both sides of a deal are well advised to consider cyber due diligence as part of their transaction process to reduce this relatively new breed of risk.”

Tom Brown

13

5/ Gerry Zack, “Inventory inflation schemes come in many flavours”, Fraud Magazine November / December 2016, p. 8.

However, there are some common triggers which may lead a buyer to uncover fraudulent behaviour. BRG experts often see buyers become suspicious when they discover soon after closing, to their surprise, that the target entity is in need of additional liquidity.

Even in the absence of unforeseen liquidity needs it is often appropriate to conduct post-closing due diligence. If this reveals unknown off balance sheet liabilities, or that the seller’s

accounting has gone beyond optimism, then there might be a case for fraud. A difficult task is ahead: unpicking financial statements requires a combination of expertise of transaction specialists, forensic accountants and even intelligence professionals, all trying to unravel something other experienced professionals have sought to conceal.

The most common financial reporting fraud scheme is incorrect revenue recognition.5 We therefore focus on this topic in the next section.

Corruption risk in transactionsCorruption is a type of occupational fraud that can be categorised into bribery, conflicts of interest, illegal gratuities and economic extortion. Of these, allegations of bribery have received significant press coverage in recent times, and enforcement of anti foreign-corruption statutes has been stepped up in many countries. The downsides of uncovering corruption post-closing, and the reputational and other damage, can be significant. It is therefore appropriate where relevant to involve specialist expertise in the financial due diligence.

“If a company buys another company that has been involved in corruption, for example bribing foreign officials, the liability for wrongdoing may transfer with the M&A. In situations where corruption might be an issue, I recommend post deal due diligence to shake any problems out. That way you can control the issue and be on top of it, rather than getting surprised by a whistle-blower.” Piers de Wilde

“We see many M&A disputes in Asia, where foreign investors acquiring local targets operate in an unfamiliar business environment, and where standards of corporate governance and regulatory scrutiny are often not as mature as in more developed markets.”

Mustafa Hadi

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6/ The International Accounting Standards Board (IASB) and US Financial Accounting Standards Board (FASB) recently jointly issued IFRS 15 as a new revenue recognition standard to replace most existing revenue recognition rules in IAS and US GAAP. IFRS 15, which is very similar to the new US standards, will be effective 1 January 2018. The basic principle in the new IFRS 15 is that an entity recognises revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services (IFRS 15 IN7).7/ IAS 11.8/ On the other hand, if a long-term contract is expected to be loss-making, the loss should generally be recognised immediately.

Revenue recognition is the battleground for some of the largest, most high profile and complex post-M&A disputes. To a significant degree this relates to a common link between the purchase price and the earnings of the target. When profitable sales increase earnings in a period, and those earnings are used as the basis of the valuation (for example, as an EBITDA multiple), then the question of the quality of those earnings and the timing of their recognition takes centre stage. An incentive to overstate earnings is then magnified by the multiplier. For example, if the enterprise value (EV) is eight times a recent period’s EBITDA, the seller has an incentive to look for ways to increase EBITDA because it will have a direct, magnified effect on EV.

Revenue recognition rules are exceptionally complex, and important changes to IFRS and US GAAP-accounting rules are underway.6 When to recognise revenue is typically associated with two key uncertainties: whether the product or service has been provided and whether cash will be collected (i.e., whether it is realisable). Disputes originate when revenue is recognised that turns out not to be realisable or had not been earned in the relevant period. An area that is particularly vulnerable to bias is the accounting for long-term contracts. This is the focus of the next section.

Long term contractsWhen a company works on a long-term contract, it may, under certain conditions, recognise revenue before the contract is completed, by allocating contract revenue and contract costs to accounting periods in which construction work is performed. This is called the percentage of completion

(POC) method of revenue recognition.7 It means that part of the contract’s overall estimated profit can (but not necessarily should) be recognised for contracts that have not yet been completed in full.8 A judgment call is required on both the degree of completion of the work, and the overall contract profit or loss. Both are open to bias.

There are two common ways companies overstate profits using the POC method:

Overestimate the degree of completion. This accelerates the recognition of contract profitability (typically by moving it into a financial year on which the valuation is based), even in cases when the estimate of overall profitability is correct; and/or

Underestimate the costs to complete work under the contract. This means that the expected margin on the contract is overstated.

Estimating the degree of completion and the remaining costs needed to complete large, long-term projects requires a deep technical understanding of construction-related matters. These estimates are difficult even for someone who has full access to information and is familiar with the evolution of the project. They can be all the more challenging for a buyer when access to information is limited. In addition, we often observe that internal project reporting in many companies is weaker than other aspects of internal reporting.

“In my experience, in construction, one of the biggest causes of disputes is human optimism in the face of obvious uncertainty. Construction has a “bad news” culture in which business problems often don’t get dealt with until they are too big to ignore. This, combined with accounting rules for long-term contracts that require significant judgment, puts their accounting, and due diligence, at the intersection of disciplines: technical engineering competence and financial and accounting knowledge. In the context of M&A disputes and in a culture such as in construction, hindsight has many benefits.”

Sean Fishlock

Issues relating to revenue recognition

3

15

9/ The contract terms were between 36 and 48 months. They are scaled here (with some simplifying assumptions) to be comparable for analysis.

Below is a summary of cumulative profits under the POC revenue recognition method under IAS 11, reported over the lifetime of a portfolio of four long-term contracts for an undisclosed target company.9

In this acquisition, the valuation of the target company was based on the earnings of a period that included profits of the four contracts as reported before the contracts ended. Over the contract terms, management was consistently too optimistic about the overall contract profitability. The benefit of hindsight shows that this led to overstated profits up until the completion of each contract. Only when each contract ended, in the absence of any future periods into which to defer losses, did the company report the cumulative losses actually incurred over the term of the contract. In three out of four cases there were cumulative losses, despite the previously (incorrectly) reported profits. This suggests, at the very least, bias in accounting estimates. Further review revealed not only an overestimate of the overall profitability of each contract, but also of the degree of completion. In effect, this moved (ultimately non-existent) profits into even earlier reporting periods. The buyer paid for profits that, in reality, did not exist. This led to a post M&A dispute.

Overstating profitability is one of the most common areas of disagreement about revenue recognition of long-term contracts in post M&A disputes. Prematurely recognised or overstated profits are not part of recurring earnings, and buyers should not include them in the basis of valuation. Identifying bias in earnings recognition is a firststep in removing them from thebasis of valuation by quantifying an EBITDA or EBIT adjustment. An analysis of past reporting periods (like the one in the graph) is a tool to identify bias in estimates.

Reported contract profitability over time (cumulative,Cm)

20%

0

40

80

40% 60% 80% 100%

Percent completed

Contract I Contract II Contract III Contract IV

16

Capital structure, valuation and the completion mechanism

A firm engages in operating, investing, and financing activities. It does this with the intention of generating value and subsequently distributing surpluses to the investors in the firm who have given up cash to acquire entitlement to the distribution of future surpluses, whether through acquiring debt or equity.

One can value the firm and then divide the firm’s value among the various claimants—shareholders and debtholders. The relationship between firm value and the value of the claims on the firm may be set out as follows:

Value of the firm = value of debt + value of equity

In transactions, the value of the firm iscommonly referred to as enterprise value, but also as the “headline price” (oftenin letters of intent in the early phases of a deal) or “cash and debt free price”. Below is a simple version of the “equity bridge” that shows that a valuation approach that leads to the valuation of the firm (as in practice many do) requires the deduction of debt and similar items, and the addition of (free) cash and equivalents, to arrive at equity value—the price for the claims on the firm by its shareholders. In share deals, this is the price for 100% of the equity ownership interest in the target.

The buyer and seller must agree upon the items to be deducted or added to arrive at equity value in the negotiations. However, as the business (and its balance sheet) changes every day, both before and after the SPA is signed, any time delay between signing and closing of a transaction means that the parties are uncertain about the precise balance sheet to be transferred at closing.

Issues relating to net debt4

Enterprise value

-Debt-like

items

+Cash and

equivalentsEquity value

“There is due diligence and good due diligence. It isn’t enough to just tick boxes. Soon, it is likely that companies will not just have to demonstrate to regulators that they have done due diligence, they will have to demonstrate that they have done good due diligence.”

Ben Johnson

The net debt deduction and related disputesThe net amount of debt-like items less cash and equivalents is referred to as “net debt”. A net debt clause is a very common type of purchase price adjustment. As there is no legal or generally accepted accounting definition of net debt, defining items to be treated as debt-like or as free cash equivalent is a matter for the parties to negotiate and agree on. In the case of a purchase price adjustment, the document that captures this is the SPA.

Purchase price adjustments – overview A purchase price adjustment adjusts the preliminary purchase price by measuring the relevant balance sheet and other financial statement items at closing.The SPA sets out the mechanism, definitions, basis of preparation, and process to determine the adjustments. The idea is that firm value is fixed at signing.

Purchase price adjustments adjust the equity value, not the enterprise value. The adjustments relate to short-term changes between signing and closing, while the headline price is unchanged.

Purchase price adjustments pin down the exact levels of debt, cash, working capital, and other items at closing. They thus ensure that the purchaser is compensated for debt at closing and that the vendor receives value for any surplus cash at closing.

There are a number of specific purchase price adjustment mechanisms that can be used. They are listed in the table below, and discussed in this and the following sections.

BASIS OF ADJUSTMENT COMMENT

Net debt To adjust from a debt-free/cash-free basis

Net working capital Used in combination with net debt. For a seasonal business or a business subject to some volatility in trading; for a cash-free/debt-free basis as protection against seller manipulation by reducing working capital

Capital expenditure Used in combination with net debt. For a capital expenditure-intensive business and a cash-free/debt-free basis, used as protection against seller manipulation by slowing down investment spend

Net assets/equity Typically used instead of net debt adjustment (sometimes used as a “floor” in addition to a net debt adjustment). Rarely used these days

Other Marketing, R&D spend, EBITDA. Used in combination with net debt adjustment. Rare

17

In practice, a large number of items can be considered to be debt or similar in nature. Here is a list of items that are sometimes discussed in negotiations, ranked (somewhat subjectively) from “harder” items at the top (i.e., items that are commonly deducted), to “softer” items (i.e., that are less commonly treated as debt) towards the bottom. Off balance sheet liabilities

Off balance sheet liabilities come in many varieties and forms but all do broadly the same thing: reduce debt. For example, off balance sheet liabilities might relate to obligations in a whole separate entity such as a special purpose vehicle (SPV) that is not consolidated in the parent entity’s financial statements, but for which the parent company is responsible. Other common types of off balance sheet debt include: factoring of trade receivables, leasing or unfunded pension deficits.

The use of SPVs, factoring, leasing or other types of off balance sheet debt is perfectly appropriate in most circumstances and does not typically involve violations of GAAP. However, the way they affect financial statements can be used to achieve outcomes that are favourable to one party. For example, factoring, a financing transaction, may be used to maximise the cash position at closing with no offsetting deduction for factored receivables (unless it is treated as debt), leaving the buyer to pay more than the value it bargained for.

Financial statement fraud schemes perpetrated by concealing debt are a different matter. An example is Enron which used off balance sheet accounting to appear to be a high-value company when in reality it was sitting on an ocean of debt.

Agreeing net debt deductions typically reflects each side’s relative strength in the negotiating process. This section discusses three broad categories of net debt that play a significant role in practice and that could become cause for disagreement in negotiations.

Debt hot spots

Bank and other (explicitly)

interest-bearing debt

Break costs and early

repayment penalties

Current tax assets and liabilities

Deferred tax assets and liabilities

Trapped cash and cash items that are

working capital in nature (e.g., cash

in tills)

Debt factoring /other

receivables financing

Capital expenditure

creditors

Foreign exchange

losses

Deferred revenue

Intercompany items

Restructuring provisions

Dilapidation provisions

Accrued bonuses

Operating leases

Warranty provisions

Derivative instruments

Non- controlling

interest

Pension deficits

Supplier finance

Finance leases

Issues relating to net debt continued

18

10/ See, for example, “BHS buyer’s bank dropped out over pension issue”, Financial Times (7 June 2016).11/ See, for example, District Court for the Western District of Pennsylvania, Case 3:16-cv-00204-KRG.

ProvisionsA provision is a liability of uncertain timing or amount. The amount recognised as a provision has to be estimated. Some provisions, such as for pensions (see separate section below), are almost always treated as debt-like in transactions. For others, like warranty provisions, the case is less clear cut. It is because provisions require estimates that they are prone to disputes. GAAP can give significant discretion to the preparer of the financial information, and estimates can be biased or perceived to be biased.

One case BRG experts have worked on relates to the acquisition of a top-tier basketball club. The SPA definition of debt included “long and medium-term bonus claims” of players, whereas short-term obligations were not included in this definition. However, the definition of “medium-term” or “short-term” was not clear. The dispute arose over whether a significant bonus was correctly classified as “medium-term” A practical way to avoid disputes is to aim to limit the reliance on estimates at closing. Using fixed values for deductions that reflect expected valuations for liabilities, agreed at signing, is one option. Alternatively, when outcomes are uncertain, indemnifications may be a more appropriate instrument than a deduction.

Pensions Pensions don’t often cause disputes but, when they do, they can be eye-catchingly high profile because the amounts of money involved are often large relative to the size of the transaction. Even if the dispute is resolved properly and beneficiaries are not affected, a pension dispute has the potential to worry many current and former employees. 10

Pension disputes, like almost all other disputes, can occur when professionals involved in the deal do not draft definitions tightly enough. For example, at BRG we recently saw a case which rested on thedefinition of “defined benefit obligation”.The parties were in dispute about whether

a French “Indemnité de fin de Carrière”— a type of defined benefit plan—fell under the definition of “financialindebtedness” which included certain defined benefit obligations. There could have been no dispute if a list of defined benefit plans had been included in the definition of net debt.

There are also pension-related disputes where it was claimed that the actuarial report contained errors in determining the defined benefit obligation and the pension provision. 11

Other disputes related to debtDisagreements over net debt arise when a party claims that a particular item does or does not fall under the SPA definition of net debt. This can happen when the net debt definition leaves room for interpretation. For example, catchall definitions such as “... and other interest-bearing debt”, in which the term “interest-bearing” is not defined, leave considerable room for interpretation: is a pension obligation interest-bearing? Vagueness causes problems.

Disagreements also arise at the intersection of debt and working capital. For the mechanisms to work properly, a seamless interaction between the definitions of the two is important. When things go wrong in completion mechanisms, it is often here.

An item may be captured twice, both as working capital and net debt (for example a capital expenditure creditor), or an item may not be captured at all (for example accruals for outstanding supplier invoices). This may give the seller an opportunity to manipulate the cash position at the effective date. Consequently, the buyer overpays. We will look at this interaction more closely in the following section.

Net working capital

Net debt Capital expenditure

A “clean” interaction between different adjustments is important

“We look at our private affairs with friendly eyes, and our bias always gets in the way of our judgment”

Seneca

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The working capital section of the balance sheet is a hot spot for post M&A disputes.

It is the place where volatile events in the real world are most likely to have an impact on transactions. Unsurprisingly, it is therefore where the financial crisis of 2008 and 2009 left its most visible balance sheet scars.

Most businesses require a certain (positive) level of working capital as part of their normal operations. This is in part because sales usually do not convert to cash immediately and because businesses need raw material or finished good inventories. Working capital is needed to keep operations running smoothly.

What relevance is this to an M&A transaction? It is common for offer letters to specify that the headline price is based on the assumption that the business will transfer with an “appropriate”, “normal” or “adequate” level of working capital. If, at closing, that level is not “normal”, a working capital adjustment compensates for the difference. There is a good reason for this. If at closing, the business has more working capital than is normal (more than it needs to operate), then it is reasonable that the buyer should pay for the excess. If, on the other hand, there is a deficit in working capital, the purchase price should be reduced by the shortfall because the buyer will, in theory, have to inject additional liquidity to bring it back to a sufficient level.

The same concept applies to a locked box transaction, only that there is no adjustment at closing; a surplus or deficit in working capital at the locked box date should be reflected in the fixed price.

Although in principle the concept is logical, issues can arise when working capital and net debt become confused. If the net debt and the working capital mechanisms interact as they should, they exactly offset each other. As a result, the seller does not have the ability to artificially increase the cash position, thus reducing net debt, by collecting receivables early, or stretching trade payables. But if they do not work as they should, then either the buyer will pay too much, or the seller will get paid too little. While this is not necessarily a breach of provisions in the SPA, the frustration of the party that overpays contributes to the risk of a dispute.

What magnifies the risk of disputes over working capital is the scope for disagreement over valuation matters of working capital items: trade receivables are subject to estimates for unrecoverable amounts, and inventory is valued at the lower of cost or market value. This is where market volatility enters the completion mechanism. Consider rapidly changing prices for inventory in some renewables markets in recent years where volatility was such that establishing a “market price” at a specific date was a challenge. This is a reason that a disproportionate number of transactions in renewable energies companies result in disputes.

It is, therefore, vital that working capital is properly defined in the SPA and all the parties are clear about the accounting methods that will be used to calculate it. This requires considerable attention from the professionals involved. The devil really is in the detail.

Issues relating to working capital 5

What is working capital in a transaction context?There is no uniform definition of working capital in a transaction context. A convention is that working capital should, at a minimum, always include trade receivables, trade payables, and inventory. This is often called “core” or “trade” working capital. While these components should always be included in the definition of working capital, they are however, almost never sufficient.

What criteria should guide someone involved in an M&A transaction or

analysing an M&A dispute to determine whether an item in the balance sheet is, or should be, working capital? We find the following three almost always appropriate.

Operating nature: This means that working capital items are the result of business activities, not financing activities. A normal level of working capital is therefore part of the value of the operations, or EV.

Short-term conversion into cash: Working capital converts into cash wihin

a short time period. This means that customers pay, inventories turn over and suppliers get paid, all within a few weeks or months (usually well under a year).

Recurring nature: Working capital items are constantly revolving, which means as they convert into cash they are replaced by new (short-term) assets and liabilities. At any given point in time, there is a certain net level of working capital in the business (but the level may change).

“In the US, we are seeing a growing trend in ‘post deal due diligence’ on closing working capital balances. Because of the current competitive M&A market, deals may be going lighter on due diligence prior to closing, and that leads to a degree of subjectivity in the SPA as it relates to determining working capital. So, in response to this, I’m seeing companies get the diligence team back together after closing to go though the closing working capital documentation to make sure the calculations are consistent and the parties will be happy with the result.”

Dan Galante

20

Earn-outs are contingent payouts that depend on the realisation of a certain goals of the target company. They are calculated by reference to the performance of the company over a period after closing, the earn-out period. The measures of performance on which the earn-out payments are determined can be financial or non-financial. Earn-out periods are often between one and three years, but we sometimes see periods of up to five years.

The simplest reason that earn-outs are prone to disputes is that they lengthen the period of time it takes to fully determine the total purchase price. The longer the earn-out period, the more prone to disputes the transaction will probably be. This is unsurprising as a longer period means greater changes to the target business. In addition, as time passes, a seller who is no longer involved in the management of the target company is not responsible for its trading results.

As well as this obvious practical reason, there are a number of accounting reasons why earn-outs are particularly dispute-prone if based on metrics such as EBITDA, EBIT or net profit. When setting the parameters for earn-outs, it is important to ensure they are thoroughly defined. They should also be closely related to “value”.

When measures of profitability such as EBITDA are used, questions over the quality of the profits can arise. Profits can include, for example, non-cash, non-recurring earnings that may have nothing to do with “value”: if the target has historically set aside provisions that are too high, they might be released into income, increasing profits. Similarly, earnings that are artificially lowered by mere accounting changes or non-cash, non-recurring write offs may reduce — or altogether wipe out — any earn-out payment, to the frustration of the seller. All these things could cause the seller and buyer to fall out during the earn-out period.

Issues relating to earn-outs6

“I have noticed one trend in earn-out disputes that happens time and time again. Earn-outs are often used to bring small entrepreneur-owned businesses into larger corporations, many of which are public-reporting entities. Often the entrepreneur continues to run that part of the business as a separate division. If things go well, that part of the business gets access to a bigger market and can grow revenue considerably, but this leads to considerably more back-office costs, some of which support the growth and some of which could be related to public-reporting requirements. If that’s not addressed in the SPA in terms of which costs apply against the earn-out, it can lead to a dispute.”

Ron Evans

One way to minimise the risk of a dispute is to use comparatively simple earn-out parameters that, further, leave little to the buyer’s discretion when they are determined. A general rule is that the higher up in the profit and loss the parameter is, the fewer opportunities to “manage” the earn-out basis. Sales, or even volumes sold or prices, are often less dispute-prone than net profit. Thorough definitions of the accounting policies to be applied can also help avoid disputes.

Changes made to the newly acquired business after closing may affect the ability of the target to report earn-out metrics on a consistent basis. The longer the earn-out period, the more changes the buyer may make to the target company. For example, a strategic buyer may integrate the target into the acquiring company’s operations. A private equity sponsor may merge it into another portfolio company’s operations in order to achieve synergies. As a result, the company may share overhead functions and cost allocations. When the target becomes a division of the acquiring company, it may not report profits on a comparable basis as it did when it was a stand-alone company and when the earn-out was designed. In this scenario, a single recharge for group services could wipe out profits which would have otherwise triggered a significant earn-out payment. Anticipating the reporting structure during the earn-out period is therefore important, and if it is the intention to integrate the target into other operations post-closing, earn-outs should be linked to metrics that are not affected by the integration.

Finally, it is important to ensure the buyer has access rights to the target company to review the seller’s calculation of earn-out payments. These rights need to be specified in the SPA.

21

The purpose of an earn-out clause Earn-outs can be very useful mechanisms. However, they are also prone to disputes. Here are some reasons why earn outs are used:

1. Narrowing the price-expectation divideEarn-outs are often used in practice when the parties’ price expectations are far apart. They can be an effective mechanism to bridge the price-expectation divide.

2. Incentive for sellers remaining in the businessEarn-outs are also often used as a mechanism to incentivise an existing owner-manager who is selling his or her business and who will stay on managing or otherwise contributing to the company. The incentive to these types of sellers is to maximise their efforts as they will continue to share in the rewards after closing.

3. A method of acquisition financeAn earn-out is also a financing instrument. This is because the earn-out component of

the purchase price is effectively paid out of the target’s operating profits after closing only if these profits are actually achieved. This deferred component of the purchase price does not need to be financed by the buyer. This aspect made earn-outs particularly popular after the financial crisis when acquisition finance was difficult to obtain and significant components of the total consideration were deferred into the earn-out period.

4. Allocation of riskOne way to think about an earn-out is that it changes the allocation of risk between buyer and seller. A valuation before signing requires estimates of future returns of the target company. These estimates are almost always subject to significant uncertainty. Without an earn-out, the buyer typically bears the risk associated with their achievement: if the target falls short of the projections, then the buyer receives less in value (at closing) than they bargained for. If the actual developments exceed expectations, then the buyer receives more.

Case study: A clarification missing in an earn-out clause leads to a complicated multi-party dispute.

In ICC 14691, US and Brazilian companies (purchasers/claimants) entered into an SPA with Brazilian and German sellers (respondents) over the purchase of shares in a Brazilian subsidiary. The SPA included an earn-out provision that made additional payments conditional on the achievement of certain targets. An advance on the earn-out payments was paid by the buyers in US$. The earn-out itself was payable in R$ (Brazilian real). After closing, the claimants alleged intentional breaches of representations and warranties. One respondent counterclaimed for the earn-out component of the purchase price. The parties disagreed over the exchange rate to be used to convert the advance payment made in US$ into R$. The buyers argued for the exchange rate just before closing, whereas the sellers argued that

the exchange rate should be the rate at the time the earn-out was paid, two years later. Further, the counterclaim related to the earn-out basis which excluded several items (recurring credits) in the P&L. The tribunal found that the appropriate exchange rate was that prevailing near the time the main earn-out payment became due. Further, the tribunal held that an expert determination, which had excluded the recurring items credits, was final and binding.

The tribunal noted the parties “devoted substantial time and effort, both in their written submissions and at the hearing…”12 to the question of the exchange rate. This claim dispute could have been avoided by inserting a clarification in the SPA, for example specifying that the exchange rate at the due date of the earn-out payment should be used and, further, specifying the source of the exchange rate (for example Bloomberg or Reuters mid-spot rate).

12/ ICC Case 14691 Final Award in ICC International Court of Arbitration Bulletin, Vol 24, No. 1 (2013), p. 132.

22

The concept of the locked box first appeared in private equity auctions in Europe in the early 2000s. It has come to be adopted in a wide range of transactions and is now the most popular completion mechanism in Europe. Locked boxes are generally considered to be seller friendly.

In a locked box transaction, the transfer of the target company is economically (but not legally) backdated to a historical date, typically the date of the last audited balance sheet. There is no true-up at closing for net debt, working capital or other items. The date of the economic acquisition is termed the “locked box date” or “effective date”. The time between this date and closing is known as the “locked box period”. During this period, profits generated by the target principally accrue to the benefit of the buyer who obtains the closing date balance sheet without further adjustments to the purchase price.

An advantage of a locked box is that a fixed purchase price makes it easier for a seller to compare bids in an auction process. Other advantages of the locked box are that it avoids the necessity to prepare completion accounts and the often time-consuming negotiations over accounting definitions in the SPA. This can save considerable time and effort. This also eliminates significant scope for disagreement post-deal.

Profits generated by the target business between the effective date and closing accrue to the purchaser (as cash generated is transferred to the buyer). To compensate for the fact that the seller foregoes those profits, the SPA sets out an interest rate, sometimes called the “daily profit charge”, to be applied to the purchase price. The interest, or daily profit charge, is payable by the buyer for the locked box period. This charge represents the opportunity cost to the seller of backdating the transaction.

“Locking the box” stipulates that the seller does not extract value from the business between the reference date and closing. No value must leak. This means there

Locked box-related disputes7

“Whereas the damages related to a misrepresented income stream may be assessed by determining the capitalised loss of profit, there is also the need to consider the valuation impact on the remainder of the business enterprise.

If, for instance, the pricing mechanism is based on a multiple of EBITDA, then consideration should be given as to whether there should be a reduction in that multiple. This may arise because the overall level of true profitability suggests that the size of the enterprise now falls below a benchmark of previously comparable entities, or, perhaps more understandably, a concern that there may be other, as yet undiscovered, problems that will impact on profitability. If discounted cash flow is the primary valuation approach, then this will result in an increase in the discount rate to reflect this additional uncertainty, or perceived risk.“

Andrew Caldwell

should be comprehensive “value leakage protections” in the SPA. Leakage can come in many forms, from dividend payments before closing to changes in transfer prices with related parties, changes to management compensation, management fees, or waiving liabilities. Effective leakage protection requires foreseeing any such eventuality.

It is important to keep in mind that the items giving rise to purchase price adjustments are equally relevant to the locked box: even though there are no price adjustments when a locked box is used, the fixed purchase price should reflect debt items, any deficit or surplus in working capital against a normal level, and any deficit in investment spend.The difference is that these items are measured in a locked box at the locked box date, and in a purchase price adjustment at closing.

This brings us to disputes. The absence of purchase price adjustments in locked boxes makes locked box SPAs less complex than those containing a purchase price adjustment. The fixed purchase price removes the price adjustment as an important area of post M&A disputes and therefore reduces significantly the risk of disputes in locked box transactions. Disputes do occur, however, and these often relate to warranty breaches, alleged fraud or closing conditions (e.g. MAC clauses). Locked box-specific disputes also have to do with leakage. These disputes can be over interpretations of what constitutes a breach of a leakage covenant. For example, we have seen disputes related to the interpretation of “arm’s length” transactions with related parties.

In conclusion, while simpler to handle than other closing mechanisms, the locked box is not immune to disputes. As we have seen throughout this paper, imprecise drafting can lead to problems down the line. However, a locked box eliminates disputes in relation to purchase price adjustments.

23

A short word about quantum in M&A disputes

End word

8

Damages theories differ significantly between jurisdictions. Whether related to fraud, breaches of representations and warranties or other matters, damages in M&A disputes often involve claims of lost profits or lost business value or both. Lost profits can be defined as the difference between the claimant’s profits but for the wrong doing and the claimant’s actual profits. Damages experts use a variety of valuation approaches, including the income approach (in particular the discounted cash flow method), the market approach and the net asset approach. The valuation itself may relate to a single asset or liability, or alternatively to the value of the equity interest in the target entity or the value of the business.

One way damages can be categorised is into actual (but for) damages, caused directly by the wrong doing, and consequential (or indirect) damages. Consequential damages may include effects on other products of the acquiring company or on the target’s competitive positioning or reputation. Their assessment can be particularly complex.

In the context of valuing damages related to income streams of a going concern, or valuing long-term liabilities, discount rate often takes centre stage. The fact that present values can be very sensitive to even minor changes in discount rates has been magnified by the current interest rate environment.

In putting together this paper, we have spoken to BRG experts across the firm’s practice areas and geographies, in order to shed light on how disputes come about, how to deal with them effectively, and how to avoid them. I hope that you have found that each expert interviewed for this paper has brought a unique perspective to post M&A disputes. It is the combination of these perspectives that helps us understand disputes better. Such diversity of thinking characterises BRG.

Disputes have lots of different causes, but many disputes are avoidable. A few lessons have emerged: Technical mistakes in transactions that lead to disputes often occur at the intersection of disciplines. For example, the SPA, a legal document which may incorporate accounting and financial terminology and concepts needs to have drafting input from more than just a lawyer, or more than just an accountant, or even more than just a lawyer and an accountant.

Judgment errors often occur because of overconfidence or groupthink. Likeminded individuals working on the same task have a tendency to validate each other and replicate mistakes. A diverse transaction team will combat this. Diverse groups tend to break groupthink and be more creative at problem-solving and better at anticipating what can go wrong. Diverse teams tend to lead to better investment decisions.

There is no substitute for thoroughness. Getting the detail right is vital. This means that even at two in the morning on the day before signing, we know we can’t cut corners.

Fraud frequently goes unnoticed at the timeof a transaction, but seems more easilydetectable with the benefit of hindsight.The truth is that often warning signs arenot taken seriously. Understanding the factors that may make fraud more likely in a transaction and getting an expert to examine red flags may well save time andmoney in the long run.

Lastly, parties should consider carefully how unforeseen events around closing could impact the transaction and find their way into provisions in the SPA: where could volatility meet ambiguous wording or vague measurement concepts used in the SPA? Then, the parties should aim to limit or eliminate where possible subjective elements in SPA definitions or in accounting policies. They should also consider different scenarios for the fallout of major political decisions or other external disruptions.

It is, of course, impossible to always expect the unexpected, but if we go into every situation aware that all of our assumptions may turn out to be false, we will, at the very least, be prepared when disruption strikes. Heiko Ziehms

“The low interest rate economy can make calculating the discount rate used to value long-term contracts problematic. Low or negative interest rates result in lower discount rates and therefore the value of your future losses is higher. And many post-M&A disputes involve the quantification of future losses.”

David Saunders

24

Heiko ZiehmsHeiko Ziehms focuses on the quantification of damages and forensic matters in complex commercial

disputes, including M&A, joint venture, and insolvency-related matters. He has been appointed as expert in multiple disputes. He has worked on matters in ICC, DIS, LCIA, ICSID and SIAC arbitration forums, ad hoc arbitrations and the courts. Heiko has worked on some of the most complex corporate disputes in Europe with values up to several billion euros. He is experienced in giving oral expert testimony. Heiko also provides transaction advisory services and advises on completion mechanisms in M&A transactions. He has advised on several hundred transactions. Heiko is based in London.

Heiko ZiehmsManaging Director+44 (0) 20 3514 8578hziehms@thinkbrg.com

Daniel GalanteDan Galante has more than 25 years of experience and has developed extensive transaction experience

serving as an adviser to companies all over the world. He has been involved with more than 600 buy- or sell-side transactions for scores of different private equity investors, hedge funds, lenders, and strategic corporate acquirers. Dan provides transaction-related diligence that typically includes a blend of commercial, financial, operational, and tax services. He has advised on target companies ranging from startups to more than $3 billion in revenues. Dan is based in New York.

Daniel Galante Managing Director+1 312 429 7982dgalante@thinkbrg.com

Sean FishlockSean Fishlock is a member of EMEAA Construction Group of BRG with over 30 years of experience in

the construction industry. He trained in surveying, construction management, project management and engineering with a major international contractor, and spent 14 years in site and construction management, four years in property development and asset management and three years managing £1billion prime contracts constructing and maintaining land and marine infrastructure, housing and property and estates for the UK Ministry of Defence in the UK and overseas. Sean is based in London.

Sean FishlockManaging Director+44 (0) 20 3725 8380sfishlock@thinkbrg.com

Simon EdeSimon Ede is an economist with over 15 years of experience working with companies operating in

the global energy markets. His broad range of project experience includes transaction support, market analysis and forecasting, arbitration, litigation, strategy development, and auctions. He also provides expert analysis for clients in disputes. Simon is based in London.

Simon EdeDirector +44 (0) 20 3725 8368sede@thinkbrg.com

Piers de WildePiers de Wilde has over 10 years experience in the investigations industry. In his career he has focused

on pre-transactional due diligence, specialist investigations and strategic intelligence. His work has included: assisting in activist investor situations; supporting M&A strategies through the provision of intelligence; informing clients’ strategic communications in complex disputes; overseeing major fraud and corruption investigations including UKBA and FCPA matters; asset tracing and litigation support; providing new market entry support and political risk analysis; and conducting anti-counterfeit investigations.

Piers’ clients have included private equity firms, financial institutions, family offices, law firms, multi-national corporations and governments. He has worked throughout Europe, Africa, and the Middle East, and is based in London.

Piers de WildeDirector+44 (0) 20 3514 7147pdewilde@thinkbrg.com

Biographies

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Ben JohnsonBen Johnson is a member of BRG’s Global Investigations + Strategic Intelligence practice. He

has over 17 years of experience in forensic accounting, including fraud and financial investigations, bribery and corruption, audit negligence, asset tracing, and litigation and arbitration. Ben has led many investigations and reviews into suspected accounting irregularities, bribery and corruption issues, and misconduct on behalf of regulators and private clients in both civil and criminal proceedings. He has significant financial services experience, having led investigations into alleged misconduct at banks in multiple jurisdictions, and he has led more than eight investigations on behalf of accountancy regulators in relation to accounting issues in recent accounting scandals. Ben is based in London.

Ben JohnsonManaging Director+44 (0) 20 3808 4758 ben.johnson@thinkbrg.com

Daniel RyanDaniel Ryan is the co-head of BRG’s London office. Daniel has over 20 years of experience in valuing

businesses, shares, and intellectual property assets in both contentious and non-contentious matters, including sale and purchase transactions, shareholder and post-acquisition disputes, intellectual property licensing, infringement of intellectual property rights, fiscal valuation, and transfer pricing. He is regularly appointed as an expert witness and is experienced in oral testimony. His experience covers matters in the UK High Court, before arbitral tribunals in the UK and internationally, in fiscal courts, and before the Copyright Tribunal.

Daniel RyanManaging DirectorCo-Head of London Office+44 (0) 20 3725 8358dryan@thinkbrg.com

Ron EvansRon Evans is a member of BRG’s Corporate Finance/Transaction Advisory Services practice. He has

over 16 years of due diligence experience serving a variety of private equity and strategic clients. He has worked on over 250 transactions providing buy and sell-side financial due diligence, synergy validation, carve-out transactions, and finance department integration, and has advised clients with developing balanced scorecards and strategic plans. Ron has significant private equity experience and public and private corporate experience. His primary industry expertise includes construction, energy, manufacturing and distribution, transportation, and retail. He has also worked on transactions in a variety of other industries, including media and telecommunications, banking and insurance, and consumer and industrial markets. Ron is based in Miami.

Ron EvansManaging Director+1 786 725 3806revans@thinkbrg.com

David SaundersDavid Saunders is an expert accountant and the co-head of BRG’s London office. He works

in a variety of industries, jurisdictions, and forums, including the UK courts and international arbitrations, with particular expertise in valuations and the quantification of damages. David has been appointed as expert accountant on over 70 occasions and has given oral testimony on 15 occasions both in the UK courts and to arbitral tribunals in a range of jurisdictions. He is an experienced fraud and regulatory investigator. David’s cases have covered a range of business sectors, including oil and gas, commodity trading, construction, property, pharmaceutical, telecommunications, manufacturing, hotels, retail, entertainment, and financial services. David is based in London.

David SaundersManaging DirectorCo-Head of London Office+44 (0) 20 3725 8361dsaunders@thinkbrg.com

Shireen MeerShireen Meer is an applied economist with a speciality in behavioural economics. She applies economic

analysis to litigation and consulting matters related to areas such as class action, intellectual property, antitrust, breach of contract, product liability, healthcare reimbursement, and general commercial damages. Her work has spanned industries such as healthcare, high technology products, consumer products, metal refining products, banking, and pharmaceuticals. She has taught undergraduate courses, been published in a variety of journals, is a public arbitrator for the Financial Industry Regulatory Authority and a member of the American Economic Association, American Bar Association, and Women’s Council on Energy and the Environment. She has a Ph.D. and M.A. in economics from Emory University. Shireen is based in Washington DC.

Shireen MeerAssociate Director+1 202 480 2695smeer@thinkbrg.com

Thomas BrownTom Brown is Global Leader of Berkeley Research Group’s Cyber Security/Investigations practice. He

specialises in helping clients manage cyber risk, respond to incidents, remediate vulnerabilities, and address post-incident regulatory enquiries and litigation.

Prior to joining BRG, Tom served for 12 years as an Assistant United States Attorney in the U.S. Attorney’s Office in Manhattan, where he supervised the Complex Frauds and Cyber Crime Unit. He led some of the most technologically challenging cases ever pursued by the U.S. government, including successful investigations of the underground drug website Silk Road and the hacktivist group Anonymous. Tom is a recipient of the FBI Director’s Award for Outstanding Cyber Investigation and was named “Prosecutor of the Year” by the Federal Law Enforcement Foundation in 2011. He is a member of the New York bar. Tom is based in New York.

Thomas BrownGlobal Leader, Cyber Security/Investigations+1 646 862 0979tbrown@thinkbrg.com

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Andrew CaldwellAndrew Caldwell is an experienced valuation specialist in the United Kingdom, with more than

30 years of involvement in the valuation of companies, shares, and intellectual property. His experience includes fiscal and statutory valuations, and those required for financial reporting and regulatory purposes, particularly of Level 2 and Level 3 assets; and acting for FTSE 100 companies.

Andrew has been instructed as an expert witness in a large number of cases, in respect to both valuation and the quantum of damages or loss of profits arising from breach of warranty or contract claims, post-acquisition and cross-border disputes, and the infringement of intellectual property rights. Andrew is based in the London office.

Andrew CaldwellManaging Director+44 (0) 20 3725 8354acaldwell@thinkbrg.com

Mustafa HadiMustafa Hadi is the Head of Disputes and International Arbitration for Greater China and North

Asia, and is based in BRG’s Hong Kong office. He is an experienced consultant on economic, financial, accounting, and strategic business issues, and specialises in addressing issues of valuation and damages in the context of commercial disputes.

Mustafa has been instructed as an expert witness in both national courts and international arbitrations, and is experienced in giving oral testimony. He has worked on cases involving the valuation of businesses, shares, and intangible assets, and the quantification of complex damages arising from contractual, shareholder, joint venture, post-acquisition, and intellectual property disputes. Mustafa was “highly rated” by Who’s Who Legal in its 2016 guide to leading experts in international arbitration.

Mustafa HadiHead of Disputes and International Arbitration – Greater China and North Asia+852 2297 2271mhadi@thinkbrg.com

Sarah Keeling Sarah Keeling is a member of BRG’s Global Investigations + Strategic Intelligence practice. A

former senior British government official, she has 23 years of experience in national security and intelligence matters across jurisdictions both in the United Kingdom and overseas. After leaving government service, Sarah embarked on a career in the private sector. Her practice includes helping global corporates enter high-risk new and emerging markets. She also provides strategic, survival-level intelligence and support in assessing and managing risk to their operations. She has worked on numerous complex multijurisdictional investigations including FCPA, asset tracking and asset recovery. She also consults on litigation matters for international arbitration and disputes. Sarah is based in the London office.

Sarah Keeling Managing Director+44 (0) 20 3514 6973skeeling@thinkbrg.com

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