Is there a difference in enforcement between an arbitration award and an expert determination pursuant to a contract? The answer is yes, according to a recent ruling by the 3rd Circuit U.S. Court of Appeals that includes important lessons for those drafting arbitration provisions.

In Sapp v. Indus. Action Servs. LLC, No. 22-2181 (3d Cir. 2023), the court addressed this issue in relation to the sale of companies that produced chemical cleaning and equipment cleaning for industrial equipment, pursuant to an Asset Purchase Agreement (Purchase Agreement).  In consideration for the sale, the Appellants Kevin Sapp and Jamie Hopper (Sapp) were to receive (i) a $12 million payment at closing, (ii) $1.5 million of stock, (iii) $3 million in deferred compensation, and (iv) three potential and variable payments called Earn Out Consideration, if appellee Industrial Action Services LLC (“IAS”) met certain benchmarks over the next three years.

Section 2.6(c) of the Purchase Agreement specified that IAC had to provide Sapp with an Earn Out Statement of EBITDA (Statement) at the end of each of the 12 month Earn Out Periods.  (EBITDA means earnings before interest, taxes, depreciation, and amortization.)  The Statement would become final unless, within 30 days of its delivery, Sapp submitted its challenges to IAC in writing, known as a “notice of disagreement.” Any disagreement would be settled according to Section 2.3(e), which refers to resolution by an accounting firm.  Section 11.17, however, directed the parties generally to use non-binding mediation, followed by litigation if mediation failed. 

IAS determined that the post-merger company (Company) did not meet its EBITDA targets for any of the three Earn Out Periods.  Sapp claimed that IAS intentionally prevented the Company from meeting its targets – in violation of Purchase Agreement, Section 2.6(g), which prohibited IAS from “taking any action designed to circumvent payment of Earn out Consideration.” Id. at 7.

Citing Section 11.17 of the Purchase Agreement, Sapp sued for breach of contract and tortious interference and, four months later, filed a ‘Notice of Disagreement’ and sought to compel arbitration under Section 2.3(e), which refers resolution of the Notice of Disagreement to an accounting firm.  Section 2.3 (e) provides that

If a Notice of Disagreement is received by Buyer in a timely manner, then the Statement (as revised in accordance with this sentence) will become final and binding upon Buyer and Sellers on the earlier of (A) the date Buyer and [Sellers] resolve in writing any differences they have with respect to the matters specified in the Notice of Disagreement, or (B) the date any disputed matters are finally resolved in writing by the Accounting Firm. During the 60-day period following the delivery of a Notice of Disagreement, Buyer and [Sellers] shall meet and work in good faith to resolve any differences that they may have with respect to the matters specified in the Notice of Disagreement. During such period, the Sellers shall give Buyer and its auditors, accountants and advisors reasonable access to all working papers and other documents of the Sellers and . . . its auditors, accountants and advisors, to the extent used in connection with the preparation of the Notice of Disagreement. At the end of such 60-day period, Buyer and the Sellers shall submit to an independent accounting firm (the “Accounting Firm”) for resolution of any and all matters that remain in dispute and were properly included in the Notice of Disagreement.

The Accounting Firm will be Ernst & Young or, if such firm is unable or unwilling to act, a nationally recognized independent public accounting firm as shall be agreed upon by the parties. Buyer and the Sellers agree to use commercially reasonable good faith efforts to cause the Accounting Firm to render a decision resolving the matters submitted to the Accounting Firm within 30 days. Judgment may be entered upon the determination of the Accounting Firm in any court set forth in Section 11.6.

The award of the accounting firm confirmed that no Earnout was due. Sellers moved to vacate the award before the district court and the motion to vacate was denied.  The Magistrate Judge issued a Report and Recommendation that Section 2.3(3) of the Purchase Agreement called for expert determination, not arbitration, under Delaware law.  The District Court disagreed with the Report and Recommendation, and held that the Purchase Agreement contained a valid agreement to arbitrate.

The court stated that an “arbitrator can award a legal remedy, ‘such as damages or injunctive relief,’ that courts will enforce.  By contrast, experts decide narrower issues using a less formal process … The authority of an expert ‘is limited to its mandate to use its specialized knowledge to resolve a specified issue of fact’ and does not extend to making ‘binding decisions on issues of law or legal claims.”  Op. at pg. 10.

Further, the court stated that:

Arbitration and expert determination, in most states, are two distinct forms of private alternative dispute resolution that produce binding results. They have similarities, leading some commentators to call them “close cousins” and some courts struggling to apply the differences between them. Despite these similarities, “the fundamental difference” between the two methods is “the type and scope of authority that is being delegated by the parties to the decision maker.”

On the one hand, arbitration occurs when “the parties . . . intend[] to delegate to the decision maker authority to decide all legal and factual issues necessary to resolve the matter.” The arbitrator functions like “a judge in a judicial proceeding.” … After resolving all factual and legal questions in a formal process that mirrors a judicial proceeding, the arbitrator can award a legal remedy, “such as damages or injunctive relief,” that courts will enforce.

By contrast, experts decide narrower issues using a less formal process. Under this method, the parties appoint a person or entity with specialized knowledge, “usually of a technical nature,” to determine a confined issue. The authority of an expert “is limited to its mandate to use its specialized knowledge to resolve a specified issue of fact” and does not extend to making “binding decisions on issues of law or legal claims.” It makes its decision without following court-like procedures: there are usually no pleadings, evidentiary hearings, or the taking of witness testimony.

Sapp, Op, at 11 (citations omitted).

The court determined that the Purchase Agreement gave the Accounting Firm the authority to hear specific challenges in each of the three years to the Earn Out Statement for the relevant year – all within a 30-day time period.  The challenges were limited to whether the Statement was prepared in accord with generally accepted accounting principles, whether the parties had reasonable access to all working papers, and/or whether there were mathematical errors.

Second, the court found that the 30 days within which the Accounting Firm had to make its decisions was insufficient time for it to perform the “broad-based investigation” that an arbitrator would undertake.  Third, the court found that the provisions did not include any procedural rules that would govern the alleged arbitration, nor outline its own rules for selection of the decision-maker, discovery, submission of briefing and evidence or holding a merits hearing — as would typically be indicated when the parties intended to arbitrate a dispute. Finally, the Purchase Agreement provided that the disputes should be “submitted to non-binding mediation” and, if mediation failed, to litigation.

Lessons Learned

It’s important when drafting arbitration provisions to understand the dispute resolution provision in the contract as a whole and determine whether the “expert determination” is intended to be an “arbitration.” If the “determination” is labeled an “arbitration,” then the expert’s scope and authority can be tailored to function as an arbitrator, and the expert’s determination is more likely to be final without a right of appeal. 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 contact 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.