Private Equity

Many private company acquisition agreements contain provisions providing a mechanism for resolving disputes over post-closing purchase price adjustments, without resort to litigation. In most cases, this involves contractually referring the dispute to an independent accountant with limited authority to resolve the parties’ disagreements regarding accounting methodology and calculations. It is rare that contracting parties actually intend to imbue an independent accountant with court-like authority to make legal determinations that go beyond an accountant’s typical role of making specific factual determinations. Nonetheless, a general failure to understand the difference between an “expert determination” and an “arbitration,” or a lack of clarity in drafting for the intended outcome, has led to much litigation over the actual scope of an independent accountant’s role in resolving post-closing purchase price adjustments. And Vice-Chancellor Laster’s recent opinion in Archkey Intermediate Holdings Inc. v. Mona, 2023 WL 6442815 (Del. Ch. Oct. 3, 2023) serves as warning to transactional lawyers to say what they mean, and know what they say actually means, when it comes to the alternative dispute resolution arena. There is also a warning in Archkey concerning the possible existence of an implied covenant not to act “maliciously” in making post-closing adjustments.

Expert Determination versus Arbitration.

A little over ten years ago, the Committee on International Commercial Disputes of the Association of the Bar of the City of New York issued a report that noted that “[t]here is significant confusion as to just what a purchase price adjustment proceeding is from a legal point of view.”¹ The conclusion of the report was that “many practitioners assume that a Purchase Price Adjustment Clause must be an arbitration agreement because, if it is not an arbitration agreement, then it is not clear what else it could be.” As a result, there is sometimes a tendency to use words in these clauses that have arbitral overtones. But an “arbitration” is fundamentally different than the normally limited “expert determination” contemplated by referring a purchase price adjustment dispute to an independent accountant. And just because an expert determination is not a binding arbitration agreement does not make the expert’s determination any less binding, at least as to factual issues.² The basic distinctions between a binding arbitration agreement and an expert determination were summarized in two prior posts to Weil’s Global Private Equity blog as follows:

The powers granted to an arbitrator are “analogous to the powers of a judge.” 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.” 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. 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.”³

In those prior blog posts, these distinctions were likened to the fundamental differences between zebras and horses (whether striped or not).

And that brings us to what Vice Chancellor Laster called the “Accountant True-Up Mechanism” contained in the Stock Purchase Agreement (the “SPA”) at issue in the recent Archkey decision. In Archkey, a private equity-backed buyer purchased a private company from its founder. The headline purchase price was made subject to certain potential adjustments based on the difference between the estimated closing balance sheet for the company (the “November Balance Sheet”), which had been used to determine the headline price paid at closing, and an “Adjusted Closing Balance Sheet,” prepared by the buyer after closing. As is customary, the buyer was obligated to prepare the Adjusted Closing Balance Sheet “in good faith and in accordance with GAAP and consistent with the past practices of [the Company] and the November Balance Sheet.” As is also customary, the seller was entitled to object to the Adjusted Closing Balance Sheet and, to the extent the buyer and seller were unable to resolve those objections, the dispute was to then be submitted to an “Independent Accountant” whose determinations regarding the disputed items in the Adjusted Closing Balance Sheet “shall be final, binding, conclusive and non-appealable for all purposes hereunder, other than manifest error.” All pretty standard. But to throw a wrench into the Accountant True-Up Mechanism, the SPA specified that “[t]he Independent Accountant shall act as an arbitrator.”

The buyer’s position was that, by specifying that the Independent Accountant was to “act as arbitrator,” the Accountant True-Up Mechanism was effectively an arbitration provision and the Independent Accountant was to make all decisions, both legal and factual, concerning any disputes arising out of the disputed purchase price adjustments. The seller, on the other hand, contended that the Accountant True-up Mechanism was an expert determination only, and that the court retained authority to make all decisions as the meaning of the contractual provisions that governed the determinations the expert was required to make.

Notwithstanding the reference to the Independent Accountant acting “as an arbitrator,” Vice Chancellor Laster agreed that the Accountant True-Up Mechanism was an expert determination, not an arbitration provision. Thus, “the Federal Arbitration Act and its associated doctrinal framework, including the concepts or substantive and procedural arbitrability,” were inapplicable. But in so deciding, the Vice Chancellor also noted that the general distinctions between an expert determination and an arbitration do not always apply, even when a provision is clearly an expert determination provision and not an arbitration provision. Rather, arbitration and expert determination are “[b]oth forms of binding ADR [Alternative Dispute Resolution]” that “fall along a spectrum” depending on the language used in the contract creating those mechanics. Nonetheless, a standard “Accountant True-Up Mechanism is far enough along the spectrum that it is not legal arbitration, no matter what labels the parties use for the independent accountant.” Here, Vice Chancellor Laster concluded that the Accountant True-Up Mechanism was a “beefed-up expert determination, not a slimmed down legal arbitration.” But the “beefed-up” part meant that the seller’s position as to the limits of the Independent Accountant’s role was no more correct than buyer’s view of the expansive role the Independent Accountant had as an “arbitrator.” Instead, it was somewhere in between the two extremes (more like a domesticated zebra).

Having determined that the Accountant True-Up Mechanism was a “beefed up” expert determination provision, not an arbitration agreement, Vice Chancellor Laster proceeded to determine what issues the court needed to resolve in order for the Independent Accountant to do its work. The seller argued that the court needed to “declare what ‘past practices’ means” to permit the Independent Accountant to then resolve whether the Adjusted Closing Balance Sheet was prepared “in accordance with GAAP and consistent with the past practices of the Company and the November Balance Sheet.” While noting that the seller’s position was “too extreme,” and that “[t]he more closely related the term or provision is to the expert’s area of expertise, the more likely it is that an expert can interpret the term without judicial assistance,” Vice Chancellor Laster nonetheless provided some guidance.

First, according to Vice Chancellor Laster, “[past practices in accordance with GAAP] and its variants simply mean using the same method of accounting treatment that was used in the reference statement, provided that method is currently in accordance with GAAP.” And, “[t]o the extent an item requires the exercise of judgment, as accounting statements often do, the concept of consistency with past practice calls for reaching an outcome by a method that is as analogous as possible to the method management used historically.” Or, “[p]ut another way, the outcome for the post- closing statement should be, to the extent possible, the outcome that the management team would have reached if the same circumstances had been presented when they prepared the reference statement.” Second, the GAAP compliance requirement simply means that “past practices” cannot trump GAAP to the extent those past practices were not GAAP compliant. But in selecting a GAAP-compliant method for the Adjusted Closing Balance Sheet, when the November Balance Sheet used a method that was not GAAP-compliant, the buyer is required to choose the GAAP-compliant method that is the most consistent with the Company’s past practices, not just the one that may be the most advantageous to the buyer. But, “[a]ccountants operating within the framework of Accountant True-Up Mechanisms routinely make determination about consistency with past practice[,] [and] [t]he Independent Accountant can do so here.”

The seller also argued that it was up to the court to decide now before the Independent Accountant was asked to make its expert determination, whether the Adjusted Closing Balance Sheet had been prepared in “good faith,” as was expressly required by the Accountant True-Up Mechanism. The seller argued that this requirement was an overriding obligation to act in good faith in the entire transaction. Vice Chancellor Laster rejected that interpretation of the good faith requirement: “The good faith requirement relates to the preparation and delivery of the Adjusted Closing Balance Sheet. It is not a freestanding obligation to act in good faith.” Instead, “[t]he concept of good faith in this setting means that the preparer must believe that the accounting entries are accurate, fairly reflect the financial position of the company, and comply with the contractual standard.” And according to Vice Chancellor Laster, it was well within the Independent Accountant’s expertise to determine whether the accounting determination that the buyer made in the Adjusted Closing Balance Sheet were “so extreme as to show a lack of good faith.” Thus, Vice Chancellor Laster noted that the Independent Accountant’s determination as to whether the Adjusted Closing Balance Sheet was prepared in good faith would “bind the parties for purposes of any further proceedings in this court.”

With this guidance Vice Chancellor Laster stayed the court proceedings until the Independent Accountant could make its determinations regarding the disputed items in the Adjusted Closing Balance Sheet because “[f]urther litigation in this court will take into account the Independent Accountant’s determinations.”

Implied Anti-Maliciousness Covenant

Despite the limited meaning of the express good faith requirement, and the Independent Accountant’s role in determining whether the Adjusted Closing Balance Sheet was prepared consistent with that requirement, Vice Chancellor held open the possibility that the seller might still have a separate claim for breach of an implied obligation of good faith and fair dealing. According to Vice Chancellor Laster, a recent Delaware Supreme Court decision, Baldwin v. New Wood Res. LLC, 283 A.3d 1099 (Del. 2022), may have expanded the covenant of good faith and fair dealing to include an implied covenant not to take any action “maliciously in an effort to harm the contractual counterparty.” And, based on the facts pled by the seller and evidence introduced, Vice Chancellor Laster noted that the seller’s “amalgamation of evidence suggest that the Purchaser made adjustments when preparing the [Adjusted Closing Balance Sheet] that are so extreme as to indicate malice.” The seller’s basic claim was that the buyer had completely changed the company’s accounting approach post-closing such that it was in fact inconsistent with past practices and specifically designed to reduce the purchase price as much as possible.

Here, the proposed adjustment was over $12.6 million off a headline price of $21 million (i.e., 2/3rds of the headline price). But “extreme” presumably must be determined by comparison to the actual calculation that was required by the express terms of the purchase agreement (which was required to be consistent with past practices), not just the actual size of the adjustment itself.

Delaware contract law, unlike tort law, has fairly consistently treated intentional breaches of contract the same as unintentional breaches, unless there is something in the contract requiring a different outcome in the event of a “willful breach.” Indeed the concept of “efficient breach” suggests that parties should be able to breach an agreement for any reason provided that they are prepared to pay the resulting damages occasioned by that breach. Is a “malicious” contractual breach an exception to that rule, even in the absence of a tort connected to that maliciousness? Vice Chancellor Laster notes that “the intent to harm intentionally—malice—goes beyond an intent to take self-interested action that happens to inflict consequential or collateral harm[,] [and] [i]t thus transcend situations involving efficient breach or intentional failure to comply with a contractual obligation that gives rise to a claim for damages.”

But, doesn’t compliance with an implied covenant, even one not to act maliciously, also constitute a mere breach of contract giving rise to damages? And because implied covenants are traditionally gap-fillers, what gap is being filled by this implied covenant given that the purchase agreement already contained a contractual standard (good faith) against which the preparation of the Adjusted Closing Balance Sheet was to be judged? A prior blog post interpreted the Delaware Supreme Court’s decision, in Baldwin v. New Wood Res. LLC, as simply providing, as a gap filler, an implied contractual standard (good faith) to govern the making of an otherwise fully discretionary decision by one party concerning whether another party was in compliance with an agreed standard of conduct.⁴ Is there more to it than that? Vice Chancellor Laster suggests there well may be.

But, if the Independent Accountant determines that the Adjusted Closing Balance Sheet was not prepared in good faith, what additional remedy would there be as a result of the court’s determination that there had also been a breach of an implied covenant not to act maliciously in preparing that Adjusted Closing Balance Sheet? There is no suggestion that the buyer committed a tort in the preparation of the Adjusted Closing Balance Sheet, even though the term “malicious” has a tort-like flavor.⁵

If, on the other hand, the Independent Accountant determines that the Adjusted Closing Balance Sheet was prepared in good faith, is the court bound by that determination for purposes of invoking the implied covenant? The court suggests that it is. After all, the test for determining express good faith by the Independent Accountant was whether the adjustment was so extreme as to indicate a lack of good faith, and the test for maliciousness is similarly the extreme nature of the adjustment.

There are many questions left unanswered by the possible existence of an implied covenant that serves as a means of testing a party’s intent in breaching a contract’s express terms. There is undoubtedly more to come.

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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 2 (June, 2013).

2 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’s Global Private Equity Watch, January 6, 2016. The binding effect of an expert determination appears limited, however, to factual determinations, not legal determinations. Thus, according to a recent Delaware Supreme Court decision, Terrell v. Kiromic Biopharma, Inc., 297 A.3d 610 (Del. 2023), where an expert has been granted the right to interpret legal documents, those legal determinations, unlike in the case of an arbitration decision, are subject to a de novo review by a court.

3 Glenn West & Miae Woo, The Zebra versus Striped Horse Phenomenon Rears its Head Again—Distinguishing an Expert Determination from an Arbitration, Weil’s Global Private Equity Watch, February 13, 2019; Glenn West, Post-Closing Purchase Price Adjustment Mechanics—Distinguishing Expert Determinations from Arbitrations, Weil’s Global Private Equity Watch, August 6, 2018, both quoting Steven H. Reisberg, What is Expert Determination? The Secret Alternative to Arbitration, N.Y.L.J., Vol. 250, No. 115 (Dec. 13, 2013).

4 See Glenn West, Musings on the Exercise of “Sole Discretion,” Weil Global Private Equity Watch, August 29, 2022.

5 Purchase Price Adjustment mechanics have not been immune from claims of fraud. See Roma Landmark Theaters, LLC v. Cohen Exhibition Company LLC, 2020 WL 58165759 (Del. Ch. Sept. 30, 2020), discussed in Glenn West, The Latest Effort to Use Fraud to Overcome a No-Indemnity Deal—The Target’s Preparation of the Preliminary Closing Statement, Weil Insights, Weil’s Global Private Equity Watch, October 14, 2020.