Well-written agreements prepared for merger and acquisition (M&A) transactions specify the conditions required to execute the transaction. However, even better M&A agreements proactively consider and thoroughly evaluate potential issues that may arise after the transaction has closed. An area where buyers and sellers most often find disagreement post-close is accounting-related items, typically in the form of working capital and earn-out disputes.
Fortunately, it is now very common for the parties to agree that an accounting arbitrator will adjudicate such disagreements, most commonly through a medium that is far more efficient, and far less expensive, than traditional dispute forums such as litigation and arbitration. This process is the joint-retention of an accounting arbitrator by buyers and sellers.
In a post-acquisition dispute, the process of hiring an accounting arbitrator is not as straightforward as some M&A agreements may depict. The disputing parties need to consider several steps when they retain an accounting arbitrator, starting with the drafting of the M&A agreement and concluding with the engagement of the professional who will settle the dispute. Although certain considerations may appear straightforward, if not explicitly defined in the M&A agreement, the absence of such language can cause unnecessary delays in the dispute resolution process.
Key items related to accounting disputes, and the retention of an accounting arbitrator that should be considered prior to the execution of an M&A agreement include:
- What actions by the parties are required to trigger the alternative dispute resolution proceedings that allow for an accounting arbitrator to be retained?
- What have the parties agreed that the accounting arbitrator will decide?
- Should the accounting arbitrator follow a certain accounting methodology?
- What qualifications should the accounting arbitrator have?
- How will the accounting arbitrator’s fees be allocated amongst the parties?
- What is the nature of any conflicts of interest that the accounting arbitrator or his or her firm may have with either party?
What triggers the use of an accounting arbitrator?
A well-written purchase agreement will identify the dispute resolution options available to the parties, and identify the forum to be used for each type of dispute (not just limited to accounting disputes). Certain disputes may warrant traditional litigation (in state or federal courts), other disagreements may be assigned to an arbitration panel, while others may require mediation as a first step.
With respect to accounting-related disputes, assuming that the parties agreed that an accounting arbitrator will resolve such disputes, the purchase agreement often identifies the actions required to initiate those proceedings. This process generally includes the following steps:
- The seller prepares an estimated accounting of certain items (e.g., an estimated closing balance sheet).
- The buyer prepares its own accounting of those same items (within a predetermined time period) and delivers this information to the seller.
- The seller reviews the information prepared by the buyer, and if the seller rejects this information, the seller formally notifies the buyer of its objection (again, within a predetermined time period).
- If the parties cannot resolve the dispute themselves, then the process of retaining an accounting arbitrator commences.
What is an accounting arbitrator?
An accounting arbitrator for a post-acquisition dispute is the professional charged with resolving accounting-related disputes that arise after the transaction has closed. The most common items that an accounting arbitrator is requested to settle are working capital and earn-out disputes. These are items where the parties typically find that they cannot resolve themselves, and agree that an accounting expert is best positioned to adjudicate the claims made by the parties.
M&A agreements use different names for accounting arbitrators—these may include neutral accountant, accounting expert, accounting referee, independent accountant, accounting arbitrator or national accounting firm—but they all essentially fulfill the same role.
Arbitration vs. accounting arbitration vs. expert determination
There are important distinctions between arbitrations, accounting arbitrations and expert determinations, the legal interpretations of which are beyond the scope of this article. However, it is important for attorneys who draft M&A agreements to be mindful of these distinctions and work with the parties to ensure that the language surrounding the dispute resolution process and the role of the accounting arbitrator achieves the desired objectives and does not jeopardize or protract what should be a final determination from the accounting arbitrator.
For purposes of this article, the terms accounting arbitrator, neutral accountant, accounting expert, accounting referee or independent accountant all refer to a professional with the necessary expertise to make a determination as to which party prevails on specific accounting-related items that arise after a transaction has closed.
Conflicts of interest
The accounting arbitrator must identify any conflicts of interest (actual and potential) and disclose those conflicts to both parties. For accounting arbitrator services, conflicts of interest may relate to traditional business conflicts, or may relate to auditor independence rules.
Business conflicts may arise where the accounting firm performs or has performed non-attest services for a party to the transaction, the significance of which could impair the accounting arbitrator’s ability to provide services with integrity, objectivity and independence, and due care.1
Depending on the nature, size and when those services were or are being performed, the parties may mutually agree to waive such a conflict. However, the accounting arbitrator has a professional obligation not to accept such an engagement if he or she feels the firm’s current or prior relationship with one of the parties could impair his or her objectivity.
Further, if the accounting arbitrator is employed by a public accounting firm, and the public accounting firm provides attest services (e.g., financial statement audit services) for either party, then the accounting arbitrator may not be allowed to provide services to resolve the post-acquisition dispute.2 SEC and AICPA independence rules may preclude the accounting firm from providing these services, irrespective of whether the parties decide to waive any real or potential conflicts of interest.
Designation of accounting arbitrator in the M&A agreement
Often, the parties will designate the name of the public accounting firm to provide accounting arbitrator services when drafting the M&A agreement as a proactive measure; this foresight can streamline what may otherwise be an arduous and contentious process once it becomes evident that the parties will commence dispute proceedings.
The parties (through their attorneys, or independently), would be wise to notify the selected public accounting firm of their intent to name that firm in the M&A agreement so the firm can perform a conflict check and evaluate their candidacy. (Note that even if the firm agrees to be named in the M&A agreement, they will have to perform the conflict check again should a dispute subsequently arise.)
It is also prudent to avoid identifying a specific office location of the public accounting firm from which the accounting arbitrator would be selected. This helps to avoid a situation where qualified professionals from the preferred office location are not available during the desired timeframe due to other client commitments. Further, restricting the selection of an accounting arbitrator to a specific location may unintentionally negate one of the primary reasons for selecting that firm in the first place: the public accounting firm’s breadth and depth of professional resources.
Post-closing acquisition disputes often involve subjective accounting areas such as reserves for inventory obsolescence and the accounts receivable allowance for doubtful accounts. Similarly, earn-out disputes may center on revenue or expense recognition policies that include elements of subjectivity. Language typically included in M&A agreements prescribing that U.S. GAAP be applied to post-closing accounts consistent with historical practice is a minefield for disputes.
Accordingly, the accounting arbitrator must possess the requisite qualifications to evaluate the accounting treatment under U.S. GAAP, determine its consistent application, understand that materiality thresholds are fundamentally different in post-acquisition proceedings than they are when preparing a traditional financial statement audit, and have experience in contested matters where parties (and their counsel) vociferously advocate their positions. The ideal candidate should possess the following qualifications:
- Be a licensed certified public accountant in good standing
- Have experience in post-closing or other commercial dispute matters
- Have access to subject matter experts within his or her firm who can provide industry or technical accounting support, if necessary
Once the parties have identified a mutually agreed-upon accounting arbitrator with the proper qualifications to resolve their dispute, they must set about discussing the arbitration process with him or her and drafting a written engagement contract. In a future article, we will cover communication protocols, timeline and other critical steps necessary to ensure a fair and thorough consideration of each party’s arguments.
1. Integrity, Objectivity and Independence, and Due Care are principles of professional conduct included within the AICPA Code of Professional Conduct.
2. In practice, this scenario is not uncommon. Many nationally recognized public accounting firms have relationships with financial sponsors (e.g., private equity firms and venture capital firms). If the accounting firm provides attest services to the financial sponsor, or to an entity controlled by the financial sponsor, then this may violate auditor independence rules. In such settings, the accounting firm is precluded from providing accounting arbitrator services.