Matter note: earn-outs and deferred consideration across borders

Deferred consideration structures are common in cross-border acquisitions. They are rarely simple. When the target sits in one jurisdiction, the acquirer in another, and the holding vehicle in a third, the earn-out mechanism becomes a contractual bridge across three legal systems – and a dispute waiting to happen if the bridge is not built carefully.

An earn-out is a contractual mechanism under which part of the acquisition price is paid after completion, contingent on the target business meeting agreed performance thresholds over a defined post-completion period. In a cross-border deal structured through Hong Kong, the governing instrument is typically the share purchase agreement, whose proper law, enforcement route and currency of payment each require deliberate choice across the deal perimeter. The alignment of vehicle, governing law and clearances across that perimeter is where the structure stands or falls.

This note describes an anonymised cross-border matter in which the earn-out mechanism became the central point of legal risk. It covers the situation, the issue, the route chosen, and the transferable lessons for groups structuring deferred consideration across the Greater China corridor and the principal offshore centres.

What was the situation?

A mid-market industrial group headquartered outside Asia had acquired a Greater China business through a BVI holding entity. The acquisition had been structured in a prior cycle. The purchase price included a deferred consideration tranche linked to the target's earnings before interest, tax, depreciation and amortisation – EBITDA (a standard accounting measure of operational profitability) – over a two-year post-completion period.

By the time the earn-out period closed, two things had changed. First, the original deal team had moved on. The principals now responsible for the deferred consideration calculation had not been involved in the original negotiation. Second, the target business had been partially restructured following completion: one operating subsidiary had been transferred to a newly incorporated Mainland entity in a group reorganisation that neither party had anticipated at signing.

The result was a dispute about the earn-out calculation. The seller argued that the EBITDA of the transferred subsidiary should be included. The buyer argued that the calculation mechanism, read strictly, excluded entities not held by the BVI vehicle as at the measurement date. The share purchase agreement was governed by English law. The dispute mechanism was Hong Kong-seated arbitration. Neither party had thought carefully at signing about how a post-completion restructuring might interact with the earn-out definition.

This is a pattern our desk sees with some regularity: the earn-out drafting reflects the structure at signing. Post-completion events – restructurings, subsidiary transfers, new licence arrangements – are not anticipated. The gap between the contractual mechanism and the commercial reality becomes the dispute.

What was the cross-border problem?

The cross-border dimension operated on three levels. Each created a distinct layer of legal risk.

The first was the governing-law question. The share purchase agreement was governed by English law, and the earn-out mechanism had been drafted by counsel advising from that system. The operating reality, however, was entirely Mainland Chinese: the target's revenues, its workforce, its licence regime and its counterparty relationships all sat within the Mainland legal environment. The EBITDA calculation drew on accounts prepared under PRC accounting standards. The question of whether the transferred subsidiary's financials were in or out of the earn-out basket was, at one level, a question of contractual interpretation under English law. At another level, it depended on what the Mainland reorganisation had actually produced – a question that required reading PRC corporate documents and the Mainland transfer agreement.

The second was the vehicle question. The BVI holding entity had been the acquisition vehicle and the counterparty to the share purchase agreement. Post-completion, the BVI entity had been used as a treasury vehicle. It did not hold all the operating businesses. When the parties came to read the earn-out definition, the reference to entities "owned by the BVI entity as at the earn-out measurement date" produced a result neither side had intended.

The third was the enforcement question. The seller was based outside Asia. Its assets were not in Hong Kong. Enforcing an earn-out award in favour of the seller – if the matter proceeded to arbitration and the seller succeeded – required a route that worked across the relevant jurisdictions. The Hong Kong-seated arbitration clause was, in principle, a sound choice: Hong Kong is a party to the New York Convention, and awards from Hong Kong-seated arbitrations enjoy wide enforceability internationally. However, the buyer's assets were predominantly in the Mainland. The interim-measures arrangement between the Mainland and Hong Kong, which has been in effect since 1 October 2019, allowed for interim relief from Mainland courts in support of Hong Kong-seated proceedings – a step the seller's counsel had not considered at the outset.

What was the route chosen?

The instruction came to our desk after the parties had exchanged positions in writing and the buyer had indicated it would not pay the disputed tranche. The seller's position was that the restructuring had been carried out by the buyer post-completion without seller consent, and that the effect was to depress the earn-out calculation artificially. The buyer's position was that the restructuring was operationally necessary and that the earn-out mechanism, properly read, excluded the transferred subsidiary.

The first step was to map the contractual architecture against the post-completion corporate structure. This required reading the share purchase agreement, the earn-out schedule, the BVI corporate documents, and the Mainland transfer agreement for the transferred subsidiary. A cross-border matter of this kind cannot be assessed from the transaction documents alone. The answer to the contractual question depended on facts generated in a different legal system.

The second step was to identify the dispute route. The share purchase agreement contained an expert-determination clause for earn-out disputes, with Hong Kong-seated arbitration as a fallback where the expert process failed or was unavailable. Expert determination and arbitration are different mechanisms with different procedural implications. Expert determination is typically faster and less costly; it is also less amenable to challenge and produces a binding result on the specific accounting question. Arbitration gives broader procedural rights and produces an enforceable award under the New York Convention. The choice of route was not academic: it determined the evidence available, the standard of challenge, and the enforcement position.

The matter turned on whether the expert-determination clause had been triggered correctly by the seller. The clause required a formal reference notice with specified content. The seller's initial letter had not met the formal requirements. This is a common point of failure in earn-out disputes. The mechanism prescribes a sequence; if the sequence is not followed, the right to use the mechanism may be lost or delayed.

Our advice was to re-commence the expert-determination process with a compliant reference notice, and simultaneously to review whether the buyer's restructuring constituted a breach of the non-interference covenant in the share purchase agreement. That covenant – present in most well-drafted earn-out provisions – prohibited the buyer from taking actions post-completion that had the effect of artificially depressing the earn-out calculation. If the restructuring had been carried out in breach of that covenant, the seller's claim was not confined to the earn-out calculation dispute. It extended to a damages claim for breach of the substantive obligation.

The sequence mattered. A damages claim for breach of the non-interference covenant could proceed to arbitration independently of the expert-determination process. The two tracks were not mutually exclusive. Running them in parallel – one focused on the accounting question, one on the breach question – changed the buyer's cost-benefit analysis materially.

The contextual bridge here is important. The sequence above describes the standard position in a well-drafted earn-out dispute. Your matter turns on the specific documents, the jurisdictions engaged, and the order in which the dispute mechanism is triggered – which is where the route is won or lost. If your earn-out dispute has already produced a stalled or adverse result from an earlier reference, a second read of the mechanism can identify whether the process was correctly invoked and what routes remain open.

To discuss how an earn-out dispute mechanism applies to your cross-border position, contact info@lockhartyip.com.

How did the sequence unfold?

The compliant reference notice was served. The buyer responded by contesting the jurisdiction of the expert on the grounds that the transferred subsidiary was outside the scope of the earn-out schedule. This was a procedural objection rather than a substantive accounting argument. Expert-determination clauses in cross-border agreements frequently produce this first battleground: the scope of the expert's mandate.

The expert-determination process under the share purchase agreement was governed by terms that gave the expert jurisdiction to determine its own scope – a kompetenz-kompetenz (the power of a tribunal or expert to determine its own jurisdiction) provision that had been incorporated by reference to standard institutional rules. The buyer's objection was addressed by the expert within the procedural timetable. The expert found jurisdiction over the substance of the earn-out calculation.

In parallel, the non-interference covenant analysis produced a finding that the buyer had not given notice of the restructuring as required under the transaction documents. The absence of notice did not automatically constitute a breach, but it strengthened the seller's position that the restructuring had been carried out without the procedural protections the earn-out mechanism was designed to provide.

The turning point was the accounting analysis. The earn-out schedule defined EBITDA by reference to the audited accounts of entities "within the group" as at the measurement date. "Group" was defined by reference to the BVI holding entity's direct and indirect subsidiaries. After the transfer, the relevant Mainland entity was a subsidiary of a different BVI entity, not the original acquisition vehicle. On a strict reading, it was outside the definition.

However, the share purchase agreement also contained a general duty of good faith in the performance of the earn-out provisions – a clause that is more common in continental European-influenced drafting than in pure English-law instruments, but which had been included here at the seller's request during negotiation. That clause provided the basis for an argument that a restructuring carried out in the earn-out period, without seller consent, and with the effect of removing an entity from the calculation base, was inconsistent with the buyer's obligations.

The matter resolved at the expert-determination stage without proceeding to arbitration. The terms are confidential. The qualitative outcome for the seller was a deferred consideration payment that was materially larger than the buyer's initial position.

What are the transferable lessons?

Four lessons emerge from this matter. They apply across the range of cross-border earn-out and deferred consideration structures we encounter in our practice.

First: the earn-out definition must track the structure through completion, not just at signing. A definition anchored to the acquisition vehicle's subsidiaries as at a specific date will produce a disputed result if the structure changes post-completion. Drafting that contemplates post-completion reorganisations – requiring seller consent, buyer notification, or an adjustment mechanism – is not over-engineering. It is the minimum required to make the earn-out work as intended.

Second: the governing law of the agreement and the legal system in which the target operates are not the same thing. English-law drafting applied to a Mainland Chinese business may produce a contractual mechanism that does not interact correctly with the operating reality. An earn-out definition that draws on accounting concepts needs to specify which accounting standards apply and how differences between those standards and the governing law's accounting framework are to be resolved. In a Hong Kong-structured deal with Mainland operating companies, this is a live issue on almost every transaction.

Third: the dispute mechanism must be invoked correctly, in the right sequence, with the right form of notice. Earn-out disputes are frequently lost or delayed at the procedural level before the substantive question is ever reached. The reference notice is not a formality. It is a jurisdictional trigger. Counsel advising on the dispute must read the mechanism before acting on it.

Fourth: Hong Kong as the arbitration seat provides real enforcement architecture. The New York Convention gives Hong Kong-seated awards wide enforceability internationally. The interim-measures arrangement, in force since 1 October 2019, gives additional reach into the Mainland for protective measures. For cross-border deals with Mainland and offshore dimensions, the Hong Kong seat is not a default. It is a deliberate structural choice that should be made with the enforcement picture in mind from the outset.

A second cross-border matter of a related kind reinforces the third lesson. A European strategic group had acquired a Southeast Asian platform with a Singapore-incorporated parent and an earn-out mechanism governed by Singapore law. When the earn-out period closed, the buyer disputed the calculation on the basis of accounting adjustments made in the final quarter. The seller's counsel issued a formal notice to the wrong party – the operating subsidiary rather than the Singapore parent, which was the contractual counterparty. The reference was invalid. By the time the error was corrected, the limitation period for the expert-determination process had passed under the agreement's terms. The seller was confined to a damages claim in arbitration, which was a longer and more expensive route to the same destination. The lesson is simple: identify the correct counterparty and the correct form of notice before the clock runs.

For a structured assessment of your earn-out or deferred consideration position across the relevant jurisdictions, write to us at info@lockhartyip.com.

Our work on this matter connected directly to the broader range of cross-border M&A and transaction services we provide. Details of our approach to structuring acquisition vehicles, governing-law selection and cross-border enforcement in Greater China deals are set out at our M&A & Transactions practice page. Principals considering the acquisition vehicle question from the outset will find the analysis in our guide to structuring an acquisition vehicle for a Greater China deal directly applicable. Questions specific to share purchase agreement governing law and related drafting choices are addressed at our note on share purchase agreements governed by Hong Kong law.

Related practices

• Disputes & Arbitration – enforcement and arbitration strategy for cross-border earn-out and M&A disputes
• Holding Structures – alignment of BVI, Cayman and Hong Kong vehicles for cross-border acquisition structuring

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Related

• Ma Transactions
• Structuring Acquisition Vehicle Greater China Deal Guide
• Share Purchase Agreement Governed By Hong Kong Or 2

This publication is general information and does not constitute legal advice. For advice on your situation, contact info@lockhartyip.com.