A familiar provision in asset purchase agreements is the appointment of a neutral accountant to resolve any post-closing financial disputes that may arise. Often the agreement will appoint this neutral to resolve certain accounting disputes, while also including an arbitration provision for any legal disputes. Inevitably, these provisions create an overlapping jurisdiction with respect to these two tribunals.
As a result, it is important for parties to define as clearly as possible beforehand which type of tribunal will be resolving which disputes arising out of the contract. Any uncertainty may lead to, at best, gamesmanship over which venue to resolve the disagreement, or, at worst, a decision-maker formulating a decision outside his or her area of expertise and experience.
A recent Court of Chancery decision in Delaware exemplifies the pitfalls of a misallocation of jurisdictional duties as between the neutral accountant and the legal arbitrator – resulting in an allocation of responsibility that flies in the face of common sense not to mention wise jurisprudence. In that case, the court resolved a merger agreement dispute by finding that an accountant-neutral, rather than a qualified legal arbitrator, must decide questions of law. In Matria Healthcare, Inc. v. Coral SR LLC, 2007 Del. Ch. Lexis 32 (March 1, 2007), a post-closing dispute arose over the seller’s failure to disclose that one of its largest customers had raised concerns regarding the seller’s services prior to the closing date. When the buyer eventually learned of the customer’s complaints, it sought a post-closing downward adjustment of $4.0 million. When the seller refused this adjustment, the buyer sought to advance the dispute to a neutral for resolution. However, the seller countered that the buyer was not seeking an accounting adjustment, but instead was making a claim of liability that should be presented to an arbitrator appointed pursuant to the American Arbitration Association.
When the parties’ conflicting views reached Delaware’s Court of Chancery, the court found that the language of the merger agreement expressly provided that where a dispute could be classified as a disagreement as to both final balance sheet adjustments and breach of representation, warranty, or covenant, then the dispute was to be resolved by the neutral and not through traditional arbitration. In other words, even though the buyer was, in essence, claiming a breach of representation (an issue best determined by a legal arbitrator), the contract specifically called for the neutral to make the ruling. Although recognizing that this result was not ideal, the court wrote: “One may doubt that this is what the parties intended; the Court, however, cannot read the Merger Agreement otherwise. . . . That a judge may believe that the AAA would be the preferable forum for resolution of the dispute does not (nor should it) trump the agreement of the parties.” This result shows that even a court of law cannot save the parties and the appointed neutral from an unfortunate result where either poor drafting, or imprudent allocation, of responsibility within the agreement leads to only one conclusion.
Only a year earlier, the Court of Chancery reached a conclusion opposite to the Matria Healthcare decision in similar circumstances, but based on different contract language. In OSI Systems, Inc. v. Instrumentarium Corp., 892 A.2d 1086 (Del. Ch. Ct. 2006), the asset purchase agreement set out a structure to calculate the final purchase price based on a comparison of the working capital as of the year before the purchase and then as of the closing date. Where the parties disagreed as to the working capital value, they were to submit their differences to “an independent certified public accounting firm in the United States of recognition mutually acceptable” to the parties. The independent accounting firm’s job was to make a final and binding determination of the appropriate amount of each of the line items in the modified working capital statement as to which the parties disagree.
A dispute arose when it was discovered that the seller failed to follow Generally Accepted Accounting Principles (GAAP) in the preparation of its financial statements. As a result, the buyer sought a significant decrease in the final payment price to account for the true valuation. When the parties reached the inevitable standoff, the buyer sought review by the independent accountant, who would be able to calculate the modified working capital amount as of the closing date in compliance with U.S. GAAP. However, the seller argued that the dispute should go to legal arbitration rather than the independent accounting firm because the buyer was actually making a claim for breach of a representation or warranty by the seller in preparing its financials. The struggle over which tribunal should decide was rooted in the fact that if the dispute was decided by an arbitrator as an indemnification claim, damages would be capped at 25% of the purchase price, whereas if it was decided by a neutral accountant, the resulting valuation under GAAP could have provided for a 54% reduction in the price.
The court held that legal arbitration was required because the independent accountant provision was based on the understanding that the two valuations would be based on the same accounting principles -- GAAP. The buyer bargained for the original accounting statement provided by the seller to be materially accurate and in compliance with GAAP, therefore creating a representation and warranty to that end by the seller. Whether a breach of a representation or warranty took place was for legal arbitration, not the accountant/neutral.
The OSI case shows that structure and language of some asset purchase agreements enable, presumably unwittingly, for parties’ respective strategic gaming of what dispute resolution process to invoke, i.e. neutral or legal arbitration. Although this is a better result than that in Matria Healthcare, both decisions exhibit the potential difficulties resulting from the dichotomy between the neutral and arbitration provisions.
The importance of the appointment of the correct tribunal for each possible dispute is exacerbated by the great latitude afforded neutrals and arbitrators in rendering their awards. For each, the decision made will be final and subject to an extremely limited legal review.
Where a party feels aggrieved by a domestic arbitration or neutral award, that party’s avenue of relief may be through the Federal Arbitration Act (FAA), which is explicit in its definition of certain exceptional circumstances under which a party can successfully vacate a damaging award. Essentially, fraud or serious error must be shown before an award will be negated pursuant to the statute.
Over the years, however, courts have attached a gloss to the explicit grounds for relief under the FAA that has proven to be a more fertile ground for vacating arbitration awards. Under this judicially crafted standard -- known as a manifest disregard of the law -- a court may vacate an arbitration or neutral award when the challenging party can show that the arbitrator or neutral knew the law and expressly disregarded it in rendering his or her decision.
Recently, however, the manifest disregard of the law standard has come under attack. In 2008, the United States Supreme Court put into serious question its continuing viability in Hall Street Associates, L.L.C. v. Mattel, Inc., 128 S. Ct. 1396. By rejecting the parties’ contract that purportedly granted a court enhanced judicial review of an arbitrator’s award, the Court held that the specific statutory grounds for vacating an arbitration award under the FAA are exclusive.
Subsequent to this Supreme Court opinion, lower courts have grappled with the question of whether the manifest disregard of the law standard has now been eliminated altogether, or whether that standard remains a gloss on the preexisting statutory grounds for vacatur found in §§ 10 and 11 of the FAA. Presently, there are disparate results among the appeals courts. For example, the First Circuit has found that the Hall Street decision confirmed “that manifest disregard of the law is not a valid ground for vacating or modifying an arbitral award in cases brought under the Federal Arbitration Act.” Ramos-Santiago v. United Parcel Service, 524 F. 3d 120 (1st Cir. 2008). In contrast, the Second Circuit has determined that manifest disregard of the law remains a valid rationale for vacating arbitration awards. Stolt-Nielsen SA v. Animalfeeds International Corp., 548 F.3d 85 (1st Cir. 2008). Consequently, until the Supreme Court clarifies the true impact of Hall Street, courts may remain split and, therefore, parties cannot be certain whether manifest disregard of the law remains a proper basis for vacating a neutral’s or an arbitrator’s award. Just as much, arbitrators and neutrals must remain mindful that the manifest disregard of the law standard continues to survive, at least in some jurisdictions.
In summary, parties and their agents should prudently allocate the accounting determinations of purchase price adjustment or earn-out disputes in asset purchase agreements to be made by the accounting neutral, and legal decisions, e.g. breach of representations or warranties, to be made by legal arbitrators. Further, an arbitrator or independent neutral accountant must be well advised as to the appointment provisions of the underlying merger document so that allocation of duties does not charge him or her with acting in the domain of a foreign expertise.
This advisory was prepared by Nutter’s Litigation practice. For further information, please contact your Nutter attorney.