LLC Member Pays the Price For Not Sticking to Deadlock-Breaking Script

Farrell Fritz, P.C.
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When the management of a closely held business is controlled equally by two owners, it’s wise both to anticipate possible deadlock over major decisions and to provide in the constitutive documents a deadlock breaking mechanism.

One such mechanism is to require informal efforts to resolve the deadlock within a specified period and, if unsuccessful, permitting either side to trigger a mandatory buy-sell transaction.

If the two owners are on comparable financial and informational footings, an effective ex ante, deadlock-breaking, buy-sell agreement can take the form of a “shotgun” provision.  Under such provision, Owner No. 1 tenders an offer to Owner No. 2 either to buy Owner No. 2’s interest at a specified price or to sell Owner No. 1’s interest to Owner No. 2 at the same price (or proportionate price if the percentages differ).

When it comes to implementing a deadlock-breaking shotgun agreement, what’s not wise is to load the initiating offer or the response to it with commercially unreasonable terms not required or anticipated by the agreement.

That’s the hard lesson learned by the 49% LLC member in Lard-PT, LLC v Seokoh, Inc., 2020 NY Slip Op 51208(U) [Sup Ct NY County Oct. 20, 2020], in which Manhattan Commercial Division Justice Andrew Borrok denied the 49% member’s summary judgment motion based on findings that put the 51% member on a winning path.

The Deadlock Provision

Process Technologies & Packaging, LLC (“PTP”) is a Pennsylvania-based contract manufacturer and packager of color cosmetics and other personal care products.  PTP is a manager-managed Delaware limited liability company with two voting members, both also organized as Delaware business entities, whom I’ll refer to as Kolmar (51%) and Lard-PT (49%).

In 2016, Kolmar and Lard-PT’s predecessor-in-interest entered into a sophisticated, bespoke Third Amended and Restated Operating Agreement creating a board of managers with general management authority except for certain major decisions (“Reserved Matters”) requiring unanimous member consent. The agreement allocated equal board voting power to the designees of the two members.

Section 10.2 of the LLC agreement set forth a detailed procedure by which the members could force a shotgun buy-out of one member by the other either in the event of deadlock over a Reserved Matter or a material breach of the LLC agreement. Section 10.2 (a) defined the shotgun 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) gave 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.

Under Section 10.2 (c), the notice given by the “Initiating Member” required 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.

Section 10.2 (d) set forth the procedure for determining which member was buyer or seller, and certain payment terms, as follows:

Within thirty days from receiving such notice, the Other Member shall notify the Initiating Member in writing its decision to either purchase the Initiating Member’s Interest or sell its Interest for the proportionate value of the designated price in same day funds paid at closing; provided, however, if the Other Member fails to provide such notice in a timely manner, the Other Member shall be deemed to have accepted the Initiating Member’s offer to sell; provided further, if the buyer is [Lard-PT] then (x) 10% of the purchase price shall be payable at the time of the transfer of the relevant Interests and (y) the remaining balance of the purchase price shall be payable in five (5) equal installments on each anniversary of the date of such transfer with interest accruing at the applicable federal rate under the Internal Revenue Code.

Section 10.2 (e) then addressed the unhappy consequences of a member’s breach of the deadlock/buy-sell provision:

If a Member breaches any of the provisions of Section 10.2(d) above, the non-defaulting Member shall have the option to (i) buy (if such Member was required to sell its Interests pursuant to Section 10 .2( c )) the defaulting Member’s Interests at a proportionate price determined in accordance with Section 10.2(c), discounted by 30% or (ii) sell (if such Member was required to buy the defaulting Member’s Interests) its Interests to the defaulting Member at a proportionate price determined in accordance with Section 10.2(c), increased by 30%.

Kolmar Pulls the Trigger

Justice Borrok’s Decision and Order gives a detailed recitation of the differences between Kolmar and Lard-PT over strategic, management, operational, and financial issues that arose starting around 2017.

For present purposes, I’ll skip to early 2019 when, following the resignation of PTP’s then-CEO, Lard-PT unilaterally designated a certain individual (“Wormser”) as successor CEO without obtaining Kolmar’s consent as required under the LLC agreement. Kolmar opposed Wormser’s designation as CEO because it believed he was competing against PTP through his separately owned company.

In March 2019, after Kolmar and Lard-PT failed to resolve the CEO dispute, Kolmar as non-breaching member gave Lard-PT notice that it was invoking the deadlock/shotgun procedure under Section 10.2. The notice stated that Lard-PT either could purchase Kolmar’s 51% interest for approximately $10.4 million or it could sell its 49% interest to Kolmar for $10 million. The notice also included certain conditions (eventually deemed “commercially reasonable” by Justice Borrok) that the purchasing member assume any guarantees given by the selling member of loans made by third-party lenders to PTP.

Lard-PT responded to Kolmar’s notice indicating it was exercising its option to purchase Kolmar’s 51% interest at the specified $10.4 million price. Lard-PT’s response also took the position, however, that Kolmar’s offer price included additional terms not contemplated by the LLC agreement which Lard-PT would accept provided that Kolmar accepted certain additional terms.

One such term was an extension of the PTP manufacturing facility’s lease with Kolmar at the current level of rent. Another was either the immediate resignation of Kolmar’s board designees or immediately requiring them to vote consistently with Lard-PT’s board designees prior to closing.

For the better part of a year afterward, Kolmar and Lard-PT variously sought to negotiate a resolution of the buy-out while trading accusations and denials of breach. In June 2019, Kolmar sent Lard-PT notice that it was exercising its right under Section 10.2 to flip the buy-sell and to purchase Lard-PT’s interest for $10 million while reserving the right to purchase the interest at 30% discount if the closing did not take place by the end of July 2019.

Meanwhile, PTP’s financial position deteriorated considerably. You can get the details in Justice Borrok’s Decision and Order, but the short of it is, the dispute landed in court in March 2020 with Kolmar suing Lard-PT and vice versa either to enforce their competing versions of the shotgun provision’s application and/or for damages.

The Court Denies Lard-PT’s Summary Judgment Motion

Amidst much procedural maneuvering which I won’t go into, and following Kolmar’s filing in Delaware Chancery Court of a petition to dissolve PTP, Lard-PT moved for summary judgment on its claim to enforce Kolmar’s alleged obligation to purchase its 49% membership interest for at least $7.75 million assuming Lard-PT breached Section 10.2 (d) of the LLC agreement or $13.75 million if Kolmar breached that same section. Lard-PT denied that it breached Section 10.2 (d) of the LLC agreement by adding improper terms as conditions to its election to purchase Kolmar’s interest because Kolmar repeatedly added its own additional terms and conditions in response.

Justice Borrok wasted no words in his opening assessment of Lard-PT’s argument: “Put simply, they are wrong.”

He then listed three separate breach events by Lard-PT, including its  response to Kolmar’s initial shotgun notice, offering to purchase Kolmar’s interest conditioned on additional, commercially unreasonably terms:

The contract is straightforward. The fallacy behind Lard’s arguments stems from their failure to perform on no less than three occasions with respect to critical contractual obligations under the Operating Agreement. First, they breached the Operating Agreement when they attempted to install a CEO without board approval as their right to designate a CEO in Section 7.10(b) is subject to the other provisions of the Operating Agreement (including, Section 7.10(a) which indicates that officers must be approved by the Board). Second, when they received the valid March [2019] Deadlock Notice, they interposed commercially unreasonable terms not required or anticipated by the Operating Agreement and then failed to ultimately close. Third, when Kolmar validly exercised its rights under Section 10.2(e) to reverse the transaction and buy Lard out due to Lard’s failure to close, on the record before the court, it appears that Lard continued to stymie the operation of the Operating Agreement by failing to move forward even when Kolmar offered to buy Lard out without application of the 30% discount which they had an absolute right to do. This continued breach discharged Kolmar’s obligations.

In contrast to his finding that Lard-PT added commercially unreasonable conditions to its buy-out offer, Justice Borrok commented favorably on Kolmar’s inclusion in its initial shotgun offer of the condition that the buyer assume the seller’s guarantee of any PTP third-party debt:

Kolmar’s subsequent unilateral offers to resolve this matter including bringing the Kolmar Lawsuit were not accepted prior to Kolmar rescinding its prior offers to resolve this matter. Kolmar had a right to rescind the March Deadlock Notice because the terms contained in the Deadlock Notice were commercially reasonable (i.e., no one would expect to have to continue to guaranty loans in a business that they are exiting) and they continued to act in a commercially reasonable manner including by attempting to call a meeting to seek dissolution of [PTP] effectively rescinding its March Deadlock Notice which Lard refused. Finally, no reading of the Operating Agreement supports the notion that the Deadlock Provision is designed to have the acquiring member satisfy [PTP’s] obligation to repay the member loans. Accordingly, summary judgment is denied.

Lard-PT’s Lessons

The pending claims and counterclaims in the New York lawsuit and the concurrent dissolution litigation in Delaware Chancery Court present a complicated picture procedurally and on the merits.

Absent an appellate reversal, it seems clear that Justice Borrok’s findings, that:

  • Lard-PT breached the LLC agreement by its unilateral appointment of a successor CEO,
  • Lard-PT breached Section 10.2 with its conditional response to Kolmar’s initial shotgun offer, and
  • Kolmar rightfully rescinded its subsequent offer to resolve the matter by purchasing Lard-PT’s interest,

put Kolmar on higher ground in both the New York and Delaware cases.

I see two lessons in Justice Borrok’s ruling for the rest of us. First, if you’re a transactional lawyer drafting a shareholder or operating agreement with a deadlock provision that utilizes a shotgun buy-out, you should consider using language either that specifies reasonably anticipated conditions unrelated to price (such as relieving the seller of any guarantees of company obligations) and/or that provides the offeror with blanket authority to specify terms and conditions.

Drafting in such a manner might avoid judicial second-guessing as to the reasonableness of such conditions, unlike in Lard-PT where the shotgun provision only allowed the offeror to specify price.

Second, if you’re approaching deadlock with an agreement that includes a deadlock-breaking mechanism utilizing a shotgun buy-out notice that only specifies price, (a) identify as early as possible any conditions other than price that are essential to a workable buy-out and (b) engage in bilateral negotiations to reach agreement on such conditions in advance of the applicable deadlines to make or respond to a shotgun offer.

[View source.]

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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