• Failure to Define Terms in Buyout Agreements Leads to Litigation Woes
  • November 15, 2010 | Author: Peter A. Mahler
  • Law Firm: Farrell Fritz, P.C. - New York Office
  • Time and again this blog has highlighted cases stemming from dysfunctional buyout agreements among partners, LLC members and close corporation shareholders in which the parties fail to define with adequate clarity the price determination process or parameters for the interest being transferred.  One can't ignore the irony of agreements intended to avoid uncertainty and costly litigation, doing exactly the opposite.

    Three recent cases join the ever-growing catalog of buyout agreements gone awry.  Two of the cases, decided by New York courts, involve a law firm partnership agreement and a settlement agreement in an underlying shareholder derivative action.  The third case, decided by the Wisconsin Supreme Court, involves a disability buyout provision in a shareholders agreement.         

    Costello v. Costello, Shea & Gaffney, LLP, 2010 NY Slip Op 33058(U) (Sup Ct Nassau County Oct. 22, 2010):  Dispute over the term "capital interest" in law firm partnership agreement   

    In Costello v. Costello, Shea & Gaffney, LLP,  the executors of the estate of Joseph Costello sued for an accounting and payment for his capital account in a dissolved law firm.  The 1993 partnership agreement included a provision dealing with the retirement or death of Mr. Costello and another senior partner.  Here's the relevant portion:

    Should [Costello] elect retirement, it is agreed that the partnership shall use its best efforts to pay [him] the sum of $100,000 annually, such payment to include first the return of his capital for a period up to and including December 31, 1999, and thereafter the sum of $50,000 until his demise. . . . Upon the retirement or death of [Costello], he or his estate shall surrender his entire capital interest in the firm to the firm which shall then revert to the remaining members of the executive committee for distribution to any member or members thereof in its sole discretion, without regard to any other proposition.  [Emphases added.]

    Costello never retired and was a member of the firm when he died in 2007, at which time his capital account exceeded $130,000.  The surviving partners took the position that, under the second sentence in the above-quoted provision, Costello agreed to forfeit his capital account if he failed to retire before his death.  Costello's executors argued that "capital interest" as used in the second sentence is different from "capital account," otherwise the provision for "return of his capital" in the first sentence would be rendered meaningless.  They also argued that the called-for surrender of Costello's "capital interest" referred to the termination of his voting participation in the management of the firm. 

    The court's decision, by Nassau County Commercial Division Justice Ira B. Warshawsky, agreed with the executors that, in order to give effect to all portions of the provision, the terms "capital account" and "capital interest" must have different meanings.  As Justice Warshawsky explained:

    If, on retirement, [Costello] relinquished [his] interest in [his] capital account, to be distributed by the executive committee to any member or members in their sole discretion, it would be impossible to pay [him] $100,000 per year, going first to the repayment of the capital account, because [Costello] would have none.

    Justice Warshawsky also notes that the agreement "is actually silent on the distribution of the capital account upon death" and that the "surrender upon death or retirement can only refer to voting rights in the operation of the law firm."  He also highlights the fact that, following Costello's death, the firm paid his estate $8,250 representing the increase in Costello's capital account in the year 2007.  "Defendants' treatment of the payment of the $8,250 increase for 2007," Justice Warshawsky writes, "is inconsistent with their claim that decedent's claim to his capital account terminated upon his death.  If it did, he would not have been entitled to any payment from the account."  The court accordingly granted summary judgment in favor of the executors on the claim to recover the balance of Costello's capital account.        

    Bell v. White, 2010 NY Slip Op 07648 (3d Dept Oct. 28, 2010):  Dispute over application of minority discount under agreement calling for "fair market value" appraisal

    Bell v. White involves not so much a drafting error or inconsistency as it does a failure to understand appraisal terminology.  In 2005, plaintiff John Bell and defendant David White settled a shareholder derivative lawsuit brought by Bell as a 20% shareholder of Norpco Restaurant, Inc. and a second company.      The stipulation of settlement provided that Bell and White were to each select an appraiser to assess the "fair market value" of Bell's Norpco shares and, if the appraisers failed to agree on value, a third appraiser would be selected to perform a binding appraisal.  The party-selected appraisers failed to reach agreement following which the third appraiser valued Bell's shares at $150,000.  Bell then went back to court to have the appraisal set aside on the ground that the appraiser improperly appraised the shares according to their fair market value (FMV), rather than fair value (FV), and erroneously applied a minority discount.

    The trial court rejected Bell's argument.  Bell appealed to the Appellate Division, Third Department, which likewise enforced the stipulated use of the FMV standard, writing:

    With respect to Mellen's [the third appraiser] use of fair market value in appraising the shares, the stipulation plainly states that, in the event that the parties' respective appraisers are unable to agree on the "fair market value" of plaintiff's shares, they would agree upon a third appraiser to determine the "fair market value" of such shares. Indeed, Mellen explicitly stated in his report that, "[i]n accordance with the Stipulation, the applicable standard of value . . . is fair market value," and then went on to define the term pursuant to applicable regulations. Although plaintiff argues that it is "readily apparent" that the parties were contemplating a "fair value" standard since that standard is traditionally utilized in determining the value of shares of a closely-held corporation, "our sole function here is to interpret the stipulation of settlement and glean the intent of the parties from the plain language of the stipulation" (Mayefsky v Mayefsky, 184 AD2d at 955). As the stipulation unambiguously calls for a determination of the fair market value of plaintiff's shares, plaintiff's contrary interpretation of the parties' intent must be rejected.

    As I've written before, under New York case law the main difference between FMV and FV is the latter's exclusion of any discount for lack of control a/k/a minority discount.  The decision in Bell does not indicate the size of the minority discount applied by the third appraiser, but generally such discounts can range up to thirty or forty percent.  The cases cited by Bell on his appeal all arose in the context of dissenting shareholder or oppressed shareholder buyouts under the Business Corporation Law in which the governing statutes expressly require use of the FV standard rather than FMV.  The appellate court found these cases inapplicable based on the stipulated use of the FMV standard.  It also rejected Bell's attack on the appraiser's use of a minority discount based on Norpco's preincorporation agreement requiring unanimous shareholder approval for all corporate decisions.  While this feature gave Bell "some level of control, i.e., the ability to veto important corporate decisions," the court explained, "a minority shareholder under these circumstances nonetheless still lacks the power to unilaterally direct and compel corporate activity."

    Moral of the story: know the difference between FMV and FV if you use one or the other valuation standard in any form of buyout agreement.

    Ehlinger v. Hauser, 2010 WI 54, 785 N.W.2d 328 (2010):  Dispute over term "book value" in shareholder buyout agreement

    The third case, Ehlinger v. Hauser, hails from Wisconsin and involves the disability buyout provisions of a shareholders agreement between two 50-50 shareholders of a picture frame manufacturing company.  The agreement specified a purchase price of the greater of $350,000 or "book value" but did not define book value or set forth any process for its determination.  Ehlinger subsequently became disabled and Hauser elected to purchase his shares based on his book value calculation of approximately $430,000, which Ehlinger rejected.  Ehlinger sought to have the company's books audited for the purpose of determining book value; Hauser refused.  Ehlinger then sued for judicial dissolution of the company on the grounds of deadlock and also sought a declaratory judgment that the buyout agreement was unenforceable for lack of essential terms including the definition and means of determining book value.

    Both parties agreed that book value is defined as "assets minus liabilities" but could not agree on how to determine which assets and liabilities should be computed in the calculation and what degree of verification was needed.  Hauser argued for determination of book value based on the company's unaudited year-end financial statements.  Ehlinger countered that the statements were calculated for tax purposes, did not represent the true worth of the company's assets, and were not adequately documented.  The trial judge appointed a CPA as special magistrate to assess whether book value as reflected in the statements deviated from generally accepted accounting principles (GAAP), but the magistrate eventually reported his inability to validate 76% of the company's assets and 90% of its liabilities because of missing or otherwise deficient supporting records.  The trial judge ruled that the term "book value" was indefinite, precluding the enforceability of the buyout agreement, and therefore granted Ehlinger's petition to dissolve the company.

    Hauser appealed unsuccessfully to the intermediate appellate court, which opined that book value as used in the agreement was "ambiguous" (as opposed to indefinite) and that supporting documentation is a necessary component of a GAAP computation.  Hauser next appealed to Wisconsin's Supreme Court, again meeting defeat.  The Supreme Court ruled that it mattered not whether "book value" was indefinite or ambiguous because, even in the latter event, which would normally allow the court to hear extrinsic evidence of the parties' intent to use one or another basis for arriving at book value, the absence of supporting documentation rendered impossible the validation of book value on any basis.

    I have seen many buy-sell agreements that fix purchase price based on book value.  In most instances, the agreements expressly require computation in accordance with GAAP (which typically will entail substantial adjustments to the company's financial statements used for tax purposes) and/or provide for binding determination by the company's regular outside accounting firm or other designated CPA.