The importance of having a well-designed buy-sell agreement among owners of a closely held business can never be over emphasized. A buy-sell agreement, when done right, will enable an owner who leaves the firm, or the estate of a deceased owner, to cash out the value of his or her equity interest for a fair amount in the absence of any public market for the interest, without threatening the firm’s continuity or financial stability, and without the prospect of potentially crippling litigation.
There are two basic varieties of buy-sell agreement: a cross-purchase agreement in which the individual owners or their estates are the buyer and seller, and a redemption agreement in which the company buys (redeems) the departing or deceased owner’s interest. Which one is best for any given situation depends on a number of factors and complex tax considerations requiring the advice both of legal counsel and a tax accountant. Another critical element, with its own set of tax considerations, concerns funding sources for the buy-out. A common funding source used in buy-sell agreements triggered by the death of an owner is life insurance.
A recent court decision by Nassau County Commercial Division Justice Timothy S. Driscoll, in Deerin v. Ocean Rich Foods, LLC, Short Form Order, Index No. 600536-2014 [Sup Ct, Nassau County Mar. 21, 2014], illustrates how badly things can go when the owners — whether deliberately or not I can’t say — don’t pay sufficient attention to the design and implementation of an insurance-funded buy-sell agreement, in this case leaving the family of a deceased owner without the certainty of being able to cash out the estate’s interest.
Deerin involves a Long Island based, New York limited liability company known as Ocean Rich Foods, LLC, which is in the business of importing and distributing seafood under the trade name Ocean Edge Foods. Messrs. Deerin, Marino and Berman formed the LLC in 2006 as co-equal one-third members. According to the LLC’s insurance application (more about that below), within two years the company achieved gross sales of $46 million. The papers filed in the case contain no mention of an operating agreement, so I’m assuming none exists.
Mr. Deerin died unexpectedly in early 2013 at the age of 59. His executor, who also is his wife, filed suit about a year later against the LLC and its two surviving owners, primarily seeking to enforce an alleged 2009 Cross-Purchase Agreement funded by a $1.5 million insurance policy on Mr. Deerin’s life naming the LLC as owner and beneficiary. The complaint alternatively pleaded claims for the fair value of the Estate’s interest payable to a withdrawing member under LLC Law § 509, and for judicial dissolution of the company under LLC Law § 702. (Read complaint here.)
The Estate’s Injunction Application
At the same time she filed her complaint, Mrs. Deerin also sought a preliminary injunction preventing the LLC from utilizing the $1.5 million it apparently had already collected on the Deerin policy.
Her counsel’s supporting affirmation (read here) alleged that in 2009 the members entered into a Cross-Purchase Agreement (read here); that the Agreement mandated the LLC’s purchase of a deceased member’s interest funded by specifically identified life insurance policies insuring the lives of the three members for $1.5 million each; and that the defendants were in breach of the Agreement by refusing to pay the collected insurance proceeds to the Estate in exchange for the Estate’s membership interest. Counsel also argued that, absent an interim restraint, the Estate would be irreparably injured because the defendants would use the proceeds for other purposes leaving the LLC without the funds needed to honor its buy-out obligation.
The defendants opposed Mrs. Deerin’s application for injunctive relief. Their counsel’s opposing affirmation (read here) pointed out that the Cross-Purchase Agreement was unsigned and therefore unenforceable. Counsel also noted that the Deerin policy was purchased a year before the date of the unsigned Agreement, and that, where the policy application asked the purpose of the insurance, it was filled in “Key Person” rather than buy-sell or similar language indicating it was intended to fund a buy-out (a copy of the policy and the application are attached to counsel’s affirmation linked above).
Justice Driscoll’s Decision Denying Injunctive Relief
Justice Driscoll’s decision, after reviewing the parties’ history and positions, and after setting forth the standard for issuance of preliminary injunctions, denied the Estate’s motion with little fanfare, stating:
- The Estate “has not established a likelihood of success on the merits in light of the fact that the Agreement on which [it] relies is unsigned, and Defendants have produced the Policy which designates the Company as the beneficiary of the Policy.”
- The Estate “has also not established that [it] will suffer irreparable harm without the requested relief as [its] concern that Defendants will spend the proceeds of the Policy is an injury that is compensable by money damages.”
- The Estate “has not demonstrated that a balancing of the equities favors [it], in light of the fact that the Agreement on which [it] relies is unsigned, and Defendants have produced the Policy which designates the Company as the beneficiary.”
Does the decision mean the Estate is out of luck? It’s too early to tell. Shortly after the decision was issued, the Estate filed an amended complaint adding new claims for unjust enrichment and for an accounting.
Some Additional Observations
- The sparse record developed so far in Deerin sheds little light on what the three members had in mind. There’s been no testimony of the surviving owners or production of communications surrounding the purchase of the policies in 2008 or the preparation of the unsigned Cross-Purchase Agreement. I’ve seen other instances in which company owners jumped the gun by purchasing life policies with the intent to use them to fund buy-outs upon death, but never got around to documenting a cross-purchase or redemption agreement.
- Without such an agreement, or some other evidence of an enforceable buy-out obligation, the named beneficiary of the policy, be it the company or a surviving owner, likely cannot be compelled to use the proceeds to fund a buy-out. Of course, if the company is beneficiary the funds constitute company income and must be used for proper business purposes, thereby benefitting all owners.
- A “key person” life insurance policy, intended to be used as such, generally is not designed to fund a buy-out, nor is it limited to insuring the life of an owner. Rather, as the name suggests, it provides the company with funds for expenses of the going concern to make up for a revenue disruption caused by any key employee’s loss, or for the purpose of winding down the business if the personnel loss is catastrophic.
- Arguably it’s even more important for the owner of a minority interest in an LLC, as opposed to a closely held corporation, to make sure that an insurance-funded buy-sell upon death is properly documented. Why so? Because if there’s no enforceable buy-sell, the judicial dissolution remedy available to minority members of LLCs as interpreted by the courts under LLC Law § 702 is narrower than the oppressed-minority-shareholder remedy under § 1104-a of the Business Corporation Law.
Update March 5, 2015: By decision and order dated February 6, 2015 (read here), Justice Driscoll granted summary judgment for the defendants, dismissing Mrs. Deerin’s claims to recover the insurance policy proceeds and to compel payment for the fair value of her shares.
Update August 26, 2015: By decision and order dated August 6, 2015 (read here), Justice Driscoll denied Mrs. Deerin’s motion for reconsideration of the court’s prior decision dated February 6, 2015, granting summary judgment in favor of the defendants.