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Let's play ball?

by contributor Michael Kendall, Goodwin Procter | Published July 31, 2012 at 12:42 PM

It usually starts with an e-mail, followed quickly by the official fax notification in accordance with the purchase agreement. It is the buyer's calculation of the seller's closing date working capital (or other purchase price adjustment metric). More often than not, the number at the bottom of the schedule has brackets around it indicating that the buyer thinks the seller came up short and owes the buyer some of its money back. When the purchase agreement is dusted off and the dispute resolution provisions reviewed, both buyers and sellers can be surprised by the advantages or disadvantages facing them, depending on the choices they made in negotiating the agreement. In particular, so-called baseball arbitration provisions often can have unintended consequences, usually to the detriment of sellers.

Unlike indemnification claims for breaches of representations and warranties, which are relatively rare in the private M&A market, a substantial majority of transactions with purchase price adjustment provisions result in some level of dispute after the closing when the adjustment is being calculated. To resolve these disagreements, buyers and sellers usually include in the purchase agreement an arbitration provision requiring unresolved disputes to be decided by a qualified accountant. These accounting arbitration provisions come in various flavors, differing mainly in the latitude the arbitrator has in determining the final result.

Two frequent choices for accounting arbitration mechanisms are so-called conventional arbitration, in which the arbitrator has discretion to determine the "right" answer (sometimes limited to a range between the two amounts submitted by the parties), and final-offer arbitration, also called baseball arbitration, in which the arbitrator is compelled to choose between the two amounts submitted by the parties. Baseball arbitration became widely known beginning in the 1970s, mainly due to its use in two high-profile venues, public-sector union contract disputes and Major League Baseball player salary disputes. Academics have studied the outcomes of these arbitrations and came to a number of conclusions about the impact of baseball arbitration on the behavior of the parties to the dispute.

First, the research suggests that parties to baseball arbitrations generally view the costs of not settling the dispute to be higher than in conventional arbitration because of the increased likelihood that an adverse judgment will be outside the range in which the party might otherwise have been willing to settle. In other words, baseball arbitration involves more of a roll of the dice than conventional arbitration, in which the arbitrator is permitted to choose an amount between the two offers. Consequently, studies have shown that the threat of the arbitrator choosing the other party's position in baseball arbitration will cause the parties to submit offers in a range closer to one another than under conventional arbitration. Because the offers tend to converge, the parties will be more likely to settle or, if they don't, at least the ultimate decision of the arbitrator will be closer to what the parties would have accepted in settlement than if conventional arbitration were used. Conventional arbitration, by contrast, tends to encourage more extreme offers by the parties (and, therefore, fewer settlements) in the expectation that the arbitrator will choose a moderate position in the ultimate award.

In light of those tendencies, baseball arbitration may seem appealing to the private M&A market, which tends to favor the quick and efficient resolution of disputes. Moreover, many purchase price adjustment disputes involve relatively binary matters well suited for baseball arbitration; for example, the accounting policy argued by a buyer yields a result of $X whereas the accounting policy argued by a seller yields a result of $Y, with little logic for any amount in between. There are dangers, however, particularly for sellers, in relying on theories developed in very different venues when choosing an accounting arbitration provision. In the cases of public-union contracts and baseball player salaries, all of the relevant facts (for example, the batting and fielding statistics of comparable players) are generally available to both parties to inform their offers, and the offers are based principally on each parties' view of what is "fair" in the particular context, as well as individual risk aversion.

In M&A transactions, however, where after the closing the buyer will own and control the target, including its financial systems, personnel and service provider relationships, sellers are almost always at a substantial information disadvantage to the buyer, which can dramatically affect their ability to make a winning offer in a baseball arbitration. Imagine, for instance, a dispute over the amount of inventory indicated on the buyer's post-closing balance sheet, which includes a write-down for damaged goods. Without the ability to conduct its own physical inventory, how can a seller expect to submit a number that will be more correct than the one submitted by a buyer? Or what if the question relates to how a particular accounting policy had been applied by a target in the past, but a seller does not have any access to the chief financial officer or the relevant historical accounting records? One can conjure innumerable examples in which being on the outside would virtually ensure a loss by a seller in a baseball arbitration. With conventional arbitration, on the other hand, the inquiry conducted by the arbitrator through its information requests, submissions by the parties, question and answer sessions, and the like is highly likely to uncover the relevant information necessary for a fair outcome.

So should sellers never agree to baseball arbitration? Not necessarily; but the provision should be crafted to address the information asymmetries that would otherwise strike a seller out. First, a savvy seller should, in all cases, obtain a broadly worded access covenant ensuring that, in the period before its final offer has to be submitted, it is entitled to all relevant documents and other information in a target's or a buyer's possession. Second, a seller should request access to target personnel, as well as service providers, such as the accountants who assisted the buyer in preparing the post-closing balance sheet. Even with these protections, there is still an element of "not knowing what you don't know" because a buyer has only provided the information that has been specifically requested. To address this last issue and ultimately achieve information parity in the process, a seller could insist that final offers not be required until the parties have made and argued their positions to the arbitrator. Once both parties' cards are on the table, the information playing field is much more level and the outcome more likely to be fair.

Michael Kendall is a partner in the private equity and technology companies groups at Goodwin Procter LLP.

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