Holes in Shotgun Buy-Sell Agreement Keep Deadlock Dissolution Petition Alive

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Under both New York and Delaware law, members of an LLC may petition for judicial dissolution on the grounds that the management is so hopelessly deadlocked that the LLC can no longer function in accordance with its purpose as defined in its governing documents.

In those cases, courts will consider whether the LLC operating agreement contains some other mechanism to break the deadlock.  If the operating agreement itself provides a fair opportunity for the dissenting member who disfavors the inertial status quo to exit and receive the fair market value of her interest, it is at least arguable that the LLC can still proceed to function, because there exists an equitable way to break the impasse.

Coequal LLC members might agree in their operating agreement to break a deadlock with a shotgun buy-sell agreement.  In the event of a deadlock, the initiating member names a price, and thereby gives the other member the option to either buy the initiating member’s interest or sell his own interest at that price.  “I cut, you choose.”

In theory, because a shotgun buy-sell agreement can equitably break an impasse, a member’s electing to initiate the shotgun buy-sell procedure should foreclose a petition for deadlock-based dissolution.  In practice, disputes over the implementation of that election might make dissolution appropriate after all.  That’s the lesson of Seokoh, Inc. v Lard-PT, LLC, CV 2020-0613-JRS [Del Ch Mar. 30, 2021], in which Vice Chancellor Slights cited the flaws in the parties’ shotgun buy-sell agreement as the basis for his refusal to dismiss a 51% member’s petition for deadlock-based dissolution.

The Shotgun Buy-Sell Provision, Deadlock, and Trigger Pull

Peter Mahler previously covered here the New York theatre of litigation concerning the Pennsylvania-based cosmetic manufacturer, Process Technologies and Packaging, LLC, a Delaware LLC (“PTP”).  A brief recap: PTP is owned, 51% and 49% respectively, by members Kolmar and Lard-PT.  Ownership is governed by a comprehensive Third Amended and Restated Operating Agreement (the “Operating Agreement”), which creates a board of managers with general management authority, but requires unanimous consent for certain specified major decisions (“Reserved Matters”).

The Operating Agreement contains a shotgun buy-sell agreement as a deadlock resolution mechanism: Section 10.2(a) defines the trigger as a failure of the CEOs of the two members to reach a resolution within 20 days of meeting to discuss the matters giving rise to the deadlock or breach.  Section 10.2(b) gives either member the option to give notice to the other of its intent to implement the shotgun buy-out procedure in the case of deadlock over a Reserved Matter and to the non-breaching member only in the event of breach.  The member giving notice names the price.  Under Section 10.2(c), the notice given by the “Initiating Member” requires the “Other Member” to either, at the price specified in the notice, purchase the Initiating Member’s entire interest or sell the Other Member’s entire interest to the Initiating Member.

The Operating Agreement also sets forth a remedy for a member’s breach of the buy-sell provision.  Section 10.2(e) of the Operating Agreement states that if a Member breaches the obligation to buy or sell, or otherwise materially breaches the Operating Agreement, the non-defaulting Member has “the option” (more on this terminology later) either to buy or sell its interests to the defaulting Member at a 30% price adjustment in its favor.

New York Litigation Exposes Flaws in the Shotgun Buy-Sell Provision

After a falling out over management of PTP, Kolmar pulled the trigger on the buy-sell provision, giving Lard-PT the option of either buying Kolmar’s 51% interest for 10.4 million or selling Lard-PT’s 49% interest to Kolmar for $10 million.  Lard timely elected to purchase Kolmar’s interest, but conditioned its purchase upon Kolmar’s acceptance of several additional terms not specified in the Operating Agreement.

After almost a year of negotiating the additional terms surrounding the buyout, the parties reached an impasse.  This time, Kolmar argued that because Lard-PT had refused to close on the sale of Kolmar’s interest without adding commercially unreasonable terms, Lard-PT was in breach of the Operating Agreement.  Under Section 10.2(e), this breach gave Kolmar the “option” to reverse the transaction and purchase Lard-PT’s interest at a 30% discount, which Kolmar was exercising.

Kolmar commenced suit in New York seeking specific performance of Section 10.2(e) of the Operating Agreement.  Lard-PT responded by filing its own complaint in the New York Supreme Court seeking specific performance against Kolmar to enforce the first iteration of the deal.  Kolmar also petitioned in Delaware for the dissolution of PTP.

In New York, Justice Andrew Borrok denied Lard-PT’s motion for summary judgment on October 20, 2020.  Relevant here, the New York court held that during the deadlock process, Lard-PT breached the Operating Agreement by conditioning the sale on commercially unreasonable terms not required or anticipated by the Operating Agreement, causing the deadlock process to fail, and that Lard-PT breached the Operating Agreement when it refused to proceed with the reverse buyout transaction, in which Kolmar would buy out Lard’s interest under Section 10.2(e) of the Operating Agreement.

The Delaware Dissolution Petition

After the New York Court’s decision, the parties agreed to stay the New York action in favor of Kolmar’s Delaware dissolution petition.

Lard-PT moved to dismiss the Delaware dissolution petition on several grounds, including that Kolmar cannot plead that the parties are deadlocked because the Operating Agreement provides a comprehensive method to resolve any deadlock: the shotgun buy-sell provision.

Not only did the Operating Agreement contain a deadlock resolution mechanism, Lard-PT argued, but Kolmar already invoked that provision by exercising its option under Section 10.2(e), and, upon that exercise, a binding buyout contract had been formed, which Kolmar cannot now rescind.

Lard-PT relied principally on case a covered by this blog almost a year ago,  , which held that an LLC’s buyout rights in its Operating Agreement was a call option, so the LLC’s exercise of that option created a binding contract that the LLC could not later rescind.  Guided by Walsh, Lard-PT argued that when Kolmar exercised its option to purchase Lard-PT’s interest under Section 10.2(e), a binding contract was created.

While the New York Court declined to make a final ruling at the summary judgment stage, Lard-PT insisted, that court ultimately is going to determine which party is entitled to specific performance enforcing the shotgun buy-sell provision of the Operating Agreement and whether any of the premiums in Section 10.2(e) apply.  With a binding buyout agreement in place (albeit one being disputed and litigated) Lard-PT argued, dissolution was inappropriate.

Does the Shotgun Buy-Sell Agreement Require Dismissal of the Delaware Dissolution Petition?

Vice Chancellor Slights denied Lard-PT’s motion to dismiss Kolmar’s dissolution proceeding.  VC Slights held that although the parties may have once contemplated resolution of a deadlock with the shotgun buy-sell provision, the mere existence of the buy-sell provision does not foreclose dissolution.  Moreover, held VC Slights:

The parties’ alleged inability to break their Deadlock makes plain the Deadlock procedure’s shortcomings. The procedure does not mandate a price, pricing formula or a closing timeline at which either Member can buy out the other; negotiations regarding these terms are required as a matter of course. The parties to the Operating Agreement clearly presumed that the Members would deal with each other in a commercially reasonable manner and consummate the “divide and choose” transaction in good faith. Based on the well-pled facts in the Petition, that appears to have been wishful thinking. With PTP’s value in precipitous decline, litigation between the parties breaking out in courts across the country and no end to the deadlock in sight, I find it reasonably conceivable that judicial dissolution is warranted.”

VC Slights rejected Lard-PT’s theory that an enforceable buy-sell contract exists.  Even if, under Walsh v. White House Post, Kolmar’s invocation of the buy-sell provision was the exercise of an option contract creating a binding contract for Kolmar’s to purchase Lard-PT’s shares, VC Slights explained that the exercise of an option creates an enforceable bilateral contract.  So while Kolmar may not have been free to revoke its exercise in the ordinary course, “[a] party is excused from performance under a contract if the other party is in material breach thereof.”  Lard-PT’s refusal to close on the discounted sale constituted a material breach, excusing Kolmar’s performance.

VC Slights also made short work of Lard-PT’s remaining grounds for dismissal of the dissolution petition.  Although Kolmar failed to plead that any formal resolutions were rejected, VC Slights held that the law does not require that petitioner to make “performative proposals she knew would be dead-on-arrival as a predicate to seeking judicial dissolution.”  And although PTP was still generating revenue, VC Slights emphasized that revenues are one thing, but profits are another.  At least at the pleading stage, Kolmar adequately alleged that PTP’s revenues were residual inertia, and that the company was hemorrhaging cash, defaulting on loans, and crippled by deadlock.

Closing Thoughts

While Lard-PT has borne the brunt of both the New York and Delaware decisions to date, it is no stretch here to imagine that both sides are somewhat dissatisfied with the proceedings so far.  Both the New York and Delaware actions appear on the longer (and more expensive) path of adjudication on the ultimate merits.  Kolmar and Lard-PT will surely consider where to devote their efforts.

If the parties intended upon entering into the Operating Agreement that a deadlock be resolved with a shotgun buy-sell agreement, the ensuing litigation has exposed the serious flaws in the agreement.  The parties must now choose: will those flaws be litigated in the New York actions with the aim of furthering the contractual intent of the shotgun buy-sell provision?  Or, are those flaws grounds to abandon the provision altogether in favor of the Delaware dissolution proceeding?

In any case, Seokoh, Inc. v Lard-PT, LLC, provides lessons for those both drafting and litigating shotgun buy-sell provisions.  For drafters, consider using language that addresses other reasonably anticipated terms unrelated to price.  The more detailed the provision is at the outset, the less potential for disputes that defeat its purpose later on.  For litigators, consider that disputes over implementation of the deadlock resolution mechanism can open the door to a deadlock-based dissolution proceeding, as it did here.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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