Sapp v. Indus. Action Servs., LLC, No. 22-2181 (3d Cir. 2023) [click for opinion]

In 2015, Kevin Sapp and Jamie Hopper sold two companies to Industrial Action Services LLC ("IAS"). The sale was governed by an asset purchase agreement, which provided that, as consideration for the sale, Sapp and Hopper would receive (1) a $12 million payment at closing; (2) $1.5 million in stock; (3) $3 million in deferred compensation; and (4) three potential and variable payments, called Earn Out Consideration, if IAS performed well over the following three years.

At issue here was the Earn Out Consideration, under which Sapp and Hopper could earn an additional $15 million—up to $5 million in each of three twelve-month Earn Out Periods—if the post-merger company achieved certain EBITDA benchmarks. The asset purchase agreement provided that the IAS computation for an Earn Out Period would become final unless Sapp and Hopper submitted a "notice of disagreement" within 30 days of receiving IAS's computation.

If Sapp and Hopper sent such a notice to IAS, Sections 2.3(e) and 2.6(d) of the asset purchase agreement provided that the disagreement would be settled through negotiations, and if those negotiations were unsuccessful, by submission of the disagreement to an independent accounting firm. However, the asset purchase agreement also contained other dispute resolution provisions, including one in Section 11.17, that directed the parties generally to use non-binding mediation followed by litigation.

IAS later determined that the post-merger company did not meet its EBITDA targets for any of the three Earn Out Periods. In response, Sapp and Hopper claimed that IAS intentionally undermined the business to prevent the company from hitting those targets. Negotiations failed, and Sapp and Hopper filed a lawsuit in Texas state court (which was then removed to a Texas federal court and then transferred to a Delaware federal court). Four months after bringing suit, Sapp and Hopper submitted a "notice of disagreement"—to avoid waiving any rights—but sought a declaratory judgment that the claims in the lawsuit fell outside the dispute resolution provisions in Sections 2.3(e) and 2.6(d).

IAS sought to compel arbitration and stay the district court proceeding. The district court referred the dispute to a magistrate judge, who concluded that the section calling for determination by the accounting firm called for an expert determination, not an arbitration. As a result, the magistrate judge recommended that the district court deny the motion to stay pending arbitration.

The district court disagreed, holding that the asset purchase agreement contained a valid agreement to arbitrate, and compelled arbitration. Arbitration proceeded, and an accounting firm issued a decision in IAS's favor, determining that no adjustments to the EBITDA calculation were required under the asset purchase agreement and that Sapp and Hopper had no right to any Earn Out Consideration. Sapp and Hopper moved to vacate the award, but the district court denied their motion and entered judgment for IAS. Sapp and Hopper appealed that decision.

On appeal, the Third Circuit first discussed the differences between arbitration and expert determination. While both are alternative dispute resolution procedures that produce binding results, they differ in the type and scope of authority being delegated by the parties to the decision maker. 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, who functions like a judge, can then award a legal remedy. Unlike arbitrators, experts have specialized knowledge and are appointed by parties to decide narrower issues using a less formal process. Experts do not have authority to make binding decisions on issues of law or legal claims and their decisions are made without following court-like procedures.

In determining whether a party may be compelled to arbitrate, a court must consider (1) whether there is a valid agreement to arbitrate between the parties, and if so, (2) whether the merits-based dispute in question falls within the scope of that valid agreement. Here, the parties did not provide a label for the dispute resolution process to which they had agreed. Accordingly, the Third Circuit considered the language and structure of the asset purchase agreement to ascertain that the parties intended to have the third-party accounting firm act narrowly as an expert and not as an arbitrator.

In support of this decision, the court first considered the narrow scope of the authority granted to the accounting firm, which could decide only whether the financial statements were prepared in accordance 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 considered the short timeline—30 days—for the accounting firm to make its decision, which was deemed insufficient to perform the "broad-based investigation" that an arbitrator would normally undertake. Third, the court considered that there were no governing procedural rules for selecting the decision maker, conducting discovery, submitting briefing and evidence, or holding a merits hearing, which are ordinarily part of a party's agreement to arbitrate. Fourth, the court considered that the inclusion of the dispute resolution procedure in Section 11.17 undermined any contention that the process outlined in Section 2.3(e) and 2.6(d) was a true arbitration.

All of these considerations indicated that the parties intended the accounting firm to be an expert, not an arbitrator. The Third Circuit therefore reversed the district court's decision compelling arbitration, vacated its entry of judgment, and remanded the matter for further proceedings.

Allie Stackhouse of the Los Angeles office contributed to this summary.