BuybackIf you’ve got an owner-operated, closely held business entity that pays no dividends, and it features controlling and non-controlling ownership interests, generally it’s a good idea to include in the owners’ agreement provisions for the compulsory buyback of the non-controlling owner’s interest upon termination of employment.

The reasons are fairly obvious. The last thing anyone needs is an outside owner with trapped-in capital, possibly having to go out-of-pocket for taxes on phantom income, who may feel compelled to challenge the controller’s financial and management decision-making, possibly through a books-and-records demand and/or a lawsuit asserting derivative claims or seeking judicial dissolution, as the only means available to pressure the controller into a reasonable buyout.

While I’m a fan of such forced buybacks, I’m less wild about buyback provisions that reduce the amount to be paid for the equity interest of a non-controlling owner whose termination is for cause. I get the idea — to incentivize an owner/employee to keep to the straight and narrow — but too many times I’ve seen trumped-up terminations for cause by a financially incentivized controller followed by litigation brought by the financially penalized, expelled owner who contests cause, especially when the alleged misconduct is claimed to fall within a broad, catch-all category such as violation of company policy or failure to perform duty.

Case in point: last week’s appellate ruling in Matter of Bonamie, 2015 NY Slip Op 06191 [3d Dept July 16, 2015]. Bonamie involves a company called Ongweoweh Corp. which, according to its website, was founded in 1978 by Frank Bonamie in upstate New York and is “a Native American-owned, pallet management company providing pallet & packaging procurement, recycling services and supply chain optimization programs.” According to this trade publication, in 2010 Frank’s son Daniel became the company’s CEO and president.

The company’s shareholders included Frank (37%), Daniel (38%), and Daniel’s step-sister (25%). The shareholders’ agreement contained a compulsory buyback of the shares of a terminated officer and director. The buyback provisions set forth different valuation methods depending on whether the termination was for cause or involuntary, with the latter involving a higher valuation method.

In February 2014, the board terminated Daniel’s employment. All parties initially looked to the higher valuation method for an involuntary termination, but could not agree as to the value. Then, in May 2014, company counsel notified Daniel’s counsel by letter that the company had just discovered activities involving “self-dealing” and “dishonesty” in which Daniel had engaged while president that justified for-cause termination and, thus, valuing his stock under the lower method set forth in the buyback provision.

Daniel responded in predictable fashion, i.e., upping the ante, by filing a dissolution proceeding as an oppressed minority shareholder under Section 1104-a of the Business Corporation Law, in which he alleged that the company’s May 2014 letter constituted a repudiation and material breach of the shareholders’ agreement thereby rendering unenforceable the agreement’s compulsory buyback.

The company subsequently abandoned its demand for the lower valuation method, answered the petition, obtained an order extending its time to exercise its purchase rights under BCL Section 1118 in the event the dissolution proceeding continued, and moved for summary judgment dismissing the proceeding and directing the buyback pursuant to the shareholders’ agreement’s  higher valuation method.

By Decision and Order dated November 12, 2014 (read here), and judgment dated November 21, 2014 (read here), Tompkins County Supreme Court Justice Robert C. Mulvey agreed with the company, dismissed the dissolution petition, and directed the parties to abide by the procedure set forth in the shareholders’ agreement to determine the fair market value of Daniel’s shares using the higher valuation method.

Daniel appealed, to no avail. Last week’s decision essentially found that the company did not repudiate the agreement and that its “negotiations” following Daniel’s termination did not rise to the level of a material breach, explaining as follows:

“The written terms and conditions of a contract define the rights and obligations of the parties” (Dierkes Transp. v Germantown Cent. School Dist., 295 AD2d 683, 684 [2002] [citations ommitted]), and a breach thereof is material if it is “so substantial that it defeats the object of the parties in making the contract” (Robert Cohn Assoc., Inc. v Kosich, 63 AD3d 1388, 1389 [2009] [internal quotation marks and citation omitted]; accord Accadia Site Contr., Inc. v Erie County Water Auth., 115 AD3d 1351, 1353 [2014]; Fitzpatrick v Animal Care Hosp., PLLC, 104 AD3d 1078, 1081 n 4 [2013]). In the months immediately after petitioner was terminated by respondent, the parties disputed the amount that petitioner was to receive under the agreement and, as reflected by the (later retracted) letter of May 2014, disagreed about which provision of the agreement applied. However, respondent did not indicate that it would not adhere to a method of valuation set forth in the agreement or that it did not intend to pay petitioner under the agreement. We agree with Supreme Court that, essentially, negotiations transpired as to which provisions applied and this did not constitute a material breach of the agreement.

The court’s opinion also noted that, “under the relevant language of the agreement, petitioner’s commencement of this proceeding would also trigger the forced-buyout provisions of the agreement,” citing to Matter of El-Roh Realty Corp., a case I wrote about here. I can’t say for certain without seeing the agreement, but we can infer that a buyout triggered by a dissolution proceeding also used the higher valuation method.

We can also infer that the parameters of the higher valuation method set forth in the agreement were less favorable to Daniel than a valuation under BCL Section 1118’s “fair value” standard. Perhaps (and here I’m just guessing) the agreement called for application of a minority discount forbidden under the statutory standard.

The point of any buy-sell agreement is to provide certainty and stability when a shareholder exits. In the end, the company in Bonamie prevailed in enforcing the agreement, but its two-tier valuation method dependent on the circumstances of the shareholder’s termination was a recipe for adversity and the kind of expensive, time-consuming litigation that defeated the agreement’s purpose.