Completion accounts - a cautionary tale

United Kingdom

Completion accounts are a very common form of purchase price adjustment mechanism used in M&A transactions. The intention is to verify that the actual financial position of the target company at completion is in fact what the parties expected when, on the basis of historic financial information, they signed the deal.

The focus (whether it be working capital, net assets or another metric) varies from transaction to transaction, but the concept is that the parties agree at signing what they expect the financial position of the target to be at completion and then after completion use the completion accounts mechanism to establish retrospectively what the actual position was. The completion accounts are normally prepared on behalf of the buyer within an agreed period after completion and, once finalised, may cause an adjustment of the purchase price – whether by a repayment of part of the purchase price by the seller to the buyer or a top-up payment by the buyer to the seller.

The basis on which completion accounts are prepared is normally mapped out in detail between the buyer and seller and set out in the share purchase agreement. There will be detailed processes to resolve any disputes on the numbers, with ultimate recourse to independent accountants.

The recent case of Mihail Tartsinis v Navona Management Co demonstrates how important it is to ensure that there is no misunderstanding between the parties about the basis on which the completion accounts are prepared and how they will be used in determining the final purchase price. The case is also an unusual example of the court applying the rules of contractual interpretation to arrive at the real meaning of the contract, but then using a different process to decide that, despite its real meaning, the contract does not reflect the common intentions of the parties and should be rectified to reflect those intentions.

The facts

The target company’s subsidiary owned a fleet of ships, which had been accounted for in the historical accounts at net book value (i.e. acquisition cost less accumulated depreciation). Given the deteriorating market conditions which existed at that time, the net book valuation was calculated to be US$14.1 million higher than the approximate market value of the fleet at the time of completion – the fleet’s value had plummeted.

The SPA included a purchase price adjustment mechanism that (amongst other things) required the buyer to prepare a set of completion accounts in accordance with International Financial Reporting Standards (IFRS), from which the net asset value of the target company (which included the value of the fleet) was to be determined. A correctly drafted set of completion accounts under IFRS would not have valued the fleet at net book value; rather, under International Accounting Standard (IAS) 16 and/or IAS 36, the value of the fleet would have been substantially lower. The buyer, however, produced completion accounts that incorrectly valued the fleet at net book value. On this basis, the buyer was obliged to pay a substantially higher purchase price to the seller than it had intended, and was certainly paying more than the market value for the component attributable to the fleet. Realising its error, the buyer refused to pay the additional sums claimed by the seller on the post-completion price-adjustment.

The court understandably decided that the buyer had no right to challenge completion accounts which it had itself prepared. The buyer was therefore left to argue that, on a true interpretation of the SPA, it was not obliged to pay. The buyer claimed that the parties had in fact agreed, throughout their negotiations leading to signing the SPA, a particular value for the fleet based on market valuations: US$96.5 million, not the US$110.6 million in the completion accounts. The buyer contended that the completion accounts should be used to revalue all elements of the net asset value of the target group except for the pre-agreed value of the fleet, which was simply not to be subject to post-completion adjustment. The buyer said that this was so obvious and so critical a part of the bargain that it did not need to be stated in the SPA and, in effect, went without saying.

As an alternative, the buyer requested the court to rectify the clear mistake in the contract in relation to the fleet’s value, to state that the value of the fleet was to be fixed at US$96.5 million and that it was not subject to adjustment.

The result

The first issue was the true meaning of the SPA. The courts have developed rules as to the approach that must be taken when there is a dispute as to what a contract means. Very broadly, it is a matter of ascertaining the meaning the document would convey to a reasonable person who had all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract. That does not mean, however, that in deciding the meaning the court can take account of what the parties said to each other, for example, in the run-up to signing, or what either party thought the agreement meant. It is not the court’s function when interpreting an agreement to seek to improve upon it, or put right any inadequacies of meaning.

The judge pointed out that, if in fact the parties had intended the fleet valuation not to be adjusted, they had been perfectly capable of explicitly stating this in the SPA, but they had not done so. As a matter of interpretation of the SPA, the value attributable to the fleet was indeed subject to adjustment. That was what the SPA meant and no evidence of pre-contractual negotiations fixing the fleet element of the price as non-adjustable was admissible.

On rectification of the contract, however, the position was quite different. The judge was able to take account of the substantial evidence that there was pre-contractual agreement about the value of the fleet and was convinced. The court came to the buyer’s rescue and ordered that the contract was to be rectified by introducing a few brief words fixing the value for the fleet and removing that element from the completion accounts mechanism. The seller’s claim was therefore substantially dismissed.

Practical points

The case illustrates a number of points that should be borne in mind during an M&A transaction:

  • Those tasked with financial due diligence for the buyer should be instructed to analyse the basis on which target company’s historical accounts have been prepared, the basis on which they should have been prepared, and the basis on which the parties agree the completion accounts should be prepared, and highlight any key discrepancies to the deal team. Otherwise, there is a risk that like will not be compared with like.
  • Care should be taken when agreeing the terms of any purchase price adjustment mechanism to ensure that any input from the financial due diligence team is duly accounted for in the drafting of the SPA and the completion accounts mechanism. In particular, if any specific item is to be treated differently to the rest, this must be clearly stated.
  • It is very important that the accountants preparing the first set of completion accounts carefully take into account the relevant provisions of the SPA. 
  • It is vital for the party preparing the first draft of the completion accounts to ensure they are correctly prepared in accordance with the SPA. It will usually be extremely difficult to challenge one’s own draft completion accounts.

Rectification – approach with care but always consider its application

Although claims for rectification are not easily won, it is often worthwhile including a pleading in the alternative where it is believed a contract contains a mistake within the drafting. For rectification, a compelling case must be presented, which typically requires presenting the court with substantial evidence of a common intention that the document mistakenly failed to express. This, by necessity, means that a much broader range of evidence is admissible when pleading for rectification, compared with what the court will consider when it interprets a contract. In particular, evidence of what was said in pre-contractual negotiations is admissible, and indeed is generally essential, to prove the existence of the missing common intention. Evidence of the parties’ subjective aims and intentions is also admissible, as is evidence of their subsequent conduct insofar as it sheds light on their relevant intentions.