A Delaware decision from Chancellor Leo Strine, recently affirmed by the Delaware Supreme Court, suggests that courts will not lightly intervene in post-closing disputes, including over earn-out payments, when an agreement provides a mechanism for dispute resolution. Instead, a court is likely to treat a third party resolution as final, even when the third party is an accounting firm or other expert lacking the legal training of an arbitrator.
The recent opinion in Viacom v. Winshall highlights the need for clarity and caution when using a contingent earn-out payment as part of the consideration in a corporate transaction. Although in theory earn-out payments offer a flexible way to bridge valuation gaps and help buyers avoid the risk of overpaying, in practice they often lead to complicated post-closing disputes. As Vice Chancellor Laster aptly put it in a 2009 decision, "an earn-out often converts today's disagreement over price into tomorrow's litigation over the outcome."
The Viacom case arose from Viacom International Inc.'s 2006 purchase of Harmonix Music Systems, Inc., the maker of the popular video games Guitar Hero and Rock Band. The merger agreement provided that Viacom would pay the selling stockholders $175 million in cash, plus a contingent earn-out payment based on a multiple of gross profits for the years 2007 and 2008. If the parties could not agree on the amount of the earn-out payment, the agreement stated that they would submit their dispute to a third party independent accounting firm for resolution.
After sales flagged in 2008 and into 2009, Viacom submitted a final 2008 earn-out statement indicating that there would be no earn-out payment for 2008. It arrived at this determination by deducting the costs of manufacturing inventory that remained unsold at the end of 2008 from the net revenue for that year.
Notably, Viacom's 2008 earn-out statement did not contend that the cost of writing down unsold inventory from 2008 should be deducted from the net revenue generated by Harmonix products. Only later, when the dispute resolution process was already underway, did Viacom begin to make the alternative case that the cost of writing down the unsold inventory should be deducted from net revenue. As a result, the accountants involved in the dispute refused to consider the inventory write-down argument in calculating the amount of the earn-out. In support of their decision, the accountants cited language from the merger agreement limiting the scope of their review to issues raised in the original earn-out statement and responsive summary of issues submitted by the parties.
Following an unfavorable decision from the accountants establishing a 2008 earn-out payment of $239 million, Viacom filed suit in late 2011 arguing that the accountants erred in refusing to consider its alternative inventory write-down calculation. It argued that the accountants exceeded their authority in refusing to consider its alternative theory because the merger agreement stated that the accountants were acting as "experts and not as arbitrators." According to Viacom the issue of whether the inventory write-down costs should be included in the calculation was a threshold matter for determination by a court, and not by the accountants.
Chancellor Strine disagreed with Viacom's argument and found that the accountants were well within their authority in refusing to consider the Viacom's alternative basis for calculating the earn-out payment. Although whether to consider the alternative basis was arguably a preliminary procedural issue, Strine found that it was so tied up with the core issue of the amount of the earn-out that it was within the scope of the accountants' review. He explained that "procedural questions that are ancillary to the substantive one should be decided by the arbitrator, not the court," to avoid undermining the efficiency of the dispute resolution process. Strine also referred to the language in the merger agreement indicating that the accountants' determination was final, binding and conclusive.
The strong deference and wide scope of authority granted to third-party dispute resolution experts reaffirms the need to exercise great caution in using earn-out provisions and crafting the scope of authority of dispute resolution experts. Courts are hesitant to look over the shoulders of third party-reviewers, including accountants and other experts, lest they hinder the efficiency of the dispute resolution process. Given this, parties are best served by agreeing on clear and plain guidelines for review to minimize the risk of misunderstandings. Parties should also use care in making their original earn-out estimates, as those calculations may limit their allowable arguments in later dispute resolution proceedings. Alternative arguments or separate bases for earn-out estimates should be included where possible, and especially when an issue is likely to be disputed.
Given the frequency of post-closing disputes over earn-outs, and the apparent finality of third-party resolution, drafters should take care to clearly and precisely define the terms of an earn-out, including provisions relating to dispute resolution. Parties should understand the mechanisms in place for resolving a dispute, as well as the parameters of the issues they will be able to submit for resolution. The Viacom decision reminds us that clarity in the dispute resolution provisions is just as important as it is in the other terms of an earn-out clause. Parties may avoid future headaches by taking precautions from the start to insure a clear, well-understood dispute resolution process.