Consider Whether Your Buy-Sell Provision is a Call Option Before Pulling the Trigger
June 22, 2020
This post is authored by Peter J. Sluka, a senior associate in the Manhattan office of Farrell Fritz and a member of the firm’s Business Divorce Group.
As regular readers of the blog surely are aware, there are few provisions in an LLC or shareholders agreement more likely to be the focus of dispute than the buy-sell provision. Most times, these disputes expose a flaw in the language of the buy-sell provision itself. A poorly defined price-fixing process results in litigation over that process; failure to specify which discounts should apply to an appraisal results in litigation over appropriate discounts; allowing a single appraiser to render a binding purchase price results in litigation over whether that appraiser was independent.
Recently, Vice Chancellor McCormick of the Delaware Chancery Court considered a challenge to enforcement of a buy-sell provision grounded not in an ambiguity of the provision, but in equivocal conduct of the LLC in exercising—or refusing to exercise, depending upon which side you ask—its rights under that provision. Specifically, V.C. McCormick considered whether an LLC, after electing to purchase the departing members’ interest under the buy-sell provision, could withdraw that election before the buyout price is established. The case offers some welcome clarity on precisely when the parties to a buy-sell agreement become obligated to go through with the sale.
The dispute in Walsh v. White House Post Productions, LLC, C.A. No. 2019-0419-KSJM [Del Ch Mar. 25, 2020], stems from the decision by creative visual effects studio Carbon VFX and its majority member, White House Post Productions, to separate from two of Carbon’s founders, Kieran Walsh and Francis Devlin.
The Buy-Sell Provision
Carbon’s LLC agreement gives it the right to purchase Walsh and Devlin’s membership interests at fair market value in the event that their employment with Carbon ceases. If Carbon invokes its buyout right, the LLC agreement provides a price-fixing process requiring up to three separate appraisals. Carbon kicks off by selecting an appraiser to determine—using agreed upon minority and illiquidity discounts—the fair market value of the departing member’s interest. If the departing member does not agree with the results of this first appraisal, then he or she may select a different appraiser to perform a fair market valuation using the same discounts. If the second appraisal comes within 10% of the first, the parties are required to split the difference. If it is more than 10% higher than the first, the parties’ appraisers jointly select a third appraiser, which third appraisal is binding.
As far as buy-sell provisions in LLC operating agreements go, this one is well drafted. It specifies the standard of value, applicable discounts, and even how to account for potential swings in business resulting from the departure and replacement of the outgoing member. It also employs a three-appraiser process, which guards against disputes over the selection or independence of a single appraiser.
Carbon Starts, Then Stops
In November 2018, Carbon told Walsh and Devlin that it would not be renewing their service contracts. Anticipating their departure, Carbon obtained the first appraisal contemplated by the buy-sell provision, presenting it to Walsh and Devlin in a letter that “offered” to purchase their interests at that appraised price.
In February 2019, Walsh and Devlin advised Carbon that they disagreed with the first appraisal, and—pursuant to the price-fixing process in the LLC agreement—they would be obtaining their own appraisal. But before Walsh and Devlin could complete their own appraisal, Carbon emailed them, “we have reevaluated our needs and have decided not to exercise the Company’s right to purchase your Member Units.”
Subsequently, Walsh and Devlin’s appraisal came in at more than 10% greater than Carbon’s appraisal. They insisted that Carbon work with them to commence a third, binding appraisal, as required by the price-fixing process. Based on its decision not to exercise its purchase rights, Carbon refused to play ball.
Was Carbon’s First Appraisal a Revocable Offer or a Binding Acceptance?
Walsh and Devlin commenced suit in Delaware Chancery Court seeking to compel Carbon to finish what it started under the buy-sell provision: jointly select a third appraiser whose valuation would be binding and, ultimately, purchase their membership interests for that value. Carbon moved to dismiss the claims, arguing that it withdrew its offer to purchase Walsh and Devlin’s membership interests before they accepted.
With a nudge from V.C. McCormick, who requested supplemental briefing on the issue, the parties distilled their arguments down to the fundamentals of contract formation.
As Carbon saw things, its presenting the first appraisal to Walsh and Devlin constituted an offer, to which Walsh and Devlin could respond by either: (i) accepting, or (ii) producing their own appraisal, which, depending on its result, would require Carbon either to split the difference or commence the binding appraisal process. But until Walsh and Devlin did one of those two things, Carbon argued, it was—like any offeror—free to revoke its offer at any time.
Walsh and Devlin argued that Carbon’s transmitting the first appraisal was not an offer, but an acceptance. The buy-sell provision itself was the offer—negotiated at the time of the LLC agreement and triggered by the termination of their employment. Once Carbon kicked off the three-appraisal process by presenting the results of the first appraisal, Walsh and Devlin argued, Carbon accepted that offer and committed to purchasing their membership interests in accordance with the process outlined in the buy-sell agreement; they could not withdraw that commitment.
The Buy-Sell Provision is a Call Option, the Exercise of Which Cannot be Undone
V.C. McCormick, considering this issue of apparent first impression, sided with Walsh and Devlin. V.C. McCormick reasoned that the buy-sell provision was a call option: an offer by Walsh and Devlin to sell their interests in Carbon pursuant to the price-fixing process, which offer Walsh and Devlin were required to hold open in the event their employment with Carbon terminated. As the court wrote:
The Buyout Provision is a call option. It contains both elements of an option contract: an offer to enter into an underlying agreement for the sale of property and a promise to keep that offer open. The underlying agreement is the Company’s “right to purchase” a member’s units “[i]n the event [that] [m]ember ceases to be employed by the Company.” The collateral agreement is Plaintiffs’ promise to keep that offer open: “such [m]ember shall be obligated to sell” his units to the Company. In sum, when executing the LLC Agreement, the parties agreed that all of pre-negotiated buyout terms would bind the parties in the event the Company exercised its option. This is, in all practical effect, the way a call option operates.
The court concluded that because the buy-sell provision is a call option, Carbon’s exercise of that option constituted an irrevocable acceptance of the open offer. As a consequence, Carbon’s acceptance bound both parties to proceed with the buyout.
Because it reached the issue in the context of Carbon’s motion to dismiss for failure to state a claim, the court stopped short of actually holding the parties to the buy-sell agreement. Rather, the court held only that it was “reasonably conceivable” that by presenting the first appraisal to Walsh and Devlin, Carbon manifested an intent to exercise the option. Though it would seem an uphill battle, it remains to be seen whether Carbon will argue to the contrary.
More generally, characterization of a buy-sell agreement as a call option invites some interesting considerations and potential arguments in future litigation over buy-sell provisions. Must the call option in a buy-sell provision be supported by independent consideration? Is there a specific duration to the option—requiring the company to either exercise or forfeit is buy-sell rights? In a New York case called Breslin v Frankel, the court held that the plaintiff’s 19-year delay in attempting to exercise the option to purchase defendant’s shares in a realty-holding corporation was unreasonable as a matter of law.
In all events, counsel would be wise to refresh themselves with the fundamentals of contract formation and options in considering precisely when parties become bound to follow through with a buy-sell agreement; it may be sooner than they think.