M&A basics: Completion accounts and manifest error
What a case in the Victorian Supreme Court tells us about the enforceability of expert decisions
While not a recent case, Funtastic Ltd v Madman Film and Media Pty Ltd [2016] VSC 708 is nevertheless illuminating for accountants, lawyers and others who fret over completion accounts in share sale agreements. At the time, the decision flew under the RADAR somewhat (accounting experts and barristers paid attention). We outline the case and some key takeaways below.
Summary of the case
The case involved the 2014 sale of a group of companies engaged in film distribution. For all intents and purposes, the SPA included typical completion accounts provisions, entailing a working capital adjustment and the usual supporting machinery. Somewhat unusually, the responsibility for preparing the first draft of the completion statement rested with the seller. But, in all other respects, the clauses were unexceptional, and included:
- preparation of completion accounts in accordance with a hierarchy of accounting principles, starting with specific notes and principles incorporated by reference into the SPA, and filtering down to principles used in the target’s half year accounts, and finally the Accounting Standards;
- a dispute resolution process requiring referral of any dispute to an independent accountant who would act as an expert and not as an arbitrator; and
- provisions requiring the expert’s decision to be final and binding on the parties in the absence of manifest error and affording the expert broad discretion to determine procedural matters arising from their engagement.
The parties were unable to agree on two technical accounting matters: first, whether accrued expenses relating to the supply of particular products to the target should be treated as creditor items (and included as a liability in the completion accounts); and, secondly, whether an entitlement to be paid certain un-invoiced amounts should be treated as receivables (and included as an asset in the completion accounts).
Their dispute was referred to the independent accountant who made a determination based on the materials supplied to them and purportedly in accordance with the SPA.
The matter wound up in the Victorian Supreme Court where the parties claimed (for differing reasons) that the expert had manifestly erred in relation to the disputed items. For context, the completion payment was $21.5 million and the completion adjustment prepared by the seller in its draft completion statement was approximately $3.8 million (in favour of the seller).
Observations and findings
The following observations and findings from the case are noteworthy:
- While expert determinations are not immune from review, where the contract entrusts matters to the expert without prescription or restriction, it can be inferred that the parties intended to be bound by the expert’s good faith judgement even if it was in some way erroneous.[1]
- The expert’s authority derives from the terms of the parties’ agreement. Accordingly, whether or not a report is binding on the parties will depend on whether it is made in accordance with the terms of the SPA.
- Manifest error was not defined in the SPA (as it tends not to be). Therefore, the term needed to be given its ordinary commercial meaning. Having regard to the broad procedural discretions given to the expert and the requirement for expediency and cost-effectiveness that often characterise this type of appointment, ‘manifest error’ in the SPA should be confined to clear and obvious errors (supporting the objectives of expediency and cost-effectiveness).
- Confronted with conflicting submissions of fact by each of the parties, the expert exercised their professional judgement to reach decisions based on the information presented to them in accordance with the principles in the SPA. This was precisely what the parties had engaged the expert to do.
- Although (perhaps worryingly) the expert stated that they were ‘doing the best [they] can on the available documents’, the fact that submissions to the expert were incomplete and factually inconsistent did not negate the report. These gaps did not preclude the expert from reaching conclusions in circumstances where their engagement expressly permitted them to rely on the completeness and accuracy of information the parties provided to them (without having to independently verify it), and they were otherwise granted broad procedural discretions. These aspects of the engagement allowed the expert to evaluate the merits of submissions they received and make decisions based on the materials provided to them and on their experience and professional judgement.
- Accordingly, it was not open to either party to complain that the report was based on what that party perceived to be incomplete or insufficient evidence.
- Viewed through this lens, there was no room for a finding that the expert was manifestly wrong in relation to the more significant of the two items in dispute (ie determining whether particular items were accruals or current liabilities).
- Where the expert had manifestly erred was in relation to the less significant item in dispute (ie characterisation of particular un-invoiced amounts as receivables). These items, while correctly not dealt with in one of the specific notes or principles, had been treated as assets in the target’s half year accounts. The expert’s failure to cascade down and include these items as an asset based on their historical treatment did amount to manifest error. This item was remitted to the expert for re-determination.
Key takeaways
The obvious takeaway is that to avoid an expert filling in gaps by resorting to professional opinion rather than relying on facts (which will necessarily involve an element of guess work), the parties should pay attention to developing accounting principles with sufficient specificity to minimise the scope of the expert’s discretion. This is what the judge meant by ‘prescription of criteria or restrictions’. [2]
Failure by the expert to adhere to the agreed principles would result in their report not being in accordance with the requirements of the contract.
While not possible to be exhaustive – things are never black and white – we often see SPAs that include granular accounting principles and line-by-line completion statements (referred to as strawmen) backing up and illustrating application of those principles.
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