Buy-Sell Agreements Are Supposed to Deter Litigation, Not Foment It
April 27, 2020
Two of my pet topics — dysfunctional buy-sell agreements and application of federal court abstention doctrine in private company disputes — intersect in a decision issued last month in Ray v Raj Bedi Revocable Trust, Case No. 3:19-CV-711 DRL-MGG [N.D. IN. Mar. 11, 2020].
The District Court’s opinion tells the story of peripatetic litigation over the implementation of the buy-sell agreements’ poorly conceived appraisal provisions that, like Gilbert and Sullivan’s wandering minstrel, “tuned its supple song” as the case journeyed from Michigan state court across the border to Indiana state court and then Indiana federal court. The shame of it is, after logging all that mileage, the underlying dispute remains unresolved and likely headed back to Michigan state court. Perhaps the greater shame of it is that the agreements mandated appraisals and arbitration to resolve any disputes over pricing the buyouts.
The case arose following the death of one of two 50% owners of two realty-holding Indiana corporations named C.F.B., Inc. (“CFB”) and C.F.B. Real Estate Corp. (“CFBRE”). The owners had executed buy-sell agreements for the shares in each corporation, giving the surviving owner the option to purchase the other’s shares upon his death.
The Buy-Sell Provisions
The two agreements have different provisions governing the process for pricing the shares.
Section 10 (F) of the CFB buy-sell agreement contemplates an annual review of the shares’ value but that “the value be set by arbitration” if no value is stipulated in the same year a trigger event such as death occurs. Initially it contemplates each side appointing an arbitrator and the two arbitrators trying to reach agreement. If they can’t, “they shall appoint a third arbitrator and a decision by the majority as to the value of each share shall be binding upon each of the SHAREHOLDERS.” It further provides that “the arbitrators required hereunder shall be certified public accountants practicing in Indiana or Michigan.”
Section 10 (F) of the CFBRE buy-sell agreement provides that, absent agreement on price between the surviving shareholder and the deceased shareholder’s estate representative as to “the fair market value of any of the assets,”
then the said assets shall be appraised and valued by three (3) competent appraisers with the SHAREHOLDERS [or estate representative] each selecting a competent real estate and personal property appraiser . . . and those two (2) appraisers selecting a third appraiser, which said value shall be determined by averaging the two (2) written appraisals that are closest in value.
What’s missing from these provisions? Quite a bit. The CFB agreement doesn’t identify a standard of value. It requires no appraisal credentials or other qualifications for the selection of a CPA as appraiser. For that matter, it doesn’t even require the arbitrators to perform appraisals. It also doesn’t say what happens if each of the three appraisers arrives at a different valuation, i.e., if there’s no majority decision. The CFBRE agreement requires selection of “competent” appraisers without defining what qualifications meet that otherwise entirely subjective standard. Neither agreement addresses the process or timeline by which the arbitration or appraisal process is supposed to happen.
The Road to Federal Court
In 2017, shareholder Raj Bedi died, after which shareholder John Ray offered to purchase Bedi’s shares in both companies pursuant to the buy-sell agreements. Ray and Bedi’s trustee failed to reach agreement. In May 2018, Bedi’s trustee filed suit in Michigan state court against Ray and the companies seeking an award of the share prices for CFB and CFBRE.
The Michigan court ordered the parties to engage in the valuation processes set forth in the buy-sell agreements, but the parties thereafter could not agree on the proper procedure for the valuation processes. Bedi’s trustee then asked the Michigan court to supervise the valuation processes and specifically to order that the trust’s chosen appraiser was competent to serve in such a role under the buy-sell agreement and that Ray make an interim payment equal to his buyout offer even before the valuation was complete. The court denied the request for judicial supervision and interim payment by Ray, but did state its opinion that the appraiser selected by Bedi’s trustee under the CFBRE buy-sell agreement “is competent as a real estate appraiser.”
Meanwhile, Ray filed suit in Indiana state court seeking a judgment against the trust declaring and enforcing the terms and provisions of the buy-sell agreements including the agreements’ “timelines, valuation of shares, purchasing procedures, qualifications and competency of arbitrators and appraisers, and details regarding the arbitration and appraisal process.”
Bedi’s trustee then removed the Indiana case to federal court based on diversity jurisdiction.
The Federal Court Rejects Burford Abstention But Dismisses the Indiana Suit Anyway
A funny thing happened after Bedi’s trustee removed the case to federal court: both sides asked the court not to hear it. As the court sized it up, “[t]he court has been invited to this bout only to be asked immediately to leave once it decides which door will serve as its exit.”
- Ray argued that the federal court should remand the case to the Indiana state court based on the Burford abstention doctrine under which a federal court should decline to exercise its jurisdiction where timely and adequate state court review is available and when the case presents difficult questions of state law bearing on policy problems of substantial public, or the federal case would be disruptive of state efforts to establish a coherent policy with respect to a matter of substantial public concern.
- Bedi’s trustee asked the court to dismiss or stay the action under what’s known as the Wilton/Brillhart doctrine which affords federal courts discretion not to hear a declaratory judgment action. The doctrine is typically invoked when parallel state proceedings are ongoing, raising concerns of comity, federalism, the efficient use of judicial resources, and fairness to the parties.
I’ve written a number of times about Burford abstention in the context of federal court diversity lawsuits asserting state law claims for judicial dissolution of close corporations or LLCs (here, here, here, and here ). In most instances, the federal courts have abstained from hearing those cases under the prong of Burford abstention deferring to state efforts to establish a uniform development and interpretation of the statutory scheme governing state-created entities.
The District Court in Ray summarized the parties’ opposing Burford arguments thusly:
Mr. Ray and the CFB entities argue that the Trust is advocating for the creation of a new equitable remedy when shareholders disagree about the value of shares under a buy-sell agreement for an Indiana corporation. They further argue that the interim buyout requested by the Trust would be a sweeping policy declaration, impacting Indiana corporations at large. The Trust disagrees, arguing that this interim buyout is nothing more than specific performance of a contract, not relating to any Indiana policies concerning corporations.
The court agreed with Bedi’s trustee, finding that, “[w]hile a state might have an important interest in uniform policy concerning its corporations, the claims here don’t ostensibly implicate any of Indiana’s corporate regulations.” The court further explained:
The Burford doctrine is inspired by concerns of federalism, not singular contract rights. The parties seek a declaration about their respective rights and obligations under two buy-sell agreements. In fact, Mr. Ray and the CFB entities state in their complaint that “[t]his action concerns questions of contract interpretation,” and request the court to “establish and implement appropriate procedures for the parties’” and declare their “respective rights, duties, obligations, responsibilities, and legal relations under the [agreements].” The interpretation of two contracts would not “transcend the result” of this case or likely affect anything other than the rights of these parties. This is not one of the “essentially local problems” that would disrupt the balance of federalism; this is merely the interpretation of contracts between the parties, the effect of which would not reasonably be felt by those not bound by their terms. [Citations and record references omitted.]
Ray alternatively argued for recognition of the Indiana Commercial Court as a “special forum” that might merit Burford abstention. The District Court disagreed again, stating that, notwithstanding the newly created Commercial Court’s expertise in a broad range of commercial matters, “the same issues can be heard by courts of general jurisdiction, [contrary to] the kind of regulatory regime calling for Burford abstention.”
Turning to Bedi’s trustee’s motion to dismiss, the District Court’s opinion discusses at length the jurisprudential contours of the Wilton/Brillhart doctrine and its application to the case before ultimately exercising its discretion in favor of dismissal. The factors cited in support included:
- “The Michigan state court has already determined that the subject of share valuation is arbitrable (or appraisable) under the contracts. With that gateway dispute resolved, the subject of procedures remains with the arbitrator, not the court.”
- “The subject of the “valuation of shares”—which Mr. Ray and the CFB entities invite this court to declare duplicatively—is squarely within arbitration and appraisal among the same parties. The Michigan state court has already declared that to be so, and to ask this court to address this issue anew in any way justifies abstention based on sound principles of comity and federalism.”
- “The Michigan court has decided the qualifications of one appraiser. This court knows of no restriction on the Michigan court’s ability to decide the qualifications of a third appraiser, should the parties not be able to resolve that.”
- “The [Michigan] state court may have declined wholesale supervision of the arbitration and appraisal process, but it has remained readily involved to assist on an issue-by-issue basis, including it seems for any declaratory needs that might arise under the contracts.”
- “A declaration about an interim buyout will not terminate any controversy here. It would be an undesirable piecemeal ruling. Indeed, the parties recognize that their controversy is much bigger than a mere interim buyout. Their controversy is about the entire buyout—and the valuation of shares that drives that quarrel.”
- “This declaratory action will merely amount to duplicative and piecemeal litigation, and will not serve a useful purpose in clarifying the legal obligations and relationships among the parties.”
- “There is nothing precluding the plaintiffs from bringing this declaratory action before the Michigan court for any ripe issue, and where any confusion or concerns regarding prior orders could be properly addressed. What is more, nothing prevents the parties from seeking relief from the arbitrators for procedural issues that need be decided.”
Back to Michigan
The dismissal of the Indiana lawsuit leaves the parties where they started, in Michigan. If they can’t resolve their differences over the pricing of the shares or the appraisal process by which pricing will be determined, the Michigan state court undoubtedly will be asked to intervene once again — in effect, to supply terms that should have been included in the buy-sell agreements in the first place.
I’ve lost track how many times on this blog I’ve written about poorly planned, poorly drafted, dysfunctional buy-sell agreements. Here’s a sampling of the rogue’s gallery to which the Ray case is now a member:
The purpose of a buy-sell agreement is to establish a price or pricing mechanism and the source and terms of payout when an equity owner leaves the firm, either during his or her lifetime or upon death. A carefully planned and drafted buy-sell agreement executed at the outset of the venture, when the owners’ interests are aligned, and updated periodically as needed, can avoid future disputes and litigation when the owners’ financial interests inevitably diverge when one of them departs.