Efficient partnership dissolution under buy-sell clauses.

Buy-sell clauses are commonly used contractual provisions to determine the terms of dissolution of partnerships. Under them, one party offers a price for the partnership and the other party chooses whether to sell her share or buy her partner's share at this price. We point out that the selection of the proposing partner is essential for the performance of the clause. Moreover, if partners negotiate for the advantage of being the chooser, then buy-sell clauses result in an ex post efficient outcome. Such endogenous selection is consistent with how buy-sell clauses are drafted in practice.

1. Introduction

Partners in commercial relationships have to think about the possibility that the partnership might end. A management deadlock such as a fundamental disagreement about the future strategy of the commonly owned firm might lead to the inevitability of splitting up. Due to market inefficiencies and frictions, it is sometimes more sensible for one partner to buy out the other and realize the profits than to liquidate and sell the company to a third party. (1) Being aware of this, business attorneys recommend including a buy-sell clause (commonly referred to as shotgun clause) in the initial partnership agreement to govern the dissolution process. In brief, a buy-sell clause is a deadlock resolution mechanism that works as follows: one party proposes a price, and the other decides whether to buy or sell at that price. Actually, the buy-sell clause is considered to be such an essential part of partnership agreements, that a lawyer who fails to recommend to his clients adopting one could be accused of malpractice. (2) Thus, not surprisingly, real-life examples of partnerships that include buy-sell clauses in their partnership agreements abound. (3)

Buy-sell clauses have also caught the attention of economic theorists. In the case where partners' valuations are private information, reflecting what they know about their ability to run the business, economists do not recommend buy-sell clauses for solving a deadlock (see McAfee, 1992). Contrary to legal advice, they have stressed that buy-sell clauses could result in inefficient dissolutions, that is, the business may not end up in the hands of the partner who values it most. When partners only know their own valuation, the proposer has to set a price based on her estimate of her partner's valuation. She offers a price above (below) her valuation if she believes that she is likely to sell (buy), that is, her partner's valuation is likely to be higher (lower) than her own. Consequently, whenever her partner's valuation lies between her own and the price, she becomes a buyer, whereas efficiency requires her to sell. Similarly, when the other party's valuation lies between the price and hers, she inefficiently becomes the seller. Given this negative result, auctions have been suggested as an efficient solution to the dissolution problem (see Cramton, Gibbons, and Klemperer, 1987; McAfee, 1992). (4)

Nevertheless, the inefficiency argument against the buy-sell clause does not have bite if the right party is called to name the price. When both partners have low valuations (and would hence propose a price above their valuation), an efficient dissolution is guaranteed if the partner with the higher valuation proposes the price. Also, if both partners have high valuations, efficiency is guaranteed if the partner with the lower valuation proposes. If one partner's valuation is below the median and the other's is above, then either party proposing the price ensures efficiency. The determination of the proposer is then crucial for efficiency.

From a legal point of view, a buy-sell clause consists of two parts: a specification of the circumstances under which it applies and a description of what the partners are obliged to do in case it applies. The first part defines when a management deadlock (MD) is deemed to occur. The second part prescribes a set of actions in chronological order. It states that (possibly after a cooling-off period), either party can serve a so-called deadlock option notice, which is irrevocable, and specifies a single price at which the party giving notice (the proposer) offers to either sell all her shares at the specified price or purchase all shares held by the other party at this specified price. After receiving the deadlock option notice the other party shall, at its sole option, elect either (i) to purchase all of the shares at the price stated in the deadlock option notice, or (ii) to require the proposer to purchase all of the shares held by that other party at the price stated in the deadlock option notice. (5) The formulation of the buy-sell clause reveals that it only applies to two-parent partnerships. Furthermore, most corporate lawyers recommend its use only if both partners own (roughly) the same share in the firm (see, e.g., Hewitt, 2005). It is worth noting that the buy-sell clause covers neither the contingency where no party proposes a price nor the contingency where both propose a price. Moreover, it does not resolve the question of who has to propose. Parties who disagree on this issue might ask a court to dissolve the partnership, as the legal case Hotoyan v. Jansezian illustrates. Two partners who had signed an agreement that included a buy-sell clause went to the Ontario Court as they disputed the matter of who had to go first (see O.J. no. 4486, Court File no. 99-CL-3263, 1999).

An alternative way of settling the issue as to who has to propose was taken by Comcast UK and Telewest, each a 50% owner of the Cable London franchise. After 16 years of partnership, in February 1998, Comcast announced its intention to sell its cable interest to the NTL group. This announcement resulted in negotiations between Comcast UK and Telewest for the dissolution of their partnership. In August 1998, the Telewest spokesman announced that they had "solved an ambiguity in the original ownership agreement." They agreed that by no later than 30 September 1999, Comcast (or NTL after the amalgamation with Comcast) would notify Telewest of a price at which Telewest would be required either to purchase or sell. The buyout was completed in August 1999 with Comcast/NTL proposing a price of approximately 428 million [pounds sterling] to Telewest, who decided to buy. The agreement between Telewest and Comcast suggests that a buy-sell clause may be used after a negotiation stage to identify the proposer. (6)

Because the buy-sell clause (as formulated in partnership agreements) does not prespecify a certain partner as proposer but rather allows for the proposer to be selected endogenously by the partners if a deadlock arises, we model here the dissolution game induced by a buy-sell clause. In accordance with contractual formulations in partnership agreements, we study the performance of buy-sell clauses taking into account that parties may negotiate over the identity of the proposer, simply wait for the other party to propose, or end up in court. Our main analysis covers the classical private values environment as introduced by Cramton, Gibbons, and Klemperer (1987) and McAfee (1992). We show that if partners negotiate the role of proposer (and these negotiations start without delay after the deadlock occurs), then the partnership is dissolved efficiently, that is, the partner with the higher valuation buys all shares.

We model the negotiations as an ascending auction with parties bidding for the right to choose. It can be thought of as a simplified model of a negotiation procedure in which parties make alternating offers for the right to choose. We show that when partners take into account the information that will be revealed through their negotiations, the party with the valuation closer to the median valuation will propose and, hence, an efficient dissolution will take place. If partners engage in costly waiting for the other to propose the price (which we model as a war of attrition), the partner with the higher valuation will finally buy. As in this environment there are inefficiencies due to costly waiting, partners would agree to engage in negotiations rather than to wait. We also analyze a framework where partners are free to negotiate, delay, or name a price at any time. We show that in an equilibrium they will negotiate immediately and dissolve the partnership efficiently.

To investigate the robustness of the efficiency results, we also consider the buy-sell clause in an interdependent values model with one-sided private information, which is based on Jehiel and Pauzner (2006). We find that the buy-sell clause, though it does not achieve full efficiency, outperforms other possible dissolution mechanisms; in particular, it is better than an auction.

Our results may concern academics as well as practitioners. From a normative point of view, our analysis gives a justification as to why buy-sell clauses cannot be ruled out on the grounds of efficiency alone. In a private values model, we show that they cannot be dismissed on efficiency issues; furthermore, with interdependent valuations, they could even be advisable on the grounds of efficiency. From a positive point of view, we argue that practitioners need to make partners aware of the option to negotiate the right to choose, as this might not be explicitly stated in the partnership agreement and may avoid a costly war of attrition and/or costly and inefficient court rulings. In sum, the buy-sell clause is capable of rendering efficient dissolutions, so if efficiency is the only goal, there is no reason for not using it.