When properly designed, buy-sell provisions in shareholders’ agreements of closely held corporations, or in operating agreements of limited liability companies, can avoid disruptive and costly litigation triggered by the voluntary or involuntary dissociation of a shareholder or member. The key elements of a workable buy-sell agreement for lifetime dispositions are (1) defining the circumstances under which a shareholder or member can leave voluntarily or be forced out, (2) setting the valuation date, (3) fixing the value of, or a mechanism to value, the interest of the departing shareholder or member, and (4) setting forth the terms of payment.
Sassower v. 975 Stewart Avenue Associates, LLC, 2009 NY Slip Op 31901(U) (Sup Ct Nassau County Aug. 14, 2009), recently decided by Nassau County Commercial Division Justice Ira B. Warshawsky, illustrates the mayhem that can result when the buy-sell agreement renders uncertain the basis for valuing the departing owner’s interest in the entity.
Cardiologist Michael Sassower was one of seven physician-shareholders of a Long Island cardiology practice organized as a professional corporation. He and his fellow shareholders also were members of a real estate holding company called 975 Stewart Avenue Associates, LLC (the "Company") that owned the premises housing the medical practice. In December 2007, Sassower gave six-months notice of his resignation from the medical practice. The Company’s operating agreement provided that, upon his departure from the practice, Sassower was required to offer his 12.5% membership interest to the Company and the other members. Section 8.5(c) of the operating agreement described the following process to determine the price to be paid for his interest:
The Company and the Offering Member/New Member shall have ten (10) days to appoint a Qualified Appraiser. Upon appointment, both Qualified Appraisers shall each establish the purchase price of the Offered Interests, using the market value approach appraisal methodology, in a written opinion to the Company each such opinion to be delivered within thirty (30) days of the appointment of the latter of appraisers. If the difference between the two (2) appraisals is less than ten (10%) percent, then the valuation of the Offered Interests shall be the average of the appraisals. However, if the difference between the two (2) appraisals is more than ten (10%) percent, then the Qualified Appraisers shall mutually appoint a third Qualified Appraiser whose sole written opinion shall establish the fair market value of the Offered Interests. [Emphasis added.]
The Company and Sassower each retained an appraiser. The Company’s appraiser valued Sassower’s 12.5% interest at $850,000 versus Sassower’s appraiser’s valuation of $962,500 based on "market values" of $6.8 million and $7.8 million, respectively, for the entirety. The difference being more than 10%, the parties were required by Section 8.5(c) to secure a third, decisive appraisal.
The appraisals were exchanged in August 2008. Things started to go haywire when the Company sent Sassower an amendment to its appraiser’s report, noting that the Company’s property carried an outstanding mortgage balance of approximately $2.7 million and stating that, "at the request of the client [i.e., the Company]," it was reducing the value of the Company’s equity by the amount of the mortgage, to a little over $4.1 million, which reduced the value of Sassower’s 12.5% interest to about $350,000.
Sassower commenced a lawsuit the following month, seeking a declaration that the mortgage balance should not be deducted from the appraised market value in determining the price for his interest. Justice Warshawsky denied the Company’s initial pre-answer motion to dismiss the complaint in a Short Form Order dated December 3, 2008, finding that the meaning of "market value approach methodology" as used in Section 8.5(c) was "not clear on its face" and could not be determined without further proceedings.
A month later, in January 2009, the Company’s counsel wrote to the court contending that both appraisers had erroneously failed to deduct from their estimate of value the principal balance of the existing mortgage. The Company further contended that both appraisers had used overstated figures for the property’s net operating income, and that utilizing the actual figures based on the existing net lease held by the medical practice would bring the two appraisals within 10% of each other and therefore obviate the third appraisal.
Two months after that, in March 2009, the remaining members of the Company voted to dissolve and liquidate the Company voluntarily, by virtue of which they sought anew to dismiss as moot Sassower’s complaint to enforce the buy-out. Sassower countered with his own motion to enforce a September 2008 stipulation whereby the two sides had agreed to go forward with the third appraisal.
Justice Warshawsky’s decision earlier this month denied the Company’s motion to dismiss and granted Sassower’s motion to enforce the stipulation. As to the former, the operating agreement specified that the remaining members’ right to elect to dissolve in lieu of purchasing the departing member’s interest was time-limited by the operating agreement’s express terms. The purported voluntary dissolution in March 2009 therefore was too late, particularly given the remaining members’ interim election to purchase and the exchange of appraisals. "In the opinion of the Court," Justice Warshawsky commented pointedly, "the Defendant cannot opt to buy out the Plaintiff, then, when unhappy with the outcome of that decision, choose to dissolve the entity."
The court’s decision to enforce the stipulation also appears to provide some guidance for the third appraiser as to the underlying valuation dispute. Justice Warshawsky notes that, while the language in the operating agreement "is less than crystal clear," in his opinion "the sought after number is fair market value." The phrase "market value approach methodology," he concludes,
is not an appraisal methodology, but a defined value to be arrived at by one of the three traditional appraisal approaches, namely, direct sales comparison, income capitalization, or replacement cost. For a building of the type owned by 975 Stewart, the most appropriate approach is the direct income capitalization approach, upon which both appraisers apparently relied. . . . The deduction of the outstanding mortgage on the property from the estimate of fair market value does not produce market value, but rather equity position value.
It appears that in applying the income capitalization approach, both party-retained appraisers constructed a market rate rather than using the existing net lease between the Company and the medical practice — presumably at a below-market rate — prompting Justice Warshawsky to observe:
It would be inappropriate to rely upon this lease to determine market value. There is a good practical reason for not considering it. Certainly, if CMA decided to relocate and sell the property to a third party, they would sell free and clear of the existing lease and the arm’s length purchaser would be free to impose market rent on his prospective tenants.
I frequently see buy-sell provisions in shareholder and operating agreements that leave it entirely to the appraisers how to arrive at their appraisal. I also see many agreements containing very specific appraisal parameters, e.g., dictating use of book value, specifically excluding or including good will or other identified assets and liabilities, and specifically including or excluding minority and marketability discounts. Counsel drafting such agreements must carefully consider the nature of the business, its tangible and intangible assets, and its actual and potential liabilities. Better yet, counsel not adequately familiar with appraisal methodology should consult with the company’s outside accountant or a business appraiser before the agreement is signed.
It’s impossible to know from the language used in Sassower whether the drafter and/or the doctors who signed the agreement thought the words "market value" meant the sale value of the unencumbered real estate less the mortgage balance, or, as Justice Warshawsky construed it, an income-based valuation. What’s clear is that the ambiguous buy-sell provision in Sassower failed its essential purpose to provide a certain, speedy and litigation-free procedure for valuing a departing member’s interest.