Several weeks ago, I had the pleasure of first appearing on this blog, with a piece about a Delaware Chancery Court decision considering—as a matter of apparent first impression—whether an LLC could exercise, then walk back a call option allowing the LLC to purchase a member’s interest at a price established by a three-appraisal process.
I am equally pleased to return this week to weigh in on a recent decision by Justice Masley of the New York County Commercial Division regarding the inverse: a Delaware LLC member’s put option. A put option provides the holder with the right to sell her interest back to the LLC at a specified price. In a world where an LLC member’s exit rights is a thorny issue for the brightest (and most interested) minds—as covered here—put rights provide a member with an efficient and straightforward mechanism to cash out her interests.
While put rights generally are a strong exit mechanism, GMX Technologies v. Pegasus Capital Advisors, Dec. & Order, Index No. 654056/2019 (Sup Ct NY County Aug. 8, 2020), considers a potentially significant limitation: can an LLC member exercise a bargained-for, contractual put right if doing so would render the company insolvent?
Handbags and Herbicides
The dispute in GMX Technologies stems from a complicated cross-investment arrangement between Arnold Simon—a fashion-industry titan turned CEO of GMX Technologies LLC, an agricultural biotech startup—and Pegasus Asset Management’s Leiber Portfolio Company (“Leiber”), which owns the once-popular Judith Leiber handbag brand.
The parties initially entered into a cross-investment arrangement where Pegasus would make investments in several of Simon’s companies and in return Simon would help to save the struggling Leiber brand. When the deal soured, a global settlement resulted in Leiber taking a 12.5% membership interest in GMX. The settlement was memorialized in, among other documents, a Second Amended Operating Agreement (“Operating Agreement”) of GMX.
The Operating Agreement gave Leiber the option (the “Put Option”) to sell its 12.5% membership interests back to GMX. Leiber had the right, in its “sole and absolute discretion,” to exercise the Put Option on either the 2½ or 3½-year anniversaries of its investment. If Leiber exercised the Put Option, GMX was required to repurchase Leiber’s interest for $8 million, the sale of which would occur as follows:
At such closing, Leiber shall deliver to the Company certificates or instruments, if any, evidencing the Put Interests, duly endorsed (or accompanied by duly executed assignments) and otherwise in good form for delivery and free and clear of all liens other than as provided for in this Agreement, and the Company or Simon shall pay the Put Price in cash (by wire transfer of immediately available funds or by certified or cashier’s check).
By all accounts, the Put Option was extensively negotiated. According to Leiber, it insisted on strong exit rights because GMX was essentially a startup company with an inexperienced CEO. The Put Option was the centerpiece of those exit rights.
GMX Struggles, Leiber Exercises the Put Option
In the months following the execution of the Operating Agreement, GMX struggled. Here, the parties’ stories differ. Leiber and Pegasus explain that although they sought to raise an additional $5 million in capital to keep GMX afloat, they ultimately were unable to do so. GMX alleges that Pegasus—as part of a long-running scheme to take over GMX for pennies on the dollar—promised to raise an additional $5 million and dangled the prospect of that investment to leverage an attempted coup over 51% of GMX.
Whatever the truth, additional investments never materialized, and on June 26, 2019, Leiber provided notice in writing that it would be exercising its Put Option in full and setting the closing date—where GMX would be required to purchase Leiber’s 12.5% interest for $8 million—for July 15, 2019.
On the closing date, GMX brought suit seeking, among other relief, a declaratory judgment stating that Leiber is not entitled to exercise the Put Option and GMX is not required to honor it. GMX argued that because payment of the $8 million Put Option price would render it insolvent, it was an unlawful distribution under Delaware law. Specifically, § 18-607 of the Delaware LLC Act prohibits an LLC from making a distribution that would render it insolvent:
A limited liability company shall not make a distribution to a member to the extent that at the time of the distribution, after giving effect to the distribution, all liabilities of the limited liability company, other than liabilities to members on account of their limited liability company interests and liabilities for which the recourse of creditors is limited to specified property of the limited liability company, exceed the fair value of the assets of the limited liability company.
The Operating Agreement defines “distribution” as “the transfer of Property by the Company to one or more of its Members in his or her capacity as a Member.” (New York’s LLC Law § 102(i) defines it the same way).
Is GMX’s Payment Pursuant to the Put Option a Distribution?
Leiber moved to dismiss GMX’s declaratory judgment claim. Leiber argued that the $8 million payment under the Put Option was not a distribution because it was not a payment made to Leiber “in his or her capacity as a Member.” According to Leiber, GMX has a contractual obligation to honor the Put Option. Payment pursuant to that obligation has nothing to do with Leiber’s status as a member; the payment is owed to Leiber in his capacity as the contractual seller of an asset—a creditor.
Indeed, Leiber argued, the closing procedure set forth in the Operating Agreement requires Leiber to first tender its shares, then receive payment. So, by the time the payment is made, Leiber no longer is a member such that the payment could be considered a distribution.
The Court did not buy Leiber’s argument:
Defendants assert that, since Leiber is required to deliver his GMX certificates to GMX at the closing, and then the Put Payment is made, Leiber will no longer hold a membership interest in GMX when it receives the payment. Thus, the payment will not be made to Leiber in its capacity as member, and therefore, is not a Distribution. . . . This language [of the Operating Agreement] is clear that the payment of “immediately available funds” is made simultaneously with the delivery of the certificates. Thus, while creative, this argument is without merit. . . . [T]his portion of the declaratory judgment goes forth.
While the Court refused to dismiss GMX’s claim for a declaratory judgment alleging that GMX is not obligated to honor Leiber’s Put Option, the Court otherwise largely dismissed GMX’s other claims, including GMX’s claim that Leiber’s exercise of the Put Option constituted a breach of the duty of good faith and fair dealing.
The Court’s conclusion that GMX’s payment pursuant to the Put Option constituted a distribution subject to § 18-607 presents a difficult
balancing act for minority LLC members with put rights. When the LLC is successfully performing, a member is unlikely to exercise her put rights. But when things take a turn for the worse, the member must determine whether to exercise her put rights before things get so bad that the put obligation would render the company insolvent. This can be a narrow window, particularly where—as in GMX Technologies—the member can only exercise those put rights at certain times.
Nor is it difficult to imagine some perplexing implications. Conceivably, a put option could be unenforceable one day then enforceable the next based on the LLC’s cash flow. And a majority LLC member might use § 18-607 or its New York analogue to thwart a minority member’s put rights. Suppose, for instance, a minority member has put rights on the one-year anniversary of his membership, which he must exercise within 10 days of that anniversary. The majority member might elect to make substantial pro rata distributions in the eleventh month such that, when the Put Option becomes effective, any further distribution—i.e., payment of the put price—would render the LLC insolvent.
It also is not clear whether there is a drafting solution to these issues. Can LLC members adopt language in the operating agreement providing that the company’s payment of a put option price is not a distribution? Or will the mandatory provisions of § 18-607 (or NY LLCL § 508) trump creative drafting?
Some Closing Thoughts
Largely taking the lead from the briefing on the issue, the Court’s distribution discussion focused on—and ultimately disagreed with—Leiber’s timing-of-payment argument. But timing mechanics of the closing aside, payment of the Put Option price does not resemble what we traditionally view as distributions—divvying of profits or returning capital. As a matter of contract interpretation, it is difficult to imagine that the parties intended the Put Option payment to be subject to § 18-607 when—at least according to Pegasus—the whole purpose of the Put Option was to provide a bargained-for exit mechanism in the event that GMX did not succeed. Although not cited by the parties, consider also Justice Gammerman’s decision in Mann v. Broadwall Management of Apthorp LLC, No. 600707/09, 2009 WL 8542868 (N.Y. Sup. Ct. Apr. 10, 2009), which held that payment of a contractually required “opportunity fee” to a member was not a distribution because “the fee is owed to [the member] not in his capacity as a member, but in his capacity as a creditor.”
One interesting argument that Court did not reach requires a second look at the closing provision of the Operating Agreement: “At such closing, Leiber shall deliver to the Company certificates or instruments . . . . and the Company or Simon shall pay the Put Price in cash.” Based on this language, Leiber argued that even if the Company’s payment of the Put Price could be considered a distribution subject to § 18-607, Simon also is personally obligated to pay the put price. And Simon’s payment of the put price is not subject to the solvency requirements of § 18-607. In response, GMX argues that this language simply sets forth closing procedures; it does not create personal liability for Simon. At the motion to dismiss stage, the Court declined the parties’ invitation to choose between these competing interpretations of the Operating Agreement. Further fact development and argument on this issue is something worth watching.