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Deadlock-Breaking Mechanisms in Real Estate LLCs: Avoiding Litigation When Members and Managers Fail to Agree Buy-Sell Provisions, External and Internal Tie-Breakers, Put and Call Options, Partition or Sale Provisions, and More
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THURSDAY, FEBRUARY 22, 2018
Presenting a live 90-minute webinar with interactive Q&A
Kathleen A. Kelley, Member, Protorae Law, Tysons, Va.
Pantea F. Stevenson, General Counsel, Loci, Arlington, Va.
Craig Long, Esq., Managing Attorney, Craig Long, Cumming, Ga.
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Deadlock Breaking Mechanisms in
Real Estate LLCs
Craig Long
MANAGING ATTORNEY
CRAIG LONG, LLC
Thursday, February 22, 2018
Pantea Stevenson
GENERAL COUNSEL
LOCI
Kathleen Kelley
PARTNER
PROTORAE LAW PLLC
PRESENTED BY:
Introductions
Kathleen Kelley is a Partner at Protorae Law PLLC in Tysons, Virginia. Ms. Kelley practices general corporate and LLC law with a particular emphasis on formations, equity plans, mergers & acquisitions, joint ventures, and owner exits. She also advises clients in a wide variety of transactional matters including fiduciary duty issues, government-wide small business contracting programs, LLC management, general contract matters, securities laws and other relevant business laws. She represents clients in ownership dispute matters, both prior to a dispute and following a dispute, in negotiating an owner’s exit.
Craig Long is the Managing Attorney at Craig Long, LLC. Mr. Long
focuses his practice on real estate law, corporate law and civil litigation. His real estate transactional practice involves representing institutions, investors, creditors, property owners and consumers in commercial closings and transactions, and in his corporate practice, he represents entities from formation, to operations, to exits through M&A or dissolution, including, corporations, LLCs, partnerships, and mergers and acquisitions.
Pantea Stevenson is General Counsel at Loci.
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When Deadlocks Arise in LLC Decision Making
• What is a deadlock? – Paralysis in decision making regarding the underlying business
o One-off decisions versus operational decisions • Causes are innumerable
– See, e.g., Advanced 23, LLC et. al. v. Chambers House Partners, LLC et. al., 2017 NY Slip Op 32663(u) (N.Y. Sup. Ct. 2017) (an op. agreement with no provisions preventing deadlock require a trial to establish the party seeking dissolution has not opportunistically created a deadlock to as to require dissolution);
– In the Matter of the Dissolution of 1545 Ocean Avenue, LLC, 72 A.D.3d 121 (2010) (an op. agreement that empowers each manager to act autonomously and to unilaterally bind the entity means deadlock is an impossibility);
– Marc Magid et. al. v. Lawrence Magid et. al., 2017 NY Slip Op 32603(U) (N.Y. Sup. Ct. 2017) (ownership breakdown is irrelevant if there is a deadlock);
– In Re: Arrow Investment Advisors, LLC, C.A. No. 4091-VCS (Del. Ch. April 23, 2009) (a failure of the company to succeed as initially expected does not constitute a deadlock that necessitates judicial dissolution).
– Overarching circumstance o unanimity requirement or even number of decision makers, e.g., co-managers.
Id. o Or, a member or manager has a veto right notwithstanding owning a minority
interest. see, e.g., Marc Magid et. al. v. Lawrence Magid et. al., 2017 NY Slip Op 32603(U) (N.Y. Sup. Ct. 2017)
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When Deadlocks Arise in LLC Decision Making
• Consequences if deadlock not resolved?
– Judicial Dissolution
oDraconian
oAwarded sparingly, see, e.g., In Re: Arrow Investment Advisors, LLC, C.A. No. 4091-VCS (Del. Ch. April 23, 2009)
– Custodian or Receivership
– Business as a going concern fails
– Members cannot create and operate new business – they are stuck
8
When Deadlocks arise in LLC Decision Making: What happens
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• Management Structure of LLC – Board of Managers
– Co-Managers
– Officers
o Can officers be deadlocked?
– Members
• Unanimous Decisions vs. Supermajority Decisions vs. Majority Decisions
• Ownership Questions – Does ownership breakdown matter?
o 50%/50%; 90%/10%
When Deadlocks arise in LLC Decision Making: What happens
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• First – Look at the Operating Agreement – Does it tell you what to do?
• Second – Look at the State Statute – Does it tell you what to do?
– Does it provide a remedy?
Provisions Designed to Resolve Deadlocks
A. Background
B. Buy-sell
C. External or internal “tie breakers”
D. “Rotating/alternating” or “casting” voting procedures
E. Put or Call options
F. Partition or Sale
G. Judicial Dissolution
H. Judicial Expulsion
I. Custodian/Receivership
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Background
•Limited liability companies are creatures of contract
•Created under individual state by filing Articles of Organization
– Binding terms can be included
– The terms in the articles can be in lieu of an operating agreement – not recommended
– Although, there can be reasons to include certain terms in the articles - *
• Operating Agreement – Not required, strongly suggested *
oCourse of conduct analysis
– Ambiguity vs. Unambiguous terms/language
• Limited liability company acts govern where no written agreement exists
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Background
»The Operating Agreement (or perhaps the Articles/Certificate) are the Agreement among the parties as to the management of the LLC
»Because this is not a corporation, there is little default law under the statute – you must include
• Ownership
• Management
• Transfer restrictions
• Allocations/Distributions
• Withdrawal
• Dispute resolution
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Background
• Typically, decisions flow up to the Members and are decided by ownership vote, BUT some decisions have a higher approval requirement
• Fundamental LLC decisions tend to be unanimous – Dissolution
– Merger
– Sale of all the assets
• Other “Extraordinary Actions” tend to have a higher “Supermajority” approval requirement – Taking out a loan, or a loan above a certain amount
– Entering into contracts that obligate the Company above a certain amount
– Providing salaries to Manager/affiliates of a member
– Removing a Member/Manager
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Background
• With the wrong ownership/management combination, you can easily have:
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DEADLOCK
Buy-Sell: Generally
• A buy-sell agreement is just that – an agreement to
–Either buy or sell
–At an agreed price
–At an agreed time in the future
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Buy-Sell: Who Buys and Who Sells?
• Depends on the model discussed below; oOr
• Could describe in the Operating Agreement – for example if one party brought the Real Property into the LLC – that party may want to keep the specific property; oOr
• Flip a coin.
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Buy-Sell: At What Price?
• Shotgun Method (aka Russian Roulette, Texas Shoot Out) – One member offers to buy out the other member at a set price and with set
terms (typically payment terms)
– Offeree must either accept the offer, or buy the Offeror’s Interest at the same (equivalent percentages) terms
• This method can be very successful – Can be a fair and equitable division of assets
o Parties are incentivized to make a good, honest offer
– Method can be very fast (include a timeline in Operating Agreement)
– Cost-efficient
• But it does have some draw-backs – Favors the Member with the deepest pockets and the most information
– Dispute could be manufactured to cause Shotgun to be activated
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Shotgun Language
• If at two successive meetings of the Members, the Members are unable to reach a decision by the required vote regarding any matter at such meetings (each, a “Deadlock”), the Members shall endeavor in good faith to resolve such Deadlock.
• If after ninety (90) days the issue subject to the Deadlock has still not been resolved, then any Member (the “Purchasing Member”) shall have the right, by providing written notice (the “Purchasing Notice”) to the other Member or Members (the “Selling Member”), to purchase all of the Interests owned by the Purchasing Member at a purchase price and closing conditions stated in the Purchasing Notice.
• Within 15 days after the receipt of the Purchasing Notice, the Selling Member may either accept the offer in the Purchasing Notice to sell his or her Interest, or to purchase the Interest of the Purchasing Member, pursuant to the terms in the Purchasing Notice.
• Each Member shall take all actions as may be reasonably necessary to consummate the sale contemplated by this Section XX, including entering into agreements and delivering instruments and consents as may be deemed necessary or appropriate.
• During the continuation of any Deadlock and prior to the closing of any sale and purchase pursuant to this Section XX, the Company shall continue to operate in a manner consistent with its prior practices and this Agreement until such time as such Deadlock is resolved.
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Buy-Sell: At What Price?
• Auction Method – Sealed bid auction where the highest bidder wins OR
– Sealed bid with escalation clause
• This method can be very successful – Like the Shotgun Method it can be a fair and equitable division of assets
o Parties are incentivized to make a good, honest offer
– Method can be very fast (Make sure to include timeline in Operating Agreement)
– Cost-efficient
• But it does have some draw-backs – Again, like Shotgun Method, it favors the Member with most information
– But can be much worse for the Member with the least money – other Member can outbid easily
20
Buy-Sell: At What Price?
•Appraisal Method –Parties pick an appraiser
oWho pays for the appraiser? Split? The Company? The Departing Member?
oWho picks the appraiser? Pick a well-regarded neutral party now if possible.
–Appraiser decides value of LLC and then value of specific interest in question being bought oUse valuation discounts?
o Typically this one of my last resort
» Can be costly - Particularly if there are three appraisers
» Take too much time – Make sure to include timeline
» May not be accurate
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Appraisal Language
• The fair market value of the Interests (the “FMV”) shall be determined by the Members as of the date of the Event. The date the FMV is determined, is hereinafter referred to as the “Valuation Date.” In the event that an agreement as to the FMV is not reached among the Members, then the Manager shall select an independent valuation expert (the “Evaluator”) to determine the FMV in accordance with the following process:
– the Evaluator shall have at least ten (10) years’ experience with respect to the financial valuation and appraisal of companies in the same, or similar industries as the Company, in the XX metropolitan area;
– within fifteen (15) days of the selection or appointment of the Evaluator, the Company shall provide the Evaluator with full access to the financial and other data related to the Company, all of which the Evaluator shall agree to hold in confidence to the extent reasonably requested by the Company;
– within thirty (30) days of receipt of all necessary financial and other data,, the Evaluator shall notify the Members as to the Evaluator’s determination of the FMV; and
– the costs and expenses of the Evaluator (including reasonable attorney’s fees) will be borne by the Company, unless the Evaluator determines otherwise.
• The purchase of the Interests hereunder shall take place within nine (9) months after the Valuation Date.
• The Interests may be purchased either (a) in cash or other immediately available funds, or (b) an unsecured promissory note with substantially equal installments, payable at least annually, over a period not to exceed five years, and the principal of which will accrue interest at the applicable federal mid-term rate in effect under Code Section 1274(d) as of the settlement date, compounded annually, or (c) a combination of the consideration referenced in (a) and (b).
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Buy-Sell: At What Price?
• Formula model –Can provide for a formula to determine what the value
of the Interest will be at the Buy-Sell
–X times EBITDA/Revenue
–Real Estate Specific numbers?
23
Buy-Sell - At What Time?
•At Dispute –Define Dispute
oAny dispute?
oDispute only to the fundamental provisions?
oCould have dispute of X number of days
–After attempt to mediate?
•At specific date • Lease is terminated?
• X number of years?
•Once certain approvals are obtained
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External or Internal Tie Breaker
• Exactly what this sounds like – Something else decides for us –External time breaker can be arbitrator or some industry
executive
o Mom?
o Does an industry executive know enough to make this specific decision or recommendation?
–Internal Tie Breaker can be an independent officer or literal coin flip
o Consider implications of internal party making the decision, internal parties are never independent
–Only works for specific decisions, and will no solve underlying problems of dispute/distrust/difference of vision of Members
25
Rotating / Alternating or “Casting” Voting Procedures
• This type of provision allows for the deciding vote to rotate or alternate among the Members/Managers
• One year Member A decides, the next year, Member B decides
• Decisions cannot be fundamental – Would not want client to have Company dissolved or the Real
Estate assets sold out from under it
• Not practical for real disputes
• Can be very successful for Officer or day-to-day Manager roles – If all the Members want to be CEO/President, this can allow for
the actual day-to-day functions of the Company to rotate around with the Members
26
Put-Call-Expel
• Put (right to sell Interest) or Call (right to buy Interest) Mechanism or Expulsion (Member is expelled as a Member, but may keep economic rights) Provision
– Similar to Buy-Sell Agreement
– Members is bought out (typically by the Company) / or Member requires Company to buy Interest at a certain price upon a triggering event
• Triggering Event is the negotiating issue in the Operating Agreement – For Cause relating to individual member
– Material failure to perform its obligations under the Operating Agreement
– Failure to provide additional capital contribution
– Transfer of Interest not in accordance with terms of Operating Agreement
• Consider “punitive” measures if Member is expelled or if Member forces a buyout
– Structure as “discount” on FMV
– Can be flat amount (20%? 50%?) for expulsion
– Or for when Member leaves consider decreasing discount based upon time
o If Member leaves before 1 year, 50% discount
o If Member leaves after 1 year but before 2 years, 40% discount
o Idea is that parties intended to work together for a period of time, and if one wants to leave early, they should bear some of the consequences of that departure
27
Partition or Sale
• Partition - the right to cause the LLC to divide up its assets among the Members and then the LLC is dissolved
• Sale – the right to cause the LLC to be sold or sell all of its assets and the LLC is dissolved
• Probably not an option with a Real Estate LLC – The real property is particular
– Who gets what?
– Are formal valuations required?
– Is there a buyer when we need one?
• Works best with a Company with easily divided assets or a certain type of Services-based industry
• Destroys business model and synergies for working together
28
Partition or Sale: Under Statute
• Two types in partition – Equitable o Equity has jurisdiction in cases of partition whenever the remedy at law is
insufficient or peculiar circumstances render the proceeding in equity more suitable and just. GA. Code 44-6-140 Equitable jurisdiction (Georgia Code (2017 Edition))
o Chaney et. al. v. Upchurch, 603 S.E.2d 255, 278 Ga. 515 (2004) (legal partition insufficient because legally partitioned property would not satisfy local zoning requirements, making compliance impossible, justifying equitable partition and distribution).
– Statutory o When two or more persons are common owners of lands and tenements,
whether by descent, purchase, or otherwise, and no provision is made, by will or otherwise, as to how such lands and tenements shall be divided, any one of such common owners may apply by petition to the superior court of the county in which such lands and tenements are located for a writ of partition which shall set forth plainly and distinctly the facts and circumstances of the case, shall describe the premises to be partitioned, and shall define the share and interest of each of the parties therein. GA. Code 44-6-160 Application for writs of partition (Georgia Code (2017 Edition))
o Wallace v. Wallace, 396 S.E.2d 208, 260 Ga. 400 (1990) (title must be held as tenants-in-common and the partitioner must be in at least part possession of the property)
29
Partition or Sale: Under Statute
• Like judicial dissolution, partition is not a desirable outcome
• How to avoid: –Contract oTenants-in-common Agreement Sample provision regarding partition: To avoid the inequity of a forced sale and the potential adverse effect
on the Tenants in Common, the Tenants in Common filing such action (“Seller”) shall first make a written offer (“Offer”) to sell its undivided interest to the other Tenants in Common at a price equal to: (a) the Fair Market Value (as defined below) of Seller’s undivided interest minus (b) selling, prepayment or other costs that would apply in the event the Property was sold on the date of the Offer. The other Tenants in Common shall be entitled to purchase a portion of the Seller’s interest in proportion to their undivided interest in the Property. In the event any Tenant in Common elects not to purchase its share of the Seller’s interest, the other Tenants in Common shall be entitled to purchase additional interests based on their undivided shares in the Property. “Fair Market Value” shall mean the fair market value of Seller’s undivided interest in the Property on the date the Offer is made as determined in accordance with the procedures set forth below….
30
Partition or Sale: Under Statute
•Other Considerations: –Mortgagees o Partition often constitutes default and could trigger
foreclosure o Makes Tenant in Common Agreement of paramount
importance
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Judicial Dissolution • Delaware
– On application by or for a member or manager the Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement. Del. Code Tit. 6 Sec. 18-802 Judicial dissolution. (Delaware Code (2018 Edition))
• New York
– On application by or for a member, the supreme court in the judicial district in which the office of the limited liability company is located may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement. NY LLC Law 702 Judicial dissolution. (Laws of New York (2018 Edition))
• Georgia
– On application by or for a member, the court may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or a written operating agreement. GA. Code 14-11-603 Court-decreed dissolution (Georgia Code (2017 Edition))
• Virginia
– On application by or for a member, the circuit court of the locality in which the registered office of the limited liability company is located may decree dissolution of a limited liability company if it is not reasonably practicable to carry on the business in conformity with the articles of organization and any operating agreement. Virginia Code Sec. 13.1-1047 Judicial dissolution. (Virginia Statutes (2017 Edition)) 32
Judicial Dissolution
• In Fisk Ventures, LLC v. Segal, Delaware’s Chancery Court set out factors for a court to consider in dissolving Company
1. The Members’ vote is deadlocked at the Board level;
2. The Operating Agreement provides no relief from the deadlock; and
3. Due to the financial condition of the Company, there is no business to operate.
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Judicial Dissolution
• Facts in Fisk Ventures, LLC v. Segal, 2009 WL 73957 (Del. Ch. 2009):
• 5 Member board, but requires 75% approval for all decisions
• Board rarely met – because one faction wouldn’t meet, defeating quorum requirements
• Could not make decisions
• No means for breaking this deadlock in the Operating Agreement
• Because Board couldn’t take any actions – because they couldn’t get a vote – it was “not reasonably practicable for the Company to carry on its business”
34
Judicial Dissolution
• In re GR Burgr, LLC, C.A. No. 12825-VCS (Del. Ch. 2017)
• Gordon Ramsay and Richard Siebel entered into 50/50 LLC
• No tiebreaker
• Everything required a majority vote, which was really a unanimous vote
• Money ran out
• DEADLOCK
• Chancery Court finds that “It is no longer ‘reasonably practicable’ for [the LLC] to carry on its business in conformity with its operating agreement and, therefore dissolution of the entity is appropriate under Section 18-802.”
35
Undeadlocking Deadlocks: Where to Look
I. Statutes are usually silent regarding the subject of deadlocks
II. Statutes only authorize particular parties to file dissolution actions if there is a deadlock; and
III. Statutes only authorize courts to dissolve entities if the deadlock threatens the business purpose, not resolve the deadlock by functioning as a neutral third-party decision maker that decides and the limited liability company continues on its marry way
IV. Thus, to avoid the draconian result of judicial dissolution, deadlock resolutions have to come from:
– Private mechanisms included as terms in the articles or organization or operating agreement in order to avoid judicial dissolution
36
Judicial Expulsion
• In certain circumstances, instead of dissolving the LLC, a Court can expel a Member, effectively breaking up the logjam
• Not all statutes provide this remedy – Delaware does not
• Virginia’s statue looks for:
– Wrongful conduct. The individual’s wrongful conduct has “adversely and materially” affected, or will adversely and materially affect, the company’s activities;
– Breach of contract. The individual has “willfully and persistently” or is willfully and persistently committing, a material breach of the operating agreement or their duties or obligations as a manager or member of the LLC;
– Not reasonably practicable. The individual has engaged, or is engaging, in conduct relating to the company’s activities which makes it not reasonably practicable to carry on the activities with the person as a member.
37
Custodian / Receivership
• Some State statutes allow for the Court to appoint a Custodian or Receiver to operate the Company where the dispute is so great that the business does not operate – Not present in all LLC statutes – would the corporate code
apply?
– Does the LLC need to be insolvent – would the bankruptcy code be better?
– Can the parties just agree to a receiver? Accountant?
38
Alternative Dispute Resolution
A. Mediation
B. Arbitration
C. Others?
39
Arbitration
40
In lieu of court, parties may contract for arbitration in their governing documents and agreements, including shareholders agreements and operating agreement.
Why?
Arbitration – Why?
41
The promises of Arbitration (promises made, kept and broken)
1. Finality and binding (mixed bag)
•Double edged sword as unless the contract specifically states otherwise (and rarely do they) an arbitrator’s decision may only be appealed upon a showing of fraud, misrepresentation, arbitrariness, or capriciousness by the arbitrator
•But stops appeal after appeal process, can still have brief after brief due
Arbitration – Why?
42
2. Confidentiality (promises kept)
• Member disputes can get specially ugly because emotions are involved
• This is my number one consideration when deciding whether to place an arbitration provision or not in an agreement
Arbitration – Why?
43
3. Simplification of Procedure (promises kept)
• Relaxed rules of evidence, but still present
• Relaxed procedure
• Might not get full opportunity to cross examine witnesses
• Can set award range for arbitrator
Arbitration – Why?
44
4. Cost (mixed bag)
• Lawyers are expensive, and you are adding one more lawyer (the arbitrator) plus hefty arbitration fees based on amounts at issue
• Not necessarily faster or more efficient than court
• A properly drafted arbitration provision or ground rules may limit discovery and procedure
Arbitration – Why?
45
5. Time (mixed bag)
• Dependent on your jurisdiction, but arbitrations routinely drag on
• If the parties request a written opinion from the arbitrator, there will be an increase in time
Arbitration – Why?
46
6. Subject Matter Expert (promises kept)
•The arbitrator is usually picked by both parties and is a subject matter expert
Arbitration – Drafting Considerations
47
•If adding an arbitration clause in documents, to get the full benefits of arbitration, err on the side of adding procedure and limits.
•Drafting tips: http://www.acc.com/_cs_upload/vl/membersonly/SampleFormPolicy/409703_1.pdf
• Expertise of arbitrator
• Form of decision (written vs. just award)
• Scope of discovery
• Fee shifting
• Punitive/consequencial damages
• Confidentiality
• Injunctive relief procedure
• Location
• Number of arbitrators
Mediation
48
• Non-binding process with one or more neutral facilitators
• Parties can dictate procedure •Set timelines •Appoint a neutral fact finding •Require lawyers to withdraw if matter goes
to litigation
Mediation
49
Recommended provisions: • Set timeline for mediation with the option to go to court/arbitration if timeline not
met
• X number of days to agree on a mediator and X number of days to reach an agreement
• Set negative incentives for non-participation
• Require that the parties partake in good faith
• Carve out appropriate provisions
• i.e., if there is no dispute about amounts due, the collecting party should not have to go through mediation first
Escalation Procedure
50
• Require notice of dispute
• Start with division heads and move up to CEOs/managers
• Require person to person meeting before lawsuits (set time limits to prevent abuse of system)
• Neutral fact finder or facilitator
Special Considerations with Commercial Real Estate
• Managing/leasing the real property asset
• Avoiding loan defaults
51
Questions?
Kathleen A. Kelley Craig Long Pantea Stevenson Partner Managing Attorney General Counsel Protorae Law PLLC Craig Long, LLC Loci
703.749.8507 678.679.0680
[email protected] [email protected] [email protected]
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