Sole arbitrator’s ruling on an “Independent Auditor clause” as an alleged bar to arbitral proceedings

Background

With the proliferation of various ADR procedures, it has become customary to include so-called “multi-tiered dispute resolution clauses” (MDR clauses) in commercial contracts. Such clauses typically provide for some form of negotiation or mediation followed – in the event of failure – by binding arbitration. However, parties may also agree in an MDR clause to obtain some type of expert determination before commencing arbitration proceedings.

Like MDR clauses in general, expert determination is not legally regulated in Finland. Parties are free to agree on the procedures to be followed in the expert determination and on the powers to be conferred upon the expert. Generally, parties seek an expert determination in two types of situations: (1) where a valuation is required (e.g. in price-adjustment disputes relating to company acquisitions), or (2) where an expert opinion is needed on a technical matter (e.g. in complex construction contracts).

In Finland, the use of expert determination is quite widespread in contracts for the sale of shares or assets of a company, which often contain specific price-adjustment provisions. These can be divided into two main categories. One category deals with the net asset value of the target company, calling first for a comparison of a closing balance sheet with a predefined, earlier reference balance sheet to determine the difference in the net asset values between these two financial statements, and then for an adjustment of the price in accordance with the difference. A second category are provisions that make the price contingent on some sort of earn-out mechanism, meaning that the purchase price is wholly or (more often) partially determined by reference to the future performance of the target company in terms of profit, turnover, or some other financial measure.

When expert determination is used in the context of price-adjustment disputes, parties almost invariably agree that the person acting as an expert shall be a certified public auditor (in Finland, so-called “KHT auditor”) or an independent audit firm. A price-adjustment clause may stipulate, for example, that the seller shall prepare a draft closing balance sheet and deliver it to the buyer, who may propose adjustments to it. Failure by either party to comment on the draft balance sheet or any proposed adjustments shall constitute deemed acceptance. If the buyer and the seller cannot resolve their disagreement relating to the treatment of any items on the adjusted closing balance sheet, then the dispute shall be referred to an independent auditor or audit firm for resolution. (See Mika Savola: Multi-Tiered Dispute Resolution Clauses under Finnish Law, in American Arbitration Association: “ADR & The Law” (20th Edition), 2006, pp. 240-241.)

Parties may agree that expert determination is only one tier in an MDR clause. For instance, to continue our above example, an MDR clause may provide that if the parties fail to approve the decision issued by the independent auditor or audit firm, the dispute over the expert’s determination shall be referred to be finally settled by arbitration. Alternatively, it is not unusual for the parties to agree that the expert’s decision shall be “final and binding” on them. In the latter case, the parties are generally deemed to have waived their right to appeal the expert’s decision to an arbitral tribunal, state court, or any other authority. However, difficult issues may arise if one of the parties is dissatisfied with the conduct and/or outcome of the expert determination and seeks to challenge the expert’s decision e.g. by raising allegations of fraud, manifest error, or material departure from the parties’ instructions. Prudent parties should take such considerations into account already when drafting an expert determination clause and provide a proper mechanism for dealing with them in the contract.

Case comment

The following example from the FAI arbitration practice illustrates the difficulties that may ensue when parties have included both an expert determination clause and an arbitration clause in the contract, without clarifying the relationship between the two clearly enough.

Parties A and B had concluded a shareholders’ agreement concerning the ownership and governance of company C. In the shareholders’ agreement, B was granted the right to redeem A’s shares in C on certain conditions. The shareholders’ agreement contained an FAI arbitration clause providing that “Any dispute arising out of or in connection with this Agreement shall be finally settled in arbitration by one (1) arbitrator in accordance with the Rules of the Arbitration Board of the Finnish Central Chamber of Commerce. The arbitration proceedings shall take place in Helsinki.”

A and B disagreed on the method of calculating the share purchase price payable by B, who had exercised the right to redeem A’s shares in C. Once A commenced FAI arbitration proceedings against B, the latter objected to FAI’s jurisdiction on the grounds that there was a separate clause (so-called “Independent Auditor clause”) in the shareholders’ agreement, stating that “if mutual understanding on the Purchase price is not reached, the Purchase price (…) shall be finally determined by KHT-auditor selected by the Board of Directors (the “Independent Auditor”) (…) The decision of the Independent Auditor shall be deemed final and binding on [the parties].” A, in turn, disagreed and contended that the dispute did not concern the amount of the purchase price as such, but how the concept of “net debt” used in the shareholders’ agreement should be interpreted. In A’s opinion, this dispute fell within the scope of the arbitration clause, and the sole arbitrator was not precluded from examining and ruling on A’s claims irrespective of the fact that an audit firm appointed by the board of directors of C had already rendered an expert determination on the purchase price.

The FAI Board allowed the arbitration to proceed, finding that the prima facie jurisdictional test set out in Article 14.1 FAI Rules was satisfied. The sole arbitrator appointed by the Board decided not to rule on B’s jurisdictional objection as a preliminary question but reserved the issue to be determined in connection with the award on the merits. In the final award, the sole arbitrator concluded that he had jurisdiction to adjudicate the claims brought before him mainly on the following grounds:

– The wording of the Independent Auditor clause indicated that the task of determining the purchase price was meant to be given to a natural person (a certified public auditor), and not to an audit firm.

 Pre-dispute correspondence between the parties further supported such interpretation.

– As the board of directors of C had not appointed a certified public auditor – but only an audit firm – to determine the purchase price, the decision issued by the audit firm could not be considered binding on A, especially as A had objected to the appointment of an audit firm from the outset.

On these grounds, the sole arbitrator deemed himself competent to examine and rule on A’s claims regarding the interpretation of the concept of “net debt” in the shareholders’ agreement, regardless of the audit firm having previously determined the purchase price.

Another procedural dispute that arose between the parties concerned the question whether, in case A was not bound by the expert determination made by the audit firm in respect of the purchase price, A was nevertheless bound to accept that the purchase price be determined in a new expert determination proceeding by a certified public auditor in accordance with the Independent Auditor clause set forth in the shareholders’ agreement. A objected to such interpretation, arguing that it was not possible to initiate a new expert determination in the meaning of the Independent Auditor clause, because the right to appoint an auditor under that clause was vested with the board of directors of C, and following the termination of the shareholders’ agreement, B was entitled to appoint all of C’s board members. Thus, allowing the board of directors of C to select an auditor to determine the purchase price in a new expert determination proceeding would effectively mean that the dispute between A and B would be resolved by an expert chosen by one of the parties alone. According to A, this would be inconsistent with the public policy of Finland.

In the final award, the sole arbitrator sided with A on this question. The reasons for the arbitrator’s decision read as follows (a free translation from Finnish by the undersigned):

– The fair and impartial nature of arbitration as a dispute resolution method requires that one of the parties to the dispute that is submitted to arbitration shall not be entitled to appoint all, or even the majority, of the members of the arbitral tribunal. However, the requirements of neutrality and impartiality that are inherent in arbitration cannot be directly applied to expert determination stipulated in the Independent Auditor clause contained in section 5.2.6 of the shareholders’ agreement. As pointed out by respondent, in contrast to arbitration, there are no statutory provisions in Finland governing the conduct of expert determination, meaning that the latter is based solely on the agreement between the parties. Further, in contrast to arbitration, expert determination does not result in a decision that would be legally enforceable in the same manner as a final and binding arbitral award.

– On the other hand, a decision rendered by a certified public auditor in an expert determination proceeding has the same binding effect on the parties as a contract concluded by and between them. But it is different from a mere contract in that it is not directly based on the expression of the will of the parties, but rather on a determination reached by a third party. The parties who have agreed on an expert determination procedure, like the one provided for in the Independent Auditor clause, may be expected to have intended that the decision will be made by a neutral third person in a fair and impartial proceeding. Therefore, when assessing whether the expert determination procedure stipulated in section 5.2.6 of the shareholders’ agreement adequately guarantees that the decision will indeed be issued by a neutral person in a fair and impartial proceeding, regard shall be had to the manner in which the Independent Auditor is appointed.

– Pursuant to section 4.2.1 of the shareholders’ agreement, B has had the right to appoint three out of five board members in C’s board of directors since the transaction that was consummated on [date]. Accordingly, A has known about this when concluding the shareholders’ agreement with B. By the same token, A must be deemed to have consented to the fact that persons who were appointed to C’s board by B would have the majority of votes when the board decided on who to select as a certified public auditor under section 5.2.6. This, however, does not imply that A should be deemed to have agreed to such expert determination proceeding where the Independent Auditor is chosen by a board of directors whose members have been appointed exclusively by B, without affording A an opportunity to influence on the composition of the board in any manner.

– In conclusion, the Arbitral Tribunal finds that the provisions of the shareholders’ agreement governing the appointment of a certified public auditor under section 5.2.6 fail to give sufficient guarantees that a decision to be rendered by such person would be fair and impartial in a situation where the auditor would be selected by C’s board of directors whose composition is entirely in the hands of B. For this reason, there cannot be any new expert determination as envisaged in section 5.2.6 of the shareholders’ agreement that would have any binding effect on A. It follows that the Independent Auditor clause does not limit the Arbitral Tribunal’s authority to examine and adjudicate the claims submitted to arbitration.

 

Reported by Mika Savola
Chair, FAI Board

Posted in FAI cases |