Jul 12, 2006
In This Issue
The Delaware Chancery Court recently ruled in OSI Systems Inc. v. Instrumentarium Corp. that a purchaser seeking to reduce the price of a corporate acquisition by more than half, in this case from $46.6 million to $21.0 million, may not do so by way of the closing price adjustment accounting process set forth in the purchase agreement, but rather the dispute must be submitted to a legal arbitrator.
In 2004, OSI purchased Spacelabs, a medical products business, from Instrumentarium for $46.6 million. The purchase price calculation provision in the purchase agreement provided for an unadjusted purchase price of $57.4 million, followed by a closing adjustment based on Spacelabs’ modified working capital statement as of June 30, 2003, and a final modified working capital statement as of the closing date. The initial estimated working capital was $85.1 million and the unadjusted purchase price of $57.4 million was to be increased or decreased, based on the final modified working capital statement.
Instrumentarium arrived at a final working capital calculation of $82.2 million, which would have lowered the purchase price by $7.8 million (the purchase price was furthered decreased pursuant to other adjustment provisions that were not at issue in the case). OSI also had the right to make its own working capital calculation and it arrived at a working capital calculation of $54.2 million, which would have reduced the purchase price by $25.3 million, over 54%, to $21.0 million.
The purchase agreement provided for two types of arbitration: closing price adjustment arbitration before an independent accounting firm and indemnification claims before a legally trained commercial arbitrator. If the parties disagreed on the final working capital calculation, the dispute was to be submitted to an independent accounting firm for a final and binding determination. Disputes over the representations and warranties contained in the purchase agreement were to be submitted to a legal arbitrator.
OSI sought to have the dispute resolved by the closing price adjustment arbitration process. Instrumentarium, on the other hand, argued that OSI’s claim was really a claim for indemnification due to a breach of representations and warranties in the purchase agreement and therefore should be submitted to a legal arbitrator. Both parties sued.
The court agreed with Instrumentarium and ruled that the dispute was to be settled by a legal arbitrator. The court ruled that OSI’s claim was, in essence, that Spacelabs’ financial statements and Instrumentarium’s initial calculation of working capital were not prepared in accordance with GAAP. OSI claimed that Instrumentarium’s initial $85.1 million working capital calculation did not conform to GAAP, whereas OSI’s final calculation of $54.2 million did conform to GAAP. Instrumentarium argued, and the court agreed, that such a claim is a claim for breach of representations and warranties and thus should be settled by legal arbitration.
Further, Instrumentarium noted that the accounting firm arbitrator would be required to use the same accounting method to calculate the final working capital amount as was used to calculate the initial working capital amount. Instrumentarium contended that to the extent that OSI sought to have different accounting principles apply to the initial and final working capital calculations, OSI would have to go to the legal arbitrator and prove that the initial calculation was not in accordance with GAAP, which would amount to proving that Instrumentarium breached a representation and warranty. Thus, Instrumentarium argued, and the court agreed, the claim belongs in legal arbitration.
The court stated that the closing adjustment arbitration provision in the purchase agreement “appears on its face to simply contemplate the use of an Independent Accounting Firm if there are differences of opinion about the amount of Modified Working Capital as of the Closing Date....OSI’s current position involves the Independent Accounting Firm in an entirely different and ambitious role: that of determining that the [accounting principles] used in the [initial] reference statement were not compliant with U.S. GAAP.”
Finally, the court noted “another reality – the fact that a ruling for OSI would undermine the limitations on liability and the core dispute resolution mechanism in the Purchase Agreement.” The purchase agreement, the court pointed out, limits damages to 25% of the purchase price for any claims of breach of representations or warranties. “OSI cannot bypass the contractual Indemnification process, ignore the contractual requirement to prepare its [working capital calculation] using accounting principles consistent with those used in the Reference Statement, and then seek a gigantic Closing Adjustment by attempting to convince the Independent Accounting Firm that Instrumentarium’s Reference Statement was materially inaccurate and infected by improper accounting.”
Neil E. Fankhauser Mr. Fankhauser’s practice focuses on corporate and securities law, including mergers and acquisitions of both public and private companies, equity and debt offerings, and other general corporate representation. Additionally, he advises boards of directors on corporate governance matters, including development of appropriate governance guidelines, policies, charters, codes and best governance practices.
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