INTRODUCTION

1. Much is known and has already been written about expert determination (ED). It is a well-consolidated practice to appoint one or more specialists to decide technical issues on behalf of the parties, when they cannot reach a consensus. Still there are many difficulties to be overcome, both in practice and in theory. To identify and analyze the issues it is necessary to focus on specific areas and matters of expert determination practice, where troubles frequently arise.

2. It is particularly interesting to examine the practice of expert determination in the context of Mergers & Acquisition (M&A) transactions. Over the years, there has been a continuous flow of controversies involving expert determination related to the application of MAC clauses, Purchase Price Adjustment, Earn Out, Put & Call Options, Representations & Warranties and Losses.

3. The choice of this study is to focus on the problems that arise when experts are asked to determine the enterprise value — which is commonly used as a base for the application of Earn-out provisions and Put & Call.

4. Therefore, this article will first address problems concerning the wording of expert determination clauses (I). In this context, it will tackle the issues of legal qualification of the third person (expert or arbitrator) who intervenes to deliver a binding decision (a), and the issues regarding the different rules to fix the enterprise value (b). In a second step, this study will deal with problems arising with expert determination happening during the arbitration proceeding (II). It will identify the scope of expert determination in these circumstances (a), and will discuss troubles caused by the confrontational behavior of the parties at this stage (b).

I PROBLEMS CONCERNING THE DRAFTING OF EXPERT DETERMINATION CLAUSES

A. Ambiguities regarding the role to be performed by the third person: expert or arbitrator

5. There are a considerable number of cases where State Courts have been asked to decide upon the proper interpretation of contractual clauses that provided for expert determination or arbitration. These decisions include a broad range of situations, such as construction, real estate and M&A. The characteristics of those cases can be identified by the analysis of a recent court decision dealing with a M&A transaction.

i. Case: 2016 Brazilian High Court of Justice: "final and binding"

6. In 2016, the Brazilian High Court of Justice rendered a decision on a litigation case involving the exercise of a Put Option.1 The contract provided that, once the option was exercised, both parties should meet and agree on the company’s market value. In case the parties didn’t reach an agreement, the following provision should apply:

In case such value is not agreed upon within thirty (30) days, both parties will appoint two experts (one expert chosen by each party), who, if necessary, will appoint a third one, and shall present the enterprise market value in the maximum term of sixty (60) days. The experts’ decision will be final, definitive and observed by the parties.2

7. Firstly, the High Court stated that the terminology adopted by the contract ("expert") has little importance in the determination of the legal nature of the third person role.

8. Then, it concentrated on the final sentence of the contract provision, which provided that "the experts’ decision will be final, definitive and observed by the parties". According to the Court, if the contract had attributed to the third person decision a "non-binding" force it would have been considered as a typical expert determination case. The final and binding strength, on the other hand, sets very narrow limits for review. Therefore, the Court understood that such clauses had the legal nature of an arbitration convention and decided to refer the parties to arbitration. One of the judges, who followed the presiding judge opinion, based his reasoning on the fact that if there is doubt about the existence of an arbitration agreement, such issue must first be decided through arbitration in compliance with the principle of Compétence-Compétence.

9. There were two dissenting votes stating that in such a contract it was clear that the parties’ intention was limited to waive any further discussion about technical issues of the company’s valuation. There was no clear choice for arbitration, as it is requested by law.

ii. Discussion and proposals

10. This decision has been heavily criticized for misinterpreting the sense of the expression "final, definitive and observed by the parties". It is absolutely common in contract practice to provide that the expert determination is final and binding. Its purpose is to give efficiency to such an endeavor, which otherwise could turn out to be a mere loss of time and money. Therefore, the binding effect attributed to a decision concerning specific technical issues does not constitute an arbitration convention, unless it can otherwise be clearly interpreted from the contract.

11. To differentiate expert determination and arbitration, scholars and Courts usually consider a number of factors which can be summarized as follows:

a. The language of the specific provisions;

b. The nature of the mission conferred to the third person (technical or legal

c. The features of the procedure (whether there is provision for a hearing, for instance);

d. The existence of a general clause providing for arbitration or state court;

e. The structure and content of the decision rendered.

12. The most regrettable consequence of the position taken by the Brazilian High Court of Justice is that the decision of what most likely would be a factual expertise will be granted a res judicata effect due to its characterization as an arbitration award. Under a typical expert determination, arbitration or courts still have room to review such decisions in specific situations, which vary according to the applicable law, but usually comprise manifest mistakes, gross negligence, bad faith or fraud.3

13. A better way to avoid uncertainty about the legal nature of the role that the third person shall perform is to have a clear definition of such a role in the contract. "The expert is not an arbitrator and shall not be deemed to be acting in arbitral capacity. The expert determination can be reviewed by arbitrators in cases of manifest mistakes, gross negligence, bad faith or fraud" could be a better wording to avoid the usual confusions in the interpretation of these clauses.4 Still, there is always a risk that a court finds this wording ineffective and decides in another direction. Despite that risk, it is obvious that a more developed provision may reduce the number of cases brought to courts and save time and effort.

14. On the other hand, improvements in contractual practice do not always take place as fast and accurately as one might expect. Pathological clauses are a common fact in international practice. The example below demonstrates this kind of problem:

Any controversy arising out of the violation of this contact shall be decided by arbitration, under xx Law, which shall govern this contract. The expertise shall be carried out by Chamber of Commerce of xxx, under the rules of conciliation and arbitration of ICC-Paris. The arbitrators shall decide in accordance with international usages and the principles of international law".

15. Even in accurately drafted contracts, there are situations where technical and legal issues are combined and challenge the expert mission. Quite often, the expert is confronted with contractual terms that must be interpreted to accomplish the technical determination. For instance, the definition of closing accounts, working capital, recurring revenues or expenses, or net debt. Usually, the expert shall be capable of dealing with these matters. However, if there is a serious dispute between the parties and they make legal arguments to support their interpretation, the mission of the expert might become more challenging. In certain cases, an arbitral or court binding decision upon the legal meaning of certain terms must be rendered, and only thereafter a valid expertise may be performed.5

B. Subjectivity of the contractual parameters and of the usual technical methods to fix the "Fair Market Value"

16. The subjectivity of contractual parameters that set the scope of the expert mission is not usually discussed during contract negotiation and, for that reason, it turns out to be a recurrent source of disputes at the time expertise is to be implemented.

17. This article will focus on the discussion of the company’s "Fair Market Value" or similar expressions, which are most commonly chosen as the parameter for expert determinations regarding the application of Put & Call Options, but also in application of the Earn Out and Purchase Price Adjustment provisions. The analysis of this specific issue allows a deeper discussion and its conclusions might be extended more broadly to other similar situations.

i. Wide range of conclusions may result from the interpretation of "Fair Market Value"

18. The first problem is that "Fair Market Value" does not constitute a legal concept. Its foundations are set by Economy and Accountancy sciences. But even in these fields, there are several methods that can be employed, alone or in combined form. Moreover, each of these methods embody a certain level of subjectivity, as for instance, when it requires several projections about the future performance of the company (growth rate, profit margin, capital and operational expenditure). Notwithstanding this, there seems to be no better alternative to obtain the "Fair Market Value".

19. It is very important, in each case, to understand which is (or are) the most appropriate method(s) to be employed in order to obtain the correct value of the company. In a very interesting article, Ms. Vidya Rajarao provided a critical analysis of these methods, which will be summarized below:6

1) The Discounted Cash Flow (DCF)

20. The purpose of the DCF is to capture the capacity of the business to generate cash in the future. This method is one of the most employed, due to the common understanding that, after all, a business values the money it generates for its owners.

21. It has though, inevitable problems since it is heavily based on projections of the future performance (revenues, costs, profit margin, etc.). It also requires the definition of a discount rate, which is used to estimate the present value of the future cash flows. The definition of the discount rate comprises not only the particularities of the business, but also macro-economic factors, such as country risk, taxation and interest rates.

22. As a consequence, the method is only as good as the accuracy of those assumptions and projections. It is not uncommon that experts adopt significant different points of view on those issues, which inevitably results in very different conclusions about the fair market value.

2) The Market Method

23. This method purports to find the market value of a business through the analysis of verifiably similar businesses’ value. For example, in case of companies that are listed on the Stock Exchange, the expert will look for competitors’ value and comparable multiples upon profits or upon net equity. The expert will also research other M&A transactions that had taken effect and identify the grounds for their price fixation.

24. By benchmarking the fair value of comparable businesses, this method aims to grant a credible actual value of a certain business.

25. However, finding credible data of similar businesses is not an easy task. Not only is there little or fragmented data available, but there are often also important factors to be considered that differentiate one company from another (management, product range, markets accessed, operational costs, trademark value, etc.).

3) The Cost Method

26. This method consists of determining how much it would cost to create another business capable of generating the same economic benefits. It considers as primary reference for its calculations the audited financial statements of the company. The expert shall verify the accountancy of assets and liabilities. The excess, if any, of assets over the liabilities will constitute the "net asset value".

27. This method could be appropriate for businesses with a high level of investment in fixed assets (manufacturing businesses, infrastructure projects) or in the real estate business.

28. Despite being an objective approach, this method does not capture several important matters, such as:

a. The future cash generation of the business;

b. The market value of assets and liabilities;

c. The actual value of intangible assets like trademarks or other intellectual property rights;

d. The goodwill of the company.

29. Therefore, it is frequently used in connection with other methods.

ii. Discussion and proposal

30. It is easy to conclude that expert determination is a complex endeavor and it relies on the quality of the expert who will decide which methods to use, and their inherent subjectivity.

31. In order to mitigate the risk of wrongful determination, there are a number of improvements that can be made in contract practice. First, by creating a more objective and developed parameter to obtain the Fair Market Value.

32. For example, the formula below is frequently used to define the Fair Market Value in M&A transactions of advertising or real estate brokerage businesses:

FMV = Average EBITDA x Multiple Where,

FMV = Fair market value

Average EBITDA = the average of the company’s EBITDA for the three preceding years as of the exercise of the Put Option. The EBITDA shall be calculated by the expert using the audited financial statements.

Multiple = 5

33. By giving an objective definition of Fair Market Value, and fixing certain parameters in advance (Multiple), this kind of clause has a much better chance of being properly applied than those mentioned previously in this article.7 Of course, one might argue that there is still room for discussion about the EBITDA definition. However, this is the sort of discussion that the expert has to have capacity to handle. Parties may also include further definition of EBITDA "customizing" the general concept to their actual case.

34. Another way to improve contractual practice would be to set up a more detailed procedure for the expert determination. Considering the inherent room for subjectivity, it seems prudent not to rely on the decision of only one expert. There are well-known clauses that provide two or three experts. Still, it is mostly important to provide that the parties shall employ their best efforts to agree on methods, assumptions and projections. In case they cannot reach an agreement on all the necessary points, the experts shall jointly reach an agreement for the missing ones, and shall duly justify their decision.

35. In conclusion, it is quite clear that expert determination can be a fast and efficient tool if the parties and lawyers do not exhibit belligerent behavior, and focus on the solution of the technical problem. In this context, ambiguities in the contract, legal interpretation and major technical issues may be overcome through reasonable efforts and negotiation. Unfortunately, there are a considerable number of cases where the strategy is to postpone a decision or even foreclose any sort of determination. In these cases, it might be useful to go straight (or as quickly as possible) to arbitration, since arbitrators are more used and more equipped to deal with aggressive tactics than technical experts.

II PROBLEMS RELATED TO EXPERT DETERMINATIONS PERFORMED DURING ARBITRATION PROCEEDINGS

A. The scope

36. Expert determinations usually occur during the arbitration whenever the Arbitral Tribunal finds that:

a. The expert determination mechanism provided in the contract could not, for any reason, take place, and, therefore, ought to be done during the arbitration.

b. The expert decision rendered during the contract performance must be reviewed or entirely redone during arbitration.

37. It is important to differentiate these hypotheses from the one where the Arbitral Tribunal appoints an expert to examine and produce a technical report. It usually happens whenever the Arbitral Tribunal considers that the technical evidence gathered until a certain stage of the proceeding does not suffice to clear technical issues which are important for the decision-making process. Indeed, there are considerable differences between an expert determination taking place during contract performance and an expertise occurring during the arbitration:8

a. The determination issued during contract performance usually has a binding effect for the parties, whereas the report issued by an expert during arbitration aims only to contribute to inform the Arbitral Tribunal about issues it considers that are necessary or useful to support its decision;

b. During the performance of the contract, the expert has its mission and limits established by the contract, while during the arbitration the mission and limits of the expert are fixed by the Arbitral Tribunal;

c. There are substantial procedural differences, since during the arbitration the expert shall observe due process of law.

38. Considering these differences, the role of the Arbitral Tribunal in cases of expert determination is, in principle, to support its implementation and development.9 Within this scope, the Arbitral Tribunal may have to rule on several issues, such as:

a. The appointment of the expert;

b. The clearance of mission and limits;

c. The interpretation of contractual terms and other legal issues;

d. The production of documents and access to people.

39. In these cases, the Arbitral Tribunal does not challenge the expert technical conclusions. On the contrary, the final award would basically validate the determination issued by the expert.

B. Common difficulties

40. This notwithstanding, in certain cases it might be difficult to draw a line splitting the roles of the arbitrators and experts. It is not rare that the Arbitral Tribunal has to intervene deciding upon more than legal or contractual issues.

41. This usually takes place when parties present their own technical assistant report with plenty of considerable differences between their views, and raising issues of a legal and technical nature. Unfortunately, there are too many cases where parties’ technical assistants advocate for their clients. Not only by adopting methodologies, assumptions and projections that are biased, but also by adapting the evidence and interpreting the contract in favor of their clients.

42. Experts should refrain to act as "hired guns". By losing their credibility before the Arbitral Tribunal, their efforts might have no effect in terms of persuasion arbitrators, which obviously does not help their clients’ case.10 It also creates several troubles for the efficiency of the arbitration.11

43. Depending on the extension of the troubles caused by radical polarization of the parties and cutting criticism towards the expert work, it might happen that the expert determination ends up having the same effect as arbitral-appointed expertise. The profile of certain experts sometimes also contributes to weaken the credibility of the technical conclusions, particularly due to the expert inexperience with a belligerent context or lack of confidence to reach objective conclusions. In these cases, the expert work has little aptitude to provide credible support for the arbitrators’ decision.

44. In order to avoid contested decisions in such situations, it is paramount that the Arbitral Tribunal get involved in the technical work right from the beginning of the expertise, understanding the technical issues and making decisions together with the expert. By doing this, the arbitrators will also be in a better position to deal with parties’ criticisms. The result of the expert report will also be more solid, both from the technical and legal perspective.

CONCLUSIONS

45. This article identified troubles that frequently occur in arbitration practice, related to ambiguities in contractual provisions or the dynamics of expert determinations that take place during arbitration.

46. This article proposed specific improvement of contractual practice toward more developed and accurate clauses. It will certainly have a positive impact, particularly in overcoming issues regarding the legal nature of expert determination, and to reduce the subjectivity of contractual parameters that set the basis for expert determination. A more developed and appropriate procedure for the implementation of expert determination during the contract performance shall also reduce the risks of technical errors by the expert.

47. Despite certain ambiguities or omissions in the contract, it is quite clear that expert determination can be a fast and efficient instrument if the parties and lawyers do not have confrontational behavior, and do focus on the solution of the technical problem. In this context, ambiguities in the contract, legal interpretation and major technical issues may be overcome through reasonable efforts. Unfortunately, there are a considerable number of cases where the strategy is to postpone a decision or even foreclose any sort of determination. In these cases, it might be useful to go straight (or as quickly as possible) to arbitration, since arbitrators are more used and more equipped to deal with aggressive tactics than technical experts.

48. This notwithstanding, even during arbitration it is not an easy task to face excessive confrontational behavior from the parties, counsel and technical assistants. In these circumstances, it is important that the Arbitral Tribunals take a larger role in the expert determination, by getting deeply involved in the technical work. It seems to be the only way to obtain a credible result through more efficient arbitration.

NOTES

1
RE n. 1.569.422 – RJ (2015/0177694-9)

2
Free translation.

3
Klaus Sachs. "Solving tensions between expert determinations and arbitration under M&A contracts", in International Arbitration under Review: Essays in Honor of John Beechey, Paris, ICC, p. 366, p. 366. For grounds of review under New York Law, see e.g. Liberty Fabrics v Corporate Props. Associates 5, 636. N.Y.S.2d781 (1st Dept. 1996). For a decision under Swiss Law, see Federal Tribunal, 1ère Cour de droit civil, 4A_254/2011. For a decision under French Law, see Supreme Court, Com., 6 June 2001 in JCP E, 2002, p. 1292. For a decision under English Law, see Walton Homes Ltd v Staffordshire County Council [2013] EWHC 2554 (Ch).

4
With this respect, see the recent decision of the United States District Court — Southern District of New York 1:16-cv-03568-JMF, 10/01/2017.

5
Bernd Ehle and Matthias Scherer, "Arbitration of International M&A Disputes, in IPBA Journal, , Sept. 2007, p. 25. Klaus Sachs, ibidem, p. 369.

6
Vidya Rajarao, "Perspectives and best practices in quantifying damages, business valuations and expert witnesses", in Indian Journal of Arbitration Law, Volume V, Jodhpur, 2016, pp. 147-167.

7
This formula might not be adequate for other fields, such as manufacturing businesses, because it does not capture the market value of the assets. However, there are similar solutions for those cases that could be incorporated in the contract.

8
See Ali Yeslirmak, "Expert determination in Turkey", in ASA Bulletin, , volume 33, 2015, pp. 306-326.

9
For a different view, see Balz Gross, "M&A disputes and expert determination: getting to grips with the issues", in Cross-border, , arbitration, 2010/11, www.practicallaw.com/arbitrationhandbook, p. 4.

10
It may also affect the chances of an expert to develop a career in arbitration, because the credibility and skills of technical experts are paramount in this field.

11
At the end of the proceedings, when allocating the arbitration costs among the parties, the Arbitral Tribunal should sanction this kind of action.