Buy-sell provisions in shareholder agreements utilize various pricing mechanisms, such as book value or an earnings-based formula. Another popular method is agreed value, whereby the shareholders assign up front a fixed dollar amount per share to be paid in redemption upon the retirement, disability or death of a shareholder. The agreed-value method usually entails appending to the shareholders agreement a so-called “certificate of value” which states the price per share. The buy-sell provision also usually requires that the certificate of value be updated annually or on some other periodic basis to reflect changes in the value of the business with the passage of time.
I’ve always found the certificate-of-value method more appealing in theory than in reality, for the simple reason that the shareholders more often than not never get around to updating the share price. A well written buy-sell agreement will include a back-up valuation method when the certificate price is not updated within a defined period prior to the redemption event, usually 2 or 3 years, such as a formula adjustment to the last stated value based on current book value or earnings, or an appraisal by the company accountant or by one or more independent appraisers.
But what happens when the buy-sell agreement has no back-up valuation method, and a redemption event occurs many years later when the shares intrinsically are worth far in excess of the value stated in the original certificate? Is the redeeming shareholder, or his or her estate, stuck with a grossly undervalued price, or can the controlling shareholders of the corporation be held liable for failing to update the certificate?
According to a decision last month by Nassau County Commercial Division Justice Stephen A. Bucaria, in Nimkoff v. Central Park Plaza Associates, LLC, 2010 NY Slip Op 31374(U) (Sup Ct Nassau County May 25, 2010), at least under certain circumstances the controlling shareholders may be liable for breach of fiduciary duty.
Nimkoff involved a limited liability company rather than a corporation. Dr. Martin Nimkoff, who died in 2004, held a 3.602% membership interest in Central Park Plaza Associates, LLC (“CPPA”) whose sole asset was an office building in Plainview, New York, where Dr. Nimkoff maintained his medical practice.
CPPA’s 1995 operating agreement incorporated the transfer restriction provisions in a prior partnership agreement, Section VIII of which required the estate of a deceased partner to sell the partner’s interest to the partnership at a price equal to “the last Stated Value . . . of the Partnership (to be agreed upon on an annual basis by the Partners) multiplied . . . by the deceased Partner’s percentage interest in the Partnership.” Section VIII further provided that the Stated Value “shall be redetermined annually by the Partners on or about the anniversary date of the first Stated Value” and that, if the Partnership fails to determine the Stated Value in any given year, that “the last Stated Value shall be controlling.”
CPPA sold its office building in 2008 for $7 million, after which the the managing member tendered to the late Dr. Nimkoff’s wife and executrix the sum of $111,107.14 based upon the last computed Stated Value of $2.75 million determined in March 2001, i.e., 3 years before Dr. Nimkoff’s death.
The executrix sued CPPA, its managing member, its managing agent and the other members of CPPA for breach of contract and breach of fiduciary duty, claiming that she was entitled to recover 3.602% of the $7 million sale price, or approximately $250,000.
The defendants moved for summary judgment fixing the redemption price at the lower amount tendered to the estate. The bulk of Justice Bucaria’s decision is taken up with analysis of the executrix’s argument, which the court rejected, that CPPA technically dissolved upon Dr. Nimkoff’s death in 2004. Turning to the valuation dispute, Justice Bucaria summarized the executrix’s position that the defendants breached their manager duties of good faith and due care under LLC Law § 409, as follows:
Plaintiff alleges that the members of the LLC failed to update the “Certificate of Stated Value” for a period of three years prior to her husband’s death. She avers that the breach of this obligation to update the Certificate resulted in a loss to the decedent, as the Certificate did not reflect the true value of the LLC, and the decedent’s 3.602% interest was applied to a value which was not equal to the true market value of the LLC.
Justice Bucaria next found that the defendants satisfied their initial burden, “to establish prima facie that the failure to update the stated value for three years before Nimkoff’s death was in good faith,” by showing that the estate of another CPPA member who died shortly after Dr. Nimkoff received payment according to the 2001 Stated Value.
This shifted the burden to the plaintiff to show that the failure to update the Stated Value “was not in good faith.” Justice Bucaria found that the plaintiff satisfied her burden based on a February 2001 memorandum to the members in which CPPA’s counsel wrote:
[I]t has been several years since a Certificate of Stated Value has been executed by you in connection with the ownership of your interests in [CPPA]. It is important that the Stated Value be current so that the estate of a member is properly compensated in the event of a buy-out following a member’s death. It is strongly recommended that the Stated Value be reviewed each year.
“Based on the memorandum from CPPA’s counsel,” Justice Bucaria concluded, “plaintiff has shown a triable issue as to whether the failure to update the stated value was not in good faith.” On that basis Justice Bucaria denied the defendants’ motion for summary judgment and granted the plaintiff leave to serve an amended complaint “more clearly” stating the claim for breach of fiduciary duty based on failure to update the Stated Value.
It’s not certain that the court’s holding in Nimkoff extends beyond the peculiar facts presented in that case. Had CPPA’s counsel not sent the memorandum, presumably the ruling would have gone the other way, though it bears noting that the members initially took their counsel’s advice by recomputing the Stated Value at $2.75 million only one month after the memorandum. Also, the court’s decision does not shed light on why CPPA waited 7 years after Dr. Nimkoff’s death, and after it sold the office building, to redeem his membership interest at the 2001 Stated Value which represented only 40% of the actual sale price.
There are many reasons why certificates of value don’t get updated. Very often the business owners do not consult with legal counsel after the business entity is formed and are not aware of the update requirement. On the other hand, as a business grows in value, depending what kind of defined events trigger redemption rights, the controlling owners may have a financial incentive not to update the certificate of value in contemplation of redeeming minority interests at a bargain price. Nimkoff signals that courts will closely examine through the fiduciary lens the circumstances surrounding the failure to update. It also reinforces the need, when drafting such provisions, to include a back-up valuation method when the certificate of value turns stale.
Update February 17, 2019: Can you believe the Nimkoff case is still kicking around, almost nine years after I wrote this post? Last July I posted about an April 2018 decision in the case (read here) in which the court denied the defendants’ second shot at obtaining a summary judgment. A decision in August 2018 (read here) denied the plaintiff’s motion to exclude at trial the report and testimony of defendants’ expert witness who proffered an opinion to the effect that the decision to maintain and not to update the 2001 Certificate of Stated Value “was not made in bad faith.” Apparently the case subsequently went to trial; as yet I’m not aware of the outcome.