Unclear Exit Clauses Cause Headaches



Pete Steger for The Lawyers Weekly

October 16, 2009

"I will gladly pay you Tuesday for a hamburger today" was a typical offer from Wimpy to Popeye that sounds clear and tasty enough. However, if this type of statement were a key term of a commercial contract being scrutinized for renegotiation or termination, suddenly several determinations are required. For example, what currency is it? Which Tuesday?And, most importantly, what type of hamburger - a $0.99 value meal or a $34.95 signature burger.

In an economic downturn, existing contracts (especially long-term contracts) are carefully scrutinized for exit clauses. For parties contemplating their options to renegotiate or terminate based on financial triggers, the following common, but troublesome, financial terms illustrate how unclear exit clauses can be a headache.

Pre-tax loss

Consider an exit clause that reads, "Party A agrees to supply Product123 to Party B at the agreed fixed price, except if doing so would cause Party A to suffer a pre-tax loss."

To prove this trigger, one might jump to simply take the pre-tax figure from the company's financial statements. However, if Product123 is but one product in a multi-product company, several determination difficulties arise. First, does Party A prepare financial statements at the product level in the normal course? Second, is Product123 sold exclusively to Party B? If not, product sales to Party B must be separated from other parties. Third, how are the costs of such sales determined?

Direct costs of raw materials and labour are generally straight-forward - but what about below-the-line overhead costs that invariably require that Party A make some form of allocation down to its suite of various products? Battle lines are then drawn as the parties bog down in the typical arguments of which costs to include or exclude, whether they are they incremental or non-incremental, what the allocation approaches should be and whether they have been applied consistently.

Reasonable profit

Consider another exit clause that reads, "This Agreement shall remain in force as long as it provides reasonable profit to the parties." The immediate difficulty is that both "reasonable" and "profit" can have many alternative meanings, with huge consequences. For example, profit can be alternatively defined as: gross margin, contribution margin, EBITDA, net profit before tax or net profit after tax. Gross margins could represent, say 50 percent of sales, whereas net profit after tax could be minimal or even negative - which interpretation did the parties intend?

Value of shares

Most shareholder agreements in private companies have exit clauses for a shareholder's departure necessitating that the shares be valued at fair market value (FMV), book value, fair value or simply value. Some of these terms have a generally accepted meaning in valuation practice that may be unintended by the parties. For example, FMV (generally defined as the highest price obtainable in an open and unrestricted market between willing buyers and sellers) of a 10 percent shareholding in a small, private company will generally garner a minority discount (for the 10 percent shareholding) and a liquidity discount (for the small, private company) from the pro rata amount otherwise determined. Fair value, in contrast, excludes these discounts, and hence results in a much higher quantum.

Another consideration that is often overlooked is who is to purchase the departing shareholder's interest. If the other shareholders are the purchasers, then the selling shareholder generally enjoys the tax benefit of capital gains treatment on disposition. However, if the company is the purchaser, then the selling shareholder's proceeds will be treated as a deemed dividend and is subject to higher tax. Finally, value is determined as at a point in time; therefore, the valuation date must also be defined.

In accordance with GAAP/ IFRS

Contracts that contain a financial term as a trigger will often add the qualifier that the financial term shall be calculated "in accordance with GAAP" (or IFRS - International Financial Reporting Standards). While this is a useful qualifier, users of financial statements should know that applying GAAP/IFRS still involves significant estimates and calculation alternatives and is focused on the financial statements as a whole.

Contracts that contain a financial term as a trigger will often add the qualifier that the financial term shall be calculated "in accordance with GAAP" (or IFRS - International Financial Reporting Standards). While this is a useful qualifier, users of financial statements should know that applying GAAP/IFRS still involves significant estimates and calculation alternatives and is focused on the financial statements as a whole.

Consider the situation where a company's audited net income (prepared in accordance with GAAP/IFRS) is to be used as the basis for determining royalty payments owing to a licensor or for earn-out payments owing to a former owner. Just prior to year-end, the payor company books a large loan loss provision, which passes the auditors' tests, and is recorded in the year-end financial statements, the result of which is to significantly reduce the company's audited net income. The loan loss provision is likely the subject of significant estimates, and while it may meet the test of conservatism for the audited financial statements, it may be totally at odds with the determination of the royalty or earn-out payments.

Materiality may also be significant because an over- or under-statement of a line item that is considered immaterial to the company's financial statements as a whole (prepared in accordance with GAAP/IFRS) may be very material for a specific royalty or earn-out payment or other calculation.

Reasonable supporting documentation - It is common that the party triggering an exit clause must submit "reasonable supporting documentation" as proof. Some documentation is straight-forward - for example, when a new price formula is based on published data such as crude oil prices, public share prices or prime interest rates.

However, other triggers that are based on non-public information - for example, the profitability and internal accounting of one party - create a whole host of issues. For example, what level of documentation is required - top-level year-end financial statements or mid-level monthly sub-ledgers or base-level source accounting documents such as invoices and cheques? Who gets to review such information - the counterparty or an independent third party? Finally, what testing is the counterparty entitled to?

Contract wording can never be perfect nor anticipate all possible future events and nuances.

However, at the drafting stage, contract negotiators should do their utmost to clearly define key financial triggers in exit clauses. Using an illustrative benchmark or example calculation will clarify intentions and the proof required to trigger an exit.

However, for existing contracts saddled with unclear language, it is often necessary to call on accounting, economic and industry experts to help address financial interpretations and quantification alternatives.

Peter Steger is a managing director in the Toronto office of Navigant Consulting, where he specializes in damages quantification in commercial disputes, business valuation and forensic accounting.


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