Arbitration and other alternative dispute resolution (ADR) mechanisms are rarely used in private M&A deals to settle disputes other than purchase price and earn-out disputes. The present market is very clear on this point, so the idea of using arbitration to settle M&A disputes more generally is rarely even raised by either party in a deal. For example, the ABA’s most recent (December 2013) Private Target M&A Deal Points Study notes that only 15% of M&A agreements have a general ADR-type dispute mechanism, and based on our experience, even that seems quite high. This article explores whether it would make sense for sellers in private deals (and especially private equity sponsor sellers) to push for an increased use of arbitration in deals.
Over the past few years, especially since the onset of the great recession, perhaps coincident with increased cases of buyers’ remorse of different shapes and sizes, we have observed an increase in buyers pursuing post-closing indemnity claims for substantive claims that on the margin likely would not have been previously pursued. Deals that were modelled (and therefore priced) based on a certain level of projected EBITDA growth (which is, of course, a function both of the performance of the acquired business itself as well as the larger economy) tend to have a higher incidence of post-closing indemnity disputes when that projected level of EBITDA falls short (which has occurred more frequently over the past few years, compared to the period before the great recession). In a deal with a private equity sponsor seller, buyers of all types also now appear to be increasingly cognizant of the leverage they may have in post-closing disputes with a private equity sponsor seller most focused on maximizing its IRR (which is determined based on both the amount and timing of payments). A dragged-out and messy litigation process that may take several years to resolve will almost inevitably drag down anticipated IRR from the sale deal and as a practical matter may need to be reported to the limited partners of the applicable funds. As the holding period of portfolio companies has increased for private equity funds over the last several years, the need for sponsors to demonstrate cashon-cash returns in connection with a planned fund-raising process for a “next fund” has increased and buyers also certainly sometimes sense this. Sponsor sellers therefore may often be inclined to settle post-closing disputes even if in their “heart of hearts” they do not believe the buyer’s claims have any merit. In this environment, sponsor sellers may be better served if their post-closing disputes can be resolved through a more timely and streamlined arbitration process, rather than through a long and burdensome litigation process (or at least the threat of such a process). By briefly discussing the primary attributes of arbitration compared to litigation in the M&A context, this article explores whether sponsor sellers would be prudent to consider negotiating for arbitration covering a broader scope of post-closing private M&A disputes, rather than limiting arbitration to purchase price and earn-out disputes.
Specific Considerations for Dispute Resolution in M&A Deals
The parties to M&A agreements need to consider what forum will be used to settle their disputes. Typically neutral accounting firms (either a specific firm or by a specific process) are selected in an M&A agreement to settle ordinary course post-closing price adjustments, most typically working capital adjustments. Similarly, earn-out disputes are typically also resolved in the same manner and parties have become comfortable with this approach over time based on the particular expertise that accounting firms have in these areas. Indemnity disputes are often of a very different nature, as the resolution of an indemnity dispute may well rest on pre- or post-closing facts being applied to contract language for representations and warranties or covenants, all of which may be unclear and subject to various interpretations. The perception of the utility of arbitration varies dramatically from sponsor to sponsor. Merely raising the issue of potentially using arbitration more generally in a purchase agreement often elicits strong views from investment professionals at sponsors: while some are entirely ambivalent, others believe the process almost inevitably leads to an unprincipled “splitting of the baby” type resolution that is too difficult to handicap as to whether it is likely to be in their interest (or not). Therefore, some sponsor investment professionals may well be open to raising the increased use of arbitration as a possibility, while others will inevitably prefer to stick with the existing clear market position of using arbitration only within its present limited role.
Faster, Cheaper and Final
Arbitration matters are generally resolved faster (i.e., often decided within a matter of months, rather than over several years) and for less cost than if the same disputed substantive matters were litigated. Arbitration proceedings generally have a more streamlined procedural and pleading process, limited discovery, shorter hearings than a trial, fewer expert witnesses on balance, and decisions that are not subject to a full-blown appeal process and are instead subject to limited judicial review under the Federal Arbitration Act. Parties that agree to the relative finality of arbitration are by definition accepting the structural risk that an arbitration decision that is substantively incorrect will not be freshly reviewed by another neutral party that a litigation system affords through its appellate process.
While the great majority of private M&A indemnity disputes are settled, some do result in public litigation (with some public records), while arbitration can be conducted confidentially outside of the court system. For private equity participants, the privacy of arbitration provides a clear advantage over the public nature of litigation.
Selection of the Arbitrator
In a private M&A agreement, the parties may agree to use an arbitrator or numerous arbitrators, through various mechanisms, to settle the purchase agreement disputes. The parties are free to specify the number, qualifications and location of the arbitrators, which are located in all major commercial cities. For example, requiring an arbitration before such organizations as the American Arbitration Association (AAA), JAMS, International Chamber of Commerce (ICC) and the International Institute For Conflict Prevention & Resolution (CPR) can all be specified in the agreement, and model arbitration provisions (with numerous options) for specifying the arbitrator are readily available. In the litigation context, judges are most commonly former litigators, but M&A parties may prefer (or not prefer) to use an arbitrator who is from the private M&A deal world and conversant in the practices, realities, expectations and terms of art from that world, such as the use of materiality scrapes, pro- and anti-sandbagging provisions, items that are “deemed” disclosed on all schedules, tipping baskets, deductibles, having different classes of indemnity caps for different classes of representations, de minimus/mini-basket exclusions and the like.
Although these arbitration organizations all have their own set of default rules, these rules act more like guidelines, rather than hard and fast rules and they may be altered with the agreement of both parties. At the beginning of an arbitrated dispute, the parties are free (and generally much freer than would be possible in a litigated dispute before a court) to work with the arbitrator to craft a more specific process to fit the facts of the dispute that limits discovery, and the use of experts, etc. Of course, at such time the parties may have varying interests and such a mutually crafted approach may not then be feasible, in which case the default rules would instead apply.
Arbitration may well make sense for some sponsor sellers to consider using more broadly than they have in the past for M&A deals. While it is now rare to provide for arbitration as the means to resolve general disputes arising out of purchase agreements in the private M&A market, it may be timely for sponsor sellers that have experienced an unsatisfactory recent post-closing dispute process to consider using arbitration more broadly.