By Joshua Gelman
Sometimes, the only way to reach the sale of a business is through an earn-out. Of course, “an earn-out provision often converts today’s disagreement over price into tomorrow’s litigation over the outcome,” said Vice Chancellor Laster of the Delaware Court of Chancery in the Airborne Health, Inc. v. Squid Soap, LP case from 2009. In one recent earn-out litigation matter, where the seller was looking to all but give away one of its subsidiaries, both the buyer and the seller found themselves demanding payment from the earn-out with positions differing in the billions of dollars.
In the June 2017 Supreme Court of Delaware case of Chicago Bridge & Iron Co. N.V. v. Westinghouse Elec. Co. LLC, Chicago Bridge and Westinghouse found themselves in an earn-out dispute over the value of CB&U Stone & Webster, Inc. (Stone) a company that constructs nuclear power plants.
Chicago Bridge and Westinghouse had been collaborating on various projects. Eventually, they worked together towards the construction of two power plants by Chicago Bridge’s subsidiary, Stone. The project was to be the first new nuclear power plants in the United States in nearly 30 years. Delays and cost overruns caused the relationship to become contentious. In an attempt to resolve problems, Chicago Bridge agreed to sell Stone to Westinghouse.
Besides the fact that the deal contemplated the sale of a builder of nuclear power plants, it was unusual because Chicago Bridge agreed to sell Stone to Westinghouse with zero money changing hands at closing. Instead, an earn-out was conditioned on a target (the target was Stone’s assets less liabilities and was set at $1.174 billion) set at closing with payment obligations triggering for each party depending on whether the amount was positive or negative at a time set forth in the agreements for a true up. Put more simply, if the target was met exactly, Chicago Bridge would only receive the agreed price of zero dollars and the parties’ obligations to pay or be paid would be contingent on whether the net working capital was at, below or higher than the target.
While Chicago Bridge’s expectations for receiving payments was not high, it did obtain Westinghouse’s agreement to absorb considerable risks related to claims by third parties for the construction of the two nuclear plants. Also, Westinghouse was to release additional claims following the closing of the deal unless otherwise spelled out in the agreements.
As succinctly explained by the Court, “[i]n other words, although Chicago Bridge was to get no profit from the sale at the time of closing and had little likelihood of any future upside through the earnout, it also got to walk away and not worry about the projects.” It is worth noting, however, that Chicago Bridge was expected to spend about one billion dollars on the Stone projects before the closing.
In all the parties’ due diligence prior to closing, Westinghouse utilized Chicago Bridge’s historical accounting without complaint or objection. At the closing, following the true up, Westinghouse claimed that Chicago Bridge owed it an additional two billion dollars based upon its challenge that Chicago Bridge’s financials were not GAAP compliant causing it to be in breach of its reps and warranties.
The sum total of the logic of Westinghouse’s claims is worth stating. Based on challenges to large items included in the financials that Chicago Bridge represented were GAAP compliant, which Westinghouse knew about before closing, and which it did not use as a basis not to close, Westinghouse now says that it should keep Stone, which it got for zero dollars, and be paid by Chicago Bridge over $2 billion for taking it!
While Chicago Bridge was willing to walk away from any profit on the sale of two nuclear power plants for no money after agreeing to spend an additional billion on construction prior to closing in exchange for releases from future liability, Westinghouse demanded an additional two billion dollars from the seller based upon information it already knew.
The Supreme Court of Delaware found the parties’ conflicting interpretations of the various agreements could be clarified by applying a sensible view towards the underlying business relationship. The court found that in an earn out calculation, consistence in the application of accounting methodology was more important than a debate over the proper application of GAAP where all parties knew how the calculations were reached prior to closing. Accordingly, it precluded Westinghouse from making claims that the final purchase price should be adjusted based upon alleged inconsistencies with GAAP.
The takeaway of this earn-out litigation is pertinent to the dealmakers, their financial and accounting professionals, and their commercial attorneys: if the parties are aware of and agree upon a methodology for valuing assets prior to a deal, changing that methodology to bolster earn-out outcome comes at a risk.