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buy-sellIn a down market, partnership disputes tend to rear their heads with increasing frequency, and many partners begin looking for a way out[1]. One place they often turn is the buy-sell mechanism. But before pulling the trigger on a buy-sell, there are several things to consider in order to prepare for how the circumstances might play out.

Before turning to those considerations, let’s clarify what exactly a buy-sell provision consists of.

A buy-sell provision provides a method for participants in a joint venture to part ways under certain circumstances, one of which can be a disagreement among the partners or a deadlock over a major decision. The method of separation usually consists of an “I cut, you choose” proposition, where one partner names a price and the other partner decides whether to be a buyer or a seller at that price — that is, whether to buy the other partner’s interests in the venture and become the sole owner or to sell it’s interest to the other partner and exit the venture.

Since the partners often will not own the same percentage of the company, and since there may be other factors affecting the value of each partner’s interest (such as a right to priority distributions or a promoted interest on the back-end), the respective ownership interests of the two partners may not be equal in value. Therefore, the price named at the outset of the buy-sell procedure could be an aggregate value for all of the assets of the venture, rather than a purchase price for one partner’s interest in the venture. That aggregate value is then used to determine the purchase price for each partner’s interest by calculating the amount that each partner would have received in a hypothetical sale of all partnership assets for the aggregate price named at the outset of the buy-sell procedure.

There are many variations of the buy-sell provision and many elements to consider when drafting and negotiating a buy-sell provision; however, here we are looking at what to consider before triggering an existing buy-sell. When you open up your partnership documents to read the buy-sell provision (or have your lawyer do it), what should you look for and what questions should you ask?

1. Litigation Outlook

Perhaps the most important consideration from a legal standpoint is the litigation landscape. If you are considering invoking the buy-sell, chances are that a consensual resolution has not been feasible. There exists some disagreement or dispute, so litigation is a possibility.

Possible bases for litigation include whether the pre-conditions to triggering the buy-sell have been met. This is not an issue if the buy-sell can be freely invoked, perhaps after an initial lock-out period. But sometimes the documents may require, for example, that a major decision deadlock exist before the buy-sell can be tripped. How is a deadlock defined? Are the parties obligated to negotiate in good faith? Is there some other condition that must be met, such as some wrong-doing by the other partner? Where such conditions exist there is a potential basis for litigation, and where there is a subjective standard, such as the requirement to negotiate in good faith, there is a fact-intensive issue that could be costly and time-consuming to litigate.

There may be a number of other potential pitfalls throughout the buy-sell provision. Look for subjective standards like an obligation to be reasonable or to act in good faith. For example, if your partner has provided any guaranties, you may be required to use good faith efforts to have them released from the guaranties in the event they are the seller. This may be difficult to do, and if you are not successful, your partner could, rightfully or not, question whether the steps you took constituted good faith efforts.

These are just a few examples of the many issues that could lead to litigation. It is important to be mindful of the language in the documents and the conduct of the parties to consider what issues might arise. Once you identify the issues, you can consider the merits of potential claims along with the relative motivations and leverage of the parties. What is the process likely to cost you in the end and what is it likely to cost your partner? What does each party stand to lose or to gain and what resources is each party willing to expend to prevail?

2. Remedies and Consequences of Default

When reviewing the buy-sell provision, pay particularly close attention to what happens when a partner defaults in its obligation to close. Is the partner who elects to buy required to post a deposit? If so, in what amount and who holds it? Is a defaulting partner liable to the other for damages or are the remedies limited to specific performance or return/retention of the deposit? Are there other penalties for default, such as the opportunity to buy the defaulting partner’s interest at a discount or the loss of the defaulting partner’s voting rights?

Knowing the answers to these questions will help you prepare for what lies ahead. You may be required to put up substantial sums as a deposit early on in the process, and those monies could become tied up in litigation. You may stand to lose your voting rights if there is some hiccup that prevents you from closing.

On the other hand, there may not be sufficient remedies to compel your partner to perform. If no deposit is required, the buy-sell can become a mechanism for nuisance lawsuits and delay with no risk of financial loss to deter default. Make sure you understand the consequences to both you and your partner of a failure to close.

3. Release/Replacement of Guarantors

If one partner or its affiliate has provided guaranties or environmental indemnities on behalf of the venture, the other partner may be required to obtain, or attempt to obtain, the release of the guarantor from the obligations of the guaranties or instead provide an indemnity from any obligations that may arise under the guaranties in the future. This requirement comes into play when the partner that has provided the guaranties becomes the seller under the buy-sell. Since selling partner will no longer be involved in the project, the buy-sell provision often provides that the buying partner take on any future risk of liability under the guaranties.

This aspect of the buy-sell warrants special consideration. If your partner has provided guaranties, you may be required to procure the release of the existing guarantor in the event you are the buyer, which may be difficult if the lender is not required to accept a replacement guarantor, especially if the loan is securitized. Even if you are required only to use good faith efforts to obtain the release, this could serve as the basis for litigation as discussed above.

You also may be required to furnish an individual or entity with substantial assets to either serve as a replacement guarantor or to provide an indemnity to your partner to protect them from any liability under the guaranties that may arise in the future. The prospect of having to assume significant contingent liabilities may effect your decision of whether or not to trigger the buy-sell.

Next week, in Part 2 of this series, we will discuss three more considerations to take into account when triggering a buy-sell in a partnership dispute.

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1. The use of the terms “partnership” and “partner” in this article refer to any joint venture and its participants, regardless of form. The concepts discussed are the same whether the joint venture is organized as a partnership, a limited liability company, a corporation or any other form of business association.