M and A arbitration - three perspectives on topical issues transcript

TC: Hello everybody. Thank you very much for joining our webinar today on the topic of M&A arbitration. My name is Tom Cummins and I'm a partner in the Dispute Resolution team at Ashurst in London. Nowm M&A transactions give rise to disputes very frequently. Some disputes are resolved amicably, some are resolved in the courts, and some are resolved in arbitration. And when it comes to cross-border transactions, I think it's fair to say that international arbitration is the preferred method of resolving disputes. And I think, certainly over the last few years, we have seen more and more arbitration clauses going into transaction documents.

So, in order to explore this topic today, we wanted to touch on three different perspectives. I'm delighted to be joined by Vicki Wall who is a partner at Haberman Ilett, soon to be renamed Kroll, and she has over 20 years' experience as a forensic accountant focusing on work as an expert witness. And we wanted Vicki to participate in this webinar because, of course, M&A disputes are frequently about value and price - they're about numbers.

But legal issues also arise. And so Vicki and I are pleased to be joined by two of my colleagues at Ashurst: Thomas Karalis, who's a counsel in our London Disputes team, and is both a solicitor advocate … sorry, an English solicitor and a French advocate, and Judith Sawang who is a partner in our Frankfurt Disputes team. And Judith has a particular focus on international arbitration.

Now, Thomas and Judith are going to explore some of the issues typically addressed in M&A transactions and how those differ between the common law and civil law legal systems. Why does that matter? I think because, in a cross-border transaction, parties may hail from countries with different legal traditions, different legal rules and regulations, and even if the SPA is governed by, say, English law or New York law, there is still value for parties in understanding where their counterparties are coming from in terms of the legal background that they know and are familiar with. And I think having that understanding can avoid misunderstandings between the parties, it can avoid misunderstood expectations, and ultimately it can avoid disputes and arbitration.

So, with that brief introduction aside, let's get on to our presentation, and we have five topics that we're going to address with you today. Firstly, we're going to look at how M&A arbitrations differ from M&A litigations; second we're going to talk about warranties and indemnities and the significance of disclosure; third, damages in warranty claims and how one goes about determining loss; fourth, earnouts – where disputes arise and how you can go about avoiding them; and finally we're going to talk about adjustments and some of the issues associated with completion of disputes.

Now, I should say that we are hoping at the end of our session to have time for questions. I'm sure we will have some time. So, if you have any questions as we go along, please record them in the chat function. I will make a note of them and then I will allocate them to the appropriate panellist when we come to the end of our prepared remarks.

So let's move on now to our first topic, which is how M&A arbitrations differ from litigations. And I suspect most people on the call will have some familiarity with the difference between arbitration and litigation, but what I would like to explore is the specific value of arbitration in the context of M&A disputes. And why don't we start with you, Thomas, on that subject?

TK: Thank you, Tom. As you mentioned, there are some important differences between arbitration and litigation before an actual court, with which we are all familiar. Some of them are of particular application to M&A disputes and I would like to highlight just three. The first one is neutrality and enforcement. Now, as with any dispute, you want a neutral venue with which the parties are familiar, and this is perhaps even more important in the context of cross-border disputes. But if you take the example of a French seller and a German buyer of an Italian company, the French seller will not necessarily want to have a dispute heard in Germany and, likewise, the German buyer will not want to have a dispute heard in France. The obvious neutral choice might be Italy, but neither party would likely be familiar with the Italian court system nor necessarily want to litigate in Italian.

Arbitration allows the parties to choose the composition of the tribunal and also the language of the proceedings. And this is quite a significant point, the importance of which is often quite overlooked. I mean, we see nowadays English language commercial courts popping around, in particular in … in various countries, in Europe and Middle East and elsewhere, but the ability to select the language is a major advantage of arbitration. On enforcement, while anecdotally there is a high-level degree of voluntary compliance with arbitral awards, and there are ways to facilitate that in a SPA – for example, by providing security for continuing obligations through an escrow account – it may still be necessary to enforce through the courts any determination. Enforcement of arbitral awards is easier globally than enforcement of national court judgments. And in the UK and the rest of Europe in particular, post-Brexit, this is quite an important consideration as a UK judge will not … or no longer, I should say, automatically enforce this in the EU and vice versa.

The second point I wanted to mention is confidentiality. This is an important consideration and arbitration proceedings are, in principle, confidential although one has to be careful because the position does differ from jurisdiction to jurisdiction depending on where the arbitration takes place, and it's a point best dealt with expressly. But it could be an important point because a dispute played out in the public domain, for example, before the national courts, could damage the brand or the target that has just been acquired.

And the last point I wanted to make is one of finality. I mean, the global norm in relation to arbitral awards is that it is not really possible to appeal them, and you can only set them aside for a very limited number of reasons. If you are the seller, in particular, it is more likely that you would want to avoid being embroiled in a dispute over an asset that you have disposed of years ago.

So these are just three points I wanted to highlight which make arbitration more suitable for cross-border M&A disputes.

JS: Yes, indeed. As Thomas has just pointed out, there are several advantages which make arbitration the perfect tool to deal with cross-border M&A disputes. And maybe just to give you an overview and a feeling for the dimension we're talking about, I looked at some numbers and, from a German standpoint, I can report that since 1991, so over the last three decades, almost 50,000 transactions have been reported. Now when it comes to disputes, it is estimated that about 10 per cent of them end in a dispute. And by that I mean they have a wide understanding of a dispute including settlement negotiations and mediations, anything that goes beyond the usual post-closing issues. And again, out of all of them, it is estimated that about 2 or 3 per cent end in arbitration or litigation, with litigation being completely negligible because it really constitutes only a very small fraction of the cases that end in a proper dispute.

As I said, these are estimates because, as Thomas has already alluded to, in international arbitration confidentiality is an issue and moves for more transparency have only recently been on the rise. But nevertheless, these estimates appear to be very reliable in that there are several indicators supporting the estimate, one of them being, in the case of Germany, that there are very, very few German state court decisions, and actually the few that exist are completely disproportionate to the numbers I just reported, transaction-wise. And the few cases that do exist deal with only relatively small businesses and relatively small transactions.

And then, second, as legal advisors, we can also confirm that, whenever we draft or negotiate an SPA, which is oftentimes the case, we will almost never be faced by, or opt for any other dispute resolution mechanism than arbitration. And I dare say while it is … overall we estimate about 95 per cent of the SPAs contain an arbitration clause, I dare say that, in the context of cross-border M&A transactions, this really high number will be even higher.

And then seriously it's not only us who says that, it's also insurance and warranty indemnities insurance brokers who report the same. For deals in Germany, they say they really never see a litigation clause in the deals that they provide insurance cover for. And then finally, as Tom has already said, I am a practitioner in the area, so both as a counsel acting for a party and as an arbitrator serving on a panel, I have experienced that, whenever there is a dispute in the context of an M&A transaction, it will go to arbitration and not to litigation.

TC: Okay, Thomas and Judith, thank you very much for setting the scene in that way. Let's move on to our second topic, and the first one really dealing with substantive issues. And what we're going to talk about is warranties and indemnities and they're obviously the source of many M&A disputes.

I'm sure everyone will be familiar with the role of warranties and indemnities in M&A transactions. Essentially, they are a means of allocating risk between buyer and seller of a company or business and, as a matter of English law at least, the starting point is you have a fundamental principle of buyer beware, i.e. English law does not generally provide legal protections for buyers. They don't negotiate anything specifically with the seller. So what the buyer tends to do is negotiate warranties, and these are statements of fact given by the seller as to the condition of a company or its assets. And, if there is a breach of those warranties, that entitles the buyer to recover losses from the seller.

An indemnity, by contrast, is a contractual right to recover a sum of money on a dollar-by-dollar or euro-for-euro basis. And I think the approach that's generally taken is that warranties protect against unknown risks, whereas indemnities are included to deal with specific risks that are known and identified by the parties when they are negotiating their transaction documents. In some parts of the world, such as North America, you see a hybrid approach whereby warranties are given and then indemnities are used to back up those warranties, i.e. there is indemnity protection in respect of losses incurred for breach of warranty.

So let's talk a bit now about how warranties and indemnities issues play out in arbitration and, Thomas, do you want to start by just scoping out the English common law position?

TK: Sure. As you mentioned, Tom, the starting position under English law is the principle of buyer beware: the buyer must therefore make investigations to satisfy themselves of the asset they are buying. And more often than not though, the information on the asset is with the seller. So, as you pointed out, the buyer will require this type of information or negotiate warranties of certain facts which, if they prove to be wrong, there can be a claim.

Now, from the seller's point of view, to limit the scope for claims under the warranties, the seller will ordinarily give disclosure of certain items and then exclude liability in respect of matters disclosed. And the term we often see in SPAs governed by English law drafted by English lawyers is that liability will be excluded in relation to matters which are fairly disclosed. That's quite a common term we see. Under English law, "fairly disclosed" means that disclosure has to be quite specific and mere references in a document which has been provided, which might get the buyer to a position, following investigation, to find out about certain defects or other matters, will simply not be sufficient. From a practical point of view, disclosure will ordinarily, in the SPA specifically, include the contents of the data room and that could have quite a lot of implications when considering bringing a claim.

I was recently involved in advising a client in connection with commencing arbitration for a breach of warranty claim and that claim was in relation to a poorly maintained pipeline. The warranty in question was one of compliance with environmental laws and it was our position that operating the pipeline in that state was in breach of certain environmental regulations.

Now, warranty claims excluded matters which were fairly disclosed - the formulation which I've just mentioned - and there was a mention in documents that had been provided during the negotiations about the need to repair a small section of the pipeline. However it appeared that a much larger section, and potentially the entire pipeline, might need to be repaired. So in order to be able to advise whether a claim could be brought or whether it was a matter which had been fairly disclosed and therefore no claim could arise, the seller could evade liability, it was important to go back and check through the data room that was set up during the SPA negotiations to assess all references to this matter - what was disclosed and to what level of detail. And this was quite a significant and costly exercise. Everyone involved in SPA negotiations or disputes will know that the data room can be quite expensive. And even with the help of technology, such as predictive coding and other artificial intelligence software, it is quite a lengthy and expensive exercise. And as I mentioned, this is work that needs to be undertaken just to ascertain whether one has a claim or not in the first place, so quite early on in the process.

Now I know the position is similar under French law where the buyer beware principle equally applies, but I do understand that the position might be different under other civil law so I would be very interested to have Judith's view on this from a German and other civil law [systems] point of view.

JS: Yes, I think there are some similarities but it's also fair to say that probably under German law, from what I understand in comparison to English law, there is a focus that is stronger on the seller, on the seller's obligations. And maybe if you say buyer beware under English law, in German or under German law and maybe a lot of the other legal traditions coming from Roman law, I would have to say seller also be aware. So maybe that's the bottom line of it.

Having said that, under German law, a SPA is simply governed by sale and purchase provisions. Nevertheless, I think we all know that in cross-border M&A transactions it is common standard that the parties agree on a stand-alone regime and individually draft and negotiate their contractual provisions. Why is that so? Because they are from different legal backgrounds and have different cultures and therefore they want to make sure that they create a legal framework that reflects their expectations and makes outcomes predictable.

Nevertheless, if German law is applicable, there will be additional liability that may not be contractually excluded. And that goes back to … and that is why I alluded to Roman law tradition, that goes back to the concept of culpa in contrahendo; that is fault in negotiating or concluding a contract. And, in that respect, it's very important to see that connection between warranties and indemnities and the disclosure obligations, because the liability and the culpa in contrahendo comes from three angles in the nexus of disclosure obligations. The first being that, under German law, there is an obligation by the seller to provide certain information. If and to the extent the information is relevant to the buyer, and if the buyer has a legitimate expectation and may reasonably expect such disclosure, that is the case if the information pertains to the, let's say, the heart of the purpose pursued by the buyer. So, if there is information that the seller knows is of crucial importance to the purpose pursued by the buyer, it will have to disclose it.

The second group is, and this won't be surprising, intentional misinformation or intentional misrepresentation. And now I know there's a lot of people think the threshold for intent is very high, but actually it's much lower than you would expect because conditional intent is already considered sufficient, and the way it's circumscribed is that it is said that it's already sufficient and a statement is made as a shot in the dark. That means it's sufficient if the seller makes a statement and is not quite sure whether it's wrong or right but acknowledges that it may be wrong and nevertheless makes it. That's sufficient for intent. Intent does not have to include the damage that arises from such possibly wrong statement.

And then the third case group is wrong information. And that applies even in case of there not being obligation or disclosure. So if you're the seller and you disclose certain information voluntarily, you will be held liable under the culpa in contrahendo if that information turns out to be wrong.

TC: Thank you very much, Judith. And in terms of takeaways for me, from what you and Thomas have just said, you're clearly seeing quite different approaches in the English common law where there is that emphasis on buyer beware, limited protection for buyers, unless provisions are specifically negotiated in SPA transactions. We obviously have our own doctrines of misrepresentation, but I think less friendly towards buyers than would be the case in Germany where you have your positive obligation to disclose information; you have this emphasis and requirement that a seller doesn't mislead the buyer. So those different approaches will necessarily, I guess, inform the prospectors, the parties that come from those legal traditions, and again it's just something to be aware of if an M&A transaction is being negotiated between people who come from different jurisdictions with different backgrounds and different expectations.

Let's move on now to talk about damages and loss, which is, of course, often the element that commercial clients are most interested about when M&A disputes arise; damages in warranty claims specifically and how one goes about determining loss. One of the first questions, I think, when you're asked to look at a warranty or indemnity claim is what loss has the claimant suffered and how does one go about quantifying that.

And, Vicki, let me turn to you for the first time today. When you're instructed on a dispute of this nature, how do you go about developing your damages analysis?

VW: Well, for a breach of warranty claim in an arbitration dispute, what I'm generally instructed to calculate is the damages that would put the claimant into the position that it would have been in had the warranted information been true. So the calculation is the difference between the company's value as warranted and as is. And when I say "company's value" here, what I really mean is the market value. What I normally mean here is the market value which is typically defined as the amount exchanged between a willing buyer and a willing seller in an arm's length transaction.

So then the question is how do you get to the as warranted and as is, that market values of the company? Well, that's the easy bit, the as warranted value, because in my experience the as warranted value is equal to the price paid, and that's kind of on the assumption that the transaction took place at market value. There are sometimes reasons why that assumption isn't true, for example, in a liquidation or in a pressures to sell, or alternatively if there are pressures on the buyer such as to get access to synergies or to remove a competitor, and in these situations the prices might be lower or higher than the market value. But, in my experience, it's typically that the price is used as the as warranted value.

So this is where most of my time is taken up – how do you get to the as is value (which is the value that the buyer would have paid had the conditions that resulted in the alleged breach of warranty been known at the time of the transaction). So it's a question of, "What is it really worth, what would the buyer have paid?". Well, this is normally determined by the way the price, the as warranted value, was calculated. So it might have been five times earnings, so five times EBITDA or 20 times the weekly sales.

So how do we determine what the appropriate model is? Well, "How did the buyer arrive at his offer price?" is the question we ask. And so we generally start from the calculation that the buyer may have presented to the seller contemporaneously, at the time of the sale. Although this is only a guide, the starting point, and it may not be as simple as just using that calculation. And we take this model, this contemporaneous model, and then we adjust it for the breach [restraint] and then we see how much the value, that is the price, would differ. And it's unlikely that this impact is really just pound-for-pound, euro-for-euro; it's likely to be a multiple. So what I mean here is, taking a very simple example, say we found the model was 14 times EBITDA and that there was only one alleged breach of warranty and that reduced the EBITDA by a £1 million. So then my calculation for the breach of warranty would be 14 times £1 million, being £14 million. But it's not normally that straightforward.

So there are problems when the breach has no impact on the offer price as determined, in which case what I need to consider is how the breach would have impacted the market value, if at all. And then, alternatively, the breach may be so fundamental that it's not reasonable to assume the same multiple, say the 14 times EBITDA, would be appropriate to be applied, for example, if the long-term growth prospects would be different or the risks of the entity are substantially higher. And then I'd need to ask the legal team and the client, "Is the alleged breach of warranty so substantial that it's unlikely that the buyer would have used the same fundamental purchase calculations?".

My examples have been based on the EBITDA sales - so income statement and profit and loss figures. If the breach impacted the balance sheet, such as the value of the property or the value of the cash, it may be on a pound-for-pound, euro-for-euro basis and not a multiple, although there are exceptions: if the company was valued on a multiple or even discount to a net asset basis, then the damages would be similarly calculated.

So my final point before turning back to you, on damages, is my instructions are generally not to use hindsight, so I value the company as at the date of breach, which is generally the date of acquisition. My work will look at the expectation of the performance of the business as at the date of breach rather than its actual performance after the date of breach. And that's particularly relevant at the moment when I look at current warranty claims because if the breach occurred prior to the pandemic, the joy that we're in at the moment, the impact of the ongoing pandemic would not normally be taken into account. And that, as you can imagine, would have a significant impact on the damages that we then would end up calculating.

Thanks.

TC: No, thank you, Vicki.

And, Judith, a lot of the things that Vicki has been talking about I think we are familiar with from arbitrations in the past, but it is highly technical stuff, isn't it? How do you go about communicating convincingly the damages analysis to a tribunal as an advocate in an arbitration?

JS: Yes, that's a science in and of itself but, as Vicki has alluded to, first of all it starts with the communication between the lawyer and the expert and there are instructions as how to calculate the damages. And, as Vicki has also explained, damages are calculated by looking at the hypotheses; which situation would the buyer be in if the warranted information had been as warranted? And that actually reflects, at least under German law. And I think the same is true under other legal systems that there are various ways to calculate damages, one being reliance damages, and that requires that the buyer is put in the position it would have been in if the information it has relied on had been correct. And in that regard, at least under German law, there's a lineation of burden of proof in that it is assumed that, had the buyer had the information, the correct information, it would have been successful in negotiating a lower purchase price.

So what the lawyer will then have to prove is the delta between the actual purchase price and the hypothetically negotiated lower purchase price. And this is exactly where experts like Vicki come in and help explain how this is done.

Another way to calculate damages is expectation damages and that refers to, specifically, warranties, which under German law are treated as independent guarantees. So expectation damages require that the buyer is put in the position it would have been in if the guarantee had been adhered to.

Now, how do we make this nexus between the law and the expert? In general, it provides … it requires quite a lot of preparation. So it requires advanced planning, it requires production schedules, it requires consultation between the expert, the lawyer and the client on the methodology of how to best calculate the damage, and it's a constant process of exchange and collaboration, basically.

And then, of course, as a result, the lawyer will have to somehow condense and translate these findings for an arbitral tribunal. And I know that, also from an arbitrator's perspective, because I am always grateful for guidance because, to be honest, these expert reports are often overwhelming in their complexity and also scope. And so what lawyers do is they just try and condense and translate it in their written briefs, in their oral statements, in their opening presentations and, as in a lot of those cases, it will be helpful to use charts and figures and just visuals in general, if possible, because that often makes things much more straightforward than they may look in a fully fledged expert report.

I don't know … Vicky, what's your experience with regard to collaboration with the lawyers?

VW: Yeah, I think my experience completely agrees with yours, Judith. I think it's most productive and brings the best outcome for the client when the legal team and the experts, and probably the client as well, work closely together whilst not stepping on each other's toes. So that I can take instructions on legal points and points of fact and … but not issues with my expertise, I don't expect the client or lawyers to opine on that, and I will definitely not opine on areas of law nor areas outside of my expertise. And I do try and write up the expert report as clearly as possible. So you take the complex calculations and explain it more clearly, both for the legal team and also the arbitrators. So my duty is to assist the arbitration tribunal, so if that's explaining a technical point as clearly as possible, on either side, just independently, that's what I try and do as well. And sometimes expert tribunals actually appoint an expert themselves so that they have an independent expert to clarify a point of view.And the other point, this is not a sales pitch – it's sometimes really helpful to get quantum experts in as early as possible so that we can assess the damages. We're happy just performing a quick and dirty damages calculation in the hope that it will be helpful before we do our fully fledged, long and technically and complex work.

TK: Yeah. So I'll interject there. What you just said, Vicki, is very important and I think it's really, really key to speak to your quantum expert early and we have a lot of experiences where we get drawn into the legal … the merits of the legal argument, but forget about the quantum and then a disproportionate amount of effort has been spent on what is actually a low-value claim.

But, anecdotally, I have one experience where it validates the point, it's the exact opposite. I had a case where there was a very clear breach of warranty but the client, for various reasons, was quite hesitant in bringing a claim and, in order to assist the client with taking an informed decision as to whether to go ahead or not, we engaged a quantum expert to provide a quick and dirty valuation so that they know claim they might be waiving. And, in fact, the valuation was quite positive and that had the effect of dispelling the cloud of doubt that was in the client's head. So it can work both ways but it's clearly a point that needs to be borne in mind, we [should] not leave quantum considerations for the end.

TC: Thanks very much, Thomas. And Judith and Vicki. And I think what I'd take from that is that when you're looking at damages issues, you have this interplay between the relevant legal principles, which may be subtly different between the different governing laws, the actual accounting analysis that Vicki had described, and then finally the art of presenting this information to a tribunal, especially if you have a tribunal that may not be financially literate or experienced in this sort of thing. So that's where the real value can be added to the client in terms of how one presents the case.

Let's move on to our next topic now which is earnouts, and we're going to talk about where disputes arise and comment on how one can potentially avoid them. Earnouts are mechanisms used in M&A transactions where all or a portion of the transaction consideration is deferred and how much consideration is paid is dependent on how the target or business does over a period of time. And, Thomas, earnout disputes, I think, have in particular generated quite a lot of attention in recent years and I suppose that makes sense given that we live in such a fast-moving, disrupted world, not least given the events of the past 18 months or so. You can see that buyers and sellers would find it harder to agree on a valuation and buyers might say to sellers, "Okay, I will pay your price but I want to see if the business actually performs as you have told me it will over the course of a period of time after the transaction closes".

We have certainly had to grapple with earnout disputes issues, I'm thinking of one example in the mining sector in the past one of our matters, Thomas. But can you shed a bit of light on how earnouts are typically structured and the way in which the disputes give rise to issues in arbitrations?

TK: Sure. A typical earnout clause will usually include two elements. The first element is the actual performance target, the relevant milestones that need to be achieved, which could be a certain level of EBITDA, turnover, sales volume, and within which period of time it would need to be achieved for the earnout to be payable. And it varies from transaction to transaction and from industry to industry, but a typical period would be one or two years.

The second element of a typical earnout clause is management competence, i.e. provisions prescribing, to a certain extent, how the business will be run to ensure that the targets are met. So what we tend to see is three types of disputes in the context of such earnout provisions. The first type of dispute that we see is as to whether the relevant benchmark or milestones triggering the earnout payment were achieved or not. The second is where the milestones have not been achieved and there's a dispute on the reasons why the relevant benchmarks were not met. The third, which to a degree is a variation of the second one, is a dispute where the relevant benchmark or milestone was met but in the eyes of the seller they were met at a much lower level due to a fault on the part of the buyer.

Now I will admit here on the comments on the first type of dispute relating to whether the targets were met or not, that is quite often an accounting exercise. But as far as the second and third types of disputes are concerned, this involves looking into the common factor obligations of the buyer and therefore often involves allegations of breach of the management competence, and these types of disputes are quite frequent. So, for example, if the target is a certain level of sales volume, they might be confident in the SPA as to the conduct and obligations in relation to marketing activity and there may well be a dispute as to the marketing effort and the marketing spend of the buyer which led, or did not lead, to achieving those sales volumes.

In a slightly different context, maybe the target is obtaining a licence, a certain licence, which everyone knows will impact the target revenue and there might be a component to actually apply for the licence, and on the part of the buyer who's running the business, and avoid any incentive on the part of the buyer to delay matters so that the licence is granted after the relevant period to avoid having to pay the earnout. There may well therefore be a dispute as to how the buyer progressed the application to enable the condition to be satisfied.

So I'd be very interested to hear from Vicki on the first type of dispute, which involves a lot of looking into accounts.

VW: Absolutely. Well, in order to be able to compare to the performance target, and see whether the earnout with the third consideration is due, the company normally produces earnout accounts, so specific accounts prepared to cover the earnout period. And actually I may be asked to produce them but more frequently I'm asked to review these accounts. And the key issue is the comparability of these results that are stated in these accounts pre and post the transaction because there are likely to have been changes to processes or internal financial reporting and particularly the accounting policies, procedures and operations that may have been applied by the new owners post-transaction.

So my financial analysis is often related to whether the earnout accounts have been prepared inconsistently with the sale and purchase agreements. So ideally, to avoid dispute, the sale and purchase agreement should include details on those accounts, particularly on the format, the basis of preparation, and the definition of terms to be used. So we typically carry out our analysis and review two things. Firstly, the interpretation of terms used in the calculation of these earnout metrics – has the buyer and seller used different interpretation? And, secondly, has there been a manipulation which impacts the earnout payments?

And we take particular care because most earnout accounts are calculated based on management accounts. So management accounts are sensible because they're easy to use, they're prepared regularly by management already but the treatment of specific items in the management accounts may not be consistent pre- and post-acquisition and they're not subject to the same specific accounting standards. They're not the same as audited accounts, audited statutory accounts, for many of the items included within them.

So, for example, we've seen disputes over earnouts measured with reference to EBITDA because EBITDA isn't defined in accounting standards. So different categories may be included and excluded and we find disputes can be more easily avoided if they're clearly define the components of EBIDTA within the sale and purchase agreement.

And then we also see disputes over judgemental accounting areas such as recognising revenue on long-term contracts or provision for doubtful debt, bad debt, because the accounting wasn't clearly prescribed and is subject to each management's judgement. So this is also inconsistent treatment of exceptional or non-recurring items - should they be included or excluded?

And then the second area which I was talking about is manipulation. So it could be deliberate manipulation or simply a function of the buyers' new management change in the business. But it might be deliberate if the sellers are retained in the business and they operated the business in a certain way, to give a particular example, where, in order to meet the earnouts, they reduced, for example, the spend on marketing.

And it was to the detriment of their business' long-term performance but a short-term benefit for them because it meant they reached their earnout targets. So we'll use financial analysis in these cases to consider whether the financial results have been influenced by the use of particular accounting standards. And consider whether the accounting standards that were included in the sale and purchase agreement allow for different judgements, such as recognising particular items, in particular, accounting periods.

And if the business has been operated in a particular way which may have breached the earnout protection provisions in the sale and purchase agreement. For example, have the buyers transferred assets to other group entities or changed the intragroup allocations or increased spend on discretion areas such as marketing?

TC: Very interesting, thank you Vicki. And I think in terms of takeaways, tips to avoid disputes, that the key things from my perspective are around interpretation, how do you define your earnout provisions or your earnout metrics as clearly as possible to avoid any disputes. I was involved in an arbitration a few years ago, it was actually a German arbitration in Munich, which involved a dispute over whether earnout consideration was due or not. And we were acting for a party that was seeking to avoid paying earnout consideration.

And the way the mechanism was structured was that there was a defined earnout sum put into a pot essentially, and then the seller was entitled to receive additional consideration if certain contracts were not terminated, i.e. customer contracts were not terminated during the earnout period. This was a logistics business.

As it happened a number of contracts were terminated and the parties went to an arbitration essentially to resolve two issues. The first was what constituted a contract. Because one side was saying, for a contract to fall within the scope of this it has to be a formal contract, it has to be a written agreement. And the other side was saying no, an informal arrangement is sufficient. If an informal arrangement comes to an end then that should affect the earnout consideration.

The other element of it was whether you had to be able to point to a valid termination of a contract in order to reduce the earnout consideration. One side said it's sufficient if a customer is saying, I'm no longer going to receive good from you or services from you under this contract. And the other party was saying, no there has to be a termination which is valid as a matter of the governing law of the customer contract.

You can see, even something as straightforward as that, how many contracts remain in effect, what revenue is associated with them over a period of time, was quite quickly mired in legal debates about what is a contract and has it been validly terminated.

And, as Thomas was saying, I think the other element around this is how do you police the behaviour of management, after a transaction has been done, so that the earnout provisions are not [vague]. That is certainly something that's worth thinking about quite carefully in advance. The sort of protections that are there, for the seller, as that earnout period unfolds.

Let's move on now to our final topic, which is purchase price adjustments and completion accounts. And Vicki, why don't we go straight to you and ask you to explain some of the accounting issues which arise in arbitrations?

VW: Yeah absolutely. Well, even when there's no dispute, the value of the business at completion can be quite different to the value initially agreed. Just due to the normal changes in a trading business, particularly in cash, in debt and in working capital.

So that's the key reasons for standard purchase price adjustments to adjust for the changes in cash, debt and working capital. And we see disputes arising when there are significant and unexpected changes in these areas.

So businesses may be sold on a cash-free, debt-free basis and make an adjustment to exclude kind of cash and debt. But what is cash and what is debt, particularly when this hasn't been adequately defined in the sale and purchase agreement? And so the buyer and seller have different ideas of what should and shouldn't be adjusted. And so that leads to problems.

For example, although it may seem straightforward cash, is it deposit cash, is cash, ringfenced for regulatory reasons, really cash to be included or excluded, and should debt such as deferred income or pension deficits or a Corporation Tax liability, is that the debt that was being envisaged. And, similarly, you can have disputes over working capital. This can be more complicated, particularly as there isn't a standard definition of working capital within the legal definition on anything in IFRS.

But businesses clearly need to be sold with its working capital. So often it's compared to a normal level, a normalised level of working capital. But then disputes arise over what should and shouldn’t be included within this, such as, kind of, bad debt provisioning and so on. And to do with this, companies commonly produce completion accounts, which are prepared by one party and then sent to the other, the hopeful agreements, to adjust for actual cash and debt and other agreed areas such as working capital.

So, as I described, the area where we see many disputes is where the accounting treatment isn't defined or at least isn't clearly defined in the sale and purchase agreement. Particularly if the purchaser, which is more likely, is producing completion accounts, it may have a different idea of what treatment should be included and acted upon, than the seller.

So I would say, finally, the four most common issues that we see in completion account disputes are using a different basis for preparation of the completion accounts, than was used in the target, the comparison accounts; as I was saying before, management accounts may be produced on a different basis to the statutory accounts.

Using a different accounting treatment for a different item and adding new items in the completion accounts that weren't in the target, the comparison accounts. And then accounting for subjective judgemental areas such as provisions and revenue reclamation that I was talking about before.

Finally I'd say that there are clauses in the sale and purchase agreements that allow for disputes to be resolved through arbitration or also in expert determinations. And, as an accountant, I may be appointed to act as an expert determiner on these occasions when the issues are related solely to accounting ones or I may work with the legal team and the client to help draft the submissions. Working closely with the parties in order to do so.

TC: Thanks very much. Judith and Thomas, what's the legal position? Why are we talking about this in the context of M&A arbitration?

TK: Yes Tom, so in my experience … and as already alluded to, the SPAs will often provide the dispute related purchase price adjustment and completion accounts after the results for expert determination. And that makes sense, it's a relatively quick and cost effective way to resolve without essentially technical issues where you have a team [produced] from accountants.

A lot of difficulty with expert determination, is that it is a contractual mechanism which is not directly enforceable, so you may still need to think about arbitration. Unfortunately, if your counterparty refuses to comply with the expert determination, you would need to commence arbitration for breach of contract, i.e. a bridge to comply with a contractually agreed expert determination.

Now we all know that arbitration proceedings can be lengthy and we all have experiences of due process paranoia, which tends to give a lot of scope to a respondent to use delay tactics. And the actual party, having just gone through the expert determination procedure, having to then go through arbitration, in my view, it would be disheartening at that stage.

But, all is not lost, most arbitral rules now have summary determination procedures and there is the potential therefore for expedited proceedings. And, for example, the ELTA revised its rules last year and now provides for early determination of claims where even a claim or a defence put forward is manifested without merit. And that follows the example of other institutions like SEEIT in Singapore or the FCC in Stockholm already have similar provisions.

But seeking an award on the back of an existing expert determination is a good candidate for such an expedited process. So, I mean, to me the key point here is, choose your arbitration rules with that in mind to ensure that this is a possibility. There is the option obviously to make specific provisions in your arbitration clause and tailor the process.

But that could make an arbitration clause quite longwinded and there is also the issue of how many issues are you going to provide against in your arbitration clause. So think about your other, you know, which rules you go for, which might allow you more scope to do that as fast and as efficient as possible from a [GR] point of view.

TC: Yeah, thank you Thomas, and I think that point about summary disposal, summary determination of issues in arbitration, is a really good one to raise in this context. Because one of the historic reservations that many parties had about arbitration was that you couldn't necessarily get a DOT summary judgment as quickly as you could if you were going to the English court or the New York court or courts of other jurisdictions.

And the institutions have sought to evolve to meet that concern. And, as you say, most recently we've seen institutions like the LCIA amending their rules to bring that concept into play. It remains to be seen how expedited procedures, how summary determination procedures, will be deployed in practice.

How willing tribunals will be to make awards on that basis, but I think the circumstances you describe, where you have an arbitration following on from an expert determination, would seem to be very good circumstances for a tribunal to be able to resolve that pretty quickly. There is no reason to think that anything has gone wrong with the expert determination.

So thank you for taking us through that perspective. Now, in terms of the content, we have largely given our prepared remarks on each of the topics we said we were going to cover. What I thought we could do now is take a few of the questions that have come in.

Let me start with one for Vicki, if I may. Vicki, can you give us an example of a dispute you've worked on with a warranty claim issue and how soon did you come in as expert? I think you've given us a bit of colour on the sort of work you do. But can you give another example of that and the circumstances in which you were brought in?

VW: Sure, there was a particular breach of warranty dispute that was interesting in that it … a lot vested on the, kind of, the contemporaneous model that was used to calculate the purchase price. It was the opinion of the seller that the business was valued on a multiple of revenue. But it was the buyers' opinion that the model, that was presented to the seller, wasn't appropriate: it was actually based on a multiple of earnings of EBITDA. So effectively the net profit figure.

So the difference for the course of that was that all of the costs that were, the alleged breaches of warranty, were only impacted if you consider the earnings figure and weren't impacted at all when you considered it with the revenue figure. So although we could agree we weren't very far apart on, if the alleged breaches of warranty, what the impact would've been on the costs, it's did it actually impact the value of the company or not.

Because, if they weren't worried about costs and they were looking much more at the revenue, it would've had less of an impact. And on that case we were brought in very early to give our views on the different models and the likelihood of the different models. And, in our experience, it wasn't appropriate for that kind of sector and that kind of industry.

TC: Were you ever brought in before the lawyers, Vicky? Do you ever find that commercial clients instruct you directly and ask you to look at financial issues before the legal questions are looked at?

VW: Occasionally, I would say it's more common, at the same time as lawyers, but yes, sometimes very early on I'm approached by in-house counsel and commercial clients rather than via an external legal team asking us as well. Because the buyers and sellers may have their own opinion on how big this impact is. But it's very helpful to have an independent point of view to see whether it is reasonable or not and whether it can stand up to any kind of scrutiny.

TC: Yeah, no, that makes sense. Thank you. Judith, let me put one to you. Have you ever seen a non-lawyer appointed as an arbitrator in an M&A dispute and is this a good idea? This is a question that comes up quite a lot in the context of arbitration, doesn't it? What's your experience on that?

JS: I can tell you that originally I found the idea extremely intriguing. And when I wrote my PhD thesis on arbitral law I actually finally saw, as well, the advantages of arbitrations that you can, you know, nominate an expert rather than a lawyer as an arbitrator. But in my practice I've never seen it. And now that I've learned more about the practice, I do realise why that is the case, because it goes along with a lot of practical issues and possibly also problems.

Insofar as that usually, you know, if you have let's say one expert and two lawyers on a classic three-member arbitral tribunal, the issue will be, what will happen if those other two lawyer members disagree on the legal analysis. And then the expert won't be the one, you know, to tip the scale because they will not be in a position to judge on the law.

So that may even necessitate having a legal expert coming in to sort of inform the technical expert on the law. So that sounds messy, is messy and it's costly. And then if you look at the situation where you think about bringing in an expert on your side as a party appointed expert, you will also, in addition to that, be afraid that, at the end of the day, the two lawyers will decide by themselves, without the expert really having the competence to engage in the discussion on the law. So that's the other concern.

But having said that, I can still imagine that there are sittings where technical experts may be great arbitrators with the caveat that, in any case, I don't think a technical expert should be sole arbitrator or presiding arbitrator because this, again, would pose a lot of procedural pitfalls and ultimately endanger the enforceability of the award.

TC: Yeah, thank you Judith, and I think your experience coincides with mine as well on that front solely in the context of big commercial disputes. Thomas, one for you, what is the best way of trying to ensure enforcement of an award rendered in an M&A arbitration context?

TK: That's an important consideration because, having gone through the whole process of an arbitration in the courts and the time involved, you want to ensure that your award is enforceable. And there's a number of considerations. The first one is, obviously, you need to bear in mind where you might be enforcing, in which jurisdiction.

So, where might the other party have assets? Generally speaking, if you are and hopefully you will be in a New York convention jurisdiction, there are very limited grounds on which an award, enforcement of an award, will be refused. And some of the ones we typically see are, for example, some procedural irregularity which did not allow both parties to advance their case and there was some kind of … perhaps bias and the equal treatment of the parties was not respected.

And the other type of challenges we often see is on the basis of the local public policy. So that enforcement of the award for certain reasons might be contrary to public policy considerations. So with those considerations in mind, it's important to make sure that during the contact of the arbitration, you ensure that due process is not jeopardised.

Don't be too aggressive on the other side, which might give them the opportunity to then use that against you in the context of enforcement. But also think about potential considerations in relation to what you're trying to enforce. So, for example, if you are seeking punitive damages in an arbitration, there's a number of jurisdictions, including England, where that will not necessarily be enforceable because it's contrary to public policy. Because the price of damages is compensatory.

So think carefully about where you might want to enforce and seek advice as to whether there might be any public policy considerations that might prohibit that. So these are some of the key areas that one has to bear in mind, in my experience, when trying to enforce. And I hope and I suspect, Judith, your experience will be quite similar.

JS: Yeah. For instance the share of punitive damages is the same in Germany. So I think, to my limited knowledge, there are few jurisdictions where punitive damages are actually accepted.

TC: Okay. Well, look, that takes us very nicely to time. It remains for me to thank our speakers today, Vicki Wall, Judith Sawang and Thomas Karalis. Thank you so much to everybody else for joining us today. If we didn't get a chance to get to your question, please do feel free to drop us an email or, if you have any other comments, please feel free to contact us. But otherwise, thank you. We wish you the best for the rest of your day and goodbye.

TK: Thank you.

VW: Goodbye.

JS: Bye.