accuracy post m&a disputes research

An autopsy of cross-border M&A disputes A research paper by Accuracy

About Accuracy Accuracy is the sole, truly independent European actor in the field of financial advisory services to business leaders and their shareholders. It is wholly owned by its partners. Our firm has grown from seven consultants in 2004 to currently 280 professionals in nine countries. We have offices in Paris, Madrid, Amsterdam, Milan, Frankfurt, Brussels, London, Munich, Quebec, Montreal and New Delhi, with a new office opening in Singapore planned in early 2016. We assist our clients in dealing with a range of complex, high-stakes situations including disputes, acquisitions and companies in difficulty.

Accuracy’s forensic, litigation and arbitration experts combine technical skills in corporate finance, accounting, financial modelling, economics and market analysis with many years of forensic and transaction experience. We participate in different forms of dispute resolution, including arbitration, litigation and mediation. We also frequently assist in cases of actual or suspected fraud.

Our expert teams operate on the following basis:

An in-depth assessment of the situation

Clear, robust written expert reports, including concise summaries and detailed backup

A proven ability to present and defend our conclusions orally

The work is carried out objectively with the intention to make it easier for the arbitrators to reach a decision

An approach which values a transparent, detailed and well-argued presentation of the economic, financial or accounting issues at the heart of the case

Our approach provides for a more comprehensive and richer response to the numerous challenges of a dispute.

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The stages of an M&A deal and their stress pointsAn M&A transaction proceeds through a number of different stages. Some of the stages are more likely than others to spark a dispute. This infographic highlights the danger spots.

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An autopsy of cross-border M&A disputes A research paper by Accuracy

After the deal, the disputeEurope is in the middle of an M&A boom that is sure to be followed by an uptick in post M&A litigation. But what can dealmakers do to avoid this and, conversely, what should lawyers look for when considering if a deal can give rise to an actionable claim? Accuracy explains.

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lighTS iN loNdoN, Paris, Frankfurt and other financial centres will burn into the early hours tonight as lawyers and accountants draft documents designed to seamlessly transfer the ownership of large businesses across borders from one company to another. Deal activity is high, and in some sectors at an all-time high.

Courts and tribunals across the continent are also buzzing. London has a brand new court complex specially built for business disputes. But try getting space in one of its 31 courtrooms. You’ll have difficulty getting anything before spring. Commerce and the law are thriving together.

That’s because mergers and acquisitions often lead to disputes. Those disputes have a long tail and are expensive. New disputes caused by the 2008 financial crisis are still hitting the courts, while other unresolved disputes are reaching their third, fourth, and even fifth year of litigation.

At Accuracy we are on the front line of post-M&A disputes. As forensic accountants and valuation specialists we act

as expert witnesses helping courts and arbitration tribunals understand exactly what went wrong to cause a dispute. Our duty is to the court. We aren’t “hired guns.” We impartially autopsy the deal and present a report. We then defend our report under cross-examination from lawyers.

Over the last ten years we have worked on hundreds of disputes and over that period we have been collecting data to analyse trends. We have now built up enough data to make meaningful findings, and therefore are in a good position to explain why and how disputes happen. Overleaf we have

published a paper on the subject. This article contains highlights. All data have been anonymised to protect the confidentiality of the parties.

The first finding is telling; even though the courts are full to capacity, companies will do everything possible not to air their grievances in public. Over the last decade 57% of the disputes we have worked on weren’t litigated: they were heard in private settings before arbitration tribunals.

Almost a quarter (23%) were heard through alternative forms of dispute resolution such as mediation. Traditional litigation comes in at just 20%, making it our clients’ least favourite method of redress.

Expert witnesses don’t tend to be called in for simple or smaller disputes, so our research relates to more complex mergers and acquisitions at the top end of the market.

The good news for those who think they might get pulled into disputes is that almost a third of claims are for the relatively modest amount of €10 million or less. The bad news is that 15% of claims are for more than one billion euros. The biggest dispute we have dealt with to date was for around €10 billion. 44% of disputes come in at between €10 million and €100 million.

Smaller disputes, however, frequently do not mean less complexity. In fact, the relationship between amounts claimed and complexity is less clear than generally assumed.

What triggers a dispute? In our experience the overwhelming majority of disputes take place because the buyer gets a surprise after the deal closes. Often this manifests itself in the form of unforeseen liquidity needs. Simply speaking, unexpected bills need to be paid, or expected payments never materialise.

Much like buying a house, there is often a gap between the day the deal is agreed and the day the keys are handed over. In most circumstances, however, the purchaser of a house knows exactly what they are going to pay on the completion day. In the M&A world this only happens if a fixed purchase price is agreed. This is called a “locked box” mechanism. The price is set. It doesn’t change.

However corporate M&As are more complex than conveyancing: while a notional price is agreed when the contracts are

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signed, they are often governed by what is known as a purchase price adjustment clause. This means that the final price is set on the completion day based on conditions set out in the sale and purchase agreement (SPA).

These adjustments may mean the purchaser has to pay more than envisaged or, after completion, the value of the ownership interest in the purchased company comes out at less than expected. When these surprises can be linked to breaches of representations and warranties or other obligations, they may result in a disputes.

In short: if the purchaser either pays more than it expected, gets less for its money or believes that warranties have been breached, it calls in lawyers or forensic accountants. Often the lawyers find that there are grounds for a claim.

The statistics are clear. Locked boxes are less prone to disputes. At least 80% of the disputes we have worked on didn’t use a locked box completion method.

This observation gives rise to a simple piece of advice: if all you want is to minimise the probability of a dispute, all else being equal, then the use of a locked box agreement will achieve that. If you are a vendor, your purchaser is much less likely to look for ways to claw back value from the purchase price adjustment.

Another observation which can be put to use to minimise the risk of disputes relates to the role volatility frequently plays in disputes.

If you acquire a company and want to avoid a dispute, you should ask yourself how something unexpected in the target’s markets could impact the deal.

Then, you should seek to limit the impact of sharp price movements, and eliminate, as much as you can, any uncertainty about how the final purchase price is determined.

The paper overleaf goes into the issue of volatility in further detail. However, in our experience volatility is best combatted by a tightly-drafted SPA that leaves no or minimal room for debate.

Further, purchasers would be wise to include forensic, litigation and arbitration professionals in the financial due diligence team and ask them to identify and address potential areas of post-deal disputes before the deal.

A multidisciplinary approach yields many benefits.

So where are these disputes lurking? On what part of the balance sheet and in which paragraphs of the SPA can they be found?

The SPA is a contract that sets out both parties’ obligations including representations and warranties and, unless a locked box is used, how the final purchase price will be calculated. This means that if there is a dispute the SPA is the natural battleground.

As the SPA is a contract it is drafted by lawyers, but many of the obligations it

The statistics are clear. locked boxes are less prone to disputes. At least 80% of the disputes we have worked on didn’t use a locked box completion method.

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defines relate to financial or accounting matters.

A typical area of dispute involves the use of imprecise accounting terms. For example, we have seen loose M&A terminology in contracts such as “cash losses” described as “EBITDA.” Cash and accounting losses are not the same.

Similar problems creep into SPAs when the accounting standards which govern the determination of the final purchase price are ambiguous, or if there are conflicting standards which lack a clear hierarchy (such as consistency with past practice and generally accepted accounting principles).

On every occasion when this has happened, the person responsible for drafting the contract should have worked with an accountant or a financial expert to define precisely what they intended to take place.

From this we can deduce two lessons. The chances of a dispute can be reduced if lawyers and accountants work closely together on the elements of the SPA that involve accounting or financial reporting issues. Conversely, anyone attempting to build a claim would be well advised to carefully scrutinise the elements of the SPA that deal with these issues. It may well be the case that the contract actually says something that the drafter didn’t intend.

Of course, sometimes the seller simply tries to rip off the buyer. Around 10% of the post deal M&A disputes we work on involve allegations of fraud that are central to the claim. By its nature fraud is hard to detect as fraudsters attempt to cover their tracks.

Sometimes documents are forged to make it seem as if the company has more assets than it really owns or fewer liabilities. Most often, important information is simply not disclosed.

Fraud is also frequently associated with unnecessary complexity, intended to conceal, rather than represent faithfully, the true financial situation of the company. Complexity and an unstable

organisational structure are often advance warnings of fraud.

The research set out on the following pages goes into all of these issues and more in greater detail, and the appendix contains raw data for personal analysis. However, if dealmakers follow the few simple points laid out in this article, we believe that the chances of a post deal dispute will be substantially reduced.

One thing we can be sure of, though, is that no matter what the dealmakers do, it is impossible to guarantee that an agreement won’t be the subject of a dispute. Large, cross-border M&As are, by their nature, complicated and every M&A boom in recent years has been followed by an uptick in disputes.

We have no reason to believe that this M&A boom will be any different.

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An autopsy of cross border M&A disputes

Few corporate activities waste as much time and cost as much money as post deal disputes. They can take years to resolve and cost many millions of pounds, euros or dollars. They use up a huge amount of management time and may hinder a company’s ongoing operations. In short: they should be avoided.

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We at Accuracy have spent the last 10 years helping corporates and private equity sponsors resolve post deal disputes. Between us, we have worked on several hundred litigations and arbitrations on every continent. In our opinion, avoiding disputes should be one of the key objectives of any transaction. Avoiding a multi-year dispute is sometimes down to not getting a few words in the SPA wrong.

This study uses an analysis of post M&A disputes to identify themes and lessons for the future. We look at why disputes are avoidable. We explain our dispute-avoiding toolkit for use during due diligence. We also suggest measures to add to standard pre deal processes to reduce the risk of post deal disputes.

Although all disputes are different, we see the same themes coming up time and time again. Typically, disputes occur when:

Volatility in the target company’s markets finds its way into the transaction

There has been ambiguous drafting in the sale and purchase agreement

A fraud has taken place

The “thrill of the deal”, or external pressures to do a deal on PE sponsors or corporates

This paper will explain these themes in further detail. We do not guarantee a rock-solid way to avoid all post deal disputes, but if M&A professionals follow our guidelines, we believe that there will be a significant reduction in the number of disputes, saving everyone concerned a great deal of time, money and unnecessary stress.

Conversely, much of what we say about avoiding disputes can be used in situations where a dispute has already occurred. Our pointers can help legal teams identify where in the balance sheet actionable issues are most likely to be found. Such information is of use in the development of claim and counter-claim strategies.

The Partners, London, November 2015

The data setThe data are based on more than 900 individual claims made over a 10-year period. The claims were taken from reports written by Accuracy partners acting as expert witnesses or advising claimants or respondents in court litigation and private arbitration proceedings1.

Our work as expert witnesses mean that we are bound by professional confidentiality. This report will not make available any details of individual disputes, judgments

or rulings. The single

largest claim in our sample was worth approximately €10 billion and the smallest around €5 million. Our sample includes some of the largest post M&A disputes of recent years.

The disputes span a wide range of industries. They include manufacturing companies, large industrials, IT firms, real estate, renewables, automotive, oil & gas, music, retail, infrastructure, agriculture, aviation,

energy, sports, and food. We have looked at disputes ranging from major shipyards to leading European football clubs. We are confident that our data set provides a useful cross section of the business world.

Most of the disputes in our report relate to cross-border deals.2 We have included disputes from more than 20 countries, primarily the UK and Continental Europe. Other countries in the sample include the US, India, the UAE, South Korea,

and Japan.This study

maintains the confidentiality governing engagements in the strictest way, while making useful data available on an aggregate basis. Case studies are on a no-names neutralised basis.

1 following ICC, LCIA, DIS, SIAC and other arbitration rules.2 The acquisition by a local subsidiary of a foreign private equity sponsor is included in the definition of “cross border”.

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Here are some factors that can create volatility:

Irrational exuberance. This sometimes leads to extreme price expectations and sharp, unexpected price decreases when bubbles burst. This happened in the real estate markets in 2008

Disruptive innovation. A good example of this is music streaming, an innovation with consequences that many people in the industry didn’t foresee

Panic in financial markets, such as during the financial crisis

Lack of visibility of future profits. This typically relates to young, high growth industries or companies. Minor news can lead to disproportionate changes in the market’s perception of the value of the company

Unforeseen changes in laws or regulations. A good example is the recent retroactive change to feed-in tariffs for renewable energy in Spain

In finance, volatility is a measure of variation of price over time. Volatility can lead to disputes if “real world” events – for example, sharp movements in markets or unexpected regulatory changes – find their way into the transaction and cause a surprise.

We have seen disputes caused by each of these factors. One reason why volatility causes disputes is that it frequently affects how the final purchase price is determined. This means that on the day a deal closes, if volatility hasn’t been managed effectively, the purchaser could end up paying more, or less, than their expectation of “value”. When the parties involved in a deal have a surprise on closing day, a dispute is likely to follow soon.

Here are some reasons why volatility can have an unexpected impact on the price of a company on closing day:

Large swings in sales prices in an industry impact profit margins. Unexpected changes just before closing might suggest that the company is worth less than predicted, thus triggering a dispute.

Volatility affects equity value via the purchase price adjustment. For example, a working capital adjustment may require the determination of a “market price” for inventories in the context of the lower of cost or market value test. Significant volatility in market prices, or in fact situations around closing when markets simply do not function well enough to establish consistent prices, is a common source of disputes.

Section 1when volatility in markets finds its way into the transaction

Unexpected changes in bond yields can change the present value of liabilities on the balance sheet of a company. This can lead to a disagreement over the valuation of otherwise comparatively predictable, long-term liabilities such as pension obligations. There is a way to mitigate the impact of volatility in transactions: limit how it affects the determination of the final purchase price. To do this, price adjustments should be thoroughly defined, their extremes understood and limited, and in some instances, fixed values should be agreed. At the simplest level, you can agree a fixed purchase price that doesn’t change on closing day. Fixed purchase price deals are known by those in the industry as “locked box” transactions. See the box (right) for more information.

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Purchase price adjustments vs fixed purchase price (the “Locked Box”)

The ongoing trading of a target company between signing and closing of an SPA (if both are not on the same date) results in uncertainty as to the precise balance sheet position that will be transferred on closing of the deal. There are two principal ways to deal with the uncertainly that this causes:

A purchase price adjustment adjusts the headline price at closing. The headline price agreed for a business is typically what is known as “enterprise value,” i.e. the gross value of the operations, as funded by equity and debt. This value is adjusted at closing to reflect the level of debt, cash, working capital and, sometimes, other items measured at that time. A purchase price adjustment thus ensures that

the purchaser is compensated for debt (which is deducted from enterprise value to arrive at equity value) at closing and that the vendor receives value for any surplus cash at closing (on top of the enterprise value). As variations in cash and debt levels will vary inversely with the level of working capital, an adjustment for cash and debt at closing typically requires a corresponding working capital adjustment. The SPA sets out the mechanism, basis of preparation, and process to determine these adjustments.

The locked box concept is an alternative way of dealing with the uncertainties of the balance sheet at closing. Using this method, the parties agree a fixed price in the SPA with no subsequent

purchase price adjustments. This provides greater certainty to both parties when the deal is signed. The locked box concept is based on a historical balance sheet date (the “Effective Date”), a date before signing (typically the date of the last audited balance sheet). The net purchase price is then fixed on the basis of the Effective Date balance sheet. The fixed purchase price reflects the level of cash, debt, and working capital at this date, after which the box is “locked” (i.e. no value should leak, other than matters agreed in the SPA). Locked box agreements are therefore economically, but not legally, backdated transactions. Profits generated by the target between the

effective date and closing accrue to the purchaser (as cash generated is transferred to the buyer). It is common that the seller receives interest as additional consideration for the period between the Effective Date and closing.

There are also “hybrid” completion mechanisms, which incorporate aspects of both concepts. This is the case either when a fixed purchase price is agreed, but there is nevertheless a reason or requirement to adjust for an item at closing (for example, an intercompany balance), or alternatively when a purchase price adjustment is linked to a date such as 31 December, when annual financial statements are prepared, but the actual closing date differs.

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The only accounting policies that apply to the completion accounts are those specified in the SPA. Our research shows that missing or ambiguous definitions of accounting policies result in a disproportionate number of disputes.

The good news is that disputes about the wording of accounting policies or around representations and warranties can be easily eradicated in many cases if lawyers and accountants communicate and cooperate at the intersection of their disciplines. After all, while lawyers draft the contract, the accountants will be the ones interpreting the wording when they prepare the completion accounts on which the final price is based. Unambiguous definitions minimise the opportunity to manipulate the numbers.

Conversely, in live disputes litigators should review the sections on accounting policies with the help of specialised accountants. Even if the dispute doesn’t involve this section, it’s an exercise that often brings a new perspective to the dispute.

Frequently, disputes about accounting policies in the completion accounts involve a lack of hierarchy between the accounting policies used in the completion accounts.

Sale and purchase agreements, or SPAs, are contracts drafted by lawyers. however, they often contain sections that make reference to technical accounting or financial reporting matters, including representations and warranties, and the accounting policies that will be used in preparing the completion accounts to determine the purchase price adjustment at closing.

It is common practice for the SPA to specify:

Specific accounting policies to be used in the completion accounts

The extent to which the completion accounts will be consistent with earlier accounts

Generally accepted accounting principles1

When the completion accounts are prepared, situations can occur when accounting policies specified in this list contradict each other. For example, after closing, the buyer may uncover that the historical financials are, in their view, at least, not GAAP-compliant. In practice, GAAP is considered the higher standard in many of these cases, but this is by no means always the case. And if GAAP prevails in cases of error correction, this typically results in a “windfall” (to the benefit of one side).

Windfalls often mean major surprises which, in turn, lead to frustration by the party confronted with a sudden change in the purchase price, in particular when an accounting error is not relevant to the valuation of the target company. One party will then receive more or pay less as a result of the one-time correction of an accounting error which has nothing to do with “value”.

The parties should therefore be clear on which hierarchy to use between accounting policies before signing. They may decide, for example, to trade the possibility of a “windfall” against a greater certainty of purchase price, even if its determination

at closing were to be non-compliant with GAAP.

Alternatively, the parties may decide that GAAP should prevail no matter what. One way to look at this is that the buyer effectively uses generally accepted accounting principles as a “last line of defence” against unknown risks in the numbers. This can be useful in situations when access during the buy-side due diligence was very limited.

It may also be the case that changes in GAAP mean GAAP accounting treatments at closing are no longer consistent with the historical treatment.

All these matters can be comparatively easily resolved in many cases if the SPA specifies a hierarchy and if the SPA makes reference to GAAP at a specific date.

While this should be routine, we continue to see disputes that would not have arisen if the lawyers and accountants working on the SPA had specified an accounting hierarchy, in particular between consistency and GAAP.

See case study 1 for an example of a situation in which failure to set a hierarchy led to a multi-million-euro dispute.

The SPA should further clearly define the term “consistent” as disputes can otherwise arise over whether or not a slight adjustment to an accounting treatment falls under the definition. The devil is in the detail. See case study 4 for a real-life example.

Even so, what is most important it that these issues are resolved before signing, not afterwards in a post-deal dispute.

Section 2when there is ambiguity in the wording of the sale and purchase agreement

1 Known for short as GAAP; examples of GAAPs include IFRS, US GAAP, UK GAAP, or other local accounting standards.

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Our study shows that disputes over misleading information often arise from deliberate inaccuracies in the closing financial statements, such as material misstatements or omissions. As these are typically used as the basis for determining both working capital adjustments and to forecast future financial performance of the target, frauds like this can have a big effect on the purchase price. For more information, see case study 3.

Complexity and unstable organisational structures are frequent advance warnings of fraud. Good due diligence cuts through the complexity.

Often a fraudulent vendor company will ensure its accounts are very complicated and hard to understand. This complexity is designed to obscure, rather than represent faithfully, the financial situation of the target.

fraud is deception intended to result in gain. for example, a seller may try to deceive a potential purchaser about the value of a target by manipulating, falsifying or withholding the data that the buyer receives. examples include improperly recognised revenues and inflated earnings, overstatement of assets, manipulation or concealment of liabilities and incomplete disclosure on financial statements. These are done to create a false impression of financial strength.

The vendor could conceal obligations that will hit the purchaser after closing, obscure future losses or inflate expected returns.

On the other hand, fraud is sometimes very straightforward. In one dispute in our study relating to the property development sector, the vendor overstated the square footage of some of its sites, leading to inflated asset valuations. In another of our cases inventory records were simply forged.

The purchaser often uncovers a fraud when it encounters unexpected cash needs. For example, a unit of the purchased company may require an unexpected cash injection a few months after closing. And then another one, and another one.

Cash-flow driven analyses can therefore be an effective tool to identify areas of potential fraud before signing. For example, they could be used to work out why large accounting profits don’t translate into cash, or to identify situations where three financial quarters of negative cash-flow are followed by a fourth quarter of positive cash-flows that exceed all losses to date.

Specific diagnostic tools are available during the financial due diligence stage to detect suspected financial statement fraud. Their use substantially increases the probability of detecting fraud.

Fraud is one of the hardest dispute areas to avoid as fraudsters deliberately try to cover their tracks. However, considering that, by their nature, the disputes in our study relate to frauds that were eventually uncovered, it is fair to suggest that they could also have been uncovered during due diligence.

Section 3when a fraud is committed

litigate or arbitrate?Arbitration is popular. It allows parties to settle their disputes privately, away from the media scrutiny that an open courtroom allows. Just how popular is it though? According to our research, which uses data that span 10 years, arbitration is by far the most popular option.More than 57% of the diputes we have been invloved

in were arbitrated. What is even more interesting, though, is just how unpopular the open court route is. Only 20% of the cases we have dealt with were litigated in open court. In comparison almost 23% of the disputes were settled by alternative methods such as mediation and other alternative dispute resolution methods.

Type of dispute

Other22.9%

Litigation20%

Arbitration57.1%

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Under these pressures, buyers may brush aside adverse factors and simply try to get the deal done. The more time and resources they have already invested in the transaction process, the stronger the urge will be to brush away any remaining obstacles – notwithstanding the fact that the time and resources are “sunk costs”.

In organisational behaviour, this is known as a “commitment bias”.

In these situations, acquirers sometimes ignore due diligence findings, even “red flags”, or SPA advice because it will interfere with getting the deal done. This may be especially true when they are investing someone else’s money.

Unfortunately, this happens more frequently than one might expect, especially when the peak of the M&A market is approaching. In our estimation, a party has ignored good advice and ended up regretting it in the majority of the disputes that we deal with.

Acquirers may come under significant pressure to do deals. Private equity sponsors face expiring funds and corporates may come under pressure to spend large amounts of cash that is earning minimal interest. As a result, situations can develop in which multiple buyers chase a limited number of assets.

Section 4Pressure to acquire and the “thrill of the deal”

what is it worth?Disputes are costly. But just how costly? Our research shows that almost a third of cases that we have dealt with were for relatively modest amounts, with nearly 30% of claims amounting to €10 million and less. However, almost 15% of claims were for over €1 billion.

deals today. disputes tomorrow

The current deal-making environment resembles both the internet boom and the years preceding the financial crisis, and in some sectors there have been deals that have matched and even exceeded pre-crash highs.

Now, as then, it is a seller’s market. Potential purchasers in some sectors are actively looking for deals to be done.

The consequences are high valuations, competitive auction processes, limited access to information by bidders, and seller-friendly terms in SPAs.

Those two historic M&A booms were followed by many

post deal disputes. It is fair to suggest that this one will be too. At the most basic level an increased number of transactions will drive increases in the number of disputes. This is accentuated by an overall increasing trend to pursue disputes.

In addition, we have noticed an increase in the number of earn-out deals. Earn-outs are a type of deferred consideration which means that part of the purchase price is paid after closing and is dependent on the target meeting certain financial targets. An increase in earn-outs directly leads to an increase in disputes as every payday can trigger a difference of opinion

between buyer and seller over how the payable earn-out is determined.

However, there are some important differences from previous M&A booms this time around: today’s buyers have a preference for borrowing rather than issuing equity, and borrowing rates are far lower today than in previous M&A booms.

There is also a long-term trend in Europe towards so-called locked box completion mechanisms that, in our view, transcends the short term M&A cycle, which favours this seller-friendly mechanism. As we have previously discussed, the locked box

mechanism is inherently less prone to disputes, which means that future disputes are more likely to arise from areas independant to the specific completion mechanism.

Therefore, our bottom-line prediction is that in the next few years there will be an increase in disputes and we will see more disputes relating to earn-outs and matters that are independent of the specific completion mechanism used, such as fraud or regulatory issues.

FT, Sept 18, Megadeals for 2015 hit record high.Ecconomist, April 18. A zeal for deals

0%

5%

10%

15%

20%

29.6%

0-10 10-100Claim amount (£m)

100-1000 1000+

44.4%

11.1%

14.8%

25%

30%

35%

40%

45%

50% Distribution of claim amounts

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We have examined over 500 individual balance sheet claim items (with corresponding effects in the income statement) to determine which part of financial statements claims relate to. The results can be found below.

1 working capitalWorking capital-related disputes make up the single

largest category of financial statement-based claims in our database. Out of 515 claims in our sample, 273 relate to working capital.

Working capital is an indication of the funding required to support the day-to-day operations of a company. It is calculated by adding current operating assets then deducting current operating liabilities.

Typical disputes arise over the accounting for working capital at closing. Most purchase price adjustments in our sample included an adjustment for working capital. Given the proximity of working capital to cash, the adjustment is intended to ensure that buyers pay for “value” actually transferred on closing day. Problems arise when the value of working capital is impaired, but the impairment is not reflected in the books at closing. This means that working capital at closing may overstate the actual value transferred.

Accounting for working capital requires important estimates and assumptions about the recoverability of receivables and future losses, market prices for inventories, and types of costs capitalised into inventories, among others. Disputes tend to

which parts of financial statements give rise to claims more than others? which balance sheet positions, and which part of the profit and loss account, should purchasers and sellers be most concerned about when they want to avoid a dispute?

arise when, after closing, these estimates or assumptions turn out to be incorrect.

Trade debtors and inventories Within working capital, the largest two categories by size are disputes relating to trade debtors (71) and stocks (inventories) (58). These claims frequently show themselves as breaches of warranty.

Trade debtor related disputes typically involve debts recorded at more than the amount actually received. This often happens when the financial difficulties of a target company’s customers find their way into the transaction because the company has been too optimistic about the amount of money it is likely to recover from them. In volatile sectors this might be a recurring feature.

Claims involving inventory valuation fall into two categories:

Disagreement over gross inventory valuation, in particular technical accounting questions which arise over the depth of absorption of overheads into inventories, and disagreement over appropriate market prices in the lower-of-cost-or-market value test.

Disagreement relating to the measurement of provisions against gross inventories, for example for slow moving items. This is another area where volatile sales markets, which may make it difficult to establish market prices unambiguously, find their way into the purchase price adjustment.

2 Short-term provisions and accrualsLooking even deeper into

our statistics, 90 of the 273 working capital claims arose from disputes relating to short-

term provisions and accruals.For example, this includes the measurement at closing of provisions for warranties or for taxes. These are frequently accounting items which involve management judgment.

3 revenue recognition Revenue recognition is a central theme in many post

M&A disputes. Sixty-seven out of 515 claims relate to revenue recognition. Many of these are large and complex claims. The reason revenue recognition frequently leads to disputes is that profitable sales increase earnings in a period, and earnings are used as a basis of valuation.

In transactions where the purchase price is determined as a multiple of a measurement of earnings such as EBITDA, the incentive to overstate earnings is magnified by the multiplier applied. For example, if the enterprise value is eight times last year’s EBITDA, vendors have an incentive to look for ways to increase EBITDA as it will have a direct, multiplied, effect on price.

Some aspects of revenue recognition are governed by particularly “soft” accounting standards that are vulnerable to manipulation. For example, percentage of completion (POC) revenue recognition under International Accounting Standard 11, which is used for accounting for long-term contracts, requires important estimates.1 Estimating the degree of completion of a large project and the remaining costs to complete, for example, frequently requires sophisticated analyses by technical experts. Their findings are often disputed. See case study 4 for an example.

Section 5Statistics: where in the balance sheet do disputes lie?

1 Revenue recognition standards are being consolidated under one accounting standard, IFRS15 – Revenue from customer contracts, from 1 January 2018 as part of the ongoing harmonisation of international accounting standards and US GAAP.

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4 off-balance sheet financingSeventy out of 515 items

relate to unrecorded liabilities. Disputes typically arise when pre-existing liabilities hit the purchasers unexpectedly after closing because information was withheld by the seller either by accident or intentionally. They also occur when the parties disagree on whether a provision should have been recorded in the accounts or how it should have been measured.We also observe post-closing disputes arising from allegations of a breach of representations and warranties, including for example in relation to net assets or specific liabilities. There is a large variety of hidden debt items that end up in disputes, including out-of–the-money hedges, finance leases, pensions, contingent liabilities, and under accruals in relation to long-term contracts. In one example in the industrial sector, the purchaser claimed that project costs had been understated and should be increased by over 30%.

5 fixed asset valuationsSixty-three out of 515 claims relate to unsupported

fixed asset valuations or additions. Disputes can arise when misleading or incomplete information is supplied during the valuation exercise. We also observe disputes between joint venture parties over the total construction costs of key assets, in particular when a foreign investor has partnered with a local firm and one company is therefore closer to the ground and has greater control over the choice of EPC contractor etc. Essentially, most disputed fixed asset valuations arise either from an information asymmetry at the time the valuation is carried out

or from rapid market changes (e.g. the Spanish real estate crisis) leading to unexpected losses for the purchaser.

6 other itemsForty-two out of 515 items relate to other issues

that do not come under the categories above. As this is a catchall category, the items are naturally quite diverse, however there are some trends. One commonly occurring theme in transactions that use a purchase price adjustment is the taxation impact of the disputed adjustments. Other items in this category relate to the measurement of defined benefit pension commitments.

16

Section 5 continued...

disputes by financial statement category

This graphic takes 925 claims that we have worked on and shows which part of the financial statements they can be found on.

balance SheetTangible assets 10%Intangible assets 4%Financial assets 1%

Trade receivables & other assets 17%Inventories 11%Cash & equivalents 2%

Provisions 38%Trade payables 11%Other balance sheet items 6%

income statementRevenue 24%Cost of sales 18%Other operating expenses 38%Other income 11 %Net financial expenses 1%

Tax 7%

fiNANciAl STATeMeNTS: TArgeTco iNcorPorATed

Other issues (guaranteed breaches, technical issues) 42 out of a total of 925

Provisions – disputes are frequently over accounting items involving management judgment.

Revenue recognition – A central theme in many post M&A disputes, especially large, complex ones as earnings are used as a basis of valuation.

Trade receivables – Working capital items often require important estimates and assumptions which may be incorrect and trigger a dispute

Invest time ensuring definitions of accounting policies and financial terms in the SPA are clear. In particular, obtain input from your financial due diligence team on the accounting policies in the SPA which govern earn-outs and the completion accounts. Consider forensic accountants’ involvement in particular in the wording of SPA working capital clauses. If a dispute is live, consider the history of the negotiations and review the accounting definitions in the context of what the parties really intended.

Ensure no information is lost at the intersection of disciplines during a transaction (the in-house team, external financial, legal, operating, commercial, tax and other due diligence advisors). This means that the different due diligence teams and the in-house deal team should communicate constantly throughout the transaction process, and the financial due diligence team should see early drafts of the SPA and be in a position to understand the basis of valuation. If a dispute is live, work out what a “clean” interaction between the completion mechanism and valuation would have been. This serves to locate the problem.

Ask yourself how something unexpected, either in the target’s customer or supplier markets, or in the target’s financial markets, could impact the deal. Where could volatility find its way into the purchase price adjustment, or cause a breach of warranty? Exercise particular care when these meet “soft” accounting standards or vague measurement concepts. Once you have identified relevant areas of risk, ensure the definitions do not offer discretion and are not subject to estimates. In some instances, it may be appropriate to use fixed values – for example, pension obligations, metrics to be used in inventory valuation, or expected profit margins inherent in long-term contracts. If a dispute is live, this can be a particularly difficult area to deal with. Identify bias in the exercise of discretion by accountants who prepared financial information which may be used to argue that systematic bias resulted in extreme outcomes.

Even on the home stretch of difficult negotiations, be clear on the financial consequences of what is really intended, and whether this is appropriately reflected in the SPA. Work with flexible financial models and use simulation techniques, for example Monte Carlo or similar modelling tools, to understand possible ranges of outcomes for adjustments and for the final purchase price. Include “long tail” events in your analysis to understand extreme outcomes and avoid disappointment.

For example, model potential pay-outs of earn-outs after closing. If a dispute is live, it may be appropriate to use the same analytical tools to review whether the outcomes which have led to disappointment (such as minimal or no earn-out payments) suggest bias by whoever prepared the financial information (for example the buyer who prepares the earn-out calculation). An indication that something is wrong may be that the outcome, such as a series of zero earn-out payments, is extremely unlikely.

Review the interactions of different balance sheet items, which are subject to different types of purchase price adjustments to avoid capturing items twice (double dips) or not capturing items at all. If a dispute is live, do the same thing. There are more double dips than most people realise. Many of them go unnoticed.

Include forensic, litigation and arbitration expertise in the financial due diligence team. You should look to the team for advice beyond a simple “tick in the box” exercise or the preparation of a report to satisfy requirements of senior lenders. Seek their advice on how to reduce the probability of a post deal dispute. If a dispute occurs, use specialised forensic accountants and fraud examiners to review these

Conclusion:hindsight and lessons for the due diligence process

17

Appendix

18

Case study 1Three words missed out of a contract lead to a multi-million-euro dispute

Case study 2A fraudulent non-disclosure of liabilities leads to a massive claim

In one recent case in which Accuracy acted as expert witness the purchaser claimed that the target had incorrectly accounted for a long-term lease agreement in earlier accounts. It had classified the lease as an operating lease when it should have been classified as a finance lease1

The purchaser therefore calculated the effective lease liability on closing and included it in net debt. The seller disagreed and argued that, even if the lease was misclassified, the SPA required it to be classified as an operating lease to be consistent with the treatment in the pre-closing financial statements.

The dispute over whether consistency or GAAP should prevail would have been avoided if the lawyers had inserted either the phrase “…GAAP shall prevail” or, alternatively, “…consistency shall prevail” into the SPA.

The purchaser’s error correction brought the lease liability on the balance sheet and increased debt. This unforeseen change in leverage caused a credit ratings agency to downgrade the purchaser. The downgrade came unexpectedly, which increased the purchaser’s borrowing costs and led to an actionable claim.

Many fraud cases involve the non-disclosure of liabilities. For example, one of the disputes in our study concerned the acquisition of a manufacturing company in the pharmaceutical sector. The vendors failed to disclose a pending litigation, which stopped the company from executing a worldwide licencing agreement. The damages claimed were the difference in value between having a domestic sales model and having an international sales model.

19

1Under International Accounting Standard 17

Appendix

20

This dispute related to the measurement of a pension deficit. The target company sponsored a defined benefit pension scheme. The obligation was to be measured after Closing, using a methodology “consistent” with past practice.

Yields of highly rated (AA) bonds (which are frequently used to discount pension obligations) before the deal was signed are shown in the first graph opposite. At the time, it was straightforward to identify an appropriate discount rate, and this was the basis of how these liabilities were measured in the past.

Case study 4how significant, abrupt changes in credit markets led to a dispute

Case study 3information lost at the intersection of disciplines

An SPA included a warranty over a minimum EBITDA of £25 million for 2013, the last financial year before closing. The target company, which builds and operates waste water treatment plants in emerging markets, overstated the percentage of completion (POC) of major ongoing water plant construction sites.

It also understated the remaining costs to complete. Both misstatements combined resulted in a 25% overstatement of EBITDA in 2013. Access by the purchaser during the due diligence phase had been restricted and the overstatements came to light only after closing, as the target entity required unforeseen liquidity. A problem during the

due diligence phase had been a lack of communication between the technical and financial due diligence teams. The technical experts were therefore unable to understand the “mechanics” of how overstated estimates inflated EBITDA, and the financial due diligence team was not able to challenge the technical estimates on which POC revenue recognition was based.

While it was clearly beyond the competencies of accountants or financial experts to assess the technical degree of completion of a specific waste water treatment plant, they did not obtain this expert knowledge from other work streams. At the intersection of disciplines, important information was lost.

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intangible assets financial assets

Trade receivables/ other receivables inventories cash and

equivalents Trade payables Provisions

where in the balance sheet do disputes lie?

21

Bond yields changed, abruptly, with the arrival of the financial crisis when yields varied widely (see second graph below), mirroring substantial variations in bond prices. In effect, there was, for a time, no consistent market price.

The dispute related to what the application of a “consistent” methodology required: while on the basis of the first graph, no uplift to yields was applied for longer terms, did the scattered yields in the second graph imply a different slope of the yield curve? And did a different slope in the yield curve represent a change in the methodology used?

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6

Provisions other balance sheet items P&l other issues

Before the credit crunch bond yields were relatively predictable. After the credit crunch, they weren’t.

30th November 2008, after the credit crunch

30th June 2007, before the credit crunch

EU - AA bond yield

UK - AA bond yield

US - AA bond yield

EU - AA bond yield

UK - AA bond yield

US - AA bond yield

22

our forensic, litigation and arbitration experts

23

Alain dAVidVice Presidentcanada

Since 1990, Alain has focused his career entirely on

forensic and investigative accounting (fraud investigations), litigation support (commercial disputes), and the measurement of damages for insurance purposes (business interruptions, stock losses and employee dishonesty). He has analysed financial information from a broad spectrum of public and private entities. To that effect, he has carried out numerous assignments on a national and international scale.

Alain has been acknowledged as an expert before the Superior Court of Quebec and the Federal Court.

+1 514 788 [email protected]

Anthony TheAu-lAureNTDirectoruK

Anthony is a director in Accuracy’s London office. He specialises in the assessment of complex damages arising primarily from breaches of commercial contracts, shareholder agreements and warranty claims. He has been appointed as testifying expert for both Claimants and Respondents in ICC, ICSID and UK High Court cases, and has testified before tribunals in matters with claims amounting to several billion Euros.

Anthony also has comprehensive experience in assisting clients to acquire and divest businesses with values ranging from ten million Euros to five billion Euros.His work covers a wide range of industries including media, civil engineering, manufacturing, automotive, energy, retail, software and aerospace.

He has advised clients in the United Kingdom, Continental Europe, the Middle-East, Africa, North America and Asia.

Anthony holds a Master of Science in Management from HEC School of Management. He has dual French and British nationality and is bilingual.


chaitanya ArorAPartnerindia

Chaitanya Arora is a Partner at Accuracy,

based in New Delhi, India. He leads the “Forensics, Litigation & Arbitration” practice of Accuracy in India and South East Asia. He has worked on matters in different jurisdictions including Singapore and India. His experience spans across several sectors on disputes concerning joint ventures, termination of contracts and post-M&A disputes. He is experienced in cross-examination. Chaitanya also provides Transaction Advisory Services and has vast experience in complex valuation, due diligence and cross border M&A.

He has experience with projects in several industries such as retail, industrial manufacturing, telecom infrastructure, information technologies, power generation, agricultural commodities, hospitality, educational institutions, airport services, FMCG, real estate, renewable energy, logistics and distribution.

Chaitanya is a graduate of the University of Illinois, Urbana-Champaign, USA, and is a non-practicing member of the American Institute of Certified Public Accountants, Certified Public Accountants of Australia and the Institute of Singapore Chartered Accountants. He is also a Chartered Financial Analyst


Anne-Marie bÉlANgerVice Presidentcanada Ms. Anne-Marie Bélanger is a Vice -President at

Accuracy Canada. Over the years, she has executed litigation mandates relating to damage quantification for breach of contract, shareholder disputes, conflicts between franchisors and franchisees, family litigation, as well as insurance claims and financial fraud. She also specializes in business valuations and has prepared valuation mandates in both public and private sectors. She also has prepared and conducted many presentations on forensic accounting and damage quantification. In particular, she taught the course « Gestion des risques opérationnels (introduction à la juricomptabilité) » offered by the Faculty of administration at the Sherbrooke University in the second cycle of the CGA program in 2012 and 2013.


24


christophe SchMiTPartnerfrance

Based in Paris, Christophe Schmit is

one of Accuracy’s founding partners with 20 years of professional experience. He leads Accuracy’s Forensics, Litigation & Arbitration practice and has worked on engagements in French courts and international arbitrations. Christophe has expertise in damages quantification and analysis of disputes from economic and financial positions. He has been involved in cases covering a variety of situations and industrial sectors. In several cases, he has given evidence in international arbitrations and been subject to direct and cross examinations. He regularly acts as neutral expert appointed by both parties in M&A disputes.

Prior to co-founding Accuracy, Christophe was a partner at Ernst & Young in Paris (formerly Arthur Andersen), which he joined in 1993.

+33 1 58 75 75 [email protected]

dr. ekaterina lohwASSerDirectorgermany

Ekaterina joined Accuracy in 2009,

opening the first German office of Accuracy in Frankfurt. As a Director she is responsible for the valuation team in Germany and manages the Munich office since 2011. Prior to joining Accuracy, she worked in advisory and M&A services for seven years, mainly with PwC Munich. In this role, she gained extensive experience in leading large business valuation engagements.

While at Accuracy, Ekaterina has been appointed as expert and has worked alongside the appointed experts to assess damages and complex valuation issues, managing valuations, drafting numerous valuation reports and joint statements of experts, and taking part in national and international meetings of experts. She has also testified as an independent valuation expert in German court proceedings, attended international arbitration hearings, and contributed to examinations and cross-examinations.


edmond richArdSAssociateuK

Edmond is an Associate in the London office

of Accuracy, Forensics and Litigation Advisory practice and an Associate of the Institute of Chartered Accountants in England & Wales. He has 5 years’ experience in the forensics sector, joining Accuracy in May 2014.

Edmond has worked on a number of litigation and arbitration assignments and has assisted in giving expert advice in loss of profits, contentious valuation and fraud cases. He has also advised on transactions, both sell-side and buy-side. Edmond has a broad range of sector experience including energy, real estate, automotive, food processing and software.


erik van duiJVeNVoordePartnerfrance & uK

Erik van Duijvenvoorde is a Partner in Accuracy’s

Forensics, Litigation & Arbitration practice and is based in London and Paris. He has advised clients on business, economic, accounting and valuation issues for more than 25 years and specialises in the expert assessment and quantification of complex damages.

Erik has testified as an expert before both Courts and Arbitration Tribunals covering a wide range of situations and industry sectors. His previous experience working for a private equity fund and the Transactions team of a Big-Four accounting firm makes him particularly well placed to act as an expert in investor, transaction and shareholder-related disputes.

Erik is a Fellow of the Association of Chartered Certified Accountants (UK). He has lived and worked in France and the UK and has successfully led cross-border engagements in Europe, the Middle East, Africa, Asia and North America. His mother tongue is English and he speaks fluent French.


eduard SAurAPartnerSpain

Eduard has more than 20 years of professional experience as a financial

advisor, especially for cross-border engagements. He has led dozens of transaction projects in Asia, North and South America and Northern Africa, in addition to many countries throughout Europe. He has also been appointed independent financial expert in various international commercial and investment arbitrations.

Eduard started his career at Schlumberger, where he was a financial controller of various divisions and then spent five years in Arthur Andersen Paris, where he performed audit and due diligence work both for industrial and Private Equity firms.

He’s the author of various articles and lectured several courses on financial risk in SPA negotiations.


25

giovanni foTiPartneritaly

Giovanni Foti, Partner at the Milan Office, is specialized in Fraud

Investigation & Dispute Services. As Dottore Commercialista, he has performed valuations and financial analysis, appraisal and fairness opinion

Before setting up Accuracy Italy, Giovanni worked as an Executive Director in the Fraud Investigation & Dispute practice of Ernst & Young, for the last two years focused on fraud investigations, litigation, arbitration, Expert witness, forensic accounting and compliance risk management. Prior to joining the Fraud Investigation & Dispute Services, Giovanni has matured extensive experience as auditor in Arthur Andersen and Ernst &Young for the audits of Companies listed in Italian and Foreign Stock Exchange (New York, Paris, London).

+39 02 366 962 [email protected]

Jean-baptiste de courcelPartnerfrance

Jean-Baptiste is a partner at Accuracy in

Paris and has been with the firm since its inception. He gained audit and consulting experience from five years with Arthur Andersen prior to joining Accuracy.

Jean-Baptiste is an expert in arbitration and litigation support. He has been involved in numerous disputes before national courts and arbitration tribunals to assess damages, provide arguments on the financial, accounting and economic situations, and testify as expert.

He has also conducted numerous engagements in connection with acquisitions and disposals for investment funds or companies.


hervé de TrogoffPartneruK

Hervé is a partner in the London office and

Head of Accuracy’s Project Advisory and Disputes practice. Before joining Accuracy in 2010, Hervé worked as a construction manager for VINCI on projects in Africa, ME, South America and Europe, then spent seven years at Navigant Consulting.

Hervé is an experienced construction management professional and has been working for both contractors and consultants in a number of challenging international environments. He has given evidence to adjudicators and arbitrators in English and French and has been acting as party-appointed expert in mediations in English, French and Spanish.

Hervé has a first class honours civil engineering degree and completed a Masters of Business Administration at the London Business School (LBS) where he specialised in project risk management and project finance.


françois filioNPartnercanada

François Filion has 20 years of experience in accounting and finance.

Since 2000, he has specialised in the fields of investigative and forensic accounting and business valuation. He has carried out several mandates related to fraud investigations, financial irregularities, valuation of financial losses, litigation assistance, insurance claims and business valuation.

François has been acknowledged as an expert before various courts (more than 30 times), including the Court of Québec (criminal division), Superior Court, and Chamber of Financial Security, and has also testified in a number of insolvency cases. Francois has also given several presentations related to his field of practice, and was an author and trainer for the continuing education program of the Institute of Chartered Accountants of Quebec and the College of Corporate Directors. He is also a lecturer at Quebec University.


heiko ZiehMSPartneruK / germany

Heiko is a partner in the London and Frankfurt offices of Accuracy. He

has been appointed as expert in multiple commercial disputes, post-M&A disputes, and disputes concerning joint ventures. He has worked on matters in ICC, DIS, LCIA, and SIAC arbitration forums, ad hoc arbitrations and German courts. The value of claims involved has ranged between a few million to several billion Euros. He is experienced in giving oral expert testimony.

Heiko also provides transaction advisory services and has advised on several hundred transactions.

He holds an MBA from the Haas School of Business at UC Berkeley and another graduate degree in business (Diplom-Kaufmann) from Otto-Friedrich Universität Bamberg. A German national, he has lived and worked in the US, the UK, and Germany. He qualified and worked as a Certified Public Accountant. He has published numerous articles on financial aspects of commercial disputes, forensic accounting and valuation matters.


26

reiner SchuSTerDirectorgermany

Reiner joined Accuracy in 2014 and is an Director

in the Frankfurt office. He started his career in 2001 in the Transaction Advisory Services team of Arthur Andersen in Eschborn, which later merged with EY.

Reiner has been advising US and European banks, Corporate clients and PE houses on complex transactions and restructuring projects.

He is a Qualified German CPA (Wirtschaftsprüfer) and tax accountant (Steuerberater).


leontine KoeNS-beTZManaging PartnerNetherlands

Leontine has been responsible for the set-

up and management of Accuracy’s Dutch office since its incorporation in 2007.

Prior to joining Accuracy Leontine worked as an auditor for Arthur Andersen and as transaction specialist for KPMG Transaction Services.

Leontine has over 15 years of professional experience as a financial advisor. She has led numerous transaction, litigation and valuation engagements in the Benelux region, as well as in other European countries.

+31 20 20 66 [email protected]

Nicolas bArSAlouPartnerfrance

With 25 years of experience, Nicolas

Barsalou is one of Accuracy’s founding partners. He was a partner at Ernst & Young, worked at Arthur Andersen and started his career as financial controller at a French corporation.

Nicolas is an experienced damage valuation expert who has testified in litigation and international arbitration numerous times both in English and French. He developed investigation, analysis and negotiation skills by dealing with situations involving both financial and legal matters. He has advised clients in situations such as commercial and post-M&A disputes, construction claims and unfair competition.


roula hArfouchePartneruK

Roula is a Partner in the London office

of Accuracy, Forensics, Litigation & Arbitration practice. She specialises in contentious valuations and the assessment of quantum issues in international arbitration and litigation cases.

She has a broad range of experience valuing companies, listed and unlisted securities, and intellectual property rights, and assessing complex damages in high-value international arbitration and litigation cases in matters involving breach of contract, investment treaty claims, transaction-related disputes, and intellectual property infringement.

She has been actively involved in nearly 50 contentious cases, and has worked on matters in LCIA, ICC, SCC and ICSID arbitration forums and under the UNCITRAL rules, before the UK High Court, the UK Family Division, and Patents Court, as well as in mediation.

Roula is a Fellow of the Institute of Chartered Accountants in England & Wales and a member of the Society of Share and Business Valuers.



Report edited by James Lumley

accuracy post m&a disputes research

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