Chancery Confirms Arbitration Award Resulting in Negative Purchase Price

Parties to a transaction agreement often include a provision requiring the parties to arbitrate any disputes arising from the agreement. Such provisions are included because arbitration generally resolves disputes quicker and cheaper than litigating disputes before a court. Moreover, arbitration affords the parties greater privacy. As the Delaware Chancery Court’s recent decision in SM Buyer v. RMP Seller Holdings, C.A. No. 2023-0957-JTL (Del. Ch. Feb. 28, 2024, judgment entered Mar. 17, 2024) demonstrates, the deference afforded to an arbitrator may result in decisions with which a reviewing court may disagree but that the court is nonetheless bound to confirm.

Background and the Chancery’s Decision

The owners of a California supermarket chain (sellers), Save Mart Super Markets LLC (Save Mart), entered into an equity purchase agreement with a Los Angeles-based private equity firm, Kingswood Capital Management (buyer). By acquiring Save Mart, the buyer would also acquire a stake in a separate grocery store business (other business).

The purchase agreement contained standard provisions to calculate the purchase price, including a customary mechanism to adjust the purchase price at and after closing. Pursuant to these provisions, the buyer would pay the sellers at closing an amount based on an estimated closing balance sheet prepared by the sellers (pre-closing balance sheet). Then, after the closing, the buyer would prepare a proposed final closing balance sheet (post-closing balance sheet).

As is frequently the case, depending on the differences between the pre-closing balance sheet and the post-closing balance sheet, the buyer could be required to pay the sellers an additional amount or the sellers could be required to refund a portion of the closing proceeds to the buyer. As is also customary, the purchase agreement provided for a procedure to resolve disputes regarding any differences between the pre-closing balance sheet and post-closing balance sheet. Also in line with market practice, the buyer was acquiring 100% of the equity interests in Save Mart on a “cash-free, debt-free” basis. As such, any cash on the balance sheet would increase the purchase price, and any debt of Save Mart—or critically, its subsidiaries—would reduce the purchase price, in each case, on a dollar-for-dollar basis.

Between signing and closing, the buyer and the sellers agreed to a pre-closing reorganization that would move Save Mart’s interest in the other business to a newly formed affiliate of sellers and, pursuant to which, the sellers would sell the other business to the buyer as a separate transaction (although related to the Save Mart sale).

The other business had approximately $109 million of debt (other business debt), which was listed on the balance sheet of the other business. However, the other business debt was not listed on the pre-closing balance sheet.

At closing of the primary transaction, the sale of Save Mart, the sellers paid the buyer approximately $40 million based on the pre-closing balance sheet. Consistent with Save Mart’s historical practice, the pre-closing balance sheet did not include the other business debt. However, the buyer’s post-closing balance sheet did include the other business debt. Based on the difference between the pre-closing balance sheet and post-closing balance sheet, the sellers owed the buyer a refund of over $87 million, meaning the purchase price was negative and the buyer would be paid nearly $47 million for acquiring Save Mart.

Unsurprisingly, the sellers disputed the proposed purchase price adjustment, and the sellers and the buyer agreed to arbitrate the treatment of the other business debt. The arbitrator ruled in favor of the buyer based on a strict, technical interpretation of the defined terms used in the purchase agreement. The arbitrator reasoned that the other business debt reduced the purchase price, because the debt of Save Mart’s subsidiaries reduced the purchase price, and despite the pre-closing reorganization and separate sale of the other business, the other business was defined as a subsidiary of Save Mart.

Buyer quickly filed an action in the Delaware Court of Chancery to confirm the arbitrator’s award. The seller then filed a counterclaim to set aside the arbitrator’s award, arguing that the arbitrator had acted in manifest disregard of the law.

Under Delaware law, review of an arbitrator’s award is among the narrowest standards of judicial review. To prevail on the sellers’ “manifest disregard of the law” argument, the sellers had to show that the arbitrator knew of the relevant legal rule, appreciated that the outcome of the disputed issue turned on such legal rule, and nonetheless willfully refusing to apply the legal rule.

Mindful of the sellers’ heavy burden, the court reluctantly confirmed the arbitrator’s award. As the court explained, the arbitrator’s decision was rooted in a strict interpretation of the language of the purchase agreement and comported with a strict interpretation of the contractarian nature of Delaware law. The court noted that it disagreed with the arbitrator’s decision: A negative purchase price is economically divorced from the intended transaction, and the pre-closing balance sheet and post-closing balance sheet should have treated the other business debt consistently. However, the court’s disagreement was not sufficient to overturn the award. The arbitrator’s strict application of the literal words of the purchase agreement precluded a finding that the arbitrator manifestly disregarded the law.

Key Takeaways

This case reinforces several important principles for practitioners. First, deal lawyers must be mindful of the scope of an agreement’s defined terms and exercise care in how they are drafted. It is unlikely that the sellers intended for the other business debt to be picked up in the purchase-price mechanics of the purchase agreement, but as buyer, the arbitrator, and the court each observed, such debt was indeed picked up under a literal interpretation of the plain language of the purchase agreement. Second, consider including a sample purchase price calculation (or balance sheet) and require the parties to prepare their calculations in the same manner. Third, if you decide to change the structure of a transaction, make sure you properly amend all parts of a purchase agreement in connection therewith. Finally, all practitioners should be mindful of the heavy measure of deference to an arbitrator’s award before agreeing to arbitration and while selecting an arbitrator as you may end up bound by that arbitrator’s opinion. 

Delaware Business Court Insider | July 17, 2024