Planning for Disputes Regarding Earnout Provisions
Earnout provisions are often used to bridge valuation differences in order to finalize a deal. But, as one court put it, “Earnouts all too often transform current disagreements over price into future litigation over outcome.” Airborne Health, Inc. v. Squid Soap, LP
, 984 A.2d 126 (Del. Ch. 2009). Since January 2015 over twenty-five reported cases have been issued involving disagreements over earnouts. Numerous other disputes have been resolved via arbitration.
In general, in the purchase agreement parties are free to specify how and where disputes will be resolved. For instance, parties can state whether arbitration or litigation will serve as the dispute resolution mechanism, what location the proceedings will be held, and what law applies. Given the potential for disputes over earnouts, it is important for the purchase agreement to address how disputes over earnouts will be addressed. There are three methods of dispute resolution that are commonly specified in purchase agreements, each with its own pros and cons.
If the purchase agreement is silent as to the method of dispute resolution, disputes will be resolved through litigation. The parties can also specifically state that litigation in a particular forum will be the dispute resolution method. There are some advantages to litigation. If the trial judge or jury issues a ruling a party does not agree with, it can appeal to a higher court. Third parties who may be essential for resolution of the matter can usually be joined to the matter. Parties are able to take full discovery in litigation, gaining access to documents that may be critical to their case.
Disadvantages exist as well. Lawsuits are public proceedings, and, while rules exist to prevent public access to certain confidential information, these rules are cumbersome, and most of the proceedings will likely be subject to public scrutiny. Full discovery can be very costly, especially if significant amounts of electronic documents are implicated. In addition, as they say, “the wheels of justice turn slowly.” In the case Security Plans, Inc. v. CUNA Mutual Insurance Society
, the initial lawsuit was filed in July 2008. In January 2013 the trial court granted summary judgment for the defendant, but in October 2014 the Second Circuit Court of Appeals reversed the grant of summary judgment in part. 769 F.3d 807 (2nd
Cir. 2014). The case is still pending nearly eight years after it was initially filed.
Any provision selecting litigation as the dispute resolution method should specify where the litigation will take place. Some courts are known to have “rocket dockets” meaning they resolve cases more quickly than others. It should also address whether the matter will be subject to a jury or bench trial. Jurors are less likely to understand financial issues implicated by earnout provisions. In addition, it is often easier to get on a court’s calendar for a bench trial, which can shorten the time from the filing of a lawsuit to trial.
If you need to obtain a quick resolution, such as when your fund must close by a certain date, arbitration with an experienced arbitrator is usually a better option than litigation. Most arbitrations take place within three to six months of the filing of the notice of arbitration, although the specific timing of the hearing will depend on what arbitration service is utilized. An arbitration provision can specify when an arbitration must take place; for instance, it can state the hearing will take place no later than 90 days after the arbitration demand is filed. Arbitration is also generally less expensive than litigation. Arbitration hearings are confidential, which can be important if trade secrets are involved.
There are a number of downsides to the speed and confidentiality that come with arbitration. The right to discovery is more limited in arbitration than in a court of law, which is a positive from a cost perspective but a negative if you need access to information in the possession of your adversary or a third party. Third parties cannot be joined to an arbitration, but usually they can be added to a lawsuit. The review of an arbitration award by a court is very limited. A court will only set aside or correct an arbitration award if the award contains a material miscalculation, the arbitrator was biased, the arbitrator exceeded his or her powers, or the award was procured through corruption or fraud. 9 U.S.C. §§ 10. Courts usually will not overturn an arbitration award even if it is contrary to the facts or the law. See Wise v. Wachovia Sec., LLC,
450 F.3d 265, 268 (7th Cir. 2006).
To prevent delays and costs due to collateral disputes, arbitration provisions should specify clear and reasonable procedures for selecting the arbitrator or arbitrators. In a recent Delaware case, a purchase agreement related to a floor covering company contained an earnout provision. Weiner v. Milliken Design, Inc.
, 2015 WL 401705 (Del. Ch. Jan. 30, 2015). A dispute developed, and the agreement specified the dispute would be submitted “to an arbitrator who shall have at least 20 years of experience in the floor coverings industry.” If the parties could not agree on the arbitrator, then each party would select an arbitrator who met the qualifications, with those two then selecting the third. The parties could not agree on an arbitrator, and then the two arbitrators they selected could not agree on the third arbitrator. The court ultimately ordered the parties to each submit a list of three potential arbitrators and then the court would select the final arbitrator from one of the lists. The failure of the provision in this agreement to specify how disputes between the parties’ selected arbitrators as to the appointment of the third arbitrator led to court intervention, adding delay and cost to the resolution of the dispute.
Most arbitration clauses specify the arbitrator will be selected through an arbitration service such as the American Arbitration Association who will supply a pool of persons trained and experienced in arbitrations. But sometimes clauses instead call for the appointment as arbitrator with subject matter experience as opposed to arbitration experience. In Industrial Opportunity Partners, L.P. v. Kendrion FAS Controls Holding GmbH
, the earnout provision in a purchase agreement specified disputes would be resolved by the accounting firm Deloitte, who would render a decision after hearing presentations from the parties. 2015 WL 196339, at *2 (N.D. Ill. January 14, 2015). The provision stated the award would be final and “no party shall seek further recourse to courts, other tribunals or otherwise, other than to enforce” the award. An Illinois federal court ultimately confirmed the award rendered by Deloitte.
If an arbitrator merely needs to perform a simple calculation, then this method could best suit your needs. For instance, this may be an appropriate dispute resolution method in a situation where the seller is entitled to 3% of gross sales and the gross sales are readily ascertainable. However, if an arbitrator needs to make judgments regarding what should and should not be included in a calculation, then it may not be prudent to hand over decision making authority to one person without the ability to analyze documents relevant to the calculation and to present arguments on what should be included in it.
It is important to put some thought into how disputes will be resolved in your next earnout provision. Planning now could allow it to be resolved in a forum that is consistent with your needs and is, overall, more efficient.
About the Authors
is a partner in the Indianapolis office of Ice Miller LLP, working in the Litigation
group. He represents clients in commercial disputes, including lawsuits and arbitrations involving complicated financial issues. He can be reached at 317-236-2383 or firstname.lastname@example.org.
is a partner in the Indianapolis office of Ice Miller LLP, working in the Business
group. He represents private equity firms and privately held businesses in mergers, acquisitions, divestitures, joint ventures and other complex transactions. He can be reached at 317-236-2425 or email@example.com.
This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstances.