As if we need another case illustrating why fixed price buy-sell agreements should be avoided like the plague.

Before we get to the case: A fixed price buy-sell agreement is one in which co-owners of a business select a specific dollar amount, expressed either as enterprise or per-share value, for calculation of the future buyout price to be paid an exiting owner or his or her estate upon the happening of specified trigger events such as death, disability, retirement, or termination of employment. Such agreements can take the form of a stand-alone buy-sell agreement or may be included in a more comprehensive shareholders, operating, or partnership agreement.

Fixed price buy-sell agreements in theory offer two main advantages over pricing mechanisms that utilize formulas or appraisals at the time of the trigger event. One is certainty; everyone knows in advance the amount to be paid upon a trigger event. The other is avoidance of transactional costs; there’s no need to hire accounting or valuation professionals at the time of the trigger event and no need to hire lawyers to litigate differences that can arise with indeterminate pricing mechanisms such as those requiring business appraisals.

But when theory meets reality, reality usually triumphs. Company values can and often do change dramatically over time, for better or worse. And even though the typical fixed price buy-sell calls for periodic updates of the so-called certificate of value, it’s rarely done for any number of reasons ranging from benign neglect to inability to reach agreement on a new value among co-owners of different ages whose interests and exit horizons diverge over time. So when a buyout occurs long after a last agreed value has become out of sync with the company’s significantly higher value as of the trigger date, there’s a powerful financial and emotional incentive for the exiting owner or his or her estate representative to challenge the buyout in court, thereby defeating one of the main reasons to have a fixed price agreement in the first place.

I’ve previously featured on this blog several illustrative fixed price buy-sell lawsuits precipitated by stale or absent certificates of value, including Sullivan v Troser Management, Nimkoff v Central Park Plaza Associates, and DeMatteo v DeMatteo Salvage Co. The latest addition to this ill-fated family of cases is entitled Namerow v PediatriCare Associates, LLC, decided last November by a New Jersey Superior Court judge, in which the court enforced a fixed price buy-sell agreement among members of a medical practice where the original certificate of value hadn’t been updated for 16 years at the time of the plaintiff doctor’s retirement from the practice. Continue Reading Another Reason Not to Use Fixed Price Buy-Sell Agreements

Buy-SellAt least on paper, shotgun provisions in shareholder and operating agreements provide an elegant and efficient buy-out solution when business owners can’t get along and need a divorce. In a two-owner company, the one who “pulls the trigger” names a price at which he or she either will buy the other’s interest or sell to the other. The other owner has a specified amount of time to decide which. Since the offeror doesn’t know who will be the buyer, in theory there’s a great incentive to name an objectively fair price. The agreement usually also will prescribe payment terms. No need for appraisal. No fuss. No muss.

I’m not aware of any data-based studies on the subject, but I believe experienced lawyers would concur that shotgun clauses, although frequently included in owner agreements, are rarely invoked. Why is that? I can only speculate that owners generally prefer other ways to achieve a breakup without the uncertainty of knowing who will end up with the business. Also, owners are reluctant to be the trigger-puller, that is, there’s a natural preference to be the one with the option to buy or sell at a price named by the other.

Shotguns also can suffer from informational and financial asymmetries between the owners, a problem highlighted in my two-part, online interview of Professors Landeo and Spier some years ago (here and here). As Professor Spier described it: Continue Reading Aim Carefully Before Pulling Trigger on Shotgun Buy-Sell Agreement

CunninghamNew Hampshire lawyer John Cunningham eats, sleeps and breathes limited liability companies.

Seriously, John has carved out for himself a niche practice as one of the foremost experts in the country on the formation of limited liability companies and the drafting of LLC operating agreements.

He shares his knowledge through his many lectures and publications, including his leading LLC formbook and practice manual, co-authored by Vernon Proctor, called Drafting Limited Liability Company Operating Agreements published by Wolters Kluwer, and his highly informative blog Cunningham on Operating Agreements. John also chaired the committee that wrote the New Hampshire Revised LLC Act enacted in 2013.

From a business divorce perspective, management deadlock is a recurrent problem and precipitator of litigation for LLCs with two equal members. I didn’t fully grasp the potential magnitude of the problem, however, until I read John’s recent article in the Wealth Counsel Quarterly called “Avoiding Deadlocks in LLC Operating Agreements” in which he cited an IRS statistic that 25% of all LLCs nationwide consist of two members. My own experience jibes with John’s article’s observation, that “the members of most two-member LLCs are equal in voting and profit shares,” and that

For all of these LLCs, the issue of deadlock is major. Even in the best two-member LLC, it is likely that deadlock issues will eventually arise, and can destroy an otherwise promising LLC.

Continue Reading John Cunningham on Avoiding Deadlock in Two-Member LLCs

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. Continue Reading The Hidden Cost of a Devalued Buyback Upon Termination for Cause

MercerChris Mercer (photo right) is a name familiar to regular readers of this blog. I’ve written a number of posts about major valuation cases in which Chris testified as an expert business appraiser, including AriZona Iced TeaChiu, and Giaimo, and about his writings on the subject of statutory fair value and in particular the marketability discount. I’ve also had the pleasure of sharing the stage with Chris at continuing education programs including one upcoming on May 18 for the New York State Society of CPAs.

Chris has distinguished himself not only in the field of business appraisal, but as a deep thinker about how business owners, and especially the current wave of retiring baby boomers, can successfully reap the benefits of their ownership through diversification and careful transition planning. To that end Chris has published a number of books on buy-sell agreements and, most recently, a terrific book called Unlocking Private Company Wealth (Peabody Publishing 2014), subtitled “Proven Strategies and Tools for Managing Wealth in Your Private Business.” The book is a wake-up call for owners of closely held businesses who, caught up in the day-to-day operation and growth of their firms, pay little or no attention to managing and extracting the personal wealth tied up in their businesses and fail to devise rational exit and succession strategies.

In his book’s introduction, Chris nicely captures the credo of the quiescent business owner: Either I own the business or I don’t and there’s no in between. I’ll just keep things as they are until I sell the business or die. An owner such as this, who typically lacks an adequate shareholders or buy-sell agreement, and has no succession plan, is destined to become a client of a business divorce lawyer like me! To that owner, Chris says: “This book is written to help you understand the importance of your illiquid wealth — or the wealth locked in your private company — and present alternatives for helping you manage and eventually realize that wealth.” Continue Reading Chris Mercer on Unlocking Private Company Wealth

The next time someone tells me they’re preparing a shareholder buy-sell agreement using a fixed price memorialized in a so-called Certificate of Value, I’m going to tell them to rename it a Certificate of Legal Fees, and I’m going to tell them to read the court’s opinion in Sullivan v. Troser Management, Inc., 2013 NY Slip Op 01634 (4th Dept Mar. 15, 2013).

When intelligently prepared and implemented, buy-sell agreements among co-owners of closely-held businesses are extremely useful and effective devices to preserve business continuity and financial stability while providing a fair exit mechanism for withdrawing owners and fair compensation for the estates of deceased owners, often funded by cross-purchase plan life insurance policies.

The pricing aspect of a buy-sell agreement is perhaps its most critical feature. There are three pricing methods in general use: (1) fixed price, that is, a dollar amount usually found in an appended Certificate of Value or Schedule; (2) formula price, which can take any one of many forms based on the company’s financial metrics and/or the withdrawing owner’s historic compensation; and (3) a process-based approach involving one or more appraisers who will value the selling owner’s interest in the company as of the date of the triggering event (death, notice of withdrawal, etc.). Continue Reading Missing Certificate of Value Spawns Decade-Long Lawsuit Over Buy-Sell Agreement

Buy-sell provisions in shareholder agreements are good. Arbitration provisions in shareholder agreements are good. Inconsistent buy-sell and arbitration provisions in shareholder agreements are bad.

That pretty much sums up the lesson to be learned from an appellate opinion handed down last month in Matter of Grande’ Vie, LLC, 2012 NY Slip Op 02190 (4th Dept Mar. 23, 2012), in which a majority of the court, with one judge dissenting, ordered arbitration over an appraisal for the buy-out of a deceased LLC member’s interest notwithstanding language in the buy-sell provision stating that the appraisal “shall be binding.”

The case involves two real estate holding companies organized as LLCs owned equally by three members, one of whom died in 2008. The operating agreement included buy-sell provisions triggered, inter alia, by the death of a member whose estate was entitled to be paid a purchase price determined by appraisal. The agreement also included a broad arbitration clause. Litigation broke out in 2010 after the estate sought arbitration of the value of the decedent’s membership interest, while the surviving members sought to compel a sale at a value set forth in a written appraisal rendered by an appraiser selected by the surviving members after the appraisers specifically named in the agreement declined the assignment.

Continue Reading Clash of the Clauses: Divided Appellate Panel Rules that “Binding” Appraisal Per Buy-Sell Agreement Must be Arbitrated

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).

Continue Reading An Ill-Fated Solution to an Ill-Fated Buy-Sell Agreement

Toward the close of its 2010-11 term, the New York Court of Appeals (the state’s highest court) issued a pair of decisions in the Centro and Arfa cases that cast a dark cloud over a line of precedent established by the Manhattan-based Appellate Division, First Department, that had refused to enforce releases or fiduciary waivers given by sellers of interests in closely held businesses who later brought suit against the purchasers/controlling owners for concealing material information affecting the buy-out price, such as an impending deal to sell the company assets to a third party at a much higher valuation.

The best known of the First Department cases, Blue Chip Emerald v. Allied Partners, 299 AD2d 278 (2002), and its progeny including Littman v. Magee, 54 AD3d 14 (2008), broadly suggested that a fiduciary can never contractually relieve itself of its duty of full disclosure by withholding material information the non-controlling owner needs in making its decision to enter into the buy-out agreement. In Centro and Arfa, however, the Court of Appeals expressly disagreed with the First Department cases insofar as they would preclude a sophisticated party from giving a release or waiver in favor of its fiduciary as part of a transaction where the party understands that the fiduciary is acting in its own self-interest and the release or waiver is knowingly entered into. (Read here my post on the Centro and Arfa decisions.)

Anyone who thought Blue Chip was down for the count would be mistaken. Last week, over a vigorous two-judge dissent, a three-judge majority in Pappas v. Tzolis, 2011 NY Slip Op 06455 (1st Dept Sept. 15, 2011), unabashedly wielded Blue Chip to salvage a lawsuit brought by two owners of a realty company who, after selling their LLC membership interests to the third member under an agreement containing a fiduciary waiver, brought suit claiming the buyer intentionally concealed from them an impending deal to sell the company’s sole asset to an outside buyer at a spectactularly higher valuation.

Continue Reading The Rise and Fall and Rise of Blue Chip: Fiduciary Duty Trumps Waiver in Latest First Department Decision