Despite its pejorative-sounding name, “jerk insurance” — it’s more vulgar name is “schmuck insurance” — can serve a useful purpose in addressing a business owner’s concern about looking, well, like a jerk by selling his or her equity stake to a co-owner who then turns around and sells the company or its assets to an outside buyer at a much higher value. Basically it works by guaranteeing the seller additional monies in the event of a company sale within a defined post-buyout period, usually computed as a percentage of the net sale proceeds above a threshold value specified in the buyout agreement.
It’s a type of deal protection, for example, that would have avoided the seller’s remorse suffered by the unsuccessful plaintiffs in the well-known New York case, Pappas v Tzolis, who sold their majority stake for $1.5 million to the minority owner who, within months, sold the company’s sole asset to a third party for $17.5 million.
I can’t cite statistics, but I’d venture to say the great majority of buyers who are willing to give jerk insurance do so because they have no intention of selling the company within the defined post-buyout period. In that sense it’s giving away ice in winter, but it nonetheless can facilitate the buyout agreement by giving additional comfort to the seller that he or she is not losing out on a better deal the buyer may already have lined up to sell the company.
All of which makes all the more unusual and instructive the recently decided case of Charron v Sallyport Global Holdings, Inc., Opinion and Order, 12-cv-06837 [SDNY Dec. 10, 2014], in which one 50% shareholder bought out the other 50% shareholder for almost $41 million pursuant to a buyout agreement with a jerk insurance provision setting a $65 million threshold and, in the event of a company sale within the following year, giving the seller 20% of the entire proceeds of the sale rather than 20% of the difference between the threshold and the sale price.
And if that isn’t strange enough, following the buyout the buyer almost immediately entered into negotiations to sell the company to a third party and closed the deal for a price eventually computed by the court at about $79 million, yielding an additional payout to the first-to-sell shareholder of about $16 million.
Do the math and decide for yourself who was in greater need of jerk protection: the jerk-insured 50% shareholder who ended up with $57 million ($41 million plus $16 million) or the jerk-insurer 50% shareholder who netted $22 million ($79 million minus $57 million).
The court’s decision in Sallyport, weighing in at 41 pages, was written by U.S. District Judge William H. Pauley III of the Southern District of New York, whose opening and closing paragraphs practically ooze disdain for the parties’ dispute over a buyout involving a successful company that provided facility maintenance and logistical support for overseas U.S. military operations:
This breach of contract action arises out of a business divorce. For many in the service of their country, terrible sacrifices have been exacted in Iraq and Afghanistan. For others, including [the plaintiff and defendant], those armed conflicts presented lucrative opportunities. Just how lucrative is put into stark relief by this case. The two primary players in this lawsuit grew a startup government contractor into an enterprise with thousands of employees providing mission-critical logistical support to Government operations abroad and generating annual revenues in the tens of millions. While their business boomed, animosity between the two abounded, leading to an agreement in which [defendant] bought out [plaintiff]. But that deal had a catch: if [defendant] sold the company within one year at a sufficient price, [plaintiff] got to share in the proceeds of the sale. That provision is the primary subject of this lawsuit. . . .
. . . This lawsuit is a sad denouement to what began as a vibrant and symbiotic partnership between two West Point graduates. After serving their country in the military, they continued to serve by providing logistical support in dangerous overseas theaters. That business earned them tens of millions of dollars. Ultimately, each turned his vast fortune against the other in a litigation bonanza rivaling Warren Adler’s “The War of the Roses.” This business divorce should never have spilled into a federal courtroom.
In between, the bulk of Judge Pauley’s opinion dealt with analysis of the “enterprise value” received by the defendant shareholder upon his sale of the company, consisting of $60.7 million cash plus a 38% equity rollover interest in the acquiring company which, on paper, was valued at $3.8 million.
Coincidentally or not, those two amounts totaled $64.5 million, or half a million shy of the $65 million threshold in the jerk insurance provision (referred to as “Windfall Protection” in the buyout agreement). It’s an interesting and complex analysis in which, ultimately, Judge Pauley agreed with the expert testimony of plaintiff’s business appraiser that the equity rollover interest received by the defendant had a value, not of $3.8 million as documented in the purchase agreement, but of almost $18.3 million.
Of more interest to non-appraisers, at pages 29-34 of the opinion, is Judge Pauley’s interpretation of the “Windfall Protection” provision which defined a “Windfall Sale” as a sale of the company’s capital stock “for a price that reflects an enterprise value of the Company equal to or greater than $65,000,000” and, if such sale occurs, required the defendant to pay plaintiff “an amount equal to 20% of the proceeds received from the Windfall Sale.”
The defendant argued, based on the parties’ negotiations and drafting history, that the provision required him to pay only 20% of the proceeds above the $65 million mark. Judge Pauley disagreed, finding that the provision’s unambiguous terms precluded reliance on parol evidence showing that, in fact, the defendant had wanted a provision that applied only to proceeds above a threshold amount, writing as follows:
No reading of the Windfall Provision supports [defendant’s] interpretation. [Plaintiff] is entitled to 20% of “the proceeds received from the Windfall Sale.” There is no language introducing the concept of incremental proceeds above the $65 million enterprise value threshold. Nor does the idea of “Windfall Sale” incorporate that idea. A “Windfall Sale” is the entirety of any transaction that meets the criteria, it does not refer to the portion of the sale above the $65 million mark. Instead, the language clearly calls for [defendant] to receive 20% of “the proceeds received”–that is, all of the proceeds received, without qualification.
The provision’s straightforward reading did not solve the mystery of its odd effects at certain enterprise values. For instance, Judge Pauley queried,
Why would the parties agree to a provision that creates such a drastic penalty for selling the company for $65 million? For a dollar less, [defendant] could keep the entire proceeds, but under [plaintiff’s] interpretation, at $65 million he must pay [plaintiff] $13 million, netting $52 million. It creates a huge disincentive to sell the company for a price between $65 and $81.25 million, because [defendant] would keep more by selling the company for a dollar less than $65 million. Such a provision is seemingly counterintuitive.
Perhaps the best explanation found by Judge Pauley was the haste with which the buyout agreement was negotiated and closed. As the judge wrote:
The sense of urgency was palpable on all sides, but in retrospect, no one can explain why the parties and their highly-paid professionals rushed to conclude the transaction on an arbitrary and “self-imposed” deadline. Perhaps this litigation could have been averted by several days’ reflection.
My thanks to Jeffrey Risius of Stout Risius Ross, who testified as the plaintiff’s expert appraiser in Sallyport, for alerting me to the decision.