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

A RESEARCH PAPER BY BRG Berkeley Research Group About BRG Post transaction and Berkeley Research Group is a leading global shareholder disputes strategic advisory and expert consulting services firm that provides independent advice, Our experts have helped resolve hundreds data analytics, authoritative studies, expert of post transaction and shareholder testimony, investigations, and regulatory disputes. We have a deep and up-to-date and dispute consulting to Fortune 500 understanding of transactions and the corporations, financial institutions, accounting and financial aspects of closing government agencies, major law firms and mechanisms. This knowledge is necessary regulatory bodies around the world. to identify key issues in disputes and to link them into the quantification of damages or Our experts combine intellectual rigour investigations of fraud. with practical experience and an in-depth understanding of industries and markets. In essence, most private M&A disputes Their expertise spans economics and relate to disagreement over “value” finance, data analytics and statistics, and transferred from seller to buyer at closing. public policy in many of the major sectors The target may be worth less than what of our economy, including healthcare, the buyer paid for (for example because banking, information technology, energy, it becomes clear that the target’s future construction, and real estate. earnings will be lower than expected, or liabilities were concealed). This could be Named by Forbes as one of America’s either by accident or design. Best Management Consulting Firms in 2016, BRG is headquartered in Emeryville, Cross-border M&A and LBO transactions California, with offices across the United that end up in disputes are often resolved States and in Asia, Australia, Canada, Latin through international arbitration. BRG America, the Middle East, and the United experts often work on the quantification of Kingdom. damages and forensic accounting matters in arbitrations, including matters related to Litigation and arbitration closing accounts, breach of warranty, fraud, services and earn-out disputes. We work as advisors or expert witnesses. Where appropriate, we Our litigation and arbitration experts work closely with other experts, for example provide independent and objective analyses, in construction, investigations, or forensic litigation support, and expert testimony technology. 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.

Copyright ©2016 by Berkeley Research Group, LLC. Except as may be Disclaimer: The opinions expressed in this publication are those of the expressly provided elsewhere in this publication, permission is hereby granted individual authors and do not represent the opinions of BRG or its other to produce and distribute copies of individual works from this publication employees and affiliates. The information provided in the publication is not for non-profit educational purposes, provided that the author, source, and intended to and does not render legal, accounting, tax, or other professional copyright notice are included on each copy. This permission is in addition to advice or services, and no client relationship is established with BRG by rights of reproduction granted under Sections 107, 108, and other provisions making any information available in this publication, or from you transmitting of the U.S. Copyright Act and its amendments. an email or other message to us. None of the information contained herein should be used as a substitute for consultation with competent advisors. After the transaction is signed, but before it is closed, the largest customer of the target decides to take its business elsewhere $

Political uncertainty causes the buyer’s home currency to crash. Earn-out payments become more expensive A whistleblower calls the purchaser shortly after closing and mentions social security fraud ?

Purchaser accountants become suspicious about the level of the target’s provisions 18 months after the deal closes, the owner manager of the target sues over his earn-out What could possibly go wrong? A forensic analysis of the target’s accounts uncovers fabricated invoices

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

European country near the target elects ultrayields right move wing sharplyleader. Bond

Purchaser discovers that the target has been the victim of industrial espionage

Long-term contracts initially valued at millions of euros discovered to be worth a fraction of that amount

A few weeks after closing,$ the target’s management requests additional cash to cover unexpected operating losses

CHANCE Volatility. Disruption. Foreword At BRG we have seen more than our fair share of disputes arising from mergers Fraud. Dispute. 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 multiplied in cross border disputes where local practices differ. For example, in Europe most deals now close using a mechanism called a “locked box”, a practice that is very rare in the US. Conversely, representations and warranties insurance has long been a common feature of US deals, but has only recently caught on in continental 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.

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. 5

Elements of a Overconfidence Interest rate environment Human frailty and fallibility is a constant. and the valuation of dispute There have always been, and will always liabilities be, sellers who get “deal fever” and ignore Debt, both on and off balance sheet, plays due diligence red flags, only to regret it Disruption and volatility an important role in M&A disputes and later. Overconfidence in decision-making is fraud cases. Real interest rates have been One frequent element of an M&A dispute a major contributor to post deal disputes. exceptionally low for a significant period is disruption – the unexpected creeping In our experience, buyers systematically of time, and even negative in some large into a deal. overestimate their knowledge and ability to economies. Low interest rates are causing make a transaction a success. Curve-ball events often lead to breaches of long-term liabilities on company balance sheets to increase. They are creating representations and warranties or alleged Buyers who overestimate how well they record pension deficits which in turn material adverse effects. Surprised buyers understand the target and its markets weigh on deals. And extremely low interest tend to look for reasons for their surprise, are likely to make technical errors. They rates also affect long held practices in and, because humans make mistakes, are also likely to underestimate the valuation, both when valuing a transaction lawyers and accountants who get paid to challenges they may face when integrating or quantifying damages. uncover inconsistencies and errors, tend to their acquisition. This is why many deals We focus on this in the section on debt find them. fail, disappointment may well set in after PAGE 16 to 18 closing, and dispute could be the result. Unsurprised buyers tend not to question We highlight the perspective of a the deal they have just done, and so behavioural economist on PAGE 9 sleeping dogs are allowed to lie. It is safe to Completion assume that many breaches of warranties mechanisms and even frauds go unnoticed. Ambiguity Even level headed sellers are likely to take All of the factors listed above have led to Unexpected events can impact final prices an optimistic viewpoint when preparing disputes that BRG experts have worked on. in unexpected ways, and the world in which their accounts pre M&A. This is to be But where are these mistakes made and we are living at the moment appears to be expected as accounting, after all, allows a where is the smoking gun? one where the unexpected is increasingly great deal of scope for judgment. Disputes becoming a factor. The markets, as we often arise where judgment goes beyond For dealmakers, the deal’s blueprint is the all know, were wrong-footed by the UK optimism into bias and outside of SPA. In M&A disputes the SPA is most electorate’s decision to leave the European acceptable ranges of estimates. often – though by no means always – the Union. The market volatility that followed battleground. A key part of the SPA is the the Brexit vote is a testament to that. Nowhere is ambiguity or subjectivity in completion mechanism. transactions more relevant than in the The following article explains more. Companies with large exposure to foreign target’s projections and in the accounting exchange rate movements have been for working capital and provisions. affected considerably. This type of market We discuss this theme on PAGES 16 to 18 volatility has found its way into valuations of companies and measurements at Fraud closing. Sometimes bias can cross into intentional Add to that technology-induced volatility, misrepresentation, and intent is what often such as flash-crashes and hacked suggests fraud. customer data and it is plain to see that there are an increasing number of Fraud is particularly difficult to detect variables that can cause nasty surprises, before signing. We, however, highlight a leading to disagreement over accounting number of red flags. Overly complicated measurements when setting the final documentation might suggest a fraud is price or so-called material adverse taking place. Earnings that don’t convert change (MAC) events, which often lead to into cash is another hallmark. Also, if renegotiations of prices after signing the a seller is restricting the information it Sale and Purchase Agreement (SPA). disclosed to the buyer, it might be a sign We discuss these on PAGE 10 that they have something to hide.

Fraud most often affects revenue recognition and the recognition of earnings which are the basis of price. We discuss this on PAGE 11 6

Learning to love completion mechanisms

Whether a dispute is caused by fraud, worked on the SPA spring back into action ambiguous wording in the SPA, or just and interpret the SPA as they draw up the changed circumstances, the battleground is completion accounts. What has changed? often the SPA, and the devil really is in the What does the SPA say must be done in the detail. event of such a change? These are among the reasons why completion of an M&A Anybody who has ever been involved in the deal can be extremely complex. nitty-gritty of an M&A transaction knows that they can be fraught and pressure- The transaction timeline fuelled processes. Principals and their advisors (accountants, lawyers, bankers, There are many reasons why complex M&A consultants), under the pressure of transactions do not sign and close on the extremely tight deadlines, must deal with same day. Transactions are often subject complicated technical issues that span to antitrust and other regulatory approvals. disciplines and workstreams. At the Increased vigilance from regulatory best of times, the atmosphere is collegiate, and antitrust authorities takes time. at the worst: outright adversarial. Closing conditions are set out in the SPA. And so, after signing, an M&A deal will Once the SPA is signed, closing conditions usually go into a closing period before all need to be met. The closing period is the conditions are met and the transaction a time in which target, purchaser and closes. vendor continue to trade. Or maybe one of them goes bankrupt. Management might The closing period is often weeks or a few change. Legal disputes that the target is months, but can be significantly longer, engaged in may be resolved. New ones especially in highly regulated industries. may start. Markets might fall. Or rise. This time lag means that there is Regulators will scrutinise the deal. Key uncertainty at signing as to the precise managers or customers may leave. Large balance sheet at closing. The longer the construction projects that the target is closing period, the greater the uncertainty. engaged in may be delayed or cancelled. It is also difficult to predict the exact The target may even be the victim of a length of the closing period at signing. cyber attack. All these things can, and do, This introduces an additional source of happen. uncertainty.

Much can happen in weeks, months or a Daily changes in the balance sheet year. mean that more, or less, value could be transferred at closing than the parties And then, when the closing conditions are bargained for. The parties, therefore, need met, the lawyers and accountants who a mechanism in place to ensure that the

Diagram: Transaction timeline

Intent Final to do Signing Closing purchase the deal price

Closing period Post-closing period 7

value transferred at closing corresponds to While locked boxes tend to be generally what the parties bargained for when they seller friendly and straightforward in signed the SPA. many cases, there are good reasons to use purchase price adjustments on many As well as protecting the purchaser from deals. Purchase price adjustments have uncertainty, without safeguards it would more moving parts than locked boxes in be possible for the seller, who controls the which the purchase price is fixed. business until closing, to “extract value”, or for value to leak. Both locked boxes and purchase price adjustments have been used in thousands There are many different ways to extract of transactions, most of which never went value between signing and closing, into a dispute. However, at BRG we deal including dividend payments, adjusting with the fallout caused in the atypical transfer prices in transactions with cases where mistakes are made or related parties or changing management circumstances change and disputes take compensation. Each of these may reduce place. Maybe that makes us Cassandralike, the commercial value of the equity to be but we prefer not to repent at leisure. transferred to the buyer at closing. Even in the absence of the seller’s manipulation, We have noticed similar patterns of there is a rationale for protecting either mistakes replicated in many post M&A party from possible disadvantages due to disputes. The following article presupposes changes in the balance sheet up to closing. a level of knowledge about transactions, A good completion mechanism means a and doesn’t offer generic solutions: every fair and “clean” transaction, and therefore M&A transaction is different. However, fewer problems down the line. there is a benefit to understanding disputes and their typical causes. 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. The makings of a modern M&A dispute 9 Introduction: the makings of an M&A dispute

“A firm’s decisions, Commerce, on the whole, likes certainty, the firm’s practice areas and geographies. not volatility, disruption and unforeseen We hope that you find that each expert including those related circumstances. Yet disruption and the interviewed for this paper brings an to M&A transactions, are unforeseen have become a disturbingly interesting perspective to M&A disputes. made by individuals, and recurring theme recently. This paper summarises our findings and their behavioural traits A year ago, the probability that 2016 discusses the various ways in which a influence outcomes. would see the dual outcomes of the Brexit poorly worded SPA combined with the Research indicates that referendum and the US presidential unexpected can lead to a purchaser or elections as they were, would have been seller getting less than what they had chief executives tend to considered remote by serious market bargained for, leading them to seek be more optimistic and commentators. Similarly, predicting the redress. Although we may not be able to more open to risk than UK stock market bull run, or the volatility predict them, we are able to consider the in exchange rates that accompanied potential effects of “long tail” events. the general population. these political events, would have been exceptionally difficult. Such major First, we discuss fraud, where one party It is also a natural movements will certainly have handed sets out to deceive another party for tendency for people to some businesses unforeseen opportunities, financial gain. Or, more subtly, when a surround themselves and provided others with unexpected seller goes beyond “gilding the lily” and hurdles. They will also have made some makes fraudulent misrepresentations. with likeminded people. pending cross-border M&A transactions, We then discuss revenue recognition, the But in doing so, they for example those into the UK, more most common area of financial statement risk making themselves attractive and others less so. fraud. Our next topic is debt, both hidden and apparent. We then look at working vulnerable. One Besides political events, technological capital, an area of the balance sheet that important way to improve developments have introduced new sources can be used to double-dip a buyer, either decision-making and of disruption that would have been almost by accident or design, and an area where unheard of even a decade ago. Take cyber volatile real world events find their way avoid overconfidence security. Revelations that the Yahoo/ into balance sheets and cause surprises is diversity. The more Verizon deal is facing problems following that often lead to disputes. Our next topic diverse the pool of news that Yahoo was the victim of a is earn-outs. They are a great way to individuals involved, massive cyber attack is another example of incentivise the former managers of a target a wild card event. company, but equally a way to widen the the better the decision- window for litigation. We then consider making probably is. More generally, there haven’t been many transactions with a fixed purchase price, M&A disputes over cyber security, so the so-called “locked box”. Although it That is because diversity there isn’t a market in ideas yet. There is reduces the risk of disputes, it has its own what we call “craft ignorance” and a lack quirks. Our final topic is the assessment of combats group-think. of recognised standards. But it is fair to damages in M&A disputes. If you have a large pool assume there will be many disputes in of people working on a precisely this area in the future, and the While this publication has a technical deal, but they all think stakes are high. focus on corporate finance and accounting aspects of transactions, M&A disputes in the same way, they So, what should be the response of people have taught us the importance of “softer” all may make the same like us, people who work in M&A disputes factors, including culture, overconfidence mistaken assumptions, and transaction services? and other cognitive biases. More generally, the limitations of human beings to process and validate them to M&A disputes tend to be complicated, information play a significant role in each other.” time-wasting and expensive. In the context disputes. When volatility and disruption in of an M&A transaction, although we have a markets find their way into a transaction, Dr Shireen Meer good idea about where the usual hot spots the behavioural view becomes even more for disputes lie, we know that we can’t truly relevant. Behavioural economics has much predict what disruptive event might run a to say about this. We bring this perspective coach and horses through our carefully, into the analysis throughout the paper. or not-so-carefully worded drafting. This means that we know we can’t cut corners. But before we go any further, we must clearly set down what we mean by an “M&A In putting together this paper, we have -related dispute”. analysed a large number of M&A disputes and have spoken to BRG experts across 10

1 What is an M&A-related dispute?

It may seem obvious, but for the purpose Most M&A-related disputes arise during of this paper it is important to define what the period after closing. However, this is is meant by an M&A-related dispute. not always the case. Disputes can also An M&A-related dispute is any dispute, arise before the deal is signed, and during whether litigated, arbitrated, mediated the period in between signing and closing, or prosecuted, arising from the sale of known as the closing period. This is shown one business, or part of one business, to below. another, or a merger of two businesses.

SIGNING CLOSING

Post-closing Pre-signing Closing period period

Pre-signing disputes typically There is scope for the parties Most M&A-related disputes, relate to letters of intent, to fall out over whether fall into this category. These heads of terms, exclusivity or closing conditions have been disputes usually relate to confidentiality agreements. met if these are subject to purchase price adjustments, Disputes arise, for example interpretation. For example, or alleged breaches of when the parties fail to disputes arise over MAC representations and agree whether a letter of clauses which allow a buyer warranties. They may also intent is binding, or when to withdraw from the deal relate to seller’s obligations, one party alleges breach of if the value of a target has indemnifications, or earn- an exclusivity agreement. been adversely affected outs. Pre-signing disputes can by a significant adverse A frequent trigger of also relate to pre-contractual development before closing. post-closing disputes is duties, in particular The acquisition of Yahoo by unforeseen liquidity needs disclosure obligations. Verizon may be a case in of the target soon after point. 1 closing. As a result, many While an obvious source post M&A disputes happen of potential closing period in the months after closing. disputes, in reality, even However, mechanisms such when purchasers do threaten as earn-outs mean that the to exercise MAC clauses, buyer might have to continue MAC events are rare. Instead, to pay the seller for years it is more common that the after closing. As long as that buyer uses a potential MAC is happening, a dispute is event in order to renegotiate always on the cards. the price.

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. 11

2 Fraud

Most disputes occur because of mistakes and oversights in the negotiating process Fraud includes any and while drafting the SPA. But this is not intentional or deliberate always the case. Sometimes one party deliberately attempts to deceive the other act to deprive another party. And that is fraud. of property or money While there are different categories of fraud, this paper will focus on those that by guile, deception, or are most relevant in a transaction context: other unfair means. 2 financial statement fraud and corruption.

Financial statement fraud is the deliberate misrepresentation or omission of The fraud triangle can be a tool to financial statement data for the purpose understand fraud in a transaction context of misleading the reader and creating because M&A processes often give rise “A client in the extractives a false impression of an organisation’s to circumstances in which some or all sector who decided not financial strength. It typically relates to of the elements of the fraud triangle are misrepresentations by the target entity or particularly relevant. to do rigorous pre and the seller about the target entity. However, post-M&A due diligence we at BRG have also seen disputes where So, what is the source of pressure, in a on a deal in sub-Saharan misrepresentations were made by the transactional context? There are many buyer or by financial institutions. potential sources: the seller may come Africa, led to Department under pressure to avoid disclosing bad of Justice scrutiny. A useful framework for analysing fraud news during the negotiations. It may A catalogue of FCPA is what has become known as the fraud present inflated projections and maintain triangle. The fraud triangle was first them when things deteriorate and infringements which introduced by the American sociologist against better knowledge, which can lead breached a Deferred Donald R. Cressey who hypothesised that to inflated assumptions on which the Prosecution Agreement, three factors must be present in order purchase price is agreed. Similarly, the for someone to commit fraud: pressure, seller may feel under pressure to conceal led to punitive fines, opportunity and rationalisation. 3 debt that the buyer would have otherwise negative press deducted from the purchase price (if it coverage, activist and would not keep it from buying the business environmentalist scrutiny, altogether). Pressure often intensifies as the transaction progresses and, especially a sharp decrease in towards the end of long negotiations, some share price, dire investor sellers feel a need to avoid disclosing bad relations and, finally, the news, or to “soften” its impact, at almost any cost. demise of the company. Pressure At the risk of being a As pressure builds, the downward spiral Cassandra, conducting begins. If, in such a situation, the seller presents misleading forecasts and deep reputational due decides to stay silent about recent adverse diligence in opaque and developments (for example, the loss of a challenging jurisdictions Opportunity Rationalisation key customer), this may be considered a fraudulent misrepresentation if the buyer really does pay relies on the sellers’ forecasts. 4 dividends.” Sarah Keeling

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. 12

Fraud continued

The second element of the fraud triangle, opportunity, is due in part to the information asymmetry between the buyer Red flags for fraud and seller in a transaction. Unsurprisingly, When analysing the seller normally knows far more about the target business than the buyer, and the organisational structure seller can typically influence accounting look out for: choices or disclosures. Buyers attempt to level the playing field by conducting Impending/ Dominant recent comprehensive due diligence, but access CEO/ flotation or chairman may be limited, in particular in competitive buy-out auction processes. Importantly, detecting Unnecessarily fraud is not typically the focus or even the complicated scope of standard buy-side financial due corporate structure High diligence. However, if there are concerns Weak or financing level of finance arrangements over the numbers or “red flags” that are related party function transactions starting to emerge during the negotiations, an effective response can be to incorporate Consistent forensic expertise and fraud examination Involvement of adoption of “racy” non financial tools in the financial due diligence. See but acceptable management in some common“red flags” to look out for on accounting accounting the diagram on this page. policies

Identifying fraud before signing can be particularly difficult as one party is intentionally attempting to conceal it from When analysing profitability the other party. A seller who is committing and cash flow, “We did a cybersecurity fraud will typically also attempt to restrict look out for: check on a company that access as much as possible during the due diligence phase. was an M&A target. We Sales that do not found so many problems, Given the multitude of schemes, identifying turn into cash — red flags all of them unrelated to fraud often requires expert knowledge. include deteriorating collection ratios, receivables the deal itself, that the It can therefore be important to include ageing, inventory turnover, forensic accountants or fraud examiners and sustained cash outflow transaction was pulled in the financial due diligence team, at least from operations despite profit growth and the target needed when the risk of fraud appears significant. to spend a considerable It is also a good idea to keep an open mind and healthy scepticism throughout the amount on network Pressures on transaction process, even amid infectious Straight line profitability as upgrades. Parties on or “hockey stick” enthusiasm. “Deal fever” can lead to a evidenced by earnings/profit both sides of a deal are buyer feeling pressurised into signing a declining profit growth transaction, and regretting it later. It is, margins well advised to consider therefore, important to listen to impartial cyber due diligence as advice. High part of their transaction financing costs The last element of the fraud triangle, compared to process to reduce this debt levels rationalisation, is the ability of the person relatively new breed of who commits the fraud to convince him or risk.” herself that their actions are acceptable or justifiable. In a transaction context, there is Tom Brown often an (tacit) understanding that sellers That fraud may be found out, or may lie are expected to “dress up the bride”. It undetected on (or off) the company’s is generally true that sellers present the books. Once the transaction closes, target company in the best possible light. the new owner takes control and has In most M&A situations, the purchaser will the opportunity to find out more about accept that the lily is often gilded. But if a the target’s financial statements and seller crosses a line and makes intentional disclosures. Somewhat surprisingly, misstatements, instead of simply treating many buyers do not take advantage of the the glass as half full, a fraud has taken opportunity. It is therefore safe to assume place. that many frauds remain undetected. 13

However, there are some common accounting has gone beyond optimism, triggers which may lead a buyer to uncover then there might be a case for fraud. A fraudulent behaviour. BRG experts often difficult task is ahead: unpicking financial see buyers become suspicious when statements requires a combination of they discover soon after closing, to their expertise of transaction specialists, surprise, that the target entity is in need of forensic accountants and even intelligence additional liquidity. professionals, all trying to unravel something other experienced professionals Even in the absence of unforeseen liquidity have sought to conceal. needs it is often appropriate to conduct post-closing due diligence. The most common financial reporting fraud scheme is incorrect revenue recognition.5 If this reveals unknown off balance We therefore focus on this topic in the next sheet liabilities, or that the seller’s section.

“If a company buys Corruption risk in another company that transactions has been involved

Corruption is a type of in corruption, for occupational fraud that can be example bribing foreign categorised into bribery, conflicts officials, the liability of interest, illegal gratuities and economic extortion. Of for wrongdoing may these, allegations of bribery transfer with the M&A. have received significant press In situations where coverage in recent times, and enforcement of anti foreign- corruption might be an “We see many M&A corruption statutes has been issue, I recommend post stepped up in many countries. deal due diligence to disputes in Asia, where The downsides of uncovering foreign investors corruption post-closing, and the shake any problems out. acquiring local targets reputational and other damage, That way you can control can be significant. It is therefore operate in an unfamiliar appropriate where relevant to the issue and be on top business environment, involve specialist expertise in the of it, rather than getting and where standards of financial due diligence. surprised by a whistle- corporate governance blower.” and regulatory scrutiny Piers de Wilde are often not as mature as in more developed markets.” Mustafa Hadi

5/ Gerry Zack, “Inventory inflation schemes come in many flavours”, Fraud Magazine November / December 2016, p. 8. 14

3 Issues relating to revenue recognition

Revenue recognition is the battleground (POC) method of revenue recognition.7 It for some of the largest, most high profile means that part of the contract’s overall and complex post-M&A disputes. To a estimated profit can (but not necessarily significant degree this relates to a common should) be recognised for contracts that link between the purchase price and the have not yet been completed in full.8 A earnings of the target. When profitable judgment call is required on both the sales increase earnings in a period, and degree of completion of the work, and the those earnings are used as the basis of overall contract profit or loss. Both are the valuation (for example, as an EBITDA open to bias. multiple), then the question of the quality of those earnings and the timing of their There are two common ways companies recognition takes centre stage. An incentive overstate profits using the POC method: to overstate earnings is then magnified by the multiplier. For example, if the Overestimate the degree of completion. enterprise value (EV) is eight times a recent This accelerates the recognition of period’s EBITDA, the seller has an incentive contract profitability (typically by moving it to look for ways to increase EBITDA into a financial year on which the valuation “In my experience, in because it will have a direct, magnified is based), even in cases when the estimate construction, one of effect on EV. of overall profitability is correct; and/or the biggest causes Revenue recognition rules are exceptionally Underestimate the costs to complete of disputes is human complex, and important changes to work under the contract. This means that optimism in the face IFRS and US GAAP-accounting rules are the expected margin on the contract is of obvious uncertainty. underway.6 When to recognise revenue overstated. is typically associated with two key Construction has a “bad uncertainties: whether the product or Estimating the degree of completion and news” culture in which service has been provided and whether the remaining costs needed to complete business problems often cash will be collected (i.e., whether it large, long-term projects requires a deep is realisable). Disputes originate when technical understanding of construction- don’t get dealt with revenue is recognised that turns out not to related matters. These estimates are until they are too big to be realisable or had not been earned in the difficult even for someone who has full ignore. This, combined relevant period. access to information and is familiar with the evolution of the project. They can be with accounting An area that is particularly vulnerable all the more challenging for a buyer when rules for long-term to bias is the accounting for long-term access to information is limited. In addition, contracts that require contracts. This is the focus of the next we often observe that internal project section. reporting in many companies is weaker significant judgment, than other aspects of internal reporting. puts their accounting, Long term contracts and due diligence,

When a company works on a long-term at the intersection of contract, it may, under certain conditions, disciplines: technical recognise revenue before the contract is engineering competence completed, by allocating contract revenue and contract costs to accounting periods and financial and in which construction work is performed. accounting knowledge. This is called the percentage of completion In the context of M&A disputes and in a culture such as in construction, hindsight has many benefits.” Sean Fishlock 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. 15

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

Reported contract profitability over time (cumulative,Cm) Contract I Contract II Contract III Contract IV

Percent completed

80

40

0

20% 40% 60% 80% 100%

In this acquisition, the valuation of Overstating profitability is one the target company was based on the of the most common areas of earnings of a period that included profits disagreement about revenue of the four contracts as reported before recognition of long-term the contracts ended. Over the contract contracts in post M&A disputes. terms, management was consistently Prematurely recognised or too optimistic about the overall contract overstated profits are not part of profitability. The benefit of hindsight shows recurring earnings, and buyers that this led to overstated profits up until should not include them in the the completion of each contract. Only when basis of valuation. Identifying bias each contract ended, in the absence of any in earnings recognition is a first future periods into which to defer losses, step in removing them from the did the company report the cumulative basis of valuation by quantifying losses actually incurred over the term of an EBITDA or EBIT adjustment. the contract. In three out of four cases An analysis of past reporting there were cumulative losses, despite the periods (like the one in the previously (incorrectly) reported profits. graph) is a tool to identify bias in This suggests, at the very least, bias in estimates. 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.

9/ The contract terms were between 36 and 48 months. They are scaled here (with some simplifying assumptions) to be comparable for analysis. 16

4 Issues relating to net debt

Capital structure, valuation and the completion Purchase price adjustments – overview mechanism A purchase price adjustment adjusts the Purchase price adjustments pin down the preliminary purchase price by measuring exact levels of debt, cash, working capital, A firm engages in operating, investing, the relevant balance sheet and other and other items at closing. They thus and financing activities. It does this with financial statement items at closing. ensure that the purchaser is compensated the intention of generating value and The SPA sets out the mechanism, for debt at closing and that the vendor subsequently distributing surpluses to definitions, basis of preparation, and receives value for any surplus cash at the investors in the firm who have given process to determine the adjustments. The closing. up cash to acquire entitlement to the idea is that firm value is fixed at signing. distribution of future surpluses, whether There are a number of specific purchase through acquiring debt or equity. Purchase price adjustments adjust the price adjustment mechanisms that can be equity value, not the enterprise value. The used. They are listed in the table below, and One can value the firm and then divide adjustments relate to short-term changes discussed in this and the following sections. the firm’s value among the various between signing and closing, while the claimants—shareholders and debtholders. headline price is unchanged. The relationship between firm value and the value of the claims on the firm may be BASIS OF ADJUSTMENT COMMENT set out as follows: Net debt To adjust from a debt-free/cash-free basis

Value of the firm = value of debt + value Net working capital Used in combination with net debt. For a seasonal business of equity or a business subject to some volatility in trading; for a cash-free/debt-free basis as protection against seller In transactions, the value of the firm is manipulation by reducing working capital commonly referred to as enterprise value, Capital expenditure Used in combination with net debt. For a capital expenditure- but also as the “headline price” (often intensive business and a cash-free/debt-free basis, used in letters of intent in the early phases of a as protection against seller manipulation by slowing down deal) or “cash and debt free price”. investment spend

Below is a simple version of the “equity Net assets/equity Typically used instead of net debt adjustment (sometimes used as a “floor” in addition to a net debt adjustment). bridge” that shows that a valuation Rarely used these days approach that leads to the valuation of the firm (as in practice many do) requires the Other Marketing, R&D spend, EBITDA. Used in combination with deduction of debt and similar items, and net debt adjustment. Rare 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 net debt deduction and “There is due diligence related disputes and good due diligence. The net amount of debt-like items less It isn’t enough to just tick cash and equivalents is referred to as “net - + boxes. Soon, it is likely Enterprise Debt-like Cash and Equity debt”. A net debt clause is a very common value items equivalents value type of purchase price adjustment. As that companies will not there is no legal or generally accepted just have to demonstrate accounting definition of net debt, defining to regulators that items to be treated as debt-like or as free cash equivalent is a matter for the parties they have done due to negotiate and agree on. In the case of a diligence, they will have The buyer and seller must agree upon the purchase price adjustment, the document to demonstrate that they items to be deducted or added to arrive at that captures this is the SPA. have done good due equity value in the negotiations. However, as the business (and its balance sheet) diligence.” changes every day, both before and after the SPA is signed, any time delay between Ben Johnson signing and closing of a transaction means that the parties are uncertain about the precise balance sheet to be transferred at closing. 17

In practice, a large number of items can Agreeing net debt deductions typically be considered to be debt or similar in reflects each side’s relative strength in the nature. Here is a list of items that are negotiating process. This section discusses sometimes discussed in negotiations, three broad categories of net debt that ranked (somewhat subjectively) from play a significant role in practice and that “harder” items at the top (i.e., items that could become cause for disagreement in are commonly deducted), to “softer” items negotiations. (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 Debt hot spots same thing: reduce debt. For example, off balance sheet liabilities might relate to obligations in a whole separate entity such Bank as a special purpose vehicle (SPV) that and other is not consolidated in the parent entity’s (explicitly) financial statements, but for which the interest-bearing Finance Debt parent company is responsible. Other debt leases factoring /other common types of off balance sheet debt receivables include: factoring of trade receivables, financing leasing or unfunded pension deficits. Derivative instruments Pension The use of SPVs, factoring, leasing or other deficits types of off balance sheet debt is perfectly Supplier appropriate in most circumstances finance and does not typically involve violations of GAAP. However, the way they affect Trapped Non- financial statements can be used to cash and cash controlling achieve outcomes that are favourable items that are interest to one party. For example, factoring, a working capital in financing transaction, may be used to nature (e.g., cash maximise the cash position at closing in tills) Intercompany with no offsetting deduction for factored items Break receivables (unless it is treated as debt), costs and early leaving the buyer to pay more than the value it bargained for. Deferred repayment penalties revenue Financial statement fraud schemes Capital perpetrated by concealing debt are a expenditure different matter. An example is Enron creditors which used off balance sheet accounting to Current tax Restructuring appear to be a high-value company when in assets and provisions reality it was sitting on an ocean of debt. liabilities Dilapidation provisions Accrued bonuses Warranty Operating provisions leases Foreign exchange losses Deferred tax assets and liabilities 18

Issues relating to net debt continued

Provisions a French “Indemnité de fin de Carrière” — a type of defined benefit plan— A provision is a liability of uncertain timing fell under the definition of “financial or amount. The amount recognised as indebtedness” which included certain a provision has to be estimated. Some defined benefit obligations. There could provisions, such as for pensions (see have been no dispute if a list of defined separate section below), are almost always benefit plans had been included in the treated as debt-like in transactions. For definition of net debt. others, like warranty provisions, the case is less clear cut. It is because provisions There are also pension-related disputes require estimates that they are prone where it was claimed that the actuarial to disputes. GAAP can give significant report contained errors in determining the discretion to the preparer of the financial defined benefit obligation and the pension information, and estimates can be biased provision. 11 or perceived to be biased. Other disputes One case BRG experts have worked on relates to the acquisition of a related to debt top-tier basketball club. The SPA Disagreements over net debt arise when a definition of debt included “long party claims that a particular item does or and medium-term bonus claims” does not fall under the SPA definition of net of players, whereas short-term debt. This can happen when the net debt obligations were not included in this definition leaves room for interpretation. definition. However, the definition For example, catchall definitions such of “medium-term” or “short-term” as “... and other interest-bearing debt”, was not clear. The dispute arose over in which the term “interest-bearing” is whether a significant bonus was not defined, leave considerable room for correctly classified as “medium- interpretation: is a pension obligation term” interest-bearing? Vagueness causes A practical way to avoid disputes problems. is to aim to limit the reliance on Disagreements also arise at the estimates at closing. Using fixed intersection of debt and working capital. values for deductions that reflect For the mechanisms to work properly, expected valuations for liabilities, a seamless interaction between the agreed at signing, is one option. definitions of the two is important. Alternatively, when outcomes are When things go wrong in completion uncertain, indemnifications may be a mechanisms, it is often here. more appropriate instrument than a deduction. A “clean” interaction between different adjustments is important Pensions Pensions don’t often cause disputes but, Net working capital when they do, they can be eye-catchingly high profile because the amounts of money involved are often large relative to the size Net debt Capital of the transaction. Even if the dispute is expenditure resolved properly and beneficiaries are not affected, a pension dispute has the “We look at our private potential to worry many current and former An item may be captured twice, both as employees. 10 working capital and net debt (for example affairs with friendly eyes, a capital expenditure creditor), or an item and our bias always Pension disputes, like almost all other may not be captured at all (for example gets in the way of our disputes, can occur when professionals accruals for outstanding supplier invoices). involved in the deal do not draft definitions This may give the seller an opportunity judgment” tightly enough. For example, at BRG we to manipulate the cash position at the Seneca recently saw a case which rested on the effective date. Consequently, the buyer definition of “defined benefit obligation”. overpays. We will look at this interaction The parties were in dispute about whether more closely in the following section.

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. 19

5 Issues relating to working capital

“In the US, we are seeing The working capital section of the balance Although in principle the concept is logical, sheet is a hot spot for post M&A disputes. issues can arise when working capital a growing trend in ‘post and net debt become confused. If the net deal due diligence’ on It is the place where volatile events in debt and the working capital mechanisms closing working capital the real world are most likely to have an interact as they should, they exactly offset impact on transactions. Unsurprisingly, it is each other. As a result, the seller does not balances. Because of therefore where the financial crisis of 2008 have the ability to artificially increase the the current competitive and 2009 left its most visible balance sheet cash position, thus reducing net debt, by M&A market, deals scars. collecting receivables early, or stretching may be going lighter trade payables. But if they do not work as Most businesses require a certain (positive) they should, then either the buyer will pay on due diligence prior level of working capital as part of their too much, or the seller will get paid too to closing, and that normal operations. This is in part because little. While this is not necessarily a breach leads to a degree of sales usually do not convert to cash of provisions in the SPA, the frustration of immediately and because businesses need the party that overpays contributes to the subjectivity in the SPA as raw material or finished good inventories. risk of a dispute. it relates to determining Working capital is needed to keep working capital. So, in operations running smoothly. What magnifies the risk of disputes over working capital is the scope for response to this, I’m What relevance is this to an M&A disagreement over valuation matters of seeing companies get transaction? It is common for offer letters working capital items: trade receivables the diligence team to specify that the headline price is based are subject to estimates for unrecoverable on the assumption that the business will amounts, and inventory is valued at the back together after transfer with an “appropriate”, “normal” lower of cost or market value. This is where closing to go though the or “adequate” level of working capital. market volatility enters the completion closing working capital If, at closing, that level is not “normal”, a mechanism. Consider rapidly changing working capital adjustment compensates prices for inventory in some renewables documentation to make for the difference. There is a good reason markets in recent years where volatility sure the calculations for this. If at closing, the business has was such that establishing a “market price” are consistent and the more working capital than is normal at a specific date was a challenge. This is (more than it needs to operate), then it is a reason that a disproportionate number parties will be happy with reasonable that the buyer should pay for of transactions in renewable energies the result.” the excess. If, on the other hand, there is companies result in disputes. a deficit in working capital, the purchase Dan Galante price should be reduced by the shortfall It is, therefore, vital that working capital because the buyer will, in theory, have to is properly defined in the SPA and all the inject additional liquidity to bring it back to parties are clear about the accounting a sufficient level. methods that will be used to calculate it. This requires considerable attention from The same concept applies to a locked the professionals involved. The devil really box transaction, only that there is no is in the detail. adjustment at closing; a surplus or deficit in working capital at the locked box date should be reflected in the fixed price.

What is working capital in a transaction context?

There is no uniform definition of analysing an M&A dispute to determine a short time period. This means that working capital in a transaction context. whether an item in the balance sheet customers pay, inventories turn over A convention is that working capital is, or should be, working capital? We and suppliers get paid, all within a few should, at a minimum, always include find the following three almost always weeks or months (usually well under a trade receivables, trade payables, and appropriate. year). inventory. This is often called “core” or Operating nature: This means that Recurring nature: Working capital “trade” working capital. While these working capital items are the result items are constantly revolving, which components should always be included of business activities, not financing means as they convert into cash they in the definition of working capital, they activities. A normal level of working are replaced by new (short-term) are however, almost never sufficient. capital is therefore part of the value of assets and liabilities. At any given point the operations, or EV. in time, there is a certain net level of What criteria should guide someone Short-term conversion into cash: working capital in the business (but the involved in an M&A transaction or Working capital converts into cash wihin level may change). 20

6 Issues relating to earn-outs

Earn-outs are contingent payouts that One way to minimise the risk of a dispute depend on the realisation of a certain is to use comparatively simple earn-out goals of the target company. They are parameters that, further, leave little calculated by reference to the performance to the buyer’s discretion when they of the company over a period after closing, are determined. A general rule is that the earn-out period. The measures of the higher up in the profit and loss the performance on which the earn-out parameter is, the fewer opportunities to payments are determined can be financial “manage” the earn-out basis. Sales, or or non-financial. Earn-out periods are even volumes sold or prices, are often less “I have noticed one trend often between one and three years, but we dispute-prone than net profit. Thorough sometimes see periods of up to five years. definitions of the accounting policies to be in earn-out disputes applied can also help avoid disputes. that happens time and The simplest reason that earn-outs are time again. Earn-outs prone to disputes is that they lengthen the Changes made to the newly acquired period of time it takes to fully determine the business after closing may affect the ability are often used to bring total purchase price. The longer the earn- of the target to report earn-out metrics on small entrepreneur- out period, the more prone to disputes a consistent basis. The longer the earn-out owned businesses into the transaction will probably be. This is period, the more changes the buyer may unsurprising as a longer period means make to the target company. For example, larger corporations, greater changes to the target business. In a strategic buyer may integrate the target many of which are addition, as time passes, a seller who is no into the acquiring company’s operations. public-reporting entities. longer involved in the management of the A private equity sponsor may merge it into target company is not responsible for its another portfolio company’s operations Often the entrepreneur trading results. in order to achieve synergies. As a continues to run that result, the company may share overhead part of the business As well as this obvious practical reason, functions and cost allocations. When the there are a number of accounting reasons target becomes a division of the acquiring as a separate division. why earn-outs are particularly dispute- company, it may not report profits on a If things go well, that prone if based on metrics such as EBITDA, comparable basis as it did when it was a part of the business EBIT or net profit. When setting the stand-alone company and when the earn- gets access to a bigger parameters for earn-outs, it is important out was designed. In this scenario, a single to ensure they are thoroughly defined. They recharge for group services could wipe market and can grow should also be closely related to “value”. out profits which would have otherwise revenue considerably, triggered a significant earn-out payment. but this leads to When measures of profitability such as Anticipating the reporting structure during EBITDA are used, questions over the the earn-out period is therefore important, considerably more quality of the profits can arise. Profits and if it is the intention to integrate the back-office costs, some can include, for example, non-cash, target into other operations post-closing, of which support the non-recurring earnings that may have earn-outs should be linked to metrics that nothing to do with “value”: if the target has are not affected by the integration. growth and some of historically set aside provisions that are too which could be related high, they might be released into income, Finally, it is important to ensure the buyer to public-reporting increasing profits. Similarly, earnings that has access rights to the target company to are artificially lowered by mere accounting review the seller’s calculation of earn- requirements. If that’s changes or non-cash, non-recurring write out payments. These rights need to be not addressed in the offs may reduce — or altogether wipe out specified in the SPA. SPA in terms of which — any earn-out payment, to the frustration of the seller. All these things could cause costs apply against the the seller and buyer to fall out during the earn-out, it can lead to a earn-out period. dispute.” Ron Evans 21

The purpose of an earn-out clause

Earn-outs can be very useful mechanisms. the purchase price is effectively paid out of However, they are also prone to disputes. the target’s operating profits after closing Here are some reasons why earn outs are only if these profits are actually achieved. used: This deferred component of the purchase price does not need to be financed by 1. Narrowing the price-expectation the buyer. This aspect made earn-outs divide particularly popular after the financial crisis when acquisition finance was difficult Earn-outs are often used in practice when to obtain and significant components of the the parties’ price expectations are far total consideration were deferred into the apart. They can be an effective mechanism earn-out period. to bridge the price-expectation divide. 4. Allocation of risk 2. Incentive for sellers remaining in the business One way to think about an earn-out is that it changes the allocation of risk between Earn-outs are also often used as a buyer and seller. A valuation before signing mechanism to incentivise an existing requires estimates of future returns of owner-manager who is selling his or her the target company. These estimates business and who will stay on managing are almost always subject to significant or otherwise contributing to the company. uncertainty. Without an earn-out, the The incentive to these types of sellers is to buyer typically bears the risk associated maximise their efforts as they will continue with their achievement: if the target falls to share in the rewards after closing. short of the projections, then the buyer receives less in value (at closing) than they 3. A method of acquisition finance bargained for. If the actual developments An earn-out is also a financing instrument. exceed expectations, then the buyer This is because the earn-out component of receives more.

Case study: A clarification missing the exchange rate should be the rate at in an earn-out clause leads to a the time the earn-out was paid, two years complicated later. Further, the counterclaim related to the earn-out basis which excluded several multi-party dispute. items (recurring credits) in the P&L. In ICC 14691, US and Brazilian companies The tribunal found that the appropriate (purchasers/claimants) entered into an exchange rate was that prevailing near the SPA with Brazilian and German sellers time the main earn-out payment became (respondents) over the purchase of shares due. Further, the tribunal held that an in a Brazilian subsidiary. The SPA included expert determination, which had excluded an earn-out provision that made additional the recurring items credits, was final and payments conditional on the achievement binding. of certain targets. An advance on the earn-out payments was paid by the buyers The tribunal noted the parties “devoted in US$. The earn-out itself was payable substantial time and effort, both in their in R$ (Brazilian real). After closing, the written submissions and at the hearing…”12 claimants alleged intentional breaches to the question of the exchange rate. This of representations and warranties. One claim dispute could have been avoided respondent counterclaimed for the earn- by inserting a clarification in the SPA, for out component of the purchase price. example specifying that the exchange rate The parties disagreed over the exchange at the due date of the earn-out payment rate to be used to convert the advance should be used and, further, specifying the payment made in US$ into R$. The buyers source of the exchange rate (for example argued for the exchange rate just before Bloomberg or Reuters mid-spot rate). closing, whereas the sellers argued that

12/ ICC Case 14691 Final Award in ICC International Court of Arbitration Bulletin, Vol 24, No. 1 (2013), p. 132. 22

7 Locked box-related disputes

The concept of the locked box first should be comprehensive “value leakage appeared in private equity auctions in protections” in the SPA. Leakage can come Europe in the early 2000s. It has come to in many forms, from dividend payments “Whereas the be adopted in a wide range of transactions before closing to changes in transfer and is now the most popular completion prices with related parties, changes to damages related to a mechanism in Europe. Locked boxes are management compensation, management misrepresented income generally considered to be seller friendly. fees, or waiving liabilities. Effective leakage stream may be assessed protection requires foreseeing any such In a locked box transaction, the transfer of eventuality. by determining the the target company is economically (but capitalised loss of profit, not legally) backdated to a historical date, It is important to keep in mind that there is also the need to typically the date of the last audited balance the items giving rise to purchase price sheet. There is no true-up at closing for net adjustments are equally relevant to the consider the valuation debt, working capital or other items. The locked box: even though there are no price impact on the remainder of date of the economic acquisition is termed adjustments when a locked box is used, the the business enterprise. the “locked box date” or “effective date”. fixed purchase price should reflect debt The time between this date and closing is items, any deficit or surplus in working known as the “locked box period”. During capital against a normal level, and any If, for instance, the pricing this period, profits generated by the target deficit in investment spend.The difference mechanism is based on a principally accrue to the benefit of the is that these items are measured in a multiple of EBITDA, then buyer who obtains the closing date balance locked box at the locked box date, and in a consideration should be sheet without further adjustments to the purchase price adjustment at closing. purchase price. given as to whether there This brings us to disputes. The absence should be a reduction in An advantage of a locked box is that a of purchase price adjustments in locked that multiple. This may fixed purchase price makes it easier for boxes makes locked box SPAs less a seller to compare bids in an auction complex than those containing a purchase arise because the overall process. Other advantages of the locked price adjustment. The fixed purchase level of true profitability box are that it avoids the necessity to price removes the price adjustment as an suggests that the size of prepare completion accounts and the important area of post M&A disputes and often time-consuming negotiations over therefore reduces significantly the risk the enterprise now falls accounting definitions in the SPA. This of disputes in locked box transactions. below a benchmark of can save considerable time and effort. Disputes do occur, however, and these previously comparable This also eliminates significant scope for often relate to warranty breaches, alleged disagreement post-deal. fraud or closing conditions (e.g. MAC entities, or, perhaps more clauses). Locked box-specific disputes also understandably, a concern Profits generated by the target business have to do with leakage. These disputes that there may be other, between the effective date and closing can be over interpretations of what accrue to the purchaser (as cash generated constitutes a breach of a leakage covenant. as yet undiscovered, is transferred to the buyer). To compensate For example, we have seen disputes problems that will for the fact that the seller foregoes those related to the interpretation of “arm’s impact on profitability. profits, the SPA sets out an interest rate, length” transactions with related parties. sometimes called the “daily profit charge”, If discounted cash flow to be applied to the purchase price. The In conclusion, while simpler to handle than is the primary valuation interest, or daily profit charge, is payable other closing mechanisms, the locked box approach, then this will by the buyer for the locked box period. This is not immune to disputes. As we have charge represents the opportunity cost to seen throughout this paper, imprecise result in an increase in the the seller of backdating the transaction. drafting can lead to problems down the discount rate to reflect this line. However, a locked box eliminates additional uncertainty, or “Locking the box” stipulates that the seller disputes in relation to purchase price perceived risk.“ does not extract value from the business adjustments. between the reference date and closing. No value must leak. This means there Andrew Caldwell 23

8 A short word about quantum in M&A disputes

Damages theories differ significantly One way damages can be categorised between jurisdictions. Whether related to is into actual (but for) damages, caused fraud, breaches of representations and directly by the wrong doing, and warranties or other matters, damages in consequential (or indirect) damages. M&A disputes often involve claims of lost Consequential damages may include profits or lost business value or both. Lost effects on other products of the acquiring profits can be defined as the difference company or on the target’s competitive between the claimant’s profits but for the positioning or reputation. Their assessment wrong doing and the claimant’s actual can be particularly complex. profits. Damages experts use a variety of valuation approaches, including the income In the context of valuing damages related approach (in particular the discounted cash to income streams of a going concern, flow method), the market approach and or valuing long-term liabilities, discount the net asset approach. The valuation itself rate often takes centre stage. The fact that may relate to a single asset or liability, present values can be very sensitive to or alternatively to the value of the equity even minor changes in discount rates has interest in the target entity or the value of been magnified by the current interest rate the business. environment. End word In putting together this paper, we have Fraud frequently goes unnoticed at the time spoken to BRG experts across the firm’s of a transaction, but seems more easily practice areas and geographies, in order to detectable with the benefit of hindsight. shed light on how disputes come about, how The truth is that often warning signs are to deal with them effectively, and how to avoid not taken seriously. Understanding the them. I hope that you have found that each factors that may make fraud more likely expert interviewed for this paper has brought in a transaction and getting an expert to a unique perspective to post M&A disputes. It examine red flags may well save time and is the combination of these perspectives that money in the long run. helps us understand disputes better. Such “The low interest rate diversity of thinking characterises BRG. Lastly, parties should consider carefully economy can make how unforeseen events around closing calculating the discount Disputes have lots of different causes, but could impact the transaction and find many disputes are avoidable. A few lessons their way into provisions in the SPA: where rate used to value have emerged: could volatility meet ambiguous wording long-term contracts or vague measurement concepts used problematic. Low or Technical mistakes in transactions that lead in the SPA? Then, the parties should to disputes often occur at the intersection aim to limit or eliminate where possible negative interest rates of disciplines. For example, the SPA, a subjective elements in SPA definitions result in lower discount legal document which may incorporate or in accounting policies. They should rates and therefore accounting and financial terminology and also consider different scenarios for the the value of your concepts needs to have drafting input from fallout of major political decisions or other more than just a lawyer, or more than just an external disruptions. future losses is higher. accountant, or even more than just a lawyer And many post-M&A and an accountant. It is, of course, impossible to always expect disputes involve the the unexpected, but if we go into every Judgment errors often occur because of situation aware that all of our assumptions quantification of future overconfidence or groupthink. Likeminded may turn out to be false, we will, at the very losses.” individuals working on the same task have a least, be prepared when disruption strikes. tendency to validate each other and replicate David Saunders mistakes. A diverse transaction team will Heiko Ziehms 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. 24

Biographies Heiko Ziehms Simon Ede Heiko Ziehms focuses on the Simon Ede is an economist quantification of damages with over 15 years of and forensic matters in experience working with complex commercial companies operating in disputes, including M&A, joint venture, the global energy markets. His broad and insolvency-related matters. He has range of project experience includes been appointed as expert in multiple transaction support, market analysis disputes. He has worked on matters in and forecasting, arbitration, litigation, ICC, DIS, LCIA, ICSID and SIAC arbitration strategy development, and auctions. He forums, ad hoc arbitrations and the courts. also provides expert analysis for clients in Heiko has worked on some of the most disputes. Simon is based in London. complex corporate disputes in Europe with values up to several billion euros. He is Simon Ede experienced in giving oral expert testimony. Director Heiko also provides transaction advisory +44 (0) 20 3725 8368 services and advises on completion [email protected] mechanisms in M&A transactions. He has advised on several hundred transactions. Heiko is based in London.

Heiko Ziehms Managing Director +44 (0) 20 3514 8578 [email protected]

Piers de Wilde Daniel Galante Sean Fishlock Piers de Wilde has over Dan Galante has more than Sean Fishlock is a member 10 years experience in the 25 years of experience and of EMEAA Construction investigations industry. In has developed extensive Group of BRG with over his career he has focused transaction experience 30 years of experience in on pre-transactional due diligence, serving as an adviser to companies all the construction industry. He trained in specialist investigations and strategic over the world. He has been involved surveying, construction management, intelligence. His work has included: with more than 600 buy- or sell-side project management and engineering assisting in activist investor situations; transactions for scores of different private with a major international contractor, and supporting M&A strategies through equity investors, hedge funds, lenders, spent 14 years in site and construction the provision of intelligence; informing and strategic corporate acquirers. Dan management, four years in property clients’ strategic communications in provides transaction-related diligence that development and asset management and complex disputes; overseeing major fraud typically includes a blend of commercial, three years managing £1billion prime and corruption investigations including financial, operational, and tax services. He contracts constructing and maintaining UKBA and FCPA matters; asset tracing has advised on target companies ranging land and marine infrastructure, housing and litigation support; providing new from startups to more than $3 billion in and property and estates for the UK market entry support and political risk revenues. Dan is based in New York. Ministry of Defence in the UK and overseas. analysis; and conducting anti-counterfeit Sean is based in London. investigations. Daniel Galante Managing Director Sean Fishlock Piers’ clients have included private equity +1 312 429 7982 Managing Director firms, financial institutions, family offices, [email protected] +44 (0) 20 3725 8380 law firms, multi-national corporations and [email protected] governments. He has worked throughout Europe, Africa, and the Middle East, and is based in London.

Piers de Wilde Director +44 (0) 20 3514 7147 [email protected] 25

David Saunders Shireen Meer Thomas Brown David Saunders is an Shireen Meer is an applied Tom Brown is Global Leader expert accountant and economist with a speciality of Berkeley Research the co-head of BRG’s in behavioural economics. Group’s Cyber Security/ London office. He works She applies economic Investigations practice. He in a variety of industries, jurisdictions, analysis to litigation and consulting specialises in helping clients manage and forums, including the UK courts matters related to areas such as class cyber risk, respond to incidents, remediate and international arbitrations, with action, intellectual property, antitrust, vulnerabilities, and address post-incident particular expertise in valuations and the breach of contract, product liability, regulatory enquiries and litigation. quantification of damages. David has been healthcare reimbursement, and general appointed as expert accountant on over commercial damages. Her work has Prior to joining BRG, Tom served for 70 occasions and has given oral testimony spanned industries such as healthcare, 12 years as an Assistant United States on 15 occasions both in the UK courts high technology products, consumer Attorney in the U.S. Attorney’s Office in and to arbitral tribunals in a range of products, metal refining products, banking, Manhattan, where he supervised the jurisdictions. He is an experienced fraud and pharmaceuticals. She has taught Complex Frauds and Cyber Crime Unit. and regulatory investigator. David’s cases undergraduate courses, been published in He led some of the most technologically have covered a range of business sectors, a variety of journals, is a public arbitrator challenging cases ever pursued by the including oil and gas, commodity trading, for the Financial Industry Regulatory U.S. government, including successful construction, property, pharmaceutical, Authority and a member of the American investigations of the underground drug telecommunications, manufacturing, Economic Association, American Bar website Silk Road and the hacktivist hotels, retail, entertainment, and financial Association, and Women’s Council on group Anonymous. Tom is a recipient of services. David is based in London. Energy and the Environment. She has a the FBI Director’s Award for Outstanding Ph.D. and M.A. in economics from Cyber Investigation and was named David Saunders Emory University. Shireen is based in “Prosecutor of the Year” by the Federal Managing Director Washington DC. Law Enforcement Foundation in 2011. He Co-Head of London Office is a member of the New York bar. Tom is +44 (0) 20 3725 8361 Shireen Meer based in New York. [email protected] Associate Director +1 202 480 2695 Thomas Brown [email protected] Global Leader, Cyber Security/ Investigations +1 646 862 0979 [email protected]

Ben Johnson Daniel Ryan Ron Evans Ben Johnson is a Daniel Ryan is the co-head Ron Evans is a member of member of BRG’s Global of BRG’s London office. BRG’s Corporate Finance/ Investigations + Strategic Daniel has over 20 years Transaction Advisory Intelligence practice. He of experience in valuing Services practice. He has has over 17 years of experience in forensic businesses, shares, and intellectual over 16 years of due diligence experience accounting, including fraud and financial property assets in both contentious and serving a variety of private equity and investigations, bribery and corruption, non-contentious matters, including sale strategic clients. He has worked on audit negligence, asset tracing, and and purchase transactions, shareholder over 250 transactions providing buy and litigation and arbitration. Ben has led many and post-acquisition disputes, intellectual sell-side financial due diligence, synergy investigations and reviews into suspected property licensing, infringement of validation, carve-out transactions, and accounting irregularities, bribery and intellectual property rights, fiscal finance department integration, and has corruption issues, and misconduct on valuation, and transfer pricing. He is advised clients with developing balanced behalf of regulators and private clients regularly appointed as an expert witness scorecards and strategic plans. Ron has in both civil and criminal proceedings. and is experienced in oral testimony. His significant private equity experience and He has significant financial services experience covers matters in the UK High public and private corporate experience. experience, having led investigations Court, before arbitral tribunals in the UK His primary industry expertise includes into alleged misconduct at banks in and internationally, in fiscal courts, and construction, energy, manufacturing and multiple jurisdictions, and he has led before the Copyright Tribunal. distribution, transportation, and retail. more than eight investigations on behalf He has also worked on transactions in a of accountancy regulators in relation to Daniel Ryan variety of other industries, including media accounting issues in recent accounting Managing Director and telecommunications, banking and scandals. Ben is based in London. Co-Head of London Office insurance, and consumer and industrial +44 (0) 20 3725 8358 markets. Ron is based in Miami. Ben Johnson [email protected] Managing Director Ron Evans +44 (0) 20 3808 4758 Managing Director [email protected] +1 786 725 3806 [email protected] 26

Sarah Keeling Andrew Caldwell Mustafa Hadi Sarah Keeling is a Andrew Caldwell is an Mustafa Hadi is the member of BRG’s Global experienced valuation Head of Disputes and Investigations + Strategic specialist in the United International Arbitration for Intelligence practice. A Kingdom, with more than Greater China and North former senior British government official, 30 years of involvement in the valuation Asia, and is based in BRG’s Hong Kong she has 23 years of experience in national of companies, shares, and intellectual office. He is an experienced consultant security and intelligence matters across property. His experience includes fiscal and on economic, financial, accounting, and jurisdictions both in the United Kingdom statutory valuations, and those required strategic business issues, and specialises and overseas. After leaving government for financial reporting and regulatory in addressing issues of valuation and service, Sarah embarked on a career in purposes, particularly of Level 2 and damages in the context of commercial the private sector. Her practice includes Level 3 assets; and acting for FTSE 100 disputes. helping global corporates enter high- companies. risk new and emerging markets. She Mustafa has been instructed as an also provides strategic, survival-level Andrew has been instructed as an expert expert witness in both national courts intelligence and support in assessing witness in a large number of cases, in and international arbitrations, and is and managing risk to their operations. respect to both valuation and the quantum experienced in giving oral testimony. She has worked on numerous complex of damages or loss of profits arising He has worked on cases involving the multijurisdictional investigations including from breach of warranty or contract valuation of businesses, shares, and FCPA, asset tracking and asset recovery. claims, post-acquisition and cross- intangible assets, and the quantification She also consults on litigation matters border disputes, and the infringement of complex damages arising from for international arbitration and disputes. of intellectual property rights. Andrew is contractual, shareholder, joint venture, Sarah is based in the London office. based in the London office. post-acquisition, and intellectual property disputes. Mustafa was “highly rated” Sarah Keeling Andrew Caldwell by Who’s Who Legal in its 2016 guide to Managing Director Managing Director leading experts in international arbitration. +44 (0) 20 3514 6973 +44 (0) 20 3725 8354 [email protected] [email protected] Mustafa Hadi Head of Disputes and International Arbitration – Greater China and North Asia +852 2297 2271 [email protected]

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