The Delaware federal district court held that the purchase agreement’s requirement to submit earnout dispute to an independent accounting firm did not foreclose resolution of the matter by the court because the agreement’s language was only for expert determination and not arbitration
M&A Stories
July 21, 2022
Introduction
Earnouts are commonly used in business deals, where sellers agree to a lower initial purchase price in exchange for the possibility of additional earnings based on performance. To resolve potential disputes over earnout calculations, parties often choose an independent accounting firm. However, a recent case in Delaware shows that clear drafting is crucial to determine whether such disputes should be resolved through expert determination or arbitration.
The Deal
In this particular case, a business dealing with bus-related air conditioning installation and services was sold for $18 million, with a potential earnout of $2 million. The purchase agreement stated that any dispute over the earnout calculation would be referred to an independent accounting firm for resolution.
The Lawsuit
Following the deal’s closure, a dispute arose over the earnout calculation, leading the buyer to seek resolution in a Delaware state court. The sellers successfully transferred the case to a Delaware federal district court and requested the court to compel the buyer to pursue binding arbitration with the accounting firm. The sellers pointed to a provision in the purchase agreement that specified the accounting firm as the decision-maker for the earnout dispute.
Expert Determination vs. Arbitration: The court distinguished between expert determination and arbitration. In expert determination, the accounting firm’s role is limited to resolving accounting practices and procedures that impact the earnout calculations. On the other hand, arbitration allows the accounting firm to consider broader matters affecting earnout calculations, such as allegations of buyer misconduct or unreasonable business practices.
Court’s Decision: The court concluded that the buyer and seller had agreed to resolve the dispute through expert determination, as the purchase agreement lacked specific arbitration procedures or a statement that the accounting firm’s decision would be final in the absence of fraud or manifest error, which are typical elements in arbitration clauses. Consequently, the court declined to refer the dispute to the accounting firm and will likely handle the resolution itself.
This case is referred to as Bus Air, LLC v. Woods, C.A. No. 19-1435-RGA-CJB, United States District Court, D. Delaware, (July 11, 2022).
Key Takeaway
This case highlights the importance of clear drafting in purchase agreements. To avoid disputes over the resolution method, it is crucial to explicitly state whether the process should be arbitration or expert determination. For an arbitration specify the relevant procedures, and indicating the finality of the accounting firm’s decision in the absence of fraud or manifest error. Had these elements been present in this case, the dispute would have been resolved by the accounting firm as intended.
By John McCauley: I write about recent legal problems of buyer and sellers of small businesses.
Email: jmccauley@mk-law.com
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Check out my book: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles
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