Introduction: Third Circuit’s Ruling on Expert-Determination Clauses Versus Arbitration Clauses
Not every dispute resolution clause contained in a contract is an arbitration clause, let alone an arbitration clause governed by the Federal Arbitration Act (“FAA”). Absent a statute stating otherwise, dispute resolution clauses that are not arbitration agreements must be enforced via ordinary contract-law rules only, not through FAA- or state-arbitration-statute-authorized motions to compel arbitration, motions to stay litigation pending arbitration, or motions to confirm, vacate, or modify awards.
The U.S. Court of Appeals for the Third Circuit recently decided a case that turned on whether the dispute resolution clause in the contract was an arbitration clause, or simply a contractual provision calling for resolution of an issue by experts, sometimes referred to as an “expert-determination provision[,]” slip op. at 14, or “expert-determination clause.” In Sapp v. Indus. Action Servs., No. 22-2181, slip op. (3d Cir. July 20, 2023) the Court held that the clause before it was not an arbitration agreement, but an expert clause and consequently reversed the district court’s decision to compel arbitration and vacated the Court’s order granting the motion to confirm the expert’s decision and denying the motion to vacate it. Slip op. at 3, 19.
Whether or not you are—in a particular case—advocating for or opposing arbitration, Sapp demonstrates how important it is to make an early determination as to whether the alternative dispute resolution clause at issue is, in fact, an arbitration agreement whose enforcement is governed by the FAA or a state arbitration statute.
Another point about Sapp is that its interpretation of the Federal Arbitration Act is arguably more narrow than that of the Second Circuit. The Second Circuit has said that a dispute resolution provision otherwise falling under Section 2 of the FAA is an “arbitration agreement” for purposes of the FAA, including an “appraisal” provision in an insurance contract. The test is whether the dispute resolution provision “clearly manifests an intention by the parties to submit certain disputes to a specified third party for binding resolution.” McDonnell Douglas Finance Corp. v. Pennsylvania Power & Light Co., 858 F.2d 825, 830 (2d Cir. 1988); Bakoss v. Certain Underwriters at Lloyds of London Issuing Certificate No. 0510135, 707 F.3d 140, 143 (2d Cir. 2013). That dispute resolution clauses, such as appraisal clauses, typically do not use the term “arbitration” is of no moment—all that counts “is that the parties clearly intended to submit some disputes to their chosen instrument [e.g., appraisal] for the definitive settlement of certain grievances under the Agreement.” Id. (quotations omitted); see Bakoss, 707 F.3d at 143. (See also Arbitration Law Forum post here.)
The reason for this difference is most likely because, as we shall see, Sapp ruled that state law—specifically, that of Delaware—not federal common-law, governs what constitutes an arbitration agreement for purposes of the FAA. See Slip op. at 12-16. In the Second Circuit, however, federal common-law governs that question. See Bakoss, 707 F.3d at 143.
Background
The case arose out of a dispute concerning an asset purchase agreement (“APA”), involving the sale of two companies to an acquiring company, which was formed to facilitate the merger transaction and act as the post-merger company. The acquiring company was the wholly-owned subsidiary of another company (the “acquiring company’s parent”).
The APA said that the sellers would receive a $12 million payment at closing, $1.5 million in stock of the acquiring company’s parent, deferred compensation of $3 million, and three possible payments of “Earn Out Consideration,” which would be paid if the acquiring company’s performance over a three-year period met certain standards. Slip op. at 4. The Earn Out Consideration could be as high as $15 million, i.e., $5 million per annual period, depending on whether acquiring company achieved certain benchmarks based on earnings before interest, taxes, depreciation, and amortization (“EBITDA”). Id.
The APA provided a mechanism for stating and disputing Earn Out Consideration. Ninety days after the close of a 12-month Earn Out period the acquiring party had to distribute an “Earn Out Statement” setting forth the buyer’s EBITDA calculation for the period. Slip op. at 4-5. If the sellers did not object within 30 days, then the calculation would be deemed final.
Although “notice of disagreement” was not capitalized in this part of the agreement, “Notice of Disagreement” (in initial caps) was defined in another part of the contract as “including only ‘disagreements which are based on the Statement not having been prepared in accordance with this Section . . . or which are based on mathematical errors.’” Slip op. at 5 (quoting App. 84).
The APA stated that, if a timely notice of disagreement was sent, “the disagreement would ‘be settled according to the procedures set forth in Section 2.3(e)’ of the [APA].” Section 2.3(e) states:
If a Notice of Disagreement is received by Buyer in a timely manner, then the Statement (as revised in accordance with this sentence) will become final and binding upon Buyer and Sellers on the earlier of (A) the date Buyer and [Sellers] resolve in writing any differences they have with respect to the matters specified in the Notice of Disagreement, or (B) the date any disputed matters are finally resolved in writing by the Accounting Firm. During the 60-day period following the delivery of a Notice of Disagreement, Buyer and [Sellers] shall meet and work in good faith to resolve any differences they may have with respect to the matters specified in the Notice of Disagreement. During such period, the Sellers shall give Buyer and its auditors, accountants and advisors reasonable access to all working papers and other documents of the Sellers and its auditors, accountants and advisors, to the extent used in connection with the Notice of Disagreement. At the end of such 60-day period, Buyer and the Sellers shall submit to an independent accounting firm (the ‘Accounting Firm’) for resolution of any and all matters that remain in dispute and were properly included in the Notice of Disagreement. The Accounting Firm will be Ernst & Young or, if such firm is unable or unwilling to act, a nationally recognized independent public accounting firm as shall be agreed upon by the parties. Buyers and the Sellers agree to use commercially reasonable good faith efforts to cause the Accounting Firm to render a decision resolving the matters submitted to the Accounting Firm within 30 days. Judgment may be entered upon the determination of the Accounting Firm in any court set forth in Section 11.6.
Slip op. at 6-7.
In addition, Section 11.17 of the APA, an additional dispute resolution provision, “directs the parties generally to use non-binding mediation, followed by litigation if mediation fails.” Slip op. at 6-7.
The Litigation: Expert-Determination or Arbitration?
The acquiring company submitted the required Earn Out Consideration reports which purported to show that the acquiring company had failed to meet the prescribed EBITDA benchmarks for the three annual periods. The sellers claimed that acquiring company “intentionally undermined the business to prevent the [acquiring] company from hitting the EBITA targets,” an alleged “violation of. . . [APA] § 2.6(g), which prohibits [the acquiring company]. . . from ‘taking any action designed to circumvent payment of Earn Out Consideration.’” Slip op. at 7 (quoting App. 87). These claims were communicated to the buyer via letters, email correspondence and phone calls.
After discussions failed to resolve the dispute, the sellers filed suit in a Texas state court, asserting breach of contract, tortious interference, and a claim for declaratory relief. The case was removed on diversity grounds to the Southern District of Texas and subsequently transferred to the District of Delaware pursuant to the APA’s forum selection clause.
Four months after commencing litigation, the sellers, to reserve their rights, submitted a Notice of Disagreement under APA § 2.6(d). They also requested a declaratory judgment that the matters in the lawsuit were outside the scope of the APA’s dispute resolution provisions concerning Earn Out Consideration.
The buyers moved to compel arbitration and stay litigation. The court referred the motion to a magistrate judge, who issued a Report and Recommendation (“R&R”) recommending that the motion be denied because, under Delaware law, APA §§ 2.3(e) and 2.6(d) called for dispute resolution by expert-determination, not arbitration. But the District Court sustained the buyer’s objections to the R&R, ruled that the APA contained a valid arbitration agreement, compelled arbitration, and stayed litigation.
After the motion to compel was granted the parties set about selecting the accounting firm decision maker. Ernst & Young could not serve because it had a conflict of interest and the parties agreed Eisner/Amper LLP would serve as the accounting firm. Eisner/Amper in turn assigned two CPAs, CPA L and CPA A.
CPAs L and A issued a decision upholding the acquiring company’s position. It stated that the APA did not require any adjustment to the Earn Out Commission calculations and the sellers had no right to Earn Out Commission. The Sellers moved to vacate and buyers opposed the motion (presumably by moving to confirm). The district court denied the motion to vacate and entered judgment for the acquiring company. The appeal to the Third Circuit followed, which brought up for review both the final order and the interlocutory order compelling arbitration.
Third Circuit Explains the Difference between Arbitration and Expert-Determination
The Third Circuit acknowledged that expert-determination and arbitration share some similarities, and that both produce binding outcomes. Slip op. at 10. The Court said the key difference is “the type and scope of authority that is being delegated by the parties to the decision maker.” Slip op. at 10 (quotation and citation omitted).
“[A]rbitration,” the Court explained, “occurs when the parties intend to delegate to the decision maker authority to decide all legal and factual issues necessary to resolve the matter.” Slip op. at 10 (citation and quotation omitted; cleaned up). The arbitrator “functions like a judge in a judicial proceeding[,]” slip op. at 10 (citation and quotation omitted), in the sense that the arbitrator is not permitted to meet with either party without the other present, must hear argument only in the presence of all parties, and is required to “afford parties the due process protections of adversarial proceedings.” Slip op. at 11 (citation omitted). After resolving “all factual and legal questions in a formal process that mirrors a judicial proceeding,” the arbitrator may “award a legal remedy,” which a court can enforce. Slip op. at 11.
The Court said in expert-determination, the experts decide “narrower issues using a less formal process.” Slip op. at 11. Ordinarily, the parties appoint an individual or entity having specialized, technical knowledge “to determine a confined issue.” Slip op. at 11. The expert is authorized “to use its specialized knowledge to resolve a specified issue of fact, but not to make a binding determination of legal questions or “legal claims.” Slip op. at 11 (citation and quotation omitted).
Experts make their decisions without following “court-like procedures[,]” such as using pleadings, taking testimony, or holding evidentiary hearings. Slip op. at 11 (citation omitted). Instead of relying solely on evidence offered by the parties, experts may conduct independent investigations, and request from the parties what information they require to make their factual determination. Slip op at 11 (citation omitted).
As was the case here, accounting firms are often used as experts to resolve “questions about post-merger financial schedules.” Slip op. at 11 (citation omitted).
The Third Circuit Finds that the Dispute Resolution Clause at Issue was an Expert-Determination Provision, not an Arbitration Agreement
Whether the parties agreed to arbitrate is, the Court said, governed by state law, and under Delaware law, intent is discerned, in the first instance, by the language the parties used to express their agreement. See slip op. at 13-14. But the parties’ agreement was not labeled “arbitration agreement,” did not refer to the decision makers as “‘arbitrators’” or ‘experts, not arbitrators[,]” and otherwise was bereft of any express indication as to whether the parties intended to agree to arbitrate or had agreed to expert-determination. Slip op. at 13.
Accordingly, the Court had to make its determination by “[l]ooking at the language and structure of the” APA. Slip op. at 13. Based on APA language and structure, the Court concluded that “the parties intended to have the third-party Accounting Firm act narrowly as an expert and not as an arbitrator.” Slip op. at 13-14. The Court proceeded to discuss four reasons supporting its conclusion.
These “four characteristics of the [APA][,]” said the Court, “show that the parties agreed to (1) expert determination by the Accounting Firm of narrow accounting-related questions and (2) mediation and litigation of all other disputes.” Slip op. at 16.
Reason 1: The Narrow Scope of Authority Delegated to the Accounting Firm
Noting that an arbitration agreement “ordinarily encompasses the disposition of the entire controversy between the parties,” and an expert-determination provision “extends merely to resolution of specific issues[.]” with “all other issues being reserved for determination in a plenary action[,]” the Court said the narrow scope of delegated authority indicates that the parties intended the dispute resolution provision to be one for expert-determination, not arbitration. Slip op. at 14 (quotation omitted).
Section 2.3(e) provides “that the parties ‘shall submit to an independent accounting firm. . . for resolution of any and all matters that remain in dispute and were properly included in the Notice of Disagreement.’” Slip op. at 14 (quoting App. 84). While “any and all matters” suggests a broad grant of authority, the limiting language “matters. . . properly included in the Notice of Disagreement” indicates a “considerably narrower” scope of authority. For “a ‘Notice of Disagreement’ can ‘only include disagrements which are based on the Statement not having been prepared in accordance with this Section 2.3 or which are based on mathematical errors.’” Slip op. at 14 (quoting App. 84). The APA, said the Court, “narrows the dispute procedure to only accounting-related factual matters.” Slip op. at 14
The Court further observed that the APA “gives the Accounting Firm the authority to hear specific challenges in each of three years to, inter alia, the Earn out Statement for the relevant year[,]” and the “challenges are limited to whether the Statement was prepared in accord with generally accepted accounting principles, whether the parties had reasonable access to all working papers, and/or whether there were mathematical matters.” Slip op. at 14-15. These narrow “factual disputes” are “within the normal expertise of an accountant, and that technical expertise weighs in favor of expert determination.” Slip op. at 15.
Reason 2: The APA Limits to Thirty Days the Time for the Accounting Firm to Render its Decision
The APA required the Accounting Firm to make its determination within thirty-days, which the Court said was insufficient time for a “broad-based investigation that an arbitrator would undertake.” Slip op. at 15 (citation omitted). That, said the Court, “suggests the independent decision maker is not an arbitrator.” Slip op. at 15-16 (citations omitted).
Reason 3: The APA Provides no Procedural Rules for an Alleged Arbitration
Noting that the agreement to arbitration-like procedures indicates agreement to arbitration, the Court concluded that the absence of such agreement to arbitration-related procedural rules indicated a lack of an intent to agree to arbitration, and an intent to agree to expert-determination rather than arbitration. Slip op. at 16.
Reason 4: The APA Provides for Non-Binding Mediation Followed by Litigation, not Arbitration
Because the APA provided for non-binding mediation followed by litigation, and because “arbitration agreements generally govern all disputes stemming from a contract,” the Court found that the parties’ agreement to mediation followed by litigation, “undermines the argument that § 2.3(e) calls for arbitration.” Slip op. at 16.
The District Court Erred by Overturning the Magistrate Judge’s R&R
The Court explained that the district court rejected the magistrate judge’s R&R for two reasons— the final and binding nature of the alternative dispute resolution clause and the district court’s conclusion about the scope of authority delegated to the decision maker. But the Court found that neither provided a satisfactory basis for the district court’s decision.
District Court Erroneously Relied on the Final and Binding Nature of the Dispute Resolution Clause
While the expert-determination clause expressly made the accounting firm’s decision “final and binding,” arbitrators typically make “final and binding” decisions not only on questions of fact, but questions of law. Non-arbitrator experts ordinarily make “final and binding factual decisions limited to specific questions within their area of expertise.” Slip op. at 17 (citations omitted; emphasis added).
The expert-determination clause, however, provided that the Earn Out Statement would become “final and binding” upon the accounting firm’s review and determination. Slip op. at 17. “[T]he authority[,]” explained the Court, to resolve the parties’ legal questions—like whether [the acquiring company] violated the duty of good faith—remains with the courts.” Slip op. at 17.
That suggests the parties agreed to expert-determination, not arbitration. Id.
The District Court Erroneously Relied on a Capitalization Discrepancy in Determining the APA Delegated to the Accounting Firm Unlimited Authority Concerning the Earn Out Statement
The term “notice of disagreement” was capitalized in Section 2.6(d) of the APA, but not in Section 2.3(e). In its capitalized form it was defined as limited “only to ‘disagreements which are based on the Statement not having been prepared in accordance with this Section [] or which are based on mathematical errors.’” Slip op. at 18 (quoting App. 84).
The uncapitalized term, “notice of agreement” was used in Section 2.6(d), which delineated the expert’s scope of authority. The district court interpreted the uncapitalized term as indicating that the expert’s authority with respect to a “notice of disagreement” was more expansive than its authority would have been with respect to a (capitalized) “Notice of Disagreement.”
The Court concluded the “capitalization discrepancy” was the result of a scrivener’s error. “While[,]” said the Court, “capitalization typically alters the meaning of words, § 2.6(d) (which contains an uncapitalized ‘notice of disagreement’) directs the parties back to § 2.3(e) (which includes the capitalized ‘Notice of Disagreement’).” Slip op. at 18. A “contrary conclusion—that those two sections are governed by the same dispute procedure, but disputes under one section are narrow and disputes under the other may be expansive—does not track the many other factors in the [APA] revealing that these provisions, read together, call for narrow expert determination.”
The Court reversed the May 29, 2020, grant of the motion to compel, vacated the May 26, 2022, order entering judgment for the acquiring company, and remanded the case to the district court. Slip op. at 19.
Contacting the Author
If you have any questions about this article, arbitration, arbitration-law, arbitration-related litigation, or the services that The Loree Law Firm offers, then please contact the author, Philip J. Loree Jr., at (516) 941-6094 or PJL1@LoreeLawFirm.com.
Philip J. Loree Jr. has more than 30 years of experience handling matters arising under the Federal Arbitration Act and in representing a wide variety of clients in arbitration, litigation, and arbitration-related litigation. He is licensed to practice law in New York and before various federal district courts and circuit courts of appeals.
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Tags: ADR, ADR Clause, Arbitrability, Capitalization Discrepancy, Delaware Law, Dispute Resolution Provision, EBITDA, Existence of Arbitration Agreement, Expert-Determination, Scope of Authority, Scrivener's Error, Third Circuit
