It makes a difference whether the determination is an arbitration or an expert decision. We see these clauses frequently. Something similar to “The franchise buyout price shall be determined by submission by each side’s appraiser, whose reports shall be submitted to a third, whose decision shall be binding.” Or perhaps “the fair market rent for the future term shall be determined by the an independent licensed real estate appraiser selected by the parties.” Will the determination by these experts be nonappealable arbitration awards or expert decisions that can be challenged in court and subject to appeal?

The difference can be huge when challenging or enforcing the determination. Both determinations are creatures of contract. Where the contract does not state whether it is an arbitration or litigation, proper enforcement or challenge to the determination can take years. A decision by the U.S. Court of Appeals for the Third Circuit provides guidance on procedure and drafting.

In the case of Sapp v. Industrial Action Services, No. 22-2181 (3d Cir. 2023), the parties agreed in an asset purchase agreement that after closing, additional sales consideration could be earned by the sellers if certain post-closing EBITDA benchmarks were met (the earnout). At the three- year lookback to determine the earnout, the company was to provide a statement of EBITDA for the three past annual periods. Once the statement is delivered, the sellers had the opportunity to issue a notice of disagreement. The notice of disagreement was to contain a statements of objections to how the calculation did not comply with the asset purchase agreement or contained a mathematical error. An EBITDA calculation is not a general accepted accounting principles (GAAP) financial measure and was specifically defined in the asset purchase agreement. EBITDA is generally a measure of cash flow by calculating earnings before interest, taxes, depreciation and amortization. As the EBITDA formula in the asset purchase agreement itself was quite technical, legitimate objections could be expected. The earnout consideration in the Sapp case could be as much as $5 million for each of the trailing years, for a total of $15 million.

In Sapp, the procedure is that the company’s accounting firm would issue the earnout statement, the parties would have 60 days to meet and confer, review workpapers and if they could not agree, have a national independent accounting firm resolve the issues in the notice of determination and determine the definitive calculation. The provision further states that judgment may be entered in any court on the determination.

Note that the judgment provision is similar to language you would expect to see in any properly drafted arbitration provision. The contract elsewhere had a dispute resolution clause requiring mediation and litigation to resolve disputes arising under the contract.

In Sapp, the EBITDA statement calculated that no Earnout was due. Sellers immediately claimed that the company wrongfully acted to circumvent the proper accounting and filed suit to challenge the calculation. The buyer moved compel arbitration of the calculation by the independent national accounting firm. The motion to compel arbitration was rejected by the report and recommendation of the federal magistrate, but granted by the district court, and the independent national accounting firm was appointed to render an arbitration award. The award confirmed that no earnout was due. Sellers moved to vacate the award before the district court and the motion to vacate was denied. On appeal to the Third Circuit, the panel reversed and remanded.

The circuit court explained the distinction between arbitration and expert determination.

Speaking for the panel, Circuit Judge Thomas Ambro wrote:

Arbitration and expert determination, in most states, are two distinct forms of private alternative dispute resolution that produce binding results. They have similarities, leading some commentators to call them “close cousins” and some courts struggling to apply the differences between them. Despite these similarities, “the fundamental difference” between the two methods is “the type and scope of authority that is being delegated by the parties to the decision maker.”

On the one hand, arbitration occurs when “the parties … intend to delegate to the decision maker authority to decide all legal and factual issues necessary to resolve the matter.” The arbitrator functions like “a judge in a judicial proceeding.” … After resolving all factual and legal questions in a formal process that mirrors a judicial proceeding, the arbitrator can award a legal remedy, “such as damages or injunctive relief,” that courts will enforce.

By contrast, experts decide narrower issues using a less formal process. Under this method, the parties appoint a person or entity with specialized knowledge, “usually of a technical nature,” to determine a confined issue. The authority of an expert “is limited to its mandate to use its specialized knowledge to resolve a specified issue of fact” and does not extend to making “binding decisions on issues of law or legal claims.” It makes its decision without following court-like procedures: there are usually no pleadings, evidentiary hearings, or the taking of witness testimony. Sapp, Op, at 11 (citations omitted).

The circuit court determined that the contractual limitations on the independent accounting narrowed the scope of inquiry and authority. The sellers’ claim that the earnout calculation was suppressed due to wrongful conduct by the company should not be properly considered. The circuit court applied four factors to determine this was not an arbitration. The first was the narrow scope of authority basically limited to the work papers of the company was typical of expert accounting and not arbitration. The second was that determination was required to be completed by the accounting firm within 30 days and was not consistent with the broad based investigation that an arbitrator would be expected to perform. Third, the provision contained no set of rules of procedure to ensure due process like an arbitration. The fourth and final factor was that imposing arbitration of this provision was inconsistent with the dispute resolution elsewhere in the agreement to require mediation followed by litigation.

Lessons Learned

Like most dispute resolution provisions, these provisions are sometimes drafted better by litigators than transaction lawyers. The first lesson is to understand the dispute resolution provision in the contract as a whole and determine whether the “expert determination” should really be an “arbitration.” The advantage is that if the “determination” is labeled an “arbitration,” then the scope of the arbitration can be tailored to function as an arbitration, and it will be final without right of appeal like most arbitrations. If the contract already requires arbitration of all disputes, then it is not necessary to provide special treatment for the “expert determination” because its enforcement will be arbitration.

Where the contact does not provide for arbitration but does have a provision for expert determination, the provision should reference the existing dispute resolution provision in the body of the contract to avoid doubt on enforcement mechanisms.

Reprinted with permission from the October 5, 2023 issue of The Legal Intelligencer© 2023 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.