LLC Forced Buy-Out Pits Fair Value Against Fair Market Value Against Power to Amend Operating Agreement
December 05, 2022
Let’s see how good you are at predicting the outcome and its rationale in a recently decided case involving the following facts:
The controller of a Delaware LLC has supermajority voting rights under the initial LLC agreement to remove members for any or no reason.
The initial LLC agreement lacks any provision addressing redemption and payment rights upon removal.
The initial LLC agreement gives the controller the right to amend the agreement so long as the amendment does not “reduce any Member’s share of the Company’s distributions, income or gains, increase any Member’s share of the Company’s losses, or otherwise reduce the rights granted to any Member or increase the obligations of any Member if such reduction or increase would adversely affect such Member, without the consent of each Member to be adversely affected by the amendment.”
Came a time when the controller removed two minority members and simultaneously amended the LLC agreement by adding a “Member Repurchase Option” giving the controller the right to purchase “the Interest of any or all other Members” and deeming “any member whose interest is repurchased” a “Dissociated Member.”
The Repurchase Option uses a formula-based Repurchase Price based on a market-derived multiple of 8X EBITDA and other adjustments, less a 20% minority interest discount a/k/a discount for lack of control (DLOC) and a 20% discount for lack of marketability (DLOM).
The amendment also gives the controller the right to appoint an appraiser to “determine” the repurchase price which “shall be final and binding on all parties.”
The appraiser engaged by the controller to determine the Repurchase Price reviewed for accuracy the controller’s calculations pursuant to the formula and opined that the methodology and assumptions reflected in the formula were “reasonable.” The appraiser did not perform an independent valuation.
The controller gave written notice to the removed members enclosing a check for 100% of the determined repurchase price of approximately $550,000 each.
The removed members contested the repurchase formula and resulting price determined by the controller, raising among other objections that the application of DLOC and DLOM violated the adverse-affect restriction on the controller’s right to amend the LLC agreement by using a fair market value (FMV) standard that allows discounts instead of the fair value (FV) standard that disallows discounts.
The removed members hired their own valuation expert who determined the FV of their interests at approximately $18.3 million each without DLOC and DLOM, i.e., about thirty-three times greater than the $550,000 calculated by the controller using the Repurchase Price formula.
Keeping in mind that the Delaware LLC Act has no default provision governing the redemption of membership interests of an expelled member, is your answer:
Controller wins: Delaware law prioritizes freedom of contract. The operating agreement gives the controller removal rights and the right to amend the operating agreement to set terms and conditions of buy-out upon removal. The purchased membership interests are akin to limited partnership interests to be valued under the FMV standard as provided in Delaware’s Revised Limited Partnership Act. The FMV repurchase formula with discounts did not adversely affect any pre-amendment rights of the removed members.
Removed members win: The compelled repurchase violated the operating agreement and breached the controller’s fiduciary duties. The controller did not exercise pre-existing removal rights but, instead, breached fiduciary duty by adopting by amendment and implementing without member consent the Repurchase Option in violation of the initial LLC agreement’s adverse-affect rule. The removed members are entitled to the fair value of their interests plus rescissory damages for wrongful removal.
Removed members win partial victory: The controller properly exercised removal rights but the Repurchase Option using FMV with discounts violated the adverse-affect limitation on the right to amend by diminishing the removed members’ right to receive fair value for their membership interests by analogy to cases decided under Delaware’s Revised Uniform Partnership Act, given the subject LLC’s management structure that more closely resembles a partnership than a corporation.
None of the above.
If you guessed #1, your guessed correctly at the trial level but lost on appeal. If you guessed #3, you lost at the trial level but won on appeal.
The case involves a family-owned company organized in the late 1990s as a Delaware LLC that owns and operates skilled nursing homes and assisted living facilities. Daniel Straus is its sole manager and undisputed holder, either directly or through trusts he controls, of a supermajority interest as defined in Care One’s LLC agreement.
Care One’s other family members included Daniel’s sister Adina and her husband (later ex-husband) Jeffrey, each of whom held a 4.412% membership interest.
The provisions referenced above are found in the initial 1999 LLC agreement which was amended several times in later years. In 2014, Daniel approached Adina about purchasing her interest. In response, Adina sought valuation-related information and documentation and, feeling unsatisfied with what was provided, filed a lawsuit seeking books and records and asserting claims against Care One affiliates. Adina voluntarily dismissed the lawsuit six months later while also rejecting Care One’s buy-out proposal.
Those events set in motion Care One’s in-house counsel’s recommendation and Daniel’s decision to remove Adina and Jeffrey and pay them fair market value for their interests. To that end, Care One retained outside counsel and a financial expert to draft an amendment to the LLC agreement including developing a formula for calculating the FMV of a member’s interest.
In August 2015, Daniel executed the plan by adopting resolutions consenting to an amended and restated LLC agreement and authorizing the purchase of Adina’s and Jeffrey’s interests at fair market value with 20% reductions for each of DLOC and DLOM. Care One simultaneously filed a declaratory judgment action to validate the actions taken.
The Lower Court Grants Summary Judgment in Care One’s Favor
The litigation took a circuitous route, starting in federal court before landing in state court, that delayed the proceedings several years. Following completion of discovery, in early 2020 the parties cross-moved for summary judgment.
In November 2020, the trial judge issued orders granting summary judgment for Care One on its affirmative claims validating the removal and buy-out and dismissing Adina’s and Jeffrey’s counterclaims for breach of contract, breach of fiduciary duty, and breach of the implied covenant of good faith and fair dealing.
As briefly described in the subsequent appellate opinion, the trial judge found that the LLC agreement authorized Daniel’s removal of Adina and Jeffrey as members and held that the adverse-affect limitation on Daniel’s right to amend did not limit the right of removal.
In regard to the contested valuation formula in the Repurchase Option, as described in the appellate court’s opinion, the trial judge disagreed with Adina and Jeffrey’s argument that prior to the 2015 amendment they would have been entitled to receive “fair value” for their membership interests. Rather, the trial judge concluded that
“under Delaware law, the determination of the appropriate formula to be employed depends on whether the membership interests to be acquired are akin to general partnership interests or limited partnership interests.” The [trial] court found defendants were entitled to receive only “fair market value” for their membership interests, rather than “fair value,” because their interests in Care One were “akin to limited partnership interests” rather than general partnership interests.
The Appellate Court Disagrees and Reverses
Adina and Jeffrey appealed to the Appellate Division whose opinion, after a detailed recital of the relevant facts, frames the main issues in the case as
whether Daniel, who was the majority owner and sole managing member of Care One, and who controlled a supermajority of voting interests in the LLC, acted within his authority under the operating agreement and Delaware law, when in 2015 he: (1) removed all individual minority members of Care One, including Adina and [Jeffrey], who each owned a 4.412 percent interest in Care One; and (2) amended the Care One operating agreement to establish a formula for determining the amount to be paid when removing members through a purchase of their membership interests. Regarding the second issue, the dispute is whether the formula should have calculated the “fair value” rather than the “fair market value” of the membership interests, and, if fair market value was the appropriate calculation, whether the formula represented a reasonable calculation of fair market value.
The court’s opinion next sums up the “essence” of Adina’s and Jeffrey’s argument that, under Delaware law,
Care One members were entitled to receive “fair value” for their membership interests if they were removed as members pursuant to Section 6.4(a)(i). Section 9.8 [the Repurchase Option] was added to the operating agreement as part of the 2015 amendments. It provided that upon removal, members would be paid only “fair market value” for the purchase of their membership interests, rather than “fair value.” [Jeffrey] and Adina contend Section 9.8 violated Section 11.4 [authorizing Daniel to amend the LLC agreement] because it “otherwise reduce[d] the rights granted to” members and “adversely affect[ed]” members “without [their] consent.” In the alternative, they contended that an unfair, inaccurate formula was used to measure fair market value.
The appellate court readily agreed with the trial judge’s validation of Daniel’s unrestricted right to remove members as provided in the initial and restated LLC agreement. It instead focused its attention on whether the Repurchase Option’s FMV formula “reduced the value to be paid to Adina and [Jeffrey] upon their removal” in violation of the adverse-affect limitation upon Daniel’s power to amend the LLC agreement.
The appellate court found no guidance in Care One’s LLC agreement, the Delaware LLC Act, or the Delaware Revised Limited Partnership Act upon which the LLC Act was modeled, observing that none of those sources addressed the payment to be made upon the involuntary removal of a member or limited partner.
“Given this vacuum,” the court wrote, “we conclude the court should consider whether Care One more closely resembles a partnership, i.e., a member-managed governance arrangement, such that Delaware’s partnership statute should be applied (as in [Hillman v Hillman, 910 A.2d 262 (Del. Ch. 2006)]), or a corporation, i.e., a manager-managed entity, with a board of directors, and other corporate features, such that Delaware corporate law should be applied.”
Under this approach, the court found that Care One’s single-manager management structure and its election to be treated as a partnership for tax purposes supported the application of Delaware’s Revised Uniform Partnership Act, under Section 15-701 of which removed/expelled partners are entitled to receive the “fair value” of their partnership interests. “Therefore,” the court concluded, “prior to the 2015 amendments, defendants were entitled to receive ‘fair value’ for their membership interests in Care One, and not ‘fair market value.’”
Consequently, the court concluded, the Repurchase Option included in the 2015 amendment, adopted without Adina’s and Jeffrey’s consent and imposing a formula for repurchasing membership interests at FMV including DLOC and DLOM reductions not allowed under the FV standard, exceeded Daniel’s authority to amend the LLC agreement “because it significantly and improperly diminished defendants’ right to receive ‘fair value’ for their membership interests.”
The court also made clear that upon remand to the trial court for further proceedings to determine the amount Adina and Jeffrey should receive for their membership interests under a FV analysis, the door is not closed on the admissibility of Adina’s and Jeffrey’s expert’s opinion in support of an $18.3M valuation.
A Hidden Time Bomb?
I’ve not seen a copy of Care One’s 1999 LLC agreement so I’m not in a good position to comment on the quality or content of its draftsmanship. What I can safely say is that it’s highly unusual and risky for an LLC agreement to include a provision authorizing member expulsion without the agreement also addressing the compensation due or not due the expelled member.
If the members of Care One intended that an involuntarily expelled, non-managing member gets nothing, they should have included express language to that effect in the LLC agreement. Perhaps the omission was simply the product of oversight. Either way, when relations turn ugly and the side with the power to expel uses it, the omission of language fixing the terms for redemption of the expelled member’s interest turns out to be a hidden time bomb and virtual guarantee of litigation.