Last December, the Delaware Supreme Court released two rulings that highlighted provisions in purchase agreements that are often afterthought in negotiations. In Golden Rule Financial Corporation v. Shareholder representative services, No. 61, 2021, 2021 WL 5754866 (Del. 3 Dec. 2021) (ORDER), the Court examined the language of post-closing “adjustment” and determined that the accounting principles “applied consistently” in the true up does not necessarily mean “in the same way that was applied before closing”. And in AB Stable VIII LLC v MAPS Hotels and Resorts One LLC, –A.3d–, 2021 WL 5832875 (December 8, 2021), the Court confirmed what it means to operate a business in the ordinary course between signing and closing during a pandemic. the Golden Rule and AB Stable the decisions provide an insightful frame of reference for practitioners to rethink what these provisions mean and how they may want to rearrange them to distribute risk as intended.

Golden Rule Financial Corporation v. Shareholder representative services

This case concerned the purchase of another company. Pursuant to the Purchase Agreement, the base purchase price was subject to a post-closing purchase price adjustment. The post-closing adjustment followed the typical format: First, sellers provide prior to closing an estimated balance sheet and timeline showing an estimate of his tangible net worth. After closing, the Buyer provides the Sellers with a final statement prepared “in accordance with accounting principles, applied consistently”. The purchase contract also provided for “tangible net worth” to be determined in accordance with accounting principles. Accounting principles, in turn, follow a hierarchy:

(a) The accounting principles and policies specifically set out below (the “Specific Policies”);

(b) To the extent that this is not addressed in paragraph (a) and which is not inconsistent with GAAP, where applicable, the policies, principles, procedures, rules, practices, methodologies, categorizations and accounting definitions used to prepare the audited GAAP annual consolidated balance sheet as of December 31, 2018.. . ;

(c) To the extent not addressed in paragraphs (a) and (b), GAAP, as applicable.

If the final tangible net worth exceeded the target peg of $ 52 million, the buyer would pay the sellers the excess of the peg. Likewise, if tangible net worth fell below the ankle, sellers would align the buyer.

In preparing its estimated balance sheet and schedule, Sellers incorporated the recent update to accounting standard ASC 606, even though the target company was not required to comply with ASC 606 under accounting standards. until after the closing. ASC 606 has also been added as one of the “Specific policies” in the hierarchy of accounting principles. The sellers provided an estimated balance sheet and schedule showing a tangible net worth of $ 40.75 million, which is $ 11.25 million below the fixed rate.

When the buyer completed his post-closing statements, he discovered that the sellers had incorrectly applied ASC 606. If applied consistently with the sellers methodology, the final tangible net worth would have been 35 million dollars, or 17 million dollars below the fixed rate. If applied correctly, that number would be $ 73.7 million, well above the ankle. The buyer informed the sellers of the error and provided a final statement incorporating the incorrect but “applied consistently” ASC 606 request. The sellers disputed the final statement and the parties began to make a final decision with a third-party auditor. Prior to the final decision, the buyer filed a complaint with the Court of Chancery for a declaration that the purchase contract “requires the same consistent application of ASC 606 that had been applied” by the sellers. . The Chancellery Court dismissed the action, ruling that the final tangible net worth figure must incorporate ASC 606 as correctly applied.

The Delaware Supreme Court upheld the termination. He ruled, in essence, that because the specific ASC 606 policy was at the top of the hierarchy of accounting principles, incorrect application would effectively result in non-application of ASC 606. He disagreed with the buyer’s interpretation because “applied consistently” here is more reasonably interpreted as preventing either party from opportunistically choosing different GAAP treatments rather than applying the agreed provisions of GAAP.

Take away food:

• “Supported Consistently” does not mean applied the same incorrectly prior to closing. Look for additional protection with language in alignment layouts that allow for incorrect application.
• Anticipate any irregularities in financial statements and closing statements by performing a thorough financial due diligence.
• Make sure you are protected against incorrect application of accounting rules with adequate disclosures in the financial statements. Also consider indemnification rights and the survival period with respect to financial statement disclosures in order to preserve remedies in the event of breach.

AB Stable VIII LLC v MAPS Hotels and Resorts One LLC

In this case, the seller has entered into a purchase agreement to sell a range of indirectly owned luxury hotels. The purchase contract was signed on September 10, 2019, with closing to take place at a later date. The purchase contract contained a condition “no material adverse effect” (or “no MAE”) and the following commitment “normal course”:

Unless otherwise provided in this Agreement. . . between the date of this agreement and the closing date, except with the prior written consent of the buyer (whose consent should not be unreasonably withheld, conditioned or delayed), the business of the company and its subsidiaries should be conducted only in the ordinary course of business in accordance with past practice in all material respects. . . . (emphasis added).

The closure was delayed for a variety of reasons, including title issues on the hotel properties (someone had filed fraudulent acts against the luxury hotel properties in question and the seller’s attorney downplayed and concealed information about it). The problems prompted the closure of the COVID pandemic. The vendor closed two of its hotels and the remaining hotels operated in a “closed but open” fashion, reducing staff and suspending all non-essential capital spending. Two weeks later, the seller informed the buyer of his change of operations while insisting that he did not need the buyer’s consent to change his operations, nor that he could not reasonably withhold consent due to the pandemic. The buyer said he was not ready to give consent without more information. The seller did not respond to a request for additional information. On the scheduled closing date, the Seller gave formal notice to the Seller on the basis, among other things, of the Seller’s inability to operate in the normal course of business. The seller then filed a complaint with the Court of Chancery to request a specific execution to close the transaction. In the opinion of the Seller, to give effect to both the No EAW provision and the ordinary course obligation, the Seller must have the freedom to take reasonable responses in accordance with industry standards to the allocated systemic risks. to the Purchaser by the No EAW provision. However, the Court of Chancery sided with the buyer, concluding that the seller had violated the ordinary course obligation by making “extraordinary changes to its business that radically departed from the normal and routine operation of hotels. and were totally incompatible with previous practices ”.

The Delaware Supreme Court upheld the court’s decision, ruling that compliance with the ordinary course commitment is measured by its operational history, and not by that of the industry in which it operates. He also found that the non-EAW provision served a different purpose: the non-EAW provision spreads the risk of a change in the valuation of the target company, while the normal course commitment is included to reassure the buyer that the company target did not significantly change its activities while waiting for the transaction. Thus, the fact that the Seller was taking justifiable, reasonable and consistent measures with the industry to preserve the business in response to the pandemic did not exempt it from seeking prior consent to comply with the ordinary course commitment.

Take away food:

• Ordinary Covenants, as they are generally worded, do not allow target companies to change their business practices outside of past practices, even if such changes constitute a commercially reasonable response to outside forces.
• Delaware courts interpret material adverse effect clauses to attribute the risk of change to the valuation of the target company. Ordinary covenants, on the other hand, are intended to protect against changes in business or trade practices between signing and closing.
• If a target business needs flexibility to respond to events like the COVID pandemic between signing and closing, consider qualifying the ordinary course engagement with a “commercially reasonable efforts” clause. The Court specifically identified that changing business practices in accordance with industry practices was more akin to acting with “commercially reasonable efforts” than the ordinary course alone.
• You can also ask for consent when you act outside of the ordinary course engagement. The Court concluded by reiterating that the arrangements for prior notification and consent should not be taken lightly and that a 2 week delay between the change in business practices and the notification / consent was not negligible. . Additionally, here consent could not be unreasonably withheld, conditioned or delayed, thus providing a possible remedy for the seller if the buyer did not agree to act in accordance with industry practices during the pandemic.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.