Aim Carefully Before Pulling Trigger on Shotgun Buy-Sell Agreement
May 08, 2017
At least on paper, shotgun provisions in shareholder and operating agreements provide an elegant and efficient buy-out solution when business owners can’t get along and need a divorce. In a two-owner company, the one who “pulls the trigger” names a price at which he or she either will buy the other’s interest or sell to the other. The other owner has a specified amount of time to decide which. Since the offeror doesn’t know who will be the buyer, in theory there’s a great incentive to name an objectively fair price. The agreement usually also will prescribe payment terms. No need for appraisal. No fuss. No muss.
I’m not aware of any data-based studies on the subject, but I believe experienced lawyers would concur that shotgun clauses, although frequently included in owner agreements, are rarely invoked. Why is that? I can only speculate that owners generally prefer other ways to achieve a breakup without the uncertainty of knowing who will end up with the business. Also, owners are reluctant to be the trigger-puller, that is, there’s a natural preference to be the one with the option to buy or sell at a price named by the other.
Shotguns also can suffer from informational and financial asymmetries between the owners, a problem highlighted in my two-part, online interview of Professors Landeo and Spier some years ago (here and here). As Professor Spier described it:
Suppose that the party naming the offer is less knowledgeable and sophisticated than the party who is receiving the offer. The receiver could be opportunistic, buying when the value of the assets is high and selling when the value is low. The shotgun method will backfire in situations like this. The shotgun method can also backfire if one of the parties is financially constrained, and cannot raise the funds to complete the transaction. In this case, the party proposing the price has an incentive to make a low-ball offer, since the recipient cannot afford to purchase and will essentially be forced to sell at a deflated price.
The apparent dearth of actual trigger-pulling shotgun wielders under shareholder and operating agreements likely contributes to the dearth of reported court decisions involving disputes over shotgun agreements.
I was recently involved in one such rare lawsuit in which I represented the member who pulled the trigger (the “Tendering Member”), naming a $10,000 price which, viewed in isolation, would not suggest any problem of the sort described by Professor Spier. However, after the other member (the “Non-Tendering Member”) elected to purchase, an intractable dispute broke out over his ability and/or willingness to repay the approximately $500,000 loan balance owed by the LLC to the Tendering Member, which the LLC agreement made a condition to closing.
The court ultimately determined that the Non-Tendering Member failed to perform his obligation to close within the time period specified by the agreement, which under the LLC agreement then activated the Tendering Member’s right to purchase the Non-Tendering Member’s interest at the same $10,000 offering price, which was the happy ending for my client, made even happier by his recovery of legal fees as provided in the LLC agreement.
The LLC agreement had a relatively complex and somewhat unusual shotgun provision with the following key features:
- 30 days for the Non-Tendering Member to give notice of his election to purchase or sell after receipt of the Tendering Member’s buy-sell offer;
- once the Non-Tendering Member gives his notice of election, an additional 7 days for him to give notice of disagreement with the purchase price, thereby triggering a specified independent appraisal process producing a binding purchase price;
- in the case of an agreed purchase price, closing within 90 days of the Non-Tendering Member’s notice of election;
- in the case of disagreement and appraisal, closing within 180 days of the Non-Tendering Member’s notice of election;
- repayment at closing of any loans to the LLC by the withdrawing member and of any loan balances between members resulting from investments in the company;
- reversion to the Tendering Member of the right to purchase the Non-Tendering Member’s interest if the latter fails to close on his purchase election.
After the Non-Tendering Member gave timely notice of his election to purchase at the offered $10,000 purchase price, the Tendering Member made a written demand for adequate assurance of the Non-Tendering Member’s ability to repay at closing the LLC’s approximate $500,000 loan debt owed to the Tendering Member. The Non-Tendering Member not only failed to give adequate assurance, but also rejected any obligation to pay off the loan at closing.
The Tendering Member then brought suit for declaratory and other relief, alleging the Non-Tendering Member’s refusal and inability to meet the agreement’s closing conditions and seeking to enforce his reversionary right to purchase the Non-Tendering Member’s interest for $10,000.
The case was assigned to Manhattan Commercial Division Justice Charles E. Ramos who granted from the bench at oral argument the Tendering Member’s motion for summary judgment, essentially on the ground that the Non-Tendering Member admitted his inability to cause the LLC to repay the Tendering Member’s $500,000 loan and had failed to close within 90 days as required by the LLC agreement.
On the occasion of that ruling and the court’s subsequent written decision denying the Non-Tendering Member’s motion for reconsideration, Justice Ramos also rejected the Non-Tendering Member’s argument that the 180-day closing period applied rather than the 90-day period, and that he had lined up adequate financing for the loan repayment within the 180 days. In a subsequent order, Justice Ramos determined that the Tendering Member also was entitled to recover his legal fees as provided in the LLC agreement’s dispute resolution provision.
The court’s written decision denying the motion for reconsideration can be viewed here.
One last observation: I’ve seen many owner agreements with shotgun provisions, but until this case I’d never seen one that allowed the recipient of the buy-sell offer to re-set the purchase price after the recipient’s election to buy or sell by means of a binding fair market value appraisal. Such a provision, it strikes me, undermines the central premise of the efficiency and price-setting fairness of the shotgun mechanism, and ought to be avoided.