An Ill-Fated Solution to an Ill-Fated Buy-Sell Agreement
Let's face it: If you have a close corporation shareholders' agreement or LLC operating agreement including a buy-sell provision with a fixed share price that's supposed to be updated periodically, there's a good chance you (or your estate) are in for a nasty fight when the buy-out is triggered by the death, disability or retirement of one of the owners. Why so? Because more often than not the owners never update the agreed share price, so that when a buy-out is triggered many years later, the last agreed value no longer reflects a fair value for the ownership interest due to the growth (or decline) of the business in the interim, e.g., the Nimkoff case about which I wrote here.
Many such buy-sell agreements include an alternative valuation method when the agreed price -- often memorialized in a so-called Certificate of Value appended to the shareholders' agreement -- is not updated within a stated number of years before the trigger event, such as using an appraiser to perform a current evaluation. Such alternatives are no panacea, however, especially when the agreement fails to specify valuation parameters including the standard of value (e.g., fair market value, fair value, book value) and level of value (e.g., controlling, marketable minority, nonmarketable minority). The Sassower case, about which I wrote here and here, is a textbook illustration of the litigation woes that can follow when the buy-sell fails to articulate relevant valuation parameters.
If there's anything worse than failing to specify standards for the alternative valuation, it's providing no alternative, as when the buy-sell mandates use of the stale fixed price, which brings us to this week's featured case, DeMatteo v. DeMatteo Salvage Co., 2011 NY Slip Op 09586 (2d Dept Dec. 27, 2011).
DeMatteo is a poster child for all that can go wrong with a poorly designed buy-sell agreement. DeMatteo Salvage Co. is a Long Island based, family-owned business since the 1920's, designing and installing machinery and equipment for scrap paper and solid waste customers. In 1966, siblings Domenick, Edward, Carmine and Joseph DeMatteo entered into mirror image buy-sell agreements for DeMatteo Salvage and a second company they owned called E&J Holding Corp. The agreement requires the estate of a deceased shareholder to sell, and the companies to buy, the decedent's shares at a fixed price. The agreement does not require that the agreed value be updated periodically. Rather, it merely provides that the agreed price "may be redetermined at any time by mutual agreement of the Corporation and the Stockholders" and then goes on to specify that the failure to redetermine value for however long does not disable the last, agreed value:
The last value established preceding the death of a Stockholder shall be the value of his stock for purposes of this agreement. This provision shall not be altered by the fact that the Corporation and the Stockholders for any reason have failed to redetermine such value at any time or from time to time. All redeterminations of value shall be endorsed upon Schedule A hereof, dated and signed by the Corporation and the Stockholders.
Fifteen years later, in 1981, Schedule A was formally endorsed with new values of $7,500 per DeMatteo Salvage share and $10,000 per E&J share. Although Schedule A thereafter never was amended, on several occasions in 1984-86 there were shareholder meetings whose minutes reflected redetermined values, the last of which set per-share prices of $20,000 for DeMatteo Salvage and $37,500 for E&J.
Further muddying the issue, minutes of a shareholder meeting in March 1992 reflect a resolution to "table" the re-evaluation of the shares until October 1992, and to keep the previously set values of $66,197 per DeMatteo Salvage share and $66,666 per E&J share. (The court decisions don't reveal when those share values were set or how they were recorded.)
It appears that all of these share re-evaluations were done by the shareholders themselves without the assistance of an appraisal professional.
The eldest brother, Joseph, died sometime before 2000, which sparked the first buy-out litigation culminating with a settlement that forced the surviving three siblings to borrow funds to pay the estate. In April 2000, apparently hoping to avoid a repeat, the three surviving shareholders adopted a formal resolution stating "that the values for the shares of stock in both corporations [are] voluntarily canceled at their present value" and that "Paul Iadanza at the office of Delle Fave & Tarasco, has been retained to value both corporations."
Edward DeMatteo died two years later, in June 2002. In the interim, for reasons never made clear to the court, the designated company accountant, Mr. Iadanza, did not perform the evaluations authorized by the April 2000 resolution.
Thus began an 8-year litigation saga, commencing in 2003 when Edward's widow, Gloria, as executrix, sued DeMatteo Salvage and E&J to enforce a buy-out of the Estate's shares based on what she claimed was the last validly determined value of approximately $66,000 per share for each company based on the March 1992 resolution.
In 2004, Gloria moved for summary judgment on her buy-out claim at $66,000 per share. The companies, now owned by the two surviving siblings, cross moved for summary judgment based on what they claimed were the last valid determinations of value, namely, the 1981 endorsements on Schedule A at $7,500 per DeMatteo Salvage share and $10,000 per E&J share.
In a decision and order dated February 8, 2005, Suffolk County Commercial Division Justice Elizabeth Hazlitt Emerson concluded there were factual issues precluding a summary determination of the buy-out price. In so ruling, she found that the 1992 resolution was not binding because Dominick DeMatteo was not present at the meeting and because the values were not endorsed on Schedule A. She also found that the 1984-86 re-evaluations evidenced the siblings' intent to redetermine the value of their stock after the 1981 valuation, but that they were not conclusive as to "whether [the shareholders] took all steps necessary to redetermine the value in accordance with the buy/sell agreements."
At some point during the litigation, Mr. Iadanza prepared current appraisals of both companies, reporting values not disclosed in the court's decisions other than mentioning that they were less than the values adopted in the 1981 endorsements to Schedule A. The surviving siblings thereupon sought to enforce a buy-out based on Mr. Iadanza's valuation. In June 2009, Suffolk County Commercial Division Justice Emily Pines held a framed-issue hearing at which the surviving siblings testified that their deceased brother, Edward, drafted the April 2000 resolution and specifically chose Mr. Iadanza to perform new valuations, and that all the siblings agreed to accept Mr. Iadanza's valuations in lieu of the prior valuations over which there had been years of litigation following Joseph's death.
In her decision dated July 2, 2009, Justice Pines credited the surviving siblings' testimony and granted them summary judgment to the extent of finding that they and Edward agreed in April 2000 to scrap the prior valuations and to be bound by new valuations as of that date to be performed by Mr. Iadanza. As Justice Pines further explained:
While [Gloria's] counsel has suggested that the Iadanza evaluation that was in fact performed should not be accepted as it was lower than the one set forth by the shareholders themselves in 1981, clearly that was part of their purpose in enacting the 2000 resolution; i.e., for the valuation to reflect a number which would not place the corporations in extremis when the estate of the next shareholder was entitled to payment. They made the decision consciously with the imprimatur of [Edward] who chose the evaluator.
However, since the valuations prepared by Mr. Iadanza valued the companies as of a date some years after April 2000, Justice Pines also ordered him to prepare new valuations as of April 2000.
Approximately one year later, in August 2010, Justice Pines entered judgment based on Mr. Iadanza's new valuation reports, awarding Edward's estate the sum of approximately $500,000 for his combined interests in both companies based on an aggregate valuation of both companies of approximately $1.3 million.
Both sides thereafter appealed to the Appellate Division, Second Department which in its December 27, 2011 order, reduced the award to Edward's estate by approximately $100,000. The appellate court found that Justice Pines should not have disregarded minority and marketability discounts applied by Mr. Iadanza to the value of one of the company's shares (the decision does not specify which company), thereby reducing the per-share value for that company by a combined 30% discount, from $12,379 to $8,665. By the way, the fact that the parties litigated the applicability of discounts tends to confirm the fact that the April 2000 resolution authorizing an appraisal by Mr. Iadanza was silent concerning standards and levels of value.
Gloria's appeal argued that, pursuant to the April 2000 resolution, the shareholders did not intend to be bound by Mr. Iadanza's new report, but the appellate court declined to reach the issue on procedural grounds based on that court's dismissal of Gloria's previous appeal from Justice Pines' July 2009 decision for failure to prosecute.
[Note: The buy-sell agreements provided for the companies to procure insurance policies on the lives of the shareholders for the purchase of their shares. In September 2006, Gloria won a prior appeal to the Second Department which ordered the companies to pay Edward's estate approximately $440,000 in life insurance proceeds (read here). It's not clear if that amount is in addition to, or is applicable in satisfaction of, the lesser sum awarded in the recently decided appeal.]
Between the first buy-out litigation following the eldest brother Joseph's death, and the second lawsuit started by Gloria after Edward's death, the DeMatteo family has been warring in the courts over the value of the companies' shares for more than a decade. Whatever one thinks of the outcome, what's absolutely clear is that the buy-sell agreement failed miserably, both in its design and its implementation, in its intended purpose to ensure family control of the businesses while providing the shareholders' heirs with a measure of financial security based on a consensual, non-litigated, fair valuation of the companies' equity.
- It was a mistake to design the buy-sell agreement without requiring periodic updates.
- It was a mistake to design the buy-sell agreement without providing an alternative valuation method when a buy-out event occurs more than a year or two after the last agreed valuation.
- It was a mistake for the shareholders to come up with their own valuations over the years without seeking the guidance of a professional appraiser.
- It was a mistake for the shareholders to agree to rescind the prior valuations in favor of obtaining a professional appraisal, and then not following through by having the professional perform the appraisal until long after the death of a shareholder, when the financial interests of the surviving shareholders and the deceased shareholder's estate became antagonistic.
Business appraiser and author Z. Christopher Mercer, a leading authority on buy-sell agreements, has described fixed pricing in a buy-sell agreement as a "ticking time bomb". The DeMatteo case is a powerful demonstration of the accuracy of Chris's warning.
Update January 14, 2012: Chris Mercer has written a post on the DeMatteo case on his highly informative blog, ValuationSpeak.
Disqualification of Counsel in Business Divorce Proceedings
Scenario #1: Shareholders Moe, Larry and Curly jointly retain attorney Foghorn to form WoobWoobWoob Corp. and to prepare and supervise the execution of a shareholders' agreement. Foghorn thereafter serves as WoobWoobWoob's outside general counsel until a pie-throwing incident precipitates a judicial dissolution petition by Curly. Moe and Larry hire Foghorn to oppose the petition, arguing that the shareholders' agreement was not validly executed and that Curly is not a shareholder. Curly moves to disqualify Foghorn from representing Moe and Larry. Should the court grant Curly's motion?
Scenario #2: Moe and Larry are the original shareholders of NyukNyukNyuk Corp. Curly subsequently enters into a stock purchase agreement, thereby becoming the third shareholder, along with an amended and restated shareholders' agreement with Moe and Larry. The agreements are prepared by attorney Throckmorton acting on behalf of Moe and Larry. Curly was represented by his own counsel. Three years later, following an eye-poking incident, Curly petitions for judicial dissolution of NyukNyukNyuk. Curly also moves to disqualify Throckmorton from representing Moe and Larry on the grounds that, in preparing the agreements, Throckmorton learned confidential information about the operation of NyukNyukNyuk concerning a central issue in the dissolution litigation, and that Throckmorton may have to testify as a witness. Is the motion a winner?
Before you say, "I'm trying to think but nothing happens," the answers can be found in two recent court decisions requiring disqualification in circumstances resembling Scenario #1 but not in Scenario #2.
The first scenario is drawn from Boylan v. O'Loughlin, Short Form Order, Index No. 22665/09 (Sup Ct Suffolk County June 3, 2010), decided last year by Suffolk County Commercial Division Justice Elizabeth H. Emerson. The subject corporation, Audell Petroleum Corp., was formed in 1976 purportedly by three shareholders, Boylan, Cunningham and O'Loughlin. In 1986, attorney Weiner prepared and supervised the execution of a shareholders' agreement naming the three. The agreement included a mandatory stock buyback by the corporation upon the death of a shareholder, as well as a reciprocal right of first refusal upon death as between Boylan and Cunningham. Weiner served as the company's general counsel from 1986 through 2010. Cunningham died in 2008. His will, naming Weiner executor, bequeathed his shares to his children apparently without any acknowledgement of the first refusal or share redemption provisions in the shareholders' agreement. Weiner, as executor, denied the validity of the shareholders' agreement and contested Boylan's status as a shareholder. Weiner's law firm represented Cunningham's estate in the subsequent dissolution proceeding filed by Boylan as 27.5% shareholder.
O'Loughlin moved to disqualify Weiner's law firm under Rule 1.9 of the New York Rules of Professional Conduct based on conflict of interest, and under the attorney-witness rule contained in Rule 3.7. As to the former, Justice Emerson summarizes the applicable law as follows:
A party seeking to disqualify an attorney or law firm must establish (1) the existence of a prior attorney-client relationship and (2) that the former and current representations are both adverse and substantially related (Mancheski v. Gabelli Group Capital Partners, 22 AD2d 532, 534, citing Solow v. Grace & Co., 83 NY2d 303, 308). Under such circumstances, the presumption of disqualification is irrebutable (Id.). One who has served as attorney for a corporation may not represent an individual shareholder in a case in which his interests are adverse to the other shareholders (Morris v. Morris, 306 AD2d 449, 452; Matter of Greenberg [Madison Cabinet & Interiors], 206 AD2d 963, 965, citing Matter of Fleet v. Pulsar Constr. Corp., 143 AD2d 187).
Justice Emerson concludes that disqualification of Weiner's law firm is required. Her ruling cites (1) Weiner's long-time service as the company's general counsel, (2) his role as drafter of the disputed shareholders' agreement, and (3) the adverse positions in the litigation, on the one hand, of the Cunningham estate represented by Weiner's law firm and, on the other hand, the company and the two other shareholders. Justice Emerson also finds disqualification warranted "because it is likely that [Weiner] will be called as a witness on the issue of whether or not the shareholder agreement was executed."
Scenario #2 is drawn from Adams v. Gallagher, 2011 NY Slip Op 30277(U) (Sup Ct Nassau County Jan.13, 2011), decided last month by Nassau County Commercial Division Justice Timothy S. Driscoll. The petitioner Adams sought judicial dissolution of a real estate brokerage business named Babylon Century, LLC based on the respondents' alleged misrepresentations made to induce Adams to merge her existing business into Babylon Century and on respondents' alleged financial misconduct and exclusion of Adams from decision-making. Adams moved to disqualify the respondents' law firm, Abrams Fensterman, on the grounds it previously represented Babylon Century and that counsel from the firm may be called as a witness. Abrams Fensterman had prepared the membership purchase agreement, the new operating agreement for Babylon Century and related documents upon the merger with Adams' prior business. Abrams Fensterman performed those tasks as counsel for the individual respondents. Adams was represented by separate counsel.
Adams contended that Abrams Fensterman learned confidential information about the operation of Babylon Century which is a central issue in the litigation, that the matters involved in the litigation and the law firm's prior representation are substantially related, and that the interests of the members of Babylon Century represented by Abrams Fensterman are materially adverse to the interests of Babylon Century. Respondents argued that Abrams Fensterman never represented Babylon Century and that its work with respect to the company's formation and reconstitution is not substantially related to the current litigation concerning alleged breach of fiduciary duty. Respondents also argued that Adams failed to show that the testimony of any attorney from Abrams Fensterman was necessary or would not duplicate testimony by the parties.
After setting forth at some length the law governing disqualification (see decision at pp. 10-12), Justice Driscoll denies Adams' disqualification motion, reasoning as follows:
Plaintiff has not established that there is a prior attorney-client relationship between counsel and Babylon Century. Moreover, even assuming, arguendo, that there is a prior attorney-client relationship between Babylon Century and counsel, Plaintiff has not demonstrated that the matters involved in both representations are substantially related. The Court is not persuaded that counsel's preparation of documents related to the formation of Babylon Century is substantially related to Plaintiff's allegations that Defendants have breached the agreements among the parties, or violated their fiduciary duties to Plaintiff. Plaintiff also has not established that counsel's testimony would be necessary, particularly given the ability of the Defendants to testify regarding the relevant agreements among the parties.
When business partners form a start-up venture they will often utilize the legal services of an attorney who has a pre-existing relationship with one of the partners. The Boylan and Adams decisions underscore the importance -- both to the attorney and the principals -- of documenting the capacity in which the attorney is providing legal services and specifically identifying the client or clients for whom he or she is providing the services. Such documentation is not necessarily limited to the engagement letter; it also may warrant a written communication by the attorney to any unrepresented non-clients involved in the transaction, confirming that the attorney does not represent them and recommending that they consult with independent counsel.
Update May 7, 2011: Yesterday the Appellate Division, Fourth Department, affirmed a decision by Monroe County Commercial Division Justice Kenneth R. Fisher denying the respondents' motion in a Section 1118 buyout proceeding to disqualify the petitioner's counsel, who also represented a third party in a separate damages action against the company involved in the buyout proceeding. Matter of Stevens (Allied Builders, Inc.), 2011 NY Slip Op 03787 (4th Dept May 6, 2011). Justice Fisher ruled that the parties seeking disqualification lacked standing since they never had an attorney-client relationship with the petitioner's lawyer. Read here Justice Fisher's decision.
Court Rejects Experts' Appraisals in Fair Value Proceeding, Relies on Own Computation Using Income Approach
No matter how many times I see it happen, I'm always intrigued when a new stock valuation decision comes along in an oppressed shareholder buyout proceeding in which the opposing experts come up with valuations light years apart. How is it that two impeccably credentialed business appraisers, operating under the same independence principle, looking at the same data, and following the same valuation guidelines, can produce such divergent numbers? Is the court required to accept one or the other, or should it appoint its own neutral appraiser, or compute value itself?
Last December I wrote about one ill-fated valuation decision in which the lower court adopted wholesale one of the two widely divergent expert appraisals, only to be reversed on appeal and remanded for a new valuation hearing. Today I write about another valuation decision in which the trial court rejected both experts' appraisals and came up with its own computation of fair value. Matter of Beattie (PlanData Systems Corp.), 2009 NY Slip Op 30181(U) (Sup Ct Suffolk County Jan. 15, 2009).
PlanData Systems Corp., located in Huntington, New York, offers space management services to owners and facility managers of commercial buildings. The business uses a proprietary computer program called SpaceMan to design and manage the clients' commercial properties. In 2006, 40% shareholder Ronald Beattie sought judicial dissolution of PlanData under the oppressed minority shareholder statute, Section 1104-a of the Business Corporation Law. The 60% shareholder, Steven Smith, elected to purchase Beattie's shares for fair value under the buyout statute,BCL Section 1118. After the two shareholders failed to reach agreement on price, the fair value question went to a hearing before Suffolk County Commercial Division Justice Elizabeth Hazlitt Emerson.
Each side presented a valuation report and testimony by a well-credentialed expert business appraiser. The primary difference in approach stemmed from characterizing PlanData either as a software company or a services company. Beattie's expert testified that he was "instructed" to assume that PlanData is best described as a software company. His valuation relied on a separate calculation of the replacement cost of the SpaceMan software prepared by a computer consultant who also testified as an expert on Beattie's behalf. This expert based his calculation in the sum of $718,000 on "good-faith estimates" of the amount of time and labor expense it would take to recreate a program like SpaceMan, derived from "industry norms and his overall business experience" rather than specific data from PlanData's books and records.
Beattie's expert appraiser incorporated the $718,000 software replacement cost in his valuation of the company using the three common valuation methods: Asset (Cost) Approach, Market Approach and Income Approach. He testified that none of these methods alone provided an accurate assessment of fair value and that a weighted approach using data produced by all three methods was more appropriate. The court's decision does not disclose his weighting percentages or the underlying figures; it simply notes the expert's testimony that he selected the percentages based on his "business judgment and experience." Using his weighted approach the expert arrived at a value of $618,000 for Beattie's 40% interest. Beattie's expert also contended that no discount for lack of marketability should be applied.
Smith's expert also considered the Asset, Market and Income Approaches. He rejected the Market Approach due to lack of data on companies sufficiently similar to PlanData. He also rejected the Asset Approach because it is generally used for the companies "the real value of which is in assets such as real estate." In relying on the Income Approach alone he reasoned -- contrary to Beattie's expert -- that PlanData is a company that provides services for its clients using various software programs, but it is not a software company. He noted that over 83% of company revenue is derived from measuring and drafting services. Using the company's historical financial data and a 19.11% capitalization rate under the Income Approach, Smith's expert computed a value of $102,159 for PlanData, to which he applied a 25% discount for lack of marketability, resulting in a value of $30,648 for Beattie's 40% interest. He then added 40% of the company's "excess cash" to arrive at a total value of $128,829 for Beattie's shares. The difference between the two competing appraisals? Approximately 500%.
Justice Emerson did not adopt either side's valuation. She concluded that the record did not support Beattie's expert's use of a weighted average of the three methods and the percentage assigned to each. She faulted his use of the Market Approach for lack of sufficiently similar transactions. More importantly, she disagreed with Beattie's expert's "use of [software] replacement cost as a proper method of valuing PlanData" and noted that the analysis "also contains a number of important assumptions that do not relate to specific data derived from PlanData's books and records."
Smith's expert's analysis fared better insofar as Justice Emerson agreed that the Income Approach is the proper valuation method. She also agreed with his capitalization rate and some of his income adjustments. However, she declined to adopt his calculations in certain key respects and instead came up with her own "alternative calculation." The main differences in the court's calculation were: an increase in the company's average net income; an increase in the add-back of officer "perks"; and a significant decrease in the officer reasonable compensation figures. The court's calculation almost doubled Smith's expert's valuation of Beattie's 40% interest, to $245,626.39. (The last page of the court's decision is a helpful line-item chart of the court's adjustments to Smith's expert's Income Approach calculations.)
Finally, Justice Emerson also agreed with Smith's expert's application of a 25% marketability discount which, in my view, has become something of a default percentage in the Second Department. The discount is not applied against the allocation of excess cash.
Dissolution of LLCs vs. Corporations: There Are Important Differences
Judicial dissolution of a New York limited liability company (LLC) is governed by Section 702 of the LLC Law (LLCL), whereas judicial dissolution of a closely held business corporation is governed by Article 11 of the Business Corporation Law (BCL). Under Section 702, a court may order LLC dissolution “whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” That’s it. No more.
Article 11 of the BCL is more expansive. Section 1104(a) authorizes a petition for judicial dissolution by a 50% shareholder based on various deadlock scenarios. Section 1104-a permits judicial dissolution at the behest of an “oppressed” minority shareholder or where the controlling shareholders divert or waste company assets or otherwise are guilty of illegal or fraudulent actions toward the other shareholders.
Depending on the provisions of the LLC operating agreement, conduct that would constitute grounds for dissolution under Article 11 of the BCL also may constitute grounds under LLCL Section 702. But not always, as one minority member of an LLC recently found out when the court dismissed his request for judicial dissolution. According to the court’s decision, the minority member alleged that the majority members engaged in “illegal, fraudulent and oppressive conduct” – terms that are lifted right out of BCL Section 1104-a. The court ruled that “[w]hile such allegations are grounds for dissolution under [BCL] § 1104-a, they are not grounds for dissolution of a limited liability company”. The case, Bonanni v. Horizons Investors Corp., was decided by Justice Elizabeth Hazlitt Emerson of the Suffolk County Supreme Court, Commercial Division.
The lesson is clear: A complaint or petition for dissolution of an LLC should reflect Section 702’s provisions by alleging a genuine conflict between, on the one hand, the adverse member’s alleged misconduct or other conditions warranting dissolution and, on the other hand, the terms of the operating agreement or articles of organization.
