M&A transaction agreements often contemplate a post-closing “true-up” payment between the parties to account for the difference between the target company’s actual closing working capital and its estimated pre-closing working capital that was assumed in the negotiation of the purchase price. After the closing, the buyer and seller often invest significant time and effort into calculating post-closing working capital, since the final outcome can have a significant financial effect on each party. If the parties are unable to agree on the final calculation of the closing working capital, most transaction agreements include a provision that requires the dispute to be submitted to an accounting firm that is empowered by the transaction agreement to act as an arbitrator who then makes the final, binding determination of the amount of the closing working capital. The instructions to the auditor in the transaction agreement for resolving such disputes are generally not heavily negotiated, and as a result drafters often default to giving the arbitrator open-ended authority to determine the correct amount of closing working capital. One alternative that can serve to minimize post-closing disputes is to require the arbitrator to select either the buyer’s or the seller’s calculation of closing working capital – often referred to as “baseball” arbitration.
A transaction agreement that provides for traditional arbitration offers the arbitrator the freedom to make its own determination of closing working capital, often subject to the limitation that the amount be between the amounts calculated by the buyer and seller. In addition, the transaction agreement typically provides that the arbitrator’s costs in traditional arbitration are either split 50/50 between the parties or in a manner proportionate to the proximity of the arbitrator’s decision to the calculations submitted by the buyer and seller. For example, if the buyer submits to the arbitrator a working capital calculation of $1 million and the seller submits a calculation of $5 million, and the arbitrator determines the working capital amount to be $4 million, the buyer would pay 75 percent of the arbitrator’s fees ($4 million representing 75 percent of the difference between $1 million and $5 million), and the seller would pay 25 percent. Depending on the size of the working capital dispute, these expenses can be substantial, ranging anywhere from $25,000 to more than $100,000, subject to the complexity of the arbitration and the arbitrator’s fees incurred in connection with conducting the arbitration.
In baseball arbitration (also called “win/lose” arbitration, among other similar terms), the arbitrator has far less discretion to determine the closing working capital. The arbitrator is required to choose either the buyer’s or the seller’s calculation and is not free to choose or make any other calculation. In the example above, under baseball arbitration rules, an arbitrator would be bound to choose either the buyer’s position ($1 million) or the seller’s position ($5 million). The arbitrator’s costs follow suit: If the arbitrator chooses the buyer’s position, the seller pays 100 percent of the costs; if the arbitrator chooses the seller’s position, the buyer must pay 100 percent of the costs.
Incentives in Arbitration
All things being equal, the use of traditional arbitration in a working capital dispute is considered more seller-friendly and baseball arbitration more buyer-friendly. This difference in preference is because sellers often prefer traditional arbitration since it opens the possibility of “splitting the difference.” Even if the seller knows $5 million is an unreasonable figure, he or she might submit it to an arbitrator, hoping that the arbitrator picks a figure that is at least marginally higher (if not much higher) than $1 million. Indeed, traditional arbitration can incentivize a seller to provide an initial calculation of working capital that is as high as the seller can (credibly) defend. By contrast, choosing baseball arbitration is, in our experience, much more likely to compel reasonableness between the buyer and seller with regard to their respective calculations. Both have less of an incentive to make an unreasonable calculation because doing so makes it less likely that the arbitrator will choose their position and because they face the possibility that the losing party will have to pay the arbitrator’s fees.
Perhaps more importantly, because neither the buyer nor the seller can be fully sure of an arbitrator’s final decision – no matter how unreasonable their own or the other party’s calculation may seem – the mere existence of the concept of baseball arbitration in a transaction agreement can serve as a disincentive to allowing a working capital dispute to go to arbitration in the first place. Because this uncertainty is shared between the buyer and seller, they are more likely to seek common ground and settle before arbitration becomes necessary.
While baseball arbitration is becoming an increasingly common and popular alternative for working capital dispute mechanisms in transaction agreements, it is nonetheless important to understand the incentives underlying its importance. Whether or not traditional arbitration has been your historically preferred mechanism of choice, considering “playing baseball” may be well worth your while.