M&A disputes and expert determination: getting to grips with the issues

Practical Law UK Articles 4-502-2504 (Approx. 8 pages)

M&A disputes and expert determination: getting to grips with the issues

by Balz Gross, Homburger

Closing accounts and expert determination

Modern M&A agreements often provide that the final consideration amount is to be determined using the financial figures that are accurate at the closing date. This usually involves:

Payment by the seller of a preliminary payment at closing, which is based on an estimated transaction value, in turn based on the previous year's financial statements.
Further adjustment of this preliminary payment once the financial statements as per the closing date (the closing accounts) are available. This adjustment may involve an additional payment to the seller, or a repayment to the buyer.

In practice, the closing accounts also serve as a basis for other claims under the M&A agreement, in particular for representation and warranty claims, or for fraud or deception claims. As a result, the closing accounts have a considerable impact on the value of the transaction for both parties. They are, however, necessarily established by one party and its advisers only.

M&A agreements usually provide for a right to object to the closing accounts, followed by a short time period during which the parties endeavour to resolve their dispute amicably. If this is not possible, a mechanism to deal with disputes concerning the accuracy of the closing accounts is necessary.

Disputes over the closing accounts regularly focus on the application of agreed accounting standards and are, therefore, considered largely technical. Accordingly, expert determination clauses provide that the parties can refer the dispute to an independent expert for final determination. The independent expert (or appraiser) then independently establishes the closing accounts on behalf of both parties. According to the expert determination clause, the expert's determination shall be final and binding.

The expert's power is usually limited to determining:

Whether specific items of the closing accounts (that are disputed by the party who did not prepare them) are accurate. If they are not accurate, the expert determines what alterations are to be made to the closing accounts to correct any inaccuracies.
The adjustments that must be made to the (preliminary) consideration.

The expert determination clause may also state certain procedural rules. In particular, it may impose an obligation on both parties to provide the expert with all documentation and information relevant to the establishment of the closing accounts.

Rules governing expert determination

Expert determination is a well-established feature of many jurisdictions. Under Swiss law, expert determination is possible both in state court proceedings and in arbitration proceedings. The expert determination can occur before, during or independent of legal proceedings.

As expert determination clauses are not arbitration clauses, their validity and enforceability are not governed by international or domestic arbitration laws, but, in principle, by rules of contract only.

The Swiss courts and arbitral tribunals sitting in Switzerland generally enforce a parties' agreement where it provides for expert determination and recognise the binding nature of such determinations. The courts also apply certain standard rules that have developed on the requirements of expert determination. The new Federal Civil Procedure Code, which governs all civil proceedings in Switzerland as from 1 January 2010, has adopted these rules. The only new requirement imposed by the legislation is that an expert determination clause must be in written form.

Unlike in arbitration, there is no need for the expert to be a natural person. The expert can be a company, such as a large accounting firm. Whether company or natural person, the expert must be as impartial and independent as an arbitrator. In addition, the procedure followed by the expert must comply with the basic requirements of due process and the right to be heard.

The expert finally and definitely determines certain facts or even legal issues. The expert's determination is binding on the parties and on the arbitral tribunal (or state court) in subsequent legal proceedings. There is no binding effect, however, in any of the following cases:

If the expert lacked independence and impartiality.
If the procedure used violated the principles of due process and the right to be heard.
If the expert's determination is manifestly incorrect.

Even though the determination is binding, it does not have a res judicata effect and cannot be enforced (as it is not a judgment). There are no direct legal remedies against an expert determination (apart from a damages claim against the expert), and it cannot be appealed.

As a result, whether the determination is actually binding can only be determined in independent subsequent legal proceedings in which the expert's determination is a factor in the tribunal's decision making process. In these subsequent legal proceedings, the arbitral tribunal (or state court judge) will decide whether it is bound by the expert's determination or not.

Subsequent legal proceedings are begun under the general dispute resolution clause of the M&A agreement if either:

The expert determination is not voluntarily implemented. In relation to a dispute over closing accounts, for instance, a party should commence arbitration (or court) proceedings if it wishes to enforce a right to payment that has arisen as a result of an expert determination.
One or both parties claim that the determination is not binding. In this event, proceedings should be commenced quickly to declare that the determination is not binding. If a party fails to make a timely objection and commence proceedings, the tribunal (or court) may find that the right to object has been waived, and that it is no longer competent to review the finding.

If arbitration proceedings are commenced and the arbitral tribunal finds that the expert's determination is binding, it will base its award on that determination. If it finds that the determination is not binding, it must make its own determination. In particular, in the case of closing accounts, the arbitral tribunal will have to establish the correct accounts and the amount of final consideration to be paid.

In practice, the arbitral tribunal (or court) will often try to cure any defects in the expert determination, unless the flaws of the determination are so fundamental that this is not possible.

Problems with expert determination

A number of problems can arise in relation to expert determinations. For example:

It may be difficult to determine whether a clause in the agreement actually amounts to an expert determination clause.
Problems concerning scope of application can arise where an agreement contains two types of dispute resolution clause (that is, a general dispute resolution clause and an expert determination clause).
There may be difficulties in ensuring that the expert determination adheres to procedural requirements.
Legal issues tend to arise on an expert determination, and such issues are likely to be beyond the expert's competence.
If an arbitral tribunal (or court) decides it is not bound by the expert determination, the entire determination may need to be conducted again, which results in the repetition of proceedings and delay.

Nature of the clause

An expert determination clause may not always be clearly phrased. At times it may be difficult to tell whether a dispute resolution clause is an arbitration clause or an expert determination clause. State courts have held that the nature of the clause (expert determination or arbitration) cannot be determined based on the wording of the clause alone. The parties' intentions, rules on the costs of the expert determination, and the procedure followed by the expert must also be taken into consideration.

If the nature of the clause is unclear, and arbitration proceedings are brought after an expert determination has been made, there is a risk that the arbitral tribunal may determine that the expert in fact gave a binding arbitral award, and that the tribunal cannot re-visit the matter under the principle of res judicata.

Scope of application

Even if it is clear that the M&A agreement contains a true expert determination clause, the existence of two different dispute resolution methods in one M&A agreement may lead to problems with determining the scope of application of each clause in relation to the other.

If a matter that has been determined by an expert subsequently goes to arbitration (or litigation), the tribunal may find it difficult to determine those elements of the expert's decision it should be bound by, and those it is free to determine itself. In the case of a determination of the final accounts, for instance, while it may be clear that the arbitral tribunal is to be bound by the expert's determination of the main issue (the valuation), it may be less clear whether the tribunal should be bound by the expert's decision on other matters (for instance, the final consideration amount, which may involve contract interpretation).

Procedural requirements

The procedure involved in an expert determination must comply with the basic requirements of a fair proceeding. It must respect the parties' rights to be heard and the rules of due process. These requirements can, however, give rise to problems:

First, the expert is chosen for his expertise in accounting (or other technical) matters, rather than for legal expertise. As a result, the expert is inevitably not qualified to conduct a proceeding according to the requirements of due process and grant the parties their right to be heard.
Second, the expert is neither an arbitrator nor a judge. The expert will not have the necessary legal tools at hand to properly conduct a proceeding and make the parties observe the rules. In particular, the expert cannot force a reluctant party to comply with the expert's and the other party's requests relating to, for instance, the submission of comments, attendance at the hearing, the production of documents or the granting of access to data and persons.

Therefore, there is a considerable risk that the expert's conduct of proceedings will not withstand the scrutiny of an arbitral tribunal or court, or that the proceedings themselves are derailed by an obstructive party.

Legal issues

While it is mostly intended that the role of the expert be limited to the application of technical standards such as accounting rules, the expert is often confronted with questions of a legal nature. For instance, it may be necessary to construe and interpret the M&A agreement to establish the closing accounts. The expert may have to determine the proper definition of debt, working capital, cash and so on.

In addition, there are preliminary questions of a legal nature that must be answered to establish the closing accounts (for example, the assessment of legal risk in connection with threatened or pending proceedings must be assessed to define the amount of an accrual and so on).

As a result, standard M&A agreements often provide that the expert has competence to decide legal disputes in connection with the establishment of factual matters such as the closing accounts. In this role, in addition to being able to decide preliminary legal questions, and construe and interpret the agreement, the expert can also fill in gaps in the agreement (for example, if the parties have omitted to provide a definition without which the closing accounts cannot be established).

There are three main problems that arise if the expert is given authority to decide legal issues:

First, as mentioned above, the expert inevitably is not a legal expert and not fully qualified to decide legal issues.
Second, the proper determination of legal issues may only be possible if evidence beyond the accounting documentation is gathered and assessed. For example, the interpretation of a contract term may require that witnesses be heard, and that correspondence and drafts of the agreement be reviewed. However, the expert is usually not willing to conduct an evidence-taking procedure. In addition, the expert often lacks the procedural know-how to conduct it properly. If a decision on legal issues is made based on insufficient facts, it is not binding.
Third, it is unclear whether and to what extent an expert's decision on pure legal issues can bind an arbitral tribunal (or court) under applicable rules. In any event, a tribunal will be more willing to overrule an expert's legal decisions than his (accounting or technical) determinations. In addition, a tribunal is not bound by a decision on legal issues if the tribunal has new or different evidence, in particular if the expert did not conduct a full evidence-taking procedure relating to these issues, as is almost always the case.

The issues related to an expert's legal determinations have consequences for the expert's technical determination, as legal issues are often preliminary questions on which the expert's technical determination is based. As a result, if the expert's decisions on legal issues are not binding, all of the expert's decisions may be open to re-determination.

Non-binding determinations

If one of the parties to the expert determination proceedings is not willing to accept the findings, then the arbitral tribunal (or court) needs to determine whether it is bound by the expert's findings or not. Accordingly, the tribunal will have to look into the expert's independence and impartiality and into the procedure followed by the expert.

The arbitral tribunal will also have to review the correctness of the determination as such and determine whether it is "manifestly" incorrect. To do so, the tribunal may need to obtain third party accounting expertise, with the result that the proceedings undertaken by the expert are partially repeated.

Resolving the problems

While expert determination of technical or valuation issues has its advantages, it can give rise to problems, as set out above. These problems can delay the resolution of any dispute between the parties and distort the proceedings, making them overly complicated and costly.

One way to avoid potential problems is to provide for mandatory arbitration proceedings if the parties do not agree on a technical issue such as the closing accounts. The arbitral tribunal's tasks then mainly consist of appointing an expert and providing the legal and procedural framework for the expert to properly make a binding determination. Such an arbitral tribunal can:

Appoint the expert if the person nominated in the agreement is unavailable and the parties disagree on who should be appointed in his place.
Replace an expert who becomes unavailable or unfit.
Decide preliminary legal questions in connection with the establishment of the drawing up of the closing accounts.
Assist in the preparation of the expert's report, in particular by:
- giving guidance on procedural issues or conducting the proceedings;
- requiring parties to assist the expert, produce evidence or provide information;
- deciding on the consequences of a party's refusal to comply with a request, in particular by making negative inferences.
Make the expert's mandate more precise, or even amend it if the parties' original agreement on expert determination no longer fulfils the needs of the parties.
Cure defects in an expert's determination by giving a party its right to be heard, have the parties provide additional facts and so on.

The involvement of the arbitral tribunal may avoid most procedural problems that arise in expert determinations.

In practice, however, parties are usually willing to make use of expert determination proceedings without the assistance of parallel arbitration proceedings, given the advantages it can provide (such as speed and efficiency). In these circumstances, the M&A agreement should be structured so that each party has the right to commence arbitration proceedings at any time, but there is no requirement to do so. The agreement should provide that:

If the parties are not able to amicably resolve their dispute on a technical matter (for instance, with regard to the closing accounts), each party can refer the matter to an expert.
Both parties have the right to refer the matter to arbitration at any time during the expert determination proceedings.

If a request for arbitration is submitted before the terms of engagement of the expert are finally agreed, then the arbitral tribunal should be constituted before the expert determination proceedings continue. The expert then provides his determination within the arbitration proceeding, and holds a position that is similar to the position of a tribunal-appointed expert.

If the request for arbitration is submitted after final agreement on the expert's terms of engagement, it will not stop the expert determination proceedings, but will run in parallel. The arbitral tribunal can still assist the expert in his proceedings, and the arbitration proceedings can be tailored so that the expert's determination can be used in the hearing and for the award.

It is possible to combine expert determination in such a way with both litigation and arbitration proceedings. However, because of the flexible nature of arbitration proceedings, it is easier to combine expert determination and arbitration proceedings, and the results are more predictable.

M&A disputes and expert determination: getting to grips with the issues | Practical Law