Purchase Price Adjustment Clauses: Why Parties Should be Wary When Using Them

A purchase price adjustment clause is a clause sometimes used by parties to purchase agreements to help allocate risk in the event that the value of underlying assets and liabilities change between the signing of the agreement and the transaction closing. These price adjustments occur post-closing when closing date numbers are finally determined. Common post-closing adjustments are based upon changes in working capital, net worth or net asset value of the target company.

While carefully considered and negotiated price adjustment clauses can effectively mitigate risk to ensure that parties to an M&A transaction receive fair market value at the time of closing, disagreements over such clauses are common. Parties should be wary when using such clauses. 

Draft With Care to Avoid Ambiguity

Parties should approach the drafting of price adjustment clauses with great care. Price adjustment clauses are subject to general principles of contractual interpretation. Ambiguous price adjustment clauses can result in entire purchase agreements being void. Also, parties cannot always rely on strict interpretations of such clauses where to do so would not be in keeping with both parties’ intentions at the time of signing. Namely, it may not be enough to read the words of the contract literally where such an interpretation does not fit with the context in which the agreement was signed.[1]

Avoid The Appearance of Bad Faith

Parties should also be cognizant of when and how they invoke price adjustment clauses, in order to avoid the appearance of acting in bad faith. In a decision recently upheld by the BC Court of Appeal, Khela v. Clarke, a price adjustment clause in a purchase and sale agreement for land was unenforceable.[2] The clause was not only ambiguous, but the party seeking to rely on the clause tried to enforce it within two days of the closing date. The party seeking to rely on the clause argued that it received information from a lender nine days before closing that triggered the price adjustment clause. The judge determined that the party seeking to rely on the clause was well-versed in real estate matters and used this knowledge to take advantage of the other party. The judge held that the nature and timing of the “bad news” appeared orchestrated and fit with a long-term bad faith plan. Because the price adjustment clause was a vital term to the agreement, and because it was unenforceable, the entire contract was deemed void.

Avoid Calculation Disputes

In other cases, disputes may arise over the calculation to be used in determining the price adjustment. These disputes can result in parties needing to hire costly experts to review financial statements and other relevant documents to determine the appropriate price adjustment.[3] In other cases, disputes over the calculation to be used can arise as a result of a valuation formula included in the clause itself. In one such case, a party argued that it had agreed to an incorrect valuation formula in its price adjustment clause and sought to have the agreement rectified (i.e. altered to correct the formula). However, the Alberta Court of Appeal determined that rectification could not act as a substitute for due diligence that the party should have performed.

Takeaways

Parties should be thoughtful when they include price adjustment clauses in their agreements and should approach drafting such clauses with the utmost care. In order to avoid disputes as a result of the inclusion of such a clause, parties should ensure that they effectively perform due diligence before entering into the agreement, that they draft the clause with clear terms and as little ambiguity as possible, and that there is a clear valuation mechanism at play.

While the use of price adjustment clauses can be helpful in ensuring that parties receive fair market value at the time of closing, if a dispute arises it can lead to lengthy and expensive litigation which may ultimately result in the contract being unravelled.