Most LLC operating agreements contain a “buyout” provision allowing the LLC or its remaining members to buy the membership interest of a departing member. Buyout provisions can be structured however the LLC members see fit. Freedom of contract is one of the most attractive traits of an LLC.
(This contractual buyout right should not be confused with California’s statutory buyout right that can be triggered in response to a disgruntled member’s lawsuit for judicial dissolution.)
But operating agreement buyout provisions are sometimes unclear, leading to uncertainty, disputes, and litigation.
Below are some examples of LLC buyout-related problems:
Is a Buyout Provision an “Option”?
If the LLC elects to exercise its buyout rights pursuant to a provision in the Operating Agreement, can it later change its mind and back out of the buyout?
That depends on how the buyout provision is written, and whether it constitutes an “option.”
Under basic contract law, a new contractual offer can be revoked any time before it is accepted. Thus, if the LLC’s exercise of the buyout is construed as a new “offer” (to buy the departing member’s interest), the LLC can change its mind and back out as long as the departing member hasn’t “accepted” the buyout offer.
But options are different. An option is both an offer as well as a promise to hold that offer option. Once the option holder exercises the option by accepting that offer, a binding contract is formed. Thus, if the buyout provision is construed as an option, the buyout provision itself constitutes the departing member’s offer to sell and promise to keep that offer open. When the LLC exercises the option, a binding contract is formed, and the LLC can’t back out.
This very issue came up in an unpublished opinion from the Delaware Court of Chancery — Walsh v. White House Post Productions, LLC — where an LLC exercised an operating agreement’s buyout provision and later tried to back out during the appraisal process. The court held that the buyout provision was a call option. The member’s standing offer to sell was accepted by the LLC when it exercised the option, resulting in a binding contract from which the LLC could not escape.
Ambiguity Always Causes Problems
Disputes often arise when buyout provisions are ambiguous as to how they are supposed to operate.
In one recent LLC dispute I handled, the operating agreement contained a pretty detailed buyout provision, but specified no time frame in which the buyout could be exercised. The member had essentially parted ways with the LLC in late 2019. The LLC used its apparent “open-ended” buyout rights as leverage, first saying it would evaluate a buyout in a year or more, but then pouncing on the buyout at the depths of the Covid-19 pandemic, in an attempt to capitalize on dramatically impaired valuations. Fortunately, the slightly better written “date of value” provisions (tied to the member’s departure in late 2019) saved the member from a low-ball buyout.
In a case from the Supreme Court of New York — Breslin v. Frankel — the court held that a 19-year delay in attempting to exercise an ambiguous buyout option was “unreasonable as a matter of law,” and the option was no longer enforceable.
Even the most basic buyout provision terms can be wrecked by ambiguity. For example, in a recent unpublished opinion from California’s Fourth Appellate District — Sohrabi v. Hadjibabaie — the Court of Appeal held that an LLC operating agreement was ambiguous as to whether a buyout could be elected verbally or only in writing. Because of the ambiguity, the issue was determined according to extrinsic evidence such as the parties’ conduct, which indicated that a verbal election was sufficient.
Beware “Book Value”
Most operating agreement buyout provisions include some rules as to how the departing member’s interest is to be valued. Most use some type of appraisal process, and many simply direct the appraiser to arrive at a “book value” for the member’s interest in the LLC.
Book value, however, can be a grossly unfair valuation metric for most real estate investment LLCs.
Book value is normally the original cost of the the asset less depreciation. As noted in many accounting guidelines, because book value is based on historical cost, it can be very different from present market value. For example, if the asset was purchased several years ago and market conditions have been favorable, the market value is typically much higher than book value.
Some well-written operating agreements require adjustments to book value to reflect the market value of the LLC’s real property assets. But unfortunately, many operating agreements don’t. As a result, members can be forced to sell for a low-ball, artificially low “book value” buyout price. In that case, the selling member might be able to challenge the valuation formula based on unconscionability or some other creative legal theory, but courts generally enforce operating agreements as they are written when the language is clear.
The issues flagged above are just a small sampling of problems that can arise with LLC buyouts.
The best way to avoid these problems is, as usual, with a carefully crafted operating agreement. The ability to customize an operating agreement to match the parties’ intentions is the key benefit offered by LLCs.
But when important terms are not addressed, LLC members are left with guesswork and unpredictable outcomes, and the stage is set for litigation in The LLC Jungle.