DealLawyers.com Blog

In mid-February, in Fortis Advisors v. Stillfront (Del. Sup; 2/26), the Delaware Supreme Court determined that a merger agreement’s alternative dispute resolution provision requiring an accounting firm to resolve disputes regarding the “calculation of the earnout amount” provided for “arbitration” rather than “expert determination” (an often disputed and consequential distinction) and determined that the firm had authority to resolve all earnout issues — including legal ones. This meant that the accounting firm appropriately addressed whether the buyer acted in bad faith to reduce the earnout amount or breached operational covenants related to the earnout, even though these determinations involved no “calculations.” The Court upheld the Chancery Court’s decision enforcing the outcome of arbitration (concluding all earnout-related disputes in the buyer’s favor), which was determined fully by the accounting firm.

It has happened before (and will happen again) that a merger agreement uses the word “arbitration” when referring to an accounting firm resolving disputes, and one party argues that the firm should have only been permitted to make an “expert determination.” As this Fried Frank alert notes, that’s not what happened here. The use of the word “calculation” plus testimony factored heavily into the Court’s decision. 

Delaware courts have interpreted ADR provisions similar to the Stillfront ADR […] as calling for an expert determination, not an arbitration. The Stillfront opinion, which notes these decisions, suggests that the Supreme Court also would have found that the Stillfront ADR called for an expert determination, if not for the unique fact that the plaintiff, in oral argument at the Court of Chancery, had conceded (indeed, had been “emphatic”) that the parties had agreed to arbitrate their earnout disputes. The plaintiff changed this view only after the accounting firm arbitrator determined that no earnout amount was owed [. . .]  The Supreme Court stated that it would “hold” the plaintiff to its initial position.

It also notes that ambiguity often arises when the ADR provisions provide for resolution of “calculation” disputes.

[T]he Supreme Court viewed disputes about compliance with earnout-related operational covenants and good faith requirements as coming within the ambit of the ADR provision governing resolution of disputes over “calculation” of the earnout, as such compliance affected what the amount of the earnout would be. [. . .] The Supreme Court viewed “calculation” disputes as subsuming disputes that related to “the accuracy of the buyer’s earnout determination” (i.e., the amount of the earnout owed). Stillfront’s conduct underlying the Bad Faith Claims “had a direct bearing on how the Earnout Amount should be determined,” and indeed “proffer[ed] [Fortis’s] explanation as to why Stillfront’s Earnout Determination Statement was flawed,” the Supreme Court wrote.

After discussing recent cases with similar ADR provisions that went the other way, the alert gives some drafting tips for practitioners:

Most critically, the parties should specify whether the ADR expert will act as an arbitrator or as an expert.Parties should consider whether to identify specific issues, or types of issues, as to which the expert will act as an arbitrator, others as to which it will act as an expert, and others as to which it will not act and the court will decide. The issues specified might be those that typically require consideration of both expert and legal issues to resolve (such as whether financial statements were prepared consistent with past practice, whether an earnout statement contained sufficient detail, or whether a milestone was met); or those that are most likely to occur or to be significant in the particular factual context. Parties may want to consider a default provision that states that an arbitration, or instead an expert determination, will be utilized where it is otherwise uncertain which would apply.

Provisions calling for the decision-maker to resolve “all” disputes, or “any” dispute, or to “interpret” the parties’ agreement, often are viewed as indicating an arbitration process. Provisions calling for limited authority of the decision-maker, no specific procedures for the process, a short or informal process, no discovery or hearing, no authority to award relief, and/or a determination that is not final and binding on the parties, are often viewed as indicating an expert determination process.

A provision calling for resolution of disputes over “calculation” of an earnout (or other post-closing adjustment) may be interpreted as conferring broad authority to resolve disputes that do not involve actual calculations but relate to what the earnout amount will be. Parties should consider specifying that the decision-maker will have authority to determine only  financial- or accounting-related metrics, principles and calculations, and not broader legal issues that may relate to the earnout amount owed (such as determining whether a milestone was met, or a party complied with operational, good faith, or efforts covenants).

– Meredith Ervine