Delaware courts’ reliance on non-legal experts for dispute resolution is concerning

The disposition, treatment and application of alternative dispute mechanisms in Delaware contracts is fundamentally broken. The inclination, desire and almost reflexive attitude of many Delaware courts to transfer decision-making under Delaware-governed agreements to non-legal forums and professionals incapable of advising or legally opining on Delaware law leads to improper determinations that distort Delaware corporate law. The situation is especially flawed with Delaware-governed acquisition agreements, and, in particular, those that include so-called “earnout” arrangements or provisions that contemplate post-closing payments to the seller of a business.

Non-legal “experts,” including accountants, arbiters and arbitrators, who are unable to practice law, or to provide legal opinions on Delaware corporate legal matters, should not be permitted to decide essential legal questions arising within a Delaware-governed contract absent a clear, unequivocal and objectively discernible agreement by the contracting parties that a determination of basic legal issues by a non-legal “judge” is appropriate, desired and consistent with the principles of the Delaware General Corporation Law. Or to consider it from a slightly different perspective, why isn’t it the case that an accountant making decisions under a Delaware law contract that requires a legal conclusion is not engaged in the unauthorized practice of law? Shouldn’t the Delaware bar, and those using Delaware law for their choice of law, have a concern with persons unversed in Delaware corporate law dictating dispute outcomes that require legal analysis and a legally principled and driven conclusion?

According to an SRS Acquiom survey, nearly a third of M&A transactions that closed between 2018 and 2023 included some form of “earnout” provision. These provisions generally seek to bridge a valuation gap between buyer and seller, with future potential consideration payable to the seller conditioned upon the achievement of specified post-closing metrics. Those metrics may include the achievement of revenue or EBITDA targets and other performance-related criteria that seek to align the interests of buyer and seller. To the extent future performance meets the mutually agreed targets, the buyer, having received additional post-closing benefits from the operation and use of the transferred assets, will pay additional consideration to the seller. Earnout terms may range over one, two, three, or more years depending on the assets or sector involved.

Earnout provisions usually require a post-closing arithmetic calculation that sets forth whether or not the seller has achieved the earnout targets and should be paid – for example, how much revenue or profit was earned during the prescribed earnout period. But these provisions also include “covenants” and agreements imposed on the buyer and integrated into the acquisition agreement. These covenants and agreements generally obligate a buyer to operate the business post-closing in a specified manner so that the seller has the opportunity to achieve the potential earnout – for example, an obligation of the buyer to operate the business in “good faith,” to refrain from taking actions with the intention of avoiding an earnout payment, to manage the business consistent with past practice, or to invest, market, or conduct business in accordance with a mutually agreed business plan. In many instances, these “earnout” covenants also require the buyer to provide the seller with information regarding post-closing operations that, in theory, should permit the seller to evaluate a post-closing earnout determination statement received from the buyer.

Who decides the meaning of “good faith”? Who decides whether a buyer has acted with the “intention” of avoiding an earnout? What is the meaning under Delaware law of “consistent with past practice”? How should access to information and personnel be addressed or compelled if a buyer delays or refuses? Should the meaning of “bad faith” under Delaware law, or a determination of whether substantial performance of an operating covenant has occurred, be left to a person or tribunal with no expertise in Delaware law? Should the question of whether a party has exercised “commercially reasonable efforts” be determined by a non-legal expert - an accounting firm or CPA, for example - if the contract specifies that it is governed by Delaware law?

While many earnout disputes revolve around “calculations,” what does it really mean to “calculate” financial metrics if the very achievement of those metrics is dependent on a buyer complying with critical covenants regarding the operation and conduct of a business? How can a decision maker undertake any kind of purported “calculation” if the predicate to that exercise requires a determination of whether the buyer acted in “bad faith” when operating the business, or failed to invest as agreed, or neglected to take “commercially reasonable efforts” to make the acquired business successful? As initially conceived many years ago, the shift of earnout and similar financial decisions to an independent auditor, expert or arbitrator presumed an accelerated, less expensive process that would offer the advantage of specialized knowledge delivered by an accountant or non-legal professional familiar with financial metrics. But that logic has been distorted over the years. How can it apply when the calculation may be fundamentally and inalterably affected and influenced by the breach of operating covenants and other contractual agreements that underpin the calculation? If a buyer has failed properly to operate a business, post-closing, how can any earnout or similar calculation be considered credible, reliable or otherwise derived from a legitimate set of underlying numbers? It cannot. Or when was it decided, as a matter of public policy, that a “financial expert,” “accountant” or other non-legally trained person should interpret and decide basic questions of Delaware contract law and offer unchallengeable conclusions regarding the application of Delaware legal principles?

Courts now frequently grapple with artificial distinctions between “expert” and “arbitration” proceedings. These distinctions, unfortunately, take on special significance when one considers that the determination to refer a matter to an “arbitrator” essentially eliminates a party’s ability to later contest or question that determination. The finality, and assumed binding nature of the arbitration proceeding, may be acceptable if the objective, unambiguous intention of the parties is clear and the competencies of the non-judicial decision-maker are fully understood; but if they are not, the “final, binding and conclusive” nature of that forced non-judicial proceeding, overseen by someone without the specific competencies the issues may require, is highly questionable. To eliminate access to the courts, and, potentially, appellate review is not an acceptable model for the resolution of contractual disputes, whether in the M&A context or otherwise, when the parties’ intent lacks clarity or, is, at best, “fuzzy.”

In a recent decision applying Delaware law, the Federal District Court for the District of Delaware addressed the question of whether a Share Purchase Agreement required that disputes be submitted to an accounting firm for a final, binding decision (Barnard v. Marchex, Inc., United States District Court for the District of Delaware, Decided: Feb. 2, 2024). In its analysis, the District Court relied on a recent Third Circuit opinion (Sapp. v. Industrial Action Services, LLC, 75 F.4th 205 (3d Cir. 2023), which concluded “that the provision at issue was not an agreement to arbitrate but was instead an agreement for an expert determination of narrow, accounting-related disputes.” In evaluating the dispute provision, the Third Circuit looked at the scope of the accounting firm’s adjudicative authority, which, in Sapp, the parties had purportedly “narrowed … to only accounting-related factual matters.” The Third Circuit also assessed the process incorporated into the transaction documentation. Was the timeframe for a decision suggestive of a truly deliberative process or indicative of a simple calculation exercise? Again, in Sapp, the Third Circuit determined that a “30-day deadline for the accounting firm’s decision was insufficient to perform” the role of an arbitrator. There were no procedural rules, “like those of the American Arbitration Association,” governing the accounting firm’s determination. And, lastly, consistent with general rules of contract interpretation, the Third Circuit looked at the entirety of the contract, finding “that in another provision of the agreement, the parties had agreed to non-binding mediation that did not preclude resolution through litigation if mediation was unsuccessful.” The Third Circuit effectively determined that substance trumps form when evaluating whether the parties’ actually intended to seek an “expert” opinion on a narrow-financially focused question or a definitive decision on a broader question by an arbitrator who would issue a final and binding determination subject to no further challenge. The very necessity for such an analysis leads to uncertainty and inconsistencies. And, the purported distinction in poorly crafted acquisitions agreements between an “expert,” an “independent accountant,” an “independent financial expert,” or an “arbitrator” is neither well delineated nor well understood by many of the M&A lawyers negotiating these transactions (and, at best, it is a provision rarely focused on in the midst of tense economic negotiations).

Many outside of Delaware now question the stability of Delaware law and the historic “consistency” that has typically driven counsel to rely on Delaware law for transactional matters. Significant uncertainties, however, exist regarding the interpretation and enforcement of alternative dispute mechanisms in Delaware-governed agreements, especially in connection with the application of those provisions to earnout arrangements. Transaction counsel should question the use of Delaware law when it may be entirely uncertain whether disputes or controversies affecting that agreement will be evaluated and decided by someone who has practiced Delaware law or someone wholly unfamiliar with basic principles of Delaware law. That uncertainty is highly problematic and is exacerbated by courts’ inclination to clear their dockets and to refer those kinds of matters to an alternative forum.

Absent an overarching, definitive framework established by the Delaware Supreme Court to address these uncertainties and inefficiencies, legislative changes are required. To ensure that legal disputes, controversies and issues are addressed by legally competent decision-makers, the Delaware General Corporation Law (DGCL) should be amended. The DGCL should lay out the specific circumstances in which disputed matters require a legal decision-maker and those situations in which the matter can be decided by someone who does not practice law. Toward that end, the following change to the DGCL, adding a new Section 111(c), would offer clarity, providing that:

“(c) The determination (i) of any matter, dispute or controversy involving, alleging or asserting the breach or non-performance of an agreement governed by, or intended to be interpreted or construed under, the laws of the State of Delaware, (ii) regarding the alleged violation or non-compliance by a person of the General Corporation Law of the State of Delaware with respect to any agreement referred to in clause (i), or (iii) regarding the application of equitable remedies, including specific performance, to an agreement referred to in clause (i), shall, in the case of each of clauses (i), (ii) and (iii), be exclusively determined by, or in, a court of law or equity applying the laws of the State of Delaware or by a person qualified to practice law in the State of Delaware or who otherwise, as a matter of such person’s professional experience, has provided, or is able to provide in the ordinary course of that person’s professional service, legal advice regarding or involving the laws of the State of Delaware. The provisions of this Section 111(c) shall apply to any agreement governed by the laws of the State of Delaware and referred to in clause (c)(i) of this Section 111 whether or not the terms or provisions of the foregoing agreement refer any matter, dispute or controversy to an expert, independent arbiter, arbitrator, accounting firm or other third person, unless the subject agreement specifically, unequivocally and objectively reserves, retains and allocates the right regarding a determination of any of the matters referred to in clauses (i), (ii) or (iii), to a person, forum or other tribunal that is not expressly designated by this Section 111(c).”

Contract interpretations requiring the application of Delaware law principles should not be decided by accountants, arbitrators, or other persons unable to practice or to opine on Delaware law absent a clearly stated, objectively discernible, unambiguous intent expressly set forth within the subject contract. If a court is unable to discern and identify that specific intent from the plain language of a Delaware-law governed agreement, the presumption of any court should not be, if and when the question or controversy arises, to refer the matter to an “expert,” arbitrator or other non-legal forum, but rather to retain jurisdiction and oversight of the matter. The most expeditious way to achieve that objective, and to ensure certainty and stability within the Delaware corporate governance framework, requires relatively modest modifications of the DGCL (and, quite simply, awareness of this important issue by M&A lawyers actually implementing these procedures in acquisition agreements).