Private Equity

Designating an investment banking, accounting or valuation firm to value a business as a means of establishing the price to be paid to buy out a co-investor in that business is standard fare in the private equity deal world.  A typical provision calls for the determination of the purchase price to be paid to the affected co-investor to be based on the amount the affected co-investor would have received in a hypothetical sale of the business at a purchase price equal to its “Fair Market Value.”  In the absence of an agreement between the parties, the typical provision then calls for Fair Market Value to be determined “in good faith by a nationally recognized investment banking, accounting or valuation firm (engaged and paid for by the Company).”  There also may be selection mechanics and determinations of independence, and there may or may not be other language directing the means and manner by which Fair Market Value will be thus determined by the chosen expert.  But the basic idea behind the provision is that the chosen expert’s opinion shall be the binding means of determining Fair Market Value in the absence of an agreement between the parties.

Easy-peasy, lemon-squeezy, right?  Perhaps.  Remember, however, that valuation opinions are just that, opinions based on judgment calls about a hypothetical sale of a business by a hypothetical willing seller to a hypothetical willing buyer.  What if one of the parties believes the expert has made an error in the means or manner of thus determining Fair Market Value?  Is there a remedy?  In other words, can a party who agreed to a binding determination of value by an expert challenge that determination in court based on an alleged error made in good faith by the expert? According to a Delaware Court of Chancery opinion decided on December 30, 2015, Peco Logistics. LLC v. Walnut Investment Partners, L.P., the answer is a definitive “No”.

Because the LLC agreement at issue in this case “unambiguously grant[ed] the valuation firm the sole authority to make the value determination,” and failed to “provide[] for judicial review of disputes over that determination,” the court refused to entertain allegations about the validity of the judgement calls made by that valuation firm.  While there was a real question in this case as to whether any of those judgment calls could in fact be termed errors, the holding of the case suggests that even if they were true errors, the court would not second guess the basis upon which the expert reached its decision.  In reaching its holding, the court quoting from a prior Delaware decision as follows:

When parties contractually decide to have a qualified expert with relevant credentials make a determination of value without any indication that the expert’s judgment is subject to judicial review, on what basis would it make sense to infer that the parties intended to have a law-trained judge do a de novo review of the expert’s determination?

Obviously, the parties could have provided for judicial review of errors in applying the valuation methodology, or even of errors in the interpretation by the expert of the valuation methodology set forth in the LLC agreement.  Having failed to do so, the court was unwilling to allow the challenging party to “circumvent the structure of the deal to substitute [the court’s] judgment for that of the valuation firm.”

In 2014, an English court applied the same basic principles in upholding an expert’s valuation opinion against challenges that there had been errors made by the expert in rendering that opinion.  And the language used by that court is worth repeating here:

Parties who refer a matter to an expert for decision usually do so in order to obtain a quick and relatively inexpensive decision of a binding nature on a matter that calls for informed judgment. Often that involves the application of principles and expressions that are familiar and well understood in the particular field of endeavour, whatever that may be. In such cases it would be surprising if they had intended the expert’s decision to be of no effect if it could be shown that he had made a mistake in the application of some well recognised principle. Parties who refer a dispute to an expert must be taken to have recognised that mistakes may be made, both of fact and law, but they are prepared to take that risk because they place a high degree of confidence in their chosen expert.

So, choose your experts wisely.  And as a reminder, these same issues can arise in the resolution of working capital disputes by accountants.