A Purchase-Price Adjustment Is Not the End of the Road With Indemnification on the Table

In Golden Rule Financial Corporation v. Shareholder Representative Services LLC, the Delaware Court of Chancery held that, following a post-merger purchase-price adjustment that benefited the seller, the buyer may still receive indemnification from the seller for that adjustment payment if the adjustment was caused by a misrepresentation in the agreement or a warranty breach.

The case shows that the Delaware courts recognize that contractual purchase-price adjustments and contractual indemnification processes are not mutually exclusive, but they can complement each other in a way that allows the processes to proceed according to their terms while effectuating the commercial intent of the parties.

The case arose from a transaction where, as is typical, the merger agreement provided for an independent accounting firm to resolve disputed items in the post-closing purchase-price adjustment.

In an earlier litigation, the buyer sought an injunction to prevent the independent accountant from applying a certain GAAP accounting standard, which the parties agreed would be used for the purchase-price adjustment before they realized the standard was incorrectly applied in the target company’s pre-closing financial statements.  The Court of Chancery held that the parties’ agreement required the accounting standard to be applied correctly in the purchase-price adjustment process, even if doing so was inconsistent with the pre-closing financials.  As a result, the buyer was required to pay over $40 million as a purchase-price adjustment.

But that was not the end of the road.  The buyer was able to recoup much of this price adjustment in a later suit, successfully claiming that the seller made misrepresentations by misapplying the accounting standard in pre-closing financial materials.

I. The Transaction

The buyer acquired the seller in 2019 for a $750 million base purchase price, subject to a post-closing purchase-price adjustment based on whether certain accounting metrics at closing exceeded or fell short of agreed-upon targets.  One such metric was “tangible net worth” — which the parties agreed would be determined in accordance with GAAP’s revenue recognition standard: ASC 606.   Although the standard was new at the time, the seller represented that it had already been adopted and would have an immaterial impact on its pre-closing financials.

The merger agreement also naturally contained financial-statement representations.  Among other things, the seller represented that its financial statements were prepared in accordance with GAAP and fairly presented, in all material respects, the company’s financial condition and results of operations.  And as part of the post-closing purchase-price adjustment, the merger agreement also required that the estimated balance sheet and tangible net worth calculations be prepared in accordance with agreed accounting principles, which specifically required application of ASC 606.

II. Initial Lawsuit and Accounting True-Up

After closing, it became known that the seller had misapplied ASC 606 in its pre-closing financials.  Correcting that treatment produced a different tangible net worth adjustment by approximately $38.3 million, compared to what the buyer would have paid without the correct application of ASC 606.  Thus, the seller sought a purchase-price adjustment.  In response, the buyer filed a complaint in the Delaware Court of Chancery seeking a declaration and injunction to prevent the seller from asking the designated accountant to calculate the “Final Adjustment Amount” using an application of ASC 606 that was inconsistent with the pre-closing financial statements.  The court reasoned that the parties’ agreement required ASC 606 to be applied correctly and, thus, the agreement did not prohibit the seller from asking the accounting firm to calculate the Final Adjustment Amount.

Given the concededly incorrect application of ASC 606, the outcome in the purchase-price adjustment process was that the buyer was obligated to pay the extra $38.3 million to the selling shareholders.

III. Second Lawsuit

Following the accounting proceeding, the buyer filed a new lawsuit, this time for indemnification.  The buyer alleged that it overpaid the Final Adjustment Amount due to the seller’s breach of representations and warranties regarding the accuracy of its financial statements.

The court held that the seller breached the representation in the merger agreement that its financial statements were prepared in accordance with GAAP.  The record repeatedly showed the seller’s personnel referencing ASC 606 having been adopted or implemented and that its impact was immaterial.  The court rejected the suggestion that the buyer’s diligence should have uncovered the error, reasoning that diligence is not the same as an audit, and that diligence is expensive as is — with it being reasonable to rely instead on the seller’s representations.  The merger agreement allocated the risk of inaccurate representations to the seller side, and the buyer’s indemnification rights were not conditioned on whether it could have discovered the breach before closing.

The court also held that the seller breached the agreement’s estimated balance sheet obligations in connection with the purchase-price adjustment provision.  The estimated balance sheet had to be prepared so that the effect of ASC 606 would be reflected.  Because the estimate did not correctly apply ASC 606, the seller failed to comply.

On damages, the court held that the ASC 606 error did not affect the base purchase price but it did affect the purchase-price adjustment via the tangible net worth adjustment.  Correcting that error resulted in the buyer paying $38.3 million more than it would have paid had the seller complied with its contractual obligations.

Before reaching the merits, the court addressed and rejected two threshold defenses raised by the seller.  First, the seller argued that the buyer’s indemnification claim was barred by res judicata because the buyer could have brought the claim in the earlier purchase-price adjustment litigation.  The court disagreed.  The buyer’s claim was not ripe during the prior litigation —since, at that time, the buyer had not yet incurred a loss because there was no determination of the Final Adjustment Amount.  The court reasoned that “[h]ad the court ruled in [the buyer]’s favor … in the first action, there would have been no basis for the indemnification claim.”

Second, the seller argued that the claim was barred by the merger agreement’s no-duplication provision, which limited indemnification for losses already reflected in the final adjustment statement or taken into account in determining the Final Adjustment Amount.  In relevant part, the no-duplication provision stated that any indemnified loss “shall be determined without duplication of any amounts or state of facts reflected on the Final Adjustment Statement or taken into consideration in determining the Final Adjustment Amount … or recovery by reason of the state of facts giving rise to such Loss constituting a breach of more than one representation, warranty, covenant, or agreement.”

The court rejected this argument, too, because the no-duplication provision was intended to prevent double recovery — for example, recovering once through the purchase-price adjustment and again with indemnification — not to generally bar indemnification claims.  The court highlighted how “loss,” as used in the indemnification provision, was defined quite broadly.  The parties had not narrowed it to out-of-pocket costs or to exclude the expectancy harm that the buyer claimed.  The buyer also was not seeking to relitigate how ASC 606 should be applied for the purchase-price adjustment — rather, it sought indemnification for the seller’s breaches of its financial statement representation before closing.

Golden Rule teaches that while a purchase-price adjustment settles the final price, it does not decide who bears the risk that a representation was false or encroach on the purpose of indemnification.  Absent language making the adjustment the exclusive remedy, a broadly drafted indemnity paired with a no-duplication provision aimed at true double recovery can provide a buyer a path to recovery where the adjustment payment itself is traceable to a breached representation, warranty, or covenant.

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