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.