Delaware Law Update—Delaware Supreme Court Reverses Court of Chancery Decision that Applied the Implied Covenant of Good Faith and Fair Dealing to Allow Minority Members to Force an Exit Sale


Oxbow Carbon & Minerals Holdings, Inc. v. Crestview-Oxbow Acquisition underscores the importance of carefully reviewing and complying with an operating agreement when a limited liability company (LLC) undergoes a significant transaction.

Case Background
Two hedge funds, Crestview Partners, LP, and Load Line Capital LLC, invested approximately $265 million in Oxbow Carbon LLC to finance acquisitions in exchange for approximately 33% of Oxbow’s membership units. Oxbow is a Delaware limited liability company that provides marketing and logistics services to the global petroleum coke market. William I. Koch and his affiliates control Oxbow through Oxbow Carbon & Minerals Holdings, Inc.

The dispute centered on the interpretation of two minority protections given to Crestview and Load Line in Oxbow’s operating agreement:

1) A Put Right: The right to require Oxbow to repurchase their units after a specified period of time; and

2) An Exit Sale Right: If Oxbow refused to repurchase the shares, the party attempting to exercise the Put Right could force a sale of “all, but not less than all” of Oxbow’s equity, provided that each member of Oxbow received at least a 1.5 times return on its investment

Small holders, including Koch family members and executives of an Oxbow acquisition target, were permitted to invest approximately $35 million several years later. Oxbow and its board did not strictly comply with the procedures required under the operating agreement when admitting the small holders, including provisions requiring supermajority approval for related-party transactions and a preemptive rights provision requiring that new securities issued by Oxbow first be offered to existing members. The small holders did not provide signature pages to the operating agreement until after the litigation commenced. Notably, however, the Crestview and Load Line directors on the Oxbow board had voted in favor of issuing Oxbow units to the small holders and had treated them as members until litigation commenced.

Following disputes with Koch over the management of Oxbow, Crestview and Load Line exercised their Put Right, which Koch rejected. Crestview and Load Line then directed Oxbow to hire an investment banker and pursue an Exit Sale as required under the operating agreement, which Oxbow did. This resulted in an offer from a third party to acquire 100% of Oxbow’s equity. Under the proposed sale, the “1.5 times return” condition would have been satisfied for Oxbow Carbon & Minerals, Crestview, and Load Line, but not the small holders (who were admitted at a later time and invested at a higher valuation), creating the likely unintended result that each small holder could block an exit sale while the largest investors in Oxbow could not. The small holders, who were aligned with Koch, initiated the litigation, claiming that the failure to satisfy the “1.5 times return” condition gave them the right to block the Exit Sale.

Crestview and Load Line Arguments at Trial

  • Small holders did not have any rights under the operating agreement because they failed to sign it and were not admitted in strict compliance with its provisions. The Court of Chancery rejected this argument on the grounds of laches because the Crestview/Load Line directors had voted to approve the issuance of membership units to the small holders, and Crestview/Load Line had treated the small holders as members of Oxbow until the litigation began.
  • The Exit Sale’s “1.5 times return” condition meant only that a member who did not receive a 1.5 times return could not be forced to sell its units, but the Exit Sale could proceed for the members who did receive a 1.5 times return. The Court of Chancery rejected this argument, pointing to the plain language of the operating agreement defining an Exit Sale as a sale of “all, but not less than all” of Oxbow’s equity.
  • The operating agreement did not expressly prohibit them from voluntarily allocating part of their share of the Exit Sale proceeds to the small holders so that each small holder would receive the requisite 1.5 times return (the “top-off right” argument). The Court of Chancery rejected this argument, noting the absence of an explicit top-off right in the operating agreement and that the operating agreement required all units to be transferred “on the same terms and conditions” in an Exit Sale.
  • The operating agreement required that new members be admitted “on such terms and conditions as [Oxbow’s board] may determine” and that the board failed to specify any terms and conditions of the small holders’ admission to the company, resulting in an ambiguity in the operating agreement over what rights the small holders had. This argument is addressed below.

Court of Chancery Decision
The Court of Chancery concluded that a contractual gap existed in the operating agreement due to the Oxbow board’s failure to specify any “terms and conditions” of the admission of the small holders to the company. It noted that the board resolutions relating to the issuance of equity to the small holders used the terms “shares” and “stock” rather than “units” (the term for the existing equity interests held by Oxbow Carbon & Minerals, Crestview, and Load Line), suggesting that the board may have intended to create a different class of interests akin to common stock with fewer rights for the small holders, and simply deferred that decision for a later date. Relying on the implied covenant of good faith and fair dealing, the court attempted to fill this gap by giving Crestview and Load Line the ability to make a top-off payment to the small holders to satisfy the Exit Sale requirements.

Delaware Supreme Court Decision
On appeal, the Delaware Supreme Court agreed with the trial court that Crestview and Load Line were barred from challenging the small holders’ status as members of Oxbow, that the operating agreement did not permit Crestview and Load Line to force the members other than the small holders to sell their interests in the Exit Sale, and that the plain terms of the operating agreement did not give Crestview and Load Line the right to bypass the “1.5 times return” condition.

The Supreme Court disagreed, however, that there was any contractual gap in the operating agreement, rejecting the trial court’s finding that failure to specify the terms and conditions of the small holders’ admission created a contractual gap that should be filled by implying a top-off right. The operating agreement did not distinguish between the members or create different classes of membership interests, the Supreme Court noted. The Supreme Court also noted that Oxbow often used the terms “units,” “shares,” and “stock” interchangeably to rebut the trial court’s finding that the board intended to give the small holders different rights. Relying on the plain terms of the operating agreement, the Supreme Court found that the small holders had the power to block the Exit Sale because it failed to satisfy the “1.5 times return” condition. Because Crestview and Load Line failed to negotiate an amendment to the operating agreement that would have adjusted the “1.5 times return” condition for the smaller holders or include the top-off right at the time the small holders were admitted, the Supreme Court was obligated to enforce the plain terms of the operating agreement.

Practice Points
This case illustrates that members of LLCs and other alternative entities must carefully review and consider their operating agreements with corporate counsel when contemplating the admission of new members or other significant transactions. As Oxbow illustrates, had Crestview and Load Line (and likely the other parties) considered how the Put Right and Exit Sale would be affected by admitting the small holders, they could have used their supermajority approval rights and preemptive rights to negotiate appropriate revisions to the operating agreement.