April 2, 2020

Del. Chancery Says No Turning Back After Buyout Notice

In an effort to maintain my sanity by providing some non-pandemic content, I stumbled across the Chancery Court’s recent decision in Walsh & Devlin v. White House Post Productions, LLC, (Del. Ch.; 3/20), which involved claims arising out of an LLC’s attempt to back out of a contractual buyout process that it had started.

The LLC agreement’s buyout provision was one that is pretty common in a variety of settings involving companies with management investors alongside PE firms or other sponsors.  It gave the LLC the right to buy out management investors upon termination of employment, and established a “triple appraisal” pricing process. The LLC notified the plaintiffs that it intended to exercise that right, and duly produced the first appraisal. When the plaintiffs sought information in order to obtain a second appraisal, the LLC informed them that it had changed its mind and was no longer interested in buying their membership interests.

The plaintiffs went ahead and sought an second appraisal anyway, and when that appraisal produced a valuation that was 10% higher than the one produced buy the LLC, they sought to have a third appraisal completed. At this point, the LLC went silent. The plaintiffs responded by filing a lawsuit that essentially asked the Chancery Court to order the LLC to finish what it started.

The defendants moved to dismiss the breach of contract claim against the LLC. They argued that delivery of the buyout notice was simply an offer, which the LLC had the right to rescind at any time prior to acceptance.  The plaintiffs countered that the exercise of the buyout right created a binding “call option.”  After reviewing in detail the terms of the buyout clause, the Vice Chancellor held that the plaintiffs stated a claim:

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.

Because she concluded that the buyout provision was a call option, VC McCormick said that the Company could not withdraw from the price-fixing process after exercising that option – and she found that it was reasonably conceivable that the notice initiating the buyout process “constituted an exercise of the Company’s power of acceptance” under the buyout provision.

This kind of language is probably in thousands of buy-sell agreements, and I bet the drafters never thought for a minute that adding the language “. . .and the seller shall be obligated to sell” did anything more than add suspenders to the contractual belt. My guess is that language may get a closer look in the future.

By the way, I originally was going to title this blog “Delaware Chancery Says ‘No Backsies'” – but I concluded that was undignified, even applying the increasingly lax standards of a man who has spent the last two weeks in sweatpants staring vacantly into a seemingly endless stream of Zoom meetings.

John Jenkins