In this article for New York Law Journal, partner Matthew Solum discusses a recent ruling from the Supreme Court of Delaware in Golden Rule Financial v. Shareholder Representative Services and its impact on buyers and sellers.
On December 3, the Supreme Court of Delaware issued an important decision related to purchase price adjustments and, specifically, how a seller’s misapplication of accounting rules can leave buyer on the hook for tens of millions.
Golden Rule Financial Corporation, a health insurance company, entered into an agreement to buy USHEALTH Group for $750 million, subject to a post-closing purchase price adjustment for tangible net worth. The parties’ agreement attached an annex of “Accounting Principles” and specified that tangible net worth be determined “in accordance with the Accounting Principles, consistently applied.” Following the closing, the buyer discovered that the seller had been consistently misapplying a relatively new Accounting Principle called ASC 606. When the buyer ran the numbers, the gravity of the seller’s error became clear: If the purchase price adjustment were calculated using the seller’s (incorrect) method, tangible net worth would be $35 million. If, however, ASC 606 were correctly applied, tangible net worth would be $73.7 million. In other words, the seller’s accounting error created a $38.7 million swing in the purchase price adjustment.
Once the error became known, the buyer and the seller could not agree on the purchase price adjustment, and the dispute ended up in litigation before the Delaware Chancery Court and, later, the Delaware Supreme Court. The buyer argued that “in accordance with the Accounting Principles, consistently applied” meant that consistent application was required: The Accounting Principles should, according to the buyer, be applied in the same way both before and after closing. The selling shareholders argued that correct application of the Accounting Principles took primacy. The Chancery Court sided with the selling shareholders, holding that although the agreement’s language did not specify “correct” application of the Accounting Principles, the need to be correct was inherent.
The Delaware Supreme Court affirmed, reasoning that correct application of ASC 606 was the parties’ intent under the structure of the agreement. The parties’ inclusion of ASC 606 in the Accounting Principles, the court determined, meant that they intended for ASC 606 to be correctly applied. To interpret the language otherwise “would … read ASC 606 out of the agreement.” The court further held that the “consistently applied” language referred not to the need for a consistent misapplication of a rule, but instead referred to other scenarios, irrelevant here, where GAAP allows for a variety of treatments. Golden Rule Financial v. Shareholder Representative Services, No. 61, 2021 (Del. Dec. 3, 2021).
The decision stands in contrast with an earlier Delaware Supreme Court case, Chicago Bridge & Iron Co. v. Westinghouse Electric Co. 166 A.3d 912, 929 (Del. 2017). In that case, Chicago Bridge was selling a subsidiary to Westinghouse in a deal that included a specifically bargained-for liability bar, which prohibited post-closing claims for breaches of representations and warranties. Westinghouse, the buyer, discovered a $2 billion accounting error when calculating a net working capital true-up, and then informed Chicago Bridge that Chicago Bridge owed Westinghouse that amount. Almost all of that amount was attributable to a historical error that pre-dated the acquisition, however, and the court concluded that the liability bar meant that the true-up could only resolve changes in working capital between signing and closing.
The court in Golden Rule considered the holding of Chicago Bridge but found it distinguishable both on the basis of the liability bar (which did not exist in Golden Rule) and on the basis that the Golden Rule agreement specifically required application of ASC 606.
The Golden Rule court’s decision provides yet another reason why the seller’s calculations should be carefully scrutinized before closing.
Matthew Solum is a litigation partner in the New York office of Kirkland & Ellis.