Who Decides Disputed Valuation Under LLC Agreement’s Buy-Out Provision: Arbitrator or Appraiser?
February 15, 2021
It’s not unusual to find buy-out provisions in shareholder and operating agreements that commit the pricing of the buy-out to the “final and binding” determination of one or more appraisers. The same agreements also may include broad arbitration clauses.
So what happens when a dispute erupts over the appraisal process and the resulting appraisal? Does an arbitrator’s authority begin and end with a determination whether the appraisal process adhered to the agreement? Or can the arbitrator take it a step further, notwithstanding the agreement’s assignment of finality to the appraiser’s determination, by taking valuation evidence and awarding a buy-out price that differs from the one challenged?
These questions may ring a bell for regular readers of this blog. Last year, I wrote about the Yakuel v Gluck case in which Andrew Gluck challenged the $4.7 million appraisal by PricewaterhouseCoopers (PwC) of his 35% membership interest in a digital marketing agency called Agency Within LLC. The 65% member, Joseph Yakuel, engaged PwC under the provisions of a Repurchase Option in an amendment to the LLC agreement mandating “an appraisal of the Fair Market Value by engaging a third party appraisal firm, whose appraisal will be final and binding on all parties.” Gluck essentially claimed that Yakuel rigged the appraisal by feeding PwC false financial projections designed to depress company value while at the same time excluding Gluck from participation in the appraisal process.
In his May 2020 decision that I wrote about last year, Manhattan Commercial Division Justice Joel M. Cohen denied Yakuel’s and Gluck’s dueling petitions, respectively, to confirm and to vacate the PwC appraisal award, finding that “the record is not sufficiently clear at this stage to permit a decision on this question one way or the other” whether Gluck had “a fair opportunity to present his case” to PwC.
My prior post did not mention the broad arbitration provision in the LLC agreement or the arbitration proceeding commenced by Yakuel in November 2018 in which he sought an award enforcing the Repurchase Option. In that proceeding, Gluck counterclaimed to rescind the amendment to the LLC agreement based on allegations of fraudulent inducement and, alternatively, for an award of damages resulting from Yakuel’s allegedly improper exclusion of Gluck from the PwC appraisal process.
We now know the outcome of the arbitration, thanks to another pair of dueling petitions before Justice Cohen to confirm or vacate the arbitrator’s 26-page written award issued last July. Between the award and Justice Cohen’s December 2020 decision confirming in part and vacating in part the award, let’s just say, it’s a doozy.
The Arbitration Award
The arbitrator’s award starts off with a detailed summary of the LLC agreement’s pertinent provisions, the procedural background of the arbitration and parallel court proceedings, and the parties’ claims. In the sections addressing the merits of the claims, the arbitrator concluded:
- the amendment to the LLC agreement containing the Repurchase Option is enforceable, notwithstanding Gluck’s claims of fraudulent inducement (pages 10-12);
- Gluck is not entitled to his capital account or any company profits or other payments beyond the purchase price (page 12);
- the arbitrator “cannot evaluate PwC’s determination of the appraisal value but may determine if [Yakuel] breached the Amendment by, as [Gluck] alleges, preventing [Gluck] from participating in the appraisal” (pages 13-14);
- the Repurchase Option provision did not give Yakuel the right to exclude Gluck from the PwC appraisal process, finding that “the purpose of the appraisal was to serve the interests of both [Yakuel and Gluck], and that both could participate, with the goal of arriving at an objective and fair valuation of Mr. Gluck’s units” (pages 14-15);
- Yakuel breached the Repurchase Option by not allowing Gluck to participate meaningfully in the appraisal (pages 15-18);
- Gluck is entitled to “damages” from Yakuel’s breach equal to “the difference between the PwC valuation of his units and the amount he would have received had [Yakuel] not breached,” which the arbitrator computed based on the $23.6 million appraisal submitted by Gluck’s valuation expert (pages 21-24).
The award at page 25 ordered Yakuel and the LLC to pay Gluck $18.9 million — representing the delta between PwC’s $4.7 million appraisal and Gluck’s expert’s $23.6 million appraisal — and imposed payment terms over a period of four years consistent with the terms in the Repurchase Option.
The Dueling Petitions to Confirm and Vacate the Award
Following the arbitration award the appraisal controversy moved back to court in the form of dueling petitions by Yakuel to vacate the arbitration award and enforce the Repurchase Option based solely on the PwC appraisal, and by Gluck to enforce both the arbitration award as well as the PwC appraisal.
Yakuel’s petition primarily argued that Gluck neither sought, nor did the arbitrator award, true “damages” caused by any deprivation of Gluck’s right to participate in the PwC appraisal process, such as excessive costs Gluck incurred because of his exclusion or any effect his exclusion had on PwC’s valuation.
Rather, Yakuel argued, the arbitrator ignored the Repurchase Option’s explicit delegation of the “final and binding” valuation to the selected appraiser (PwC) by adopting wholesale the new appraisal performed by Gluck’s expert appraiser, and that by doing so the arbitrator exceeded his authority and jurisdiction. Yakuel’s supporting brief (read here) relied heavily on a 2001 federal court decision by the Southern District of New York in Katz v Feinberg in which the court vacated an arbitration award on similar grounds.
Gluck’s brief (read here), citing the “very high bar required to vacate an arbitration award” and the broad remedial authority possessed by arbitrators in “measuring damages for a contractual breach,” primarily argued on procedural grounds that Yakuel “waived” any objections to arbitrating over the appraisal. Gluck further argued that, under the arbitration forum’s own rules, issues of arbitrability are delegated to the arbitrator who, in this case, determined he had authority to award what Gluck characterized as “valuation-based damages.”
Gluck argued in the alternative that, were the court to vacate the arbitration award, it should also vacate the PwC appraisal based on the denial of his right to participate in the appraisal process.
The Court’s Decision
On December 16, 2020, Justice Cohen heard oral argument by teleconference, the transcript of which is available here. After a brief recess, Justice Cohen dictated his decision on the record starting at page 35 of the transcript. His ruling can fairly be called a split decision — one that puts the parties back at square one in the appraisal process.
Justice Cohen upheld the arbitrator’s finding with respect to Gluck’s improper exclusion from the appraisal process and its impact on PwC’s valuation. On that basis he vacated the PwC appraisal award. However, he also vacated the arbitrator’s $18.9 million award on the ground the arbitrator exceeded his authority, and he directed the parties to “select a new appraiser — not PwC — consistent with the terms of their agreement.”
The following excerpts from Justice Cohen’s decision highlight his reasoning:
The question of the valuation of the shares was unequivocally and finally delegated to an appraisal, and all other general issues were delegated to potentially arbitration. And I think the [Katz v Feinberg] court makes very, very clear when you have a specific delegation for certain issues, that controls over a general delegation over other issues and I think this is exactly that case. . . . And as the Katz court said here, the agreement did not, quote, “allow for arbitration of the valuation or a remedy which alters it.”
Here, the Award, which was that Mr. Gluck was, quote, entitled to the difference between the PwC valuation of his units and the amount he would have received had [Yakuel] not breached, in my view invades the province of what the contract delegated to an appraisal. Because however one might describe it, the end result is that Mr. Gluck got a new appraisal and that is not what the contract provided for.
The record is clear to me that [Gluck’s appraiser] undertook a de-novo review of the valuation and the arbitrator awarded Gluck the result of that valuation and that is fundamentally at odds with the agreement. . . .
The parties’ agreement, that is, the Amendment, simply does not allow for the arbitration of the substance of the valuation, and the arbitrator exceeded the scope of his authority by reviewing and refashioning that valuation. . . .
. . . [T]he claims that Mr. Gluck has raised about exclusion are not discrete small little things that one can say, Well, he complained that this number — he was prevented from showing that this five should have been a ten; and, therefore, you’d have an easy fix by making a ten rather than five. And even then, how would one know whether [PwC] would have accepted the ten rather than the five. There’s just — it’s a virtually impossible exercise. . . .
To me, what comes through very, very clearly is that the parties agreed to have the shares valued by an appraiser and that’s what should happen.
My above description of the case does not do justice to the complex factual, procedural, and legal issues involved. Even Justice Cohen, at the tail end of the teleconference, admitted that the competing arguments “certainly made me scratch my head more than a little.”
I’ve not yet seen a formal, appealable order entered in the case, but once one is entered I’ve little doubt that one or both of the parties will file notices of appeal. The huge disparity between the two valuations — $4.7 million versus $23.6 million — and the legal fees invested in the case — upwards of $4 million according to Gluck’s brief — hardly suggest otherwise.
Assuming the parties proceed to a new appraisal by a new, neutral appraiser, they likely will need to agree up front on specific ground rules for participation in the process that will allow the appraiser to navigate the major differences in financial projections and adjustments to the historical financials expected to be advocated by the two sides — not an easy or enviable position for the appraiser.
Overcoming Buy-Out Asymmetries
In many if not most buy-out scenarios, as in the Yakuel case, it’s not unusual to find a minority owner as seller without access to company data and a majority owner as buyer with unfettered access plus the loyalty and ear of upper management and the company’s outside accountants.
Absent total transparency, the knowledge and relationship asymmetries can create deserved or undeserved distrust on the seller’s part that the appraiser is receiving accurate, even-handed information from the majority owner, especially when it comes to financial projections and any other subjective assessments.
One of the techniques that can avoid such dilemmas is the use of multiple appraisers, that is, each side has access to the same information and gets its own appraisal, which are then averaged if they fall within a specified range of each other and, if not, a third appraiser chosen by the first two does an appraisal which then gets averaged with the closer of the first two appraisals. The averaging with the third appraisal incentivizes the parties to keep the first two appraisals reasonable.
Regardless how it’s done, as a general rule the more detail in the buy-out provision concerning the valuation parameters — standard of value, premise of value, valuation date, guidelines for income statement normalizations, applicability of discounts, etc. — the better.
Finally, Yakuel highlights the potential for a process breakdown when an owners’ agreement contains both a buy-out provision calling for a “final and binding” appraisal and a general, broad arbitration clause. If by “final and binding” the signatories really mean “final and binding,” it wouldn’t hurt to add a proviso to the arbitration clause making explicit its exclusion of the substance of the buy-out appraisal.