A business deal didn’t go as planned and one side wants out. All parties now need to determine how to buyout the disgruntled partner.

How exactly is a franchise buyout price determined?

Well, it matters whether the buyout determination is based on non-appealable arbitration awards or expert decisions that can be challenged in court and subject to appeal, according to a recent ruling by the 3rd Circuit U.S. Court of Appeals.

The difference can be huge when challenging or enforcing the determination. Where the contract does not state whether it is an arbitration or litigation, proper enforcement or challenge to the determination can take years.

Third Circuit Decision Provides Guidance

In the case of Sapp v. Indus. Action Servs., LLC, 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”). 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 determined that the contractual limitations on the independent accounting narrowed the scope of inquiry and authority. 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 the 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 the 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 contract 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.