An Arbitration by Any Other Name Is Still an Arbitration, Unless It’s an Expert Determination: Recent Cases Apply Delaware’s Authority Test to ADR Provisions

In M&A transaction agreements, contracting parties frequently negotiate a mechanism to make post-closing adjustments to the purchase price — for example, based on calculations of the target company’s working capital at the time of closing or an “earnout” based on the performance of the company for a specified period after closing. Because parties often disagree over these adjustments, the agreement generally will include a framework for resolving disputes. Although the particulars can vary, the parties typically will agree to negotiate in good faith and, if negotiations fail, to submit any remaining disputes to an independent accountant for final resolution.

But what happens when the parties disagree about whether the accountant has authority to resolve a particular dispute? For example, one side may believe that resolving the dispute requires a straightforward accounting exercise, while the other side contends that the crux of the dispute turns on legal issues that are outside the scope of the accountant’s expertise. In such cases, courts are often required to address a threshold question: Did the parties intend for the accountant to act as an expert or an arbitrator? The answer to this question impacts the scope of the accountant’s authority and determines whether the proceeding is subject to arbitral doctrines and the Federal Arbitration Act (FAA).

In Penton Bus. Media Holdings, LLC v. Informa PLC, 252 A.3d 445, 462 (Del. Ch. 2018), the Delaware Court of Chancery held that “parties who wish[] to obtain an expert determination from an accountant, rather than inviting an arbitration, should state that the accounting firm is to ‘act as an expert and not as an arbitrator.’” But recent decisions show that the labels parties place on their procedures will not always dictate how the court interprets their agreement. These decisions show that courts instead will look to the scope of authority the parties conferred on the decision-maker. If the terms of the agreement more closely align to an expert determination, identifying the decision-maker as an “arbitrator” will not transform the proceeding into an arbitration. Conversely, where the contract indicates that the decision-maker will have the powers of an arbitrator, the proceeding may be considered an arbitration even if the decider is labeled an “expert.” These decisions serve as a reminder that contracting parties should negotiate an alternative dispute resolution provision carefully and not rely only on designations and labels. This is particularly true when the ADR mechanism has elements of both an expert determination and an arbitration, which is often the case for post-closing disputes.

A. ArchKey Intermediate Holdings Inc. v. Mona, 302 A.3d 975 (Del. Ch. 2023)

In ArchKey, the parties negotiated for what the court described as a “run-of-the-mill” “accountant true-up mechanism.” The key question was whether designating the accountant an “arbitrator” was sufficient to establish an agreement to arbitration. As discussed in more detail below, Vice Chancellor Laster held that it was not.

  1. Background

The parties to a stock purchase agreement stipulated that the headline purchase price would be based on an estimated closing balance sheet as of November 2019 (the November Balance Sheet), but that the final purchase price would be based on an adjusted closing balance sheet as of November 2020. Purchaser was required 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.” Seller had 30 days to dispute Purchaser’s calculations by sending an objection notice. This triggered a 10-day negotiation period followed by submission of any remaining disputes to an “Independent Accountant.” The agreement stated that the accountant “shall act as an arbitrator” in resolving the parties’ disputes.

Purchaser filed suit and, after pleadings closed, moved for judgment on the pleadings or, in the alternative, to compel arbitration. Seller opposed, arguing that the dispute should remain in court because the independent accountant was prohibited from determining legal matters such as whether Purchaser’s calculation was prepared in good faith.

  1. Standard Post-Closing Adjustment Provisions Call for Expert Determinations, Not Legal Arbitrations

Vice Chancellor Laster began his analysis by evaluating the “Accountant True-Up Mechanism” generally. He described it as a distinct and well-established form of ADR that falls somewhere in the middle of the “ADR Spectrum” (i.e., between expert determinations and legal arbitrations). To evaluate whether it was closer to an expert determination or an arbitration, he applied the “authority test” prescribed by the Delaware Supreme Court in Terrel v. Kiromic Biopharma, Inc., 297 A.3d 610 (Del. 2023). Under this test, the court “compares the features of the parties’ ADR mechanism” and whether the scope of the decision-maker’s authority “more closely resembles the broad authority conferred on a legal arbitrator . . . or whether the grant is narrower and involves more fact-like determinations.”

Based on this test, the Court of Chancery concluded that accounting true-ups were generally “too far away from legal arbitration to be governed by the FAA.” Vice Chancellor Laster reasoned that applying arbitral doctrines would create “odd results,” such as the independent accountant “addressing not only accounting issues” but also purely legal issues beyond the expert’s purview, and that this “likely goes beyond what the parties intended for the independent accountant to resolve.”

As noted above, in ArchKey the parties expressly agreed that the accountant “shall act as an arbitrator.” The court held that this was not enough to shift the proceeding into the realm of arbitration because “the balance of the language [in the contract] describes a standard Accountant True-Up Mechanism involving an expert determination.” If parties want an Accountant True-Up Mechanism to be an arbitration, they must “do more” to signal their intent to arbitrate, for example, by “specifying a sponsoring arbitral organization and designating a set of arbitral rules.”

  1. ArchKey Supports Deference to Accounting Expert’s Determinations

Having concluded that the parties’ agreement called for a “beefed-up expert determination,” the court next turned to the scope of the accountant’s authority. In particular, Seller argued that the accountant had no authority to resolve disputed issues of contract interpretation, and that these issues must be resolved before the accounting proceeding could begin. The court suggested that this went too far. In Accounting True-Ups, accountants do have authority to interpret the agreement, and “[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.” The court proceeded to provide guidance regarding the interpretation of certain commonly used terms and phrases that were within the accountant’s area of expertise.

For instance, the parties’ agreement required the accountant to assess whether Purchaser’s proposed adjustments were made “in accordance with GAAP and consistent with the past practices of the Company.” Seller argued that the phrase “past practices” encompassed both past accounting and business practices, and that only a court had authority to interpret the scope of this language. The court disagreed, noting that most purchase agreements include some derivation of the phrase “past practices in accordance with GAAP,” and that “past practices” refers to past accounting practices, not past business practices. Vice Chancellor Laster concluded that “Accountants operating within the framework of Accountant True-Up Mechanisms routinely make determinations about consistency with past practice” and that “[t]he Independent Account[ant] can do so here.”

Seller similarly argued that only a court could decide whether the purchaser complied with a contractual obligation to prepare the adjusted closing statement “in good faith.” The court rejected this argument as well, reasoning that an express obligation of “good faith” is a common feature of accounting true-up provisions and is within the accountant’s authority to address.

Conversely, the court held that the accounting expert did not have authority to address Seller’s claim that Purchaser’s proposed adjustments were so extreme that they breached the implied covenant of good faith and fair dealing. Nevertheless, the court held that it would reserve any analysis of the claim until after the accounting expert had an opportunity to assess the proposed adjustments in the first instance.

B. Cedres v. Geoffrey Servs. Corp., 2020-0745-MTZ, 2024 WL 1435110 (Del. Ch. Apr. 3, 2024)

Although not in the context of post-closing accounting disputes, the Court of Chancery’s recent decision in Cedres further confirms that Delaware courts will not blindly accept labels in assessing whether an ADR provision calls for an expert determination or arbitration. In Cedres, the parties included an ADR provision in their settlement agreement that referred “all issues and disputes” regarding payment obligations to an “Independent Party.” The parties stipulated that the Independent Party would function “as an expert and not as an arbitrator.” The court did not give this representation dispositive weight, and instead looked to the various features of the parties’ agreement, which it concluded more closely resembled an arbitration. Among other things, the court noted that the parties’ agreement required the Independent Party to make judicial determinations and incorporated procedural guidelines that “sound in arbitration,” including a preliminary conference and written submissions. Because these guidelines resembled “the look and feel of a judicial proceeding,” the “ADR Provision calls for arbitration.”

C. Takeaways and Implications

  1. In the wake of ArchKey, the Court of Chancery may be more likely to treat independent accountants as experts rather than arbitrators, even if a post-closing adjustment provision expressly designates the accountant as an “arbitrator.”
  2. If contracting parties want an ADR mechanism to be subject to arbitral doctrines, they should give the ADR mechanism the look and feel of an arbitration proceeding, such as specifying a sponsoring arbitral organization and designating a set of arbitral rules. In light of ArchKey, such signals are particularly important if parties want an accounting true-up to be an arbitration.
  3. In the context of accountant true-up mechanisms, Delaware courts are likely to defer to an independent accountant’s factual determinations regarding issues delegated to the accountant, including whether a calculation was (i) in accordance with GAAP, (ii) consistent with past practices, and (iii) in good faith. In the wake of ArchKey, a court may be less inclined to find that such determinations require any preliminary judicial guidance.

This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.