Unsurprisingly, when buying or selling a business, the parties put considerable effort into negotiating the headline price and other key terms. But once heads of terms have been settled, there can sometimes be a temptation to step back and let the advisers document the deal. This can be a mistake, as staying close to the detail is often critical to securing the deal that both sides think has been made. This is especially true of price adjustment mechanisms, as a recent Court of Appeal decision from the UK shows.
A classic price adjustment mechanism allows for an upfront price to be paid at the time the deal is closed, based on the last accounts of the target company, which is then adjusted on the basis of a set of "completion accounts", drawn up and agreed after closing. One of the main challenges lies in agreeing the principles for drawing up these accounts, and then applying them afterwards.
A common approach is for buyer and seller to agree a three-stage hierarchy of accounting principles and practices that will be used when preparing the completion accounts. This usually lists specific accounting treatments negotiated by the parties, and requires these to be applied first. Typically (but not always), the accounting policies and treatments used in preparing the target's last accounts will be applied next. Only after that will generally accepted accounting practice (GAAP) be employed. Clearly, the more comprehensive the specific accounting treatments are, the less room there is for later argument.
The Court of Appeal's decision demonstrates how important it is to get this right.
In the case, the target's last accounts were defined as being GAAP-compliant, but they turned out not to be (equipment leases should have been accounted for as finance leases, not operating leases). There is nothing to suggest the buyer and seller were unaware of how the leases had been treated, even if they did not know what the correct treatment was. But the difference in the eventual price to be paid by the buyer would have been sizeable, depending on the treatment of the leases in the completion accounts.
The agreement did not specify a particular treatment for the leases. So, based on the standard completion accounts hierarchy set out in the agreement, the seller argued that the completion accounts should treat the leases as operating leases, in the same way as the last accounts. The expert accountant that the parties called in to decide the dispute concluded that the agreement obliged it to follow that approach.
Both the High Court and the Court of Appeal disagreed. In effect, the Court of Appeal said that in these circumstances – where the target's last accounts were said to be GAAP-compliant but were not – the accounting treatments used in preparing those accounts (the second stage of the hierarchy) should be ignored, to the extent they were non-compliant.
In many respects, the decision is unsurprising. After all, you would expect a court to take some convincing that buyer and seller intended to adjust the price based on a non-compliant accounting practice. Reading between the lines, though, there is a suggestion that the court's approach may not have resulted in the price that the parties had originally expected.
At first sight, you might wonder why the case contains no reference to a claim for breach of the customary accounts warranties. As it turns out, in the particular circumstances of this case, this remedy may not have been available. But, more importantly, a warranty claim will often be precluded where the matter is dealt with in the completion accounts. And, even if available, having to make a warranty claim is much less satisfactory than having recourse to a well thought-through price adjustment mechanism. The latter will usually be much easier to enforce, and will not be subject to the same package of limitations negotiated by the seller.
Whatever the outcome of this particular case, the real lesson is the need for the agreement to spell out clearly what was intended. This requires an ongoing dialogue between principals and advisers throughout the process. If this is done, there is less room for surprises – and both buyer and seller are more likely to end up with what they thought they had agreed.
Case: Shafi v Rutherford  EWCA Civ 1186