Post-Closing Purchase Price Adjustment Mechanics—Distinguishing Expert Determinations from Arbitrations

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Calling something by its correct name matters. Indeed, “[t]he power to name allows us to make important distinctions.”1 A zebra may look like a short horse with stripes, but it’s not. There are in fact critical distinctions between a horse and a zebra. And those “distinction[s] [are] important to anyone who has tried to saddle and ride a ‘striped horse.’”2 But by calling a zebra a zebra, rather than a striped horse, and by actually knowing about the differences the two names embody, the unpleasantness that can arise from learning those differences experientially can be avoided.3

What is true for the distinctions between a zebra and a horse are also true for the distinctions between an “expert determination” and an “arbitration.”4 Yet, a 2013 Report by a committee of the New York City Bar suggests that many deal lawyers lack sufficient knowledge of those distinctions and appear to assume that an expert determination is simply an arbitration with stripes.5 And in a recent Delaware Court of Chancery case,  Penton Business Media Holdings, LLC v. Informa PLC, C.A. No.2017-0847-JTL, 2018 WL 3343495 (Del Ch. July 9, 2018), Vice Chancellor Laster had occasion to address those distinctions and shut down an effort to convert an expert determination into an arbitration.

Penton Business Media involved a post-closing dispute between the buyer and the seller of a business regarding the allocation of certain transaction-related tax benefits.6 Pursuant to the terms of the Merger Agreement, the determination of what amount the buyer was required to pay to the seller for transaction-related tax benefits depended upon whether the tax benefits were allocated by the purchased company to the pre-closing period or the post-closing period. The buyer was required to pay the seller for transaction-related tax benefits allocated to the pre-closing period only the amount of any “refund” generated by those tax benefits, regardless of the amount of any reduction in taxes that may have been generated. With respect to the post-closing period, however, the Merger Agreement required the buyer to pay to the seller a flat 40% of the tax benefits, regardless of whether they generated a refund. It was in the buyer’s best interest to allocate as much of the transaction-related tax deductions to the pre-closing period as possible. And the buyer in fact allocated $40 million of the tax benefits to the pre-closing period, resulting in a proposed payment to the seller of only $600,000 (the refund generated), instead of $16 million (40 % of the $40 million). The seller disagreed as to the appropriateness of the buyer’s allocation between the pre-closing and the post-closing period.

In the event of a dispute concerning the amount owed by the buyer to the seller for transaction-related tax benefits, the Merger Agreement contemplated that the dispute would be submitted to Ernst & Young in a manner similar to the working capital dispute-resolution mechanics. Those mechanics required that Ernst & Young act “as an accounting expert only and not as an arbitrator and shall not import or take into account usage, custom or other extrinsic factors.” But the seller argued that similar did not mean identical and that the determination as to whether the buyer had properly allocated the tax benefits between the pre-closing and post-closing periods was more than a “straightforward numerical/accounting exercise.” Accordingly, the seller’s position was that Ernst & Young’s role in resolving the allocation dispute was more akin to that of an arbitrator, as to which the doctrines of substantive and procedural arbitrability applied. In this case that meant that once the court decided that Ernst & Young was actually granted the right to decide the issue in the Merger Agreement (substantive arbitrability), it was up to Ernst & Young, not the court, to interpret the Merger Agreement and determine what Ernst & Young could and would consider in making its determination (procedural arbitrability). And what the seller wanted to do was introduce certain term sheets and other pre-contract information to support its position.

The Merger Agreement was less than robust in its incorporation of the working capital dispute-resolution mechanics into the dispute-resolution mechanics for the transaction-related tax benefits, stating in the pre-closing tax benefit section that “[d]ispute resolution provisions corresponding [to the working capital dispute-resolution mechanics] shall apply,” and in the post-closing tax benefit section that “the determination of the disputed item or items shall be made by the Accounting Firm following the general procedures set forth in [the working capital dispute-resolution mechanics section], mutatis mutandis.” But the court was persuaded that whether the Latinism, mutatis mutandis,7 was used, or simply the term “corresponding,” what was contemplated was that Ernst & Young would be deciding a tax dispute rather than a working capital dispute, and would, therefore, be using its expertise in tax matters rather than accounting principles. In either case, however, the working capital dispute-resolution mechanics applied and specifically limited Ernst & Young’s role to applying its expertise to decide the issue presented, not interpret the contract or consider extrinsic evidence. In other words, an expert determination was contemplated, not an arbitration. As a result, arbitration principles that may have otherwise granted broad decisional authority to Ernst & Young were inapplicable.

The powers granted to an arbitrator are “analogous to the powers of a judge.”8 In an arbitration, “[a]rbitrators are expected to rule on issues of law, make binding interpretations of contracts, resolve disputed issues of fact, determine liability, and award damages or other forms of relief.”9 And pursuant to the Federal Arbitration Act, an arbitrator’s award is enforceable by a court and there are very limited rights to appeal or review that award.

An expert determination, on the other hand, is not a quasi-judicial proceeding at all, but instead is simply an informal determination by an expert of a specific factual issue that a contract requires to be so determined by the designated expert. One must still utilize the courts to enforce that determination as part of a broader breach of contract action. But courts typically do so if the contract so provides.10 And, unlike an arbitration, the contract can also establish the court’s standard of review, such as “the expert’s determination shall be binding on all parties, except in the case of manifest error.”11

Expert determinations have been recognized as contractually binding in the common law for more than 250 years.12 Historically they were categorized as “appraisals” because they were typically used in contracts involving “the determination of rent adjustments under long-term leases, the price to be paid upon exercise of an option to purchase shares in a private company or an option to purchase real property, and the amount of loss under an insurance policy.”13 But ever since the Federal Arbitration Act (“FAA”) was passed and the popularity of arbitrations skyrocketed in the United States, the distinction between an arbitration and an expert determination appears to have been lost in many states. According to Vice Chancellor Laster:

One national survey posits that only twenty-four states continue to recognize a distinction between experts and arbitrators. In twenty-two states, the distinction has been lost, and in four the matter has been resolved ambiguously or not at all. At the federal level, the United States Courts of Appeals have split on whether an expert determination constitutes an arbitration under the FAA.14

As a result, there are cases from several jurisdictions that suggest some very odd, if not frightening, outcomes, such as an environmental expert making legal judgments about the meaning of a contract.15 The good news is that unlike a lot of states, New York passed a specific statute 50 years ago that recognizes explicitly the distinction between expert determinations and arbitrations, as well as providing a specific procedure to judicially confirm an expert’s determination.16 And despite some prior confusion in the law of Delaware, Vice Chancellor Laster has confirmed, in Penton Business Media, that Delaware’s common law definitively recognizes a distinction between arbitrations and expert determinations as long as the parties make that intent clear in their contract. English law is equally clear for our colleagues across the Atlantic.17

Just as one should not attempt to throw a rope on, or saddle and ride, a zebra, believing it is just a striped horse, deal professionals and their counsel should be cautious in clearly describing the third-party dispute resolution process they are contemplating for any post-closing purchase price adjustments. In almost every case, the designation of an accounting firm as the third party determinator indicates that an expert determination, rather than an arbitration, is contemplated. Describing that expert as an “Accounting Arbitrator” (as some merger and acquisition agreements do), rather than an “Accounting Expert”, or an “Independent Accountant,” however, may not be the best way to so designate that expert. And do state that the accountant “is acting solely as an expert, and not as an arbitrator.” In all events, using the right terms to describe the process you actually intend, in clear and unequivocal language, is highly recommended.

 

Endnotes    (↵ returns to text)

  1. N.Y.C. Bar Report by Comm. on Int’l Commercial Disputes, Purchase Price Adjustment Clauses and Expert Determinations:  Legal Issues, Practical Problems and Suggested Improvements, at 52, n.96 (June, 2013).
  2. Id. 
  3. See id.  Zebras are apparently vicious, easily startled, and virtually impossible to domesticate. Unlike horses, they also have a ducking reflex that makes them very difficult to lasso.  See Carol Hall, Why zebra refused to be saddled with domesticity, The Conversation, Sept. 14, 2016.
  4. See N.Y.C. Bar Report, supra note 1, at 52 n.96.
  5. See id., at 63.
  6. In a prior Weil Insights blog posting, we discussed a similar kind of dispute, although it did not involve a third-party dispute resolution mechanic. See Marc Schwed, Glenn West & Alex Farr, Transaction-Related Tax Deductions and the Worst Words Ever Spoken by a Deal Professional, Weil Insights, Weil’s Global Private Equity Watch, January 31, 2018.
  7. For a prior Weil Insights blog posting discussing the meaning and use of the Latinism, mutatis mutandis, see Glenn West, Mutatis Mutandis, “What a Wonderful Phrase,” Weil Insights, Weil’s Global Private Equity Watch, October 24, 2017.
  8. Steven H. Reisberg, What is Expert Determination?  The Secret Alternative to Arbitration, N.Y.L.J., Vol. 250, No. 115 (Dec. 13, 2013).
  9. Id.
  10. See Glenn West, Contractually Designating a Valuation Expert as the Binding Decision Maker Means Just That, Even if the Expert Turns Out to be Wrong, Weil Insights, Weil’s Global Private Equity Watch, January 6, 2016.
  11. Reisberg, supra note 8.
  12. See N.Y.C. Bar Report, supra note 1, at 10.
  13. Reisberg, supra note 8.
  14. Penton Business Media, 2018 WL 3343495, at *8.
  15. See N.Y.C. Bar Report, supra note 1, at 36-38.
  16. Id. at N.Y. CPLR 7601.
  17. See N.Y.C. Bar Report, supra note 1, at 10-11.