• Banks Change Position Regarding Buy-Sell Funding Mechanism
  • April 26, 2010
  • Law Firm: Roetzel & Andress A Legal Professional Association - Akron Office
  • Sooner or later, every business relationship will come to an end. This includes the relationship between the owners of a business. Business owners with a long term view make arrangements for this so the transition will be easier andbetter for everyone involved. Often, the biggest challenge has been how to fund the buy-out of the departing owner, particularly if it is abrupt due to death. In years past, it was not unusual to purchase a life insurance policy and use the proceeds to purchase the deceased owner's share. So far, so good.

    Because of certain tax advantages, it was common to have the company redeem the deceased owner's share, rather than have the surviving owners purchase the deceased owner's share. As a result, when a life insurance policy was used to fund the redemption, the company was named as the beneficiary of the policy. The death benefits were paid to the company and the company turns around and used those funds to redeem the deceased owner's interest in the company. Sounds like a great plan, right? But, that was before the relationship between the company and its bank changed.

    As a result of the shift in the banking industry in 2008, banks have taken a more aggressive look at how their borrowers are operating and what their loan documents permit. Banks also have an increased focus on earning fees when they can. Executing the buy-out plan contained in a Buy-Sell Agreement may create a new problem for businesses.

    How it Works
    Banks typically have a lien on all of the assets of their borrowers, which includes all cash that the company has. When one of the owners dies and the company receives proceeds of a life insurance policy on them, the bank has a lien on the money that the insurance carrier pays the company. There are recent reports that banks are now prohibiting companies from using the proceeds of life insurance polices to redeem a decedent's interest in their company. The bank may require that the cash be applied to pay down/off the loan balance or that the company pay the bank a fee in exchange for the bank releasing its lien on the cash received from the insurance company. This creates some real problems.

    If the bank does not release the funds, the redemption will not be concluded. This creates a liquidity problem for the decedent's estate and family. If there is an estate tax to be paid, it is due nine months after the date of death. In these cases, it is not unusual for the decedent's interest in the company to be the lion's share of their wealth. As such, there are few assets available to pay the estate tax bill.

    The inability to consummate the redemption as part of the transition also creates issues for the surviving owners of the company. Because the redemption is not completed, the decedent's interest passes to their heirs and beneficiaries. As a result, those individuals are now part owners in the company and ascend to the rights that the decedent had, including voting rights, rights to information about the company and rights to distribution. As such, the surviving owner now has a new, unexpected partner with whom they have to deal. The only way out of this is for the surviving owner to marshal the money themselves and buy out the new owners of the decedent's interest.

    Addressing These Issues
    First, look at your loan documents and your insurance policies to see if the bank in fact would have a lien on any insurance policy proceeds and if the company is named as the beneficiary of the life insurance policy.

    Then, look at your bank and loan documents. If your company has given your bank a blanket lien on the company's assets, consider negotiating a modification agreement by which the bank releases its claim to the insurance proceeds so that the redemption plan can be executed. If the bank refuses to release its claims, consider changing the beneficiary designation and restructuring the Buy-Sell Agreement to have the surviving owners purchase the deceased owner's interest in the company.

    Unfortunately, the landscape has changed and what was originally a great transition plan for everyone may have changed. Along with other problems that have arisen in the last 18 months, companies need to also consider these issues. A little effort now can avoid a big problem in the future.