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The Delaware Court of Chancery recently explained the calculation of a put price for units in PECO Logistics, LLC v. Walnut Investment Partners, L.P.

The LLC Agreement provided as following methodology for calculating the Put Price;

“Total Equity Value” means the aggregate proceeds which would be received by the Unitholders if: (i) all of the assets of the Company were sold at their fair market value to an unrelated third-party on arm’s-length terms, with neither the seller nor the buyer being under compulsion to buy or sell such assets; (ii) the Company satisfied and paid in full all of its obligations and liabilities (including all Taxes, costs and expenses incurred in connection with such transaction and any amounts reserved by the Board with respect to any contingent or other liabilities); and (iii) such net sale proceeds were then distributed in accordance with the distribution provisions of Section 4.1(b), all as determined by the Board.

For the purpose of calculating the Total Equity Value when the Put Right has been exercised, the LLC Agreement provided that the value of the assets is subject to upper and lower limits based on certain earnings multiples calculated as of year-end 2013 (the “EBITDA Collar”):

“solely for purposes of determining the Put Price, clause (i) of the definition of “Total Equity Value” (i) may not be less than the product of (A) 6.5 multiplied by (B) the Company’s “EBITDA less Maintenance Capex” for the 12-month period ending on (1) December 31, 2013 with respect to the Rollover Put Units . . . and (ii) may not be more than the product of (A) 7.5 multiplied by (B) the Company’s “EBITDA less Maintenance Capex” for the 12-month period ending on (1) December 31, 2013 with respect to the Rollover Put Units . . .”

In addition, the LLC Agreement provided that the Company and the Rollover Investors “shall be bound by the determination of the Valuation Firm . . . with respect to the Put Price as established by the Valuation Firm . . . pursuant to this Section 9.2(b) and the terms of this Agreement.”

The defendants exercised their Put Right and the Company’s Board of Managers chose Duff & Phelps as the Valuation Firm. The defendants disagreed with the Valuation Firm’s report and declined to transfer their units to the Company.  The Company commenced a declaratory judgement action, and the defendants counterclaimed for breach of the implied covenant of good faith and fair dealing.  The action was decided on a judgment on the pleadings.

The defendants argued the pleadings raised the following issues of material fact that precluded entry of judgment in PECO’s favor as a matter of law:

  • Whether the parties agreed to modify the LLC Agreement to afford the defendants the right to participate in the valuation process and to object to the valuation firm’s determination.
  • Whether certain provisions of the LLC Agreement governing the valuation methodology were ambiguous.

The Court found the LLC Agreement required PECO to select a nationally recognized valuation firm to determine the fair market value of the preferred units in accordance with the valuation methodology set forth in the LLC Agreement. The LLC Agreement did not afford the defendants any right to participate in the selection of the valuation firm or in the valuation process itself after the valuation firm has been selected. Nor did the LLC Agreement afford the defendants any right to reject or challenge the valuation firm’s determination.

The defendants argued that the Company agreed to modify the LLC Agreement when the defendants exercised their put right to afford them the right to participate in the valuation process (e.g., to provide information to and confer with the valuation firm about its determination) and to object to the valuation firm’s determination. The Court stated the first hurdle to making this argument is Section 14.2 of the LLC Agreement, which provided that the LLC Agreement “may be amended, modified, or waived with the written consent of the Board.”

The defendants relied on well-settled Delaware law that contract provisions deeming oral modifications unenforceable can be waived by a course of conduct. Specifically, they argued that the LLC Agreement was modified by virtue of the inclusion of a reservation of rights in the defendant’s put notice, which PECO accepted by its conduct when it proceeded with the valuation without expressing any objection to the reservation of rights. This court found this argument was unavailing as a matter of law because there was no consideration to support the asserted modification. According to the Court all the defendants did was “reserve” preexisting rights they purported to (but did not) have with respect to the determination of value without giving up anything in return. In sum, there was no benefit to PECO, or detriment to the defendants, that served as the consideration necessary to support the alleged modification.

The Court also rejected the defendant’s argument that the provisions of LLC Agreement governing the valuation methodology were ambiguous. The Court said when parties to a contract agree to be bound by a contractually established valuation methodology, this Court will respect their right to order their affairs as they wish and refrain from second-guessing the substantive determination of value.  The fact that Duff & Phelps was required to make certain judgment calls in its application of the prescribed valuation methodology is irrelevant to deciding the motion because the LLC Agreement unambiguously granted the valuation firm the sole authority to make the value determination, and unambiguously stated that such determination is binding on all parties.

As to the counterclaim regarding breach of the implied covenant of good faith and fair dealing, the Court noted it is “best understood as a way of implying terms in the agreement.” Terms will only be implied “when the party asserting the implied covenant proves that the other party has acted arbitrarily or unreasonably, thereby frustrating the fruits of the bargain that the asserting party reasonably expected.” Moreover, “[t]he implied covenant only applies to developments that could not be anticipated, not developments that the parties simply failed to consider . . . .”

Applying the foregoing law, the Court found a decision to select one of two admittedly reasonable options available under the LLC Agreement does not, by definition, constitute arbitrary or unreasonable conduct that has the effect of preventing a party to a contract from receiving the fruits of the bargain that was struck—especially when that decision was made by Duff & Phelps, an independent third party.

In addition, the defendants argued it was “unreasonable and arbitrary” for PECO to “pile on debt,” which had the effect of reducing the valuation. The Court rejected the argument noting the counterclaim is devoid of any facts from which it would be reasonable to infer that the debt in question did not serve a legitimate business purpose and was incurred for the bad-faith purpose of diminishing the valuation of the put units.


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