Seven Observations Regarding Recent Earnout Litigation

A recent case decided by the United States Court of Appeals of the Fifth Circuit, Hebbronville Lone Star Rentals, L.L.C, et al, Plaintiffs – Appellees v. Sunbelt Rentals Industrial Services, L.L.C., Defendant – Appellant, Case No. 17-506123, addresses a dispute regarding an earnout provision in an asset purchase agreement.

Hebbronville Lone Star Rentals, L.L.C. (“Lone Star”) sold its assets, customer lists, customer contracts, and goodwill to Sunbelt Rentals Industrial Services, L.L.C. (“Sunbelt”).  The purchase contract included an earnout provision.  Earnouts are essentially a mechanism to pay additional purchase price amounts to the seller in a business acquisition after the closing, based on the performance of the acquired business.  In this case, the earnout was based on customer revenue.  The more revenue that Sunbelt obtained from Lone Star customers over a threshold amount, the more Lone Star was paid under the earnout.

A dispute arose concerning how to calculate customer revenue.  One customer had a slightly different name than the name used for the customer in the purchase agreement.  There was a question of whether revenue from the customer with the different spelling should be included.  The customers were apparently the same customer with the spelling difference being a comma.  Another customer was acquired by a much larger company (so the question was whether and to what extent the revenue from the acquirer should be included because the acquirer was not named in the purchase agreement).   The earnout provision called for Sunbelt to calculate the revenue used for the earnout calculation, and if Lone Star disagreed it could respond with its own proposed figures.  If the parties did not agree after that process was conducted, the provision included an arbitration clause for resolving the dispute.  In this case, the parties submitted the dispute to an accounting firm as arbitrator.  The arbitrator sided with Lone Star on the two customer revenue issues but also found that a mutual mistake existed as to the underlying revenue threshold on which the earnout was based.  The arbitrator found essentially that due to a spelling error (the comma issue again) that a customer’s revenue had been left out of the revenue threshold calculation originally meaning the revenue threshold was lower than it should have been.  The arbitrator reformed the agreement to include this revenue, thus raising the threshold. As a result, Lone Star sued in Federal Court.  The Fifth Circuit Court of Appeals found that the arbitrator, in finding mutual mistakes, had gone beyond the scope of the purchase contract’s arbitration provision.  It provided that the arbitration was only “to resolve any remaining dispute over Seller’s proposed adjustments.”

Some observations from this case:

1. It is important to select the right kind of arbitrator.  Thought should be given to the type of arbitrator who is most likely to be receptive to the arguments you intend to make in an earnout dispute.  If you prefer a very narrow focus for the arbitration, you will want an arbitrator with knowledge of the law as to limitations of arbitration scope and a willingness to stick to that narrow scope.  A non-lawyer arbitrator may go for a “common sense” or “fair” or “overall” solution to a dispute even though that solution is beyond the scope of the arbitration provision in the underlying contract.
2. In a customer revenue earnout, if a customer is acquired and absorbed into the acquirer, an appropriate definition of customers and revenue is important. The buyer’s agenda may be to narrow this definition because the buyer wants to give the seller credit for sales which are not due to the acquired business. The seller’s agenda will be to broaden the provision enough that it does not lose credit for sales due to a technicality such as a change in the customer’s name due to an acquisition. What if the acquirer is a long-standing customer of the buyer? How will sales be apportioned?
3. Earnouts are a useful tool when parties cannot agree on the upfront purchase price to be paid in cash at closing, but they leave room for future disputes because they are almost always complex.
4. The scope of the dispute resolution or arbitration procedure can be as important as the earnout clause itself because it sets the threshold as to what issues can be raised in arbitration and what possible outcomes are permitted.  In this case, the arbitration was limited solely to the seller’s proposed adjustments to the buyer’s calculations.  The arbitration provision included a further limitation on the arbitrator’s authority stating that the arbitrator could not reach a finding on any item in dispute that was higher than the highest value claimed by a party or lower than the lowest value claimed by a party. Essentially, the arbitrator had to stay within the positions actually taken by the two parties.
5. The arbitration engagement letter is important.  The scope of arbitration can be opened up beyond what was agreed to in the underlying contract if the parties agree in the arbitration engagement letter to a wider scope.
6. One major benefit of a limited scope arbitration provision is that the parties can resolve a narrow dispute without resorting to litigation in court or a general arbitration where a long list of issues could be opened up for contest and resolution.
7. Where an earnout provision refers to customer revenue, some attention should be given to the fact that there may be variation in the names used to identify customers in the records of the parties.