The owners’ agreement is the backbone of the closely-held business. In intracompany LLC disputes, few things are more important than what the operating agreement has to say on the subject. As a consequence, the pages of this blog are packed with cases pitting clashing interpretations of an operating agreement against each other (see this post, and this one, for starters).
The prospective nature of an operating agreement often makes its interpretation complicated. Operating agreements are drafted at the start of the business, then they lie dormant for years until a dispute arises. By that time, the nature of the business or the context of the provisions may have fundamentally changed. And even the provisions that seemed most straightforward years ago can become murky.
Despite those complications, when faced with differing interpretations of an operating agreement, Courts go back to the basics of contract interpretation. The First Department’s recent decision in Southern Advanced Materials, LLC v Abrams, 2023 NY Slip Op 04704 [1st Dept Sept. 21, 2023], treats us to a lengthy discussion of how those basics work.
The Operating Agreement and Dissolution Premium
The dispute in Southern Advanced concerns the sale of CV Holdings LLC, a Delaware limited liability company that held subsidiaries engaged in the design and manufacture of plastic products. Robert Abrams owned, directly or indirectly, all of the Company’s Class A interests, and Southern Advanced Materials (“SAM”) owned all of the Company’s Class C Preferred Interests, which represented approximately 8% of the Company’s ownership.
CVH’s operating agreement provided SAM with a premium return if CVH was dissolved. Specifically, Section 13.3(c) of the operating agreement provided that “upon dissolution of the Company,” SAM was entitled to a 10% preferred return if the amount that would otherwise have been distributed under the complex waterfall provisions of the operating agreement provided an annual return of less than 30%.
Section 13.1 of the operating agreement contained the dissolution triggers. It provided that CVH “shall be dissolved upon approval of the Class A Common Members holding a majority of the Class A Common Interests and Super-Majority Consent or upon the disposition by [CVH] of substantially all of its assets.”
In 2011, Abrams formed SiO2, a medical device company focused on the development of glass-lined plastic vessels. Since SiO2 required a greater capital investment than CVH could make, Abrams agreed to hold the ownership of SiO2 personally, but for the benefit of CVH. He also agreed to provide CVH with an option to purchase SiO2 for $1 upon CVH’s election, and he placed certain assets and liabilities of SiO2 on CVH’s balance sheet.
The Two-Step Wendel Transaction
In 2013, Abrams began negotiating with third-party Wendel S.A. concerning Wendel’s possible purchase of CVH. During those negotiations, however, Wendel made clear that it was not interested in acquiring CVH’s assets or liabilities related to SiO2.
As a result, Abrams and Wendel arranged a two-step deal. First, CVH in a “Pre-Closing Restructuring” divested itself of its SiO2-related assets and liabilities, including extinguishing the $1 option to acquire SiO2 outright. The next day, in an “Equity Purchase,” Wendel agreed to acquire all of CVH’s equity interests for $360 million (steps one and two, collectively, the “Wendel Transaction”).
Prior to the Wendel Transaction, Abrams separately agreed with each CVH owner the amount of compensation it would receive for both steps of the deal: CVH’s divestment of its SiO2 holdings, and its share of the net proceeds of the $360 million acquisition. SAM objected to the Wendel Transaction, approving the deal subject to a “Retained Claims Agreement” allowing it to sue for the difference between the value it received and the value to which SAM believed it was entitled.
Does the Two-Step Wendel Transaction Trigger SAM’s Right to a Dissolution Premium?
SAM eventually sued CVH for breach of the operating agreement in connection with CVH’s failure to pay SAM the 10% dissolution premium under Section 13.1 of the operating agreement. SAM insisted that because the two-step Wendel Transaction includes a “disposition” of “substantially all” of CVH’s assets, SAM was entitled to the premium.
CVH countered that because the Wendel Transaction was an equity purchase—Wendel bought the equity interests in CVH, not its assets—there was no disposition of CVH’s assets, and the dissolution premium was inapplicable.
According to SAM, calling the Wendel Transaction an “equity purchase” was a gross elevation of form over substance. Although Wendel nominally purchased CVH’s equity in phase two of the transaction, SAM contended, the Court must consider both phases together, including CVH’s pre-closing restructuring.
With steps one and two considered as one transaction, SAM argued, the Wendel Transaction was, in substance, an asset-purchase agreement: Wendel was purchasing some (but not all) of CVH’s assets, and CVH was divesting itself of the others—the SiO2 assets. And because CVH was “disposing” of all or substantially all of its assets, SAM was entitled to the dissolution premium.
SAM further pointed to evidence showing that Wendel liquidated CVH immediately after the Wendel Transaction as proof positive of its argument: this deal, said SAM, was a disguised dissolution all along.
Both sides sought summary judgment on SAM’s breach of contract claim, and the trial court denied both motions, finding issues of fact in interpretation of the operating agreement.
The First Department’s Interpretation Exercise
The First Department reversed, holding that the trial court should have granted summary judgment in favor of CVH. In so doing, the First Department gave a masters-level course on the interpretation of operating agreements. Here all the reasons, said the Court, why SAM’s dissolution premium did not apply here:
- Section 13.1 of the operating agreement provides that a dissolution of CVH occurs only upon “the disposition by the Company of substantially all of its assets.” Even pretending the Wendel Transaction was a disposition of assets, those assets were not transferred by the company when CVH’s owners sold their equity interests. SAM’s proposed interpretation of the operating agreement would make the phrase “by the company” meaningless.
- Moreover, taken to its logical end, SAM’s interpretation meant that any sale of CVH as an entity—because it would necessarily result in the transfer of control of CVH’s assets—would trigger the dissolution premium. But that cannot be, because a different section of the operating agreement, Section 14.4 provides that in the event of a sale of CVH’s equity to a third party, the shareholders are entitled to receive their respective pro rata shares of the sale proceeds without any premium.
- Finally, to the extent the phrase “disposition by the Company of substantially all of its assets,” in Section 13.1 is unclear, the next Section 13.2 gives helpful context: it contemplates a process of “winding up, liquidation, and dissolution of assets.” That did not and would not happen in connection with an equity sale.
The First Department also dismissed as irrelevant SAM’s protestations that CVH was wound down immediately after the Wendel Transaction:
Contrary to the motion court’s apparent view, the question of whether CVH continued to operate after the Wendel transaction is irrelevant to the question of whether the transaction itself constituted a dissolution of CVH. After the Wendel transaction closed, SAM no longer had any interest in CVH as an entity and any postclosing decision made by Wendel (which is not a party to this action) to reorganize the corporate structure it had purchased would have no effect on SAM’s rights or interests.”
Lessons in Operating Agreement Interpretation
Ultimately, the First Department in Southern Advanced reaches the reasonable conclusion that an equity purchase is not a “disposition of substantially all of the Company’s assets” even where it is preceded by some restructuring and divestment at the behest of the purchaser.
But it also offers a terrific example of how Courts will interpret and enforce an LLC operating agreement according to traditional contractual interpretation principles—even without resorting to outside evidence. And in that sense, its potential impact in the Business Divorce World is far more meaningful. Here are my three takeaways from the Court’s interpretation of Section 13.1:
- Every Word Matters in the Preference Against Surplusage. It is settled law that “[a] reading of the contract should not render any portion meaningless” (Cortlandt St. Recovery Corp. v Bonderman, 31 NY3d 30, 39 ). In this case, the Court took that cannon literally, rejecting SAM’s interpretation because it would render a mere three words, “by the Company,” meaningless.
- Beware the Implications. SAM’s interpretation of the dissolution trigger also failed because, in the words of the First Department, it “proved too much”—applying in every sale of CVH’s ownership interests. Smart judges test the arguments before them by pushing them to their logical extremes; ensure your interpretation of the operating agreement does not collapse under its own logic.
- Organization Within the Document Matters. The Court also found support for its reading of Section 13.1 in the title of Section 13, “Dissolution and Termination,” and the winddown provisions of the nearby Section 13.3, reinforcing the importance of the location and surrounding context of the contested provision.
Business owners and their counsel would be well-advised to keep these canons in mind when drafting or interpreting owners’ agreements.