Lessons From a Trio of Dysfunctional Buy-Sell Agreements
July 02, 2018
Three recent court decisions from three different states — New York, Pennsylvania, and Alabama — add to the rogue’s gallery of valuation cases stemming from poorly conceived and/or poorly implemented buy-sell agreements among shareholders or LLC members.
Each one, in its own way, teaches a valuable lesson for lawyers charged with drafting such agreements, and also highlights the wisdom of consulting with appraisal experts at the time of drafting.
New York: The Nimkoff Case
The Nimkoff case is an old friend of this blog, and I do mean old. I first wrote about the case in its infancy, in 2010 (read here). Eight years later, following discovery and a dozen or so motions, the case has yet to be tried.
Nimkoff is a fight over the value of a 3.6% membership interest in a single-asset realty holding LLC owned by a group of medical doctors. The plaintiff is the wife-executrix of one of the doctors, whose death in 2004 triggered the LLC’s obligation to purchase the deceased member’s interest for a “Stated Value” in accordance with the operating agreement which also required that the Stated Value be updated annually.
That’s right. This is another one of those dysfunctional cases, like the Troser case I wrote about here and the DeMatteo case I wrote about here, where the owners’ agreement includes a mandatory buy-sell upon death, retirement, etc., in which the price is fixed by an agreed “Certificate of Value” which is supposed to be updated annually but almost never is. Or, as in Troser, the owners never bothered to prepare the initial Certificate of Value. Business appraiser Chris Mercer has referred to this type of fixed-price agreement as a “ticking time bomb,” and rightly so.
Nimkoff is not as bad as some. The Stated Value was updated at least once or twice over a twenty year period by a qualified appraiser, the last time in 2001 setting the net enterprise value at $2.75 million. The buy-sell provision required use of the “last Stated Value” in the event the LLC failed to update the Stated Value in any year, no matter how stale, so after Dr. Minkoff’s death in 2004, the LLC tendered a check to his estate for the initial 10% payment for his membership interest valued in total at $99,000 representing 3.6% of the $2.75 million Stated Value as of 2001. The check was never deposited.
Fast forward to 2007, when the remaining members sold the LLC’s building for $7 million, after which the LLC tendered Dr. Nimkoff’s estate the entire $99,000 plus interest, i.e., approximately $150,000 less than what would have been the estate’s pro rata share of the net proceeds from the $7 million sale.
The estate subsequently sued for the difference, claiming that the managing members did not act in good faith and breached fiduciary duty by failing to update the Stated Value as required by the agreement. In 2010, as reported in my first post about the case, Justice Stephen A. Bucaria denied the defendants’ dismissal motion largely based on a 2001 memorandum from the LLC’s outside counsel to the members in which the lawyer cautioned, “It is important that the Stated Value be current so that the estate of a member is properly compensated in the event of a buy-out following a member’s death. It is strongly recommended that the Stated Value be reviewed each year.”
After another eight years of discovery and legal wrangling, defendants took another stab at summary judgment and, for the second time, came up short. In April of this year, having inherited the case from Justice Bucaria, Justice Timothy S. Driscoll issued a 16-page decision (read here) in which, after an exhaustive recitation of the parties’ factual contentions and arguments, he concluded that a trial is necessary, stating:
The motion papers before the Court demonstrate that there are issues of fact regarding the reasonableness and good faith of Defendants’ determination regarding the stated value of the Property. Because the stated value was an integral component of the payment made to Nimkoff’s Estate upon his death, summary judgment is inappropriate.
It’s been fourteen years since Dr. Nimkoff’s death, nine years since his estate filed suit, and there’s still no resolution. Likely the parties collectively have incurred legal fees over the last nine years far in excess of the amount at issue. Such is the cost of a fixed-price buy-sell agreement that was just waiting for the opportunity to create havoc.
Pennsylvania: The Hornberger Case
Hornberger v Dave Gutelius Excavating, Inc., 2017 PA Super 395 [Super. Ct. Dec. 15, 2017], involves a problematic buy-sell agreement of a different sort, one in which the parties invited trouble by failing to specify with sufficient precision the meaning of “Adjusted Net Book Value” to be determined by the company’s independent CPA and, in particular, the applicability of discounts for lack of control and lack of marketability.
Depending on the asset profile of a company, adjusted book value can serve as a relatively straightforward valuation approach, relatively safe from challenge when used in a buy-sell agreement. Whether or not it achieves a fair result, it retains the benefit of simplicity and transparency. In other words, it’s intended to avoid rather than foster disagreement and litigation between buyer and seller.
Which is not how it worked out in Hornberger after the plaintiff quit his employment and thereby triggered the buy-sell provision in his shareholders agreement. The provision required the company’s CPA to determine Adjusted Net Book Value which was not otherwise defined except to address certain adjustments (i) excluding goodwill (ii) recognizing certain discounts to accounts payable and receivable and (iii) requiring any real property and tangible personal property to be included at fair market value.
The CPA valued the plaintiff’s shares at around $43,000 after applying a combined 35% discount for lack of control and lack of marketability. His appraisal report noted that the discounts were “in accordance with current valuation methodologies” and that the buy-sell provision “did not limit our professional discretion as it related to adjusting the net book value” of the company.
The former shareholder disagreed that the discounts were authorized by the buy-sell provision and sued for the discounted amount of approximately $21,000. At a non-jury trial — Can you believe, litigating all the way through trial over $21,000? — the plaintiff’s appraiser opined to no avail that the three above-mentioned adjustments to book value were “exclusive” and did not permit further discounts. The trial judge found that the discounts were “consistent” with the language of the buy-sell provision and “standard practices in the industry.”
The plaintiff then appealed to the Superior Court which, unfortunately for him, agreed with the company that the specific adjustments mentioned in the buy-sell provision were not exclusive; that “adjustments based on minority interest and lack of marketability are standard industry practice when valuing shares in closely held corporations”; and that “[w]hile the parties could have contracted to exclude other adjustments, they did not do so here.”
I, for one, have some reservations about the court’s decision. First, the buy-sell provision did not mention a standard of value, such as fair market value, which would have supported consideration of discounting. Second, the buy-sell provision required the CPA to used Adjusted Net Book Value to value the company’s shares, not the shares held by the plaintiff, which seemingly would exclude consideration of a shareholder-level discount such as the discount for lack of control a/k/a minority discount.
Whether or not those reservations have merit, the fundamental point remains, when owners opt to use adjusted book value as a measure of value in their buy-sell agreement, presumably they do so to avoid the inevitable disputes leading to litigation over more subjective, “judgment call” inputs such as those involved in income approaches as well as minority and marketability discounts. To that extent, the buy-sell provision in Hornberger failed in its purpose, bigtime.
Alabama: The Lynd Case
The third case, Lynd v Marshall County Pediatrics, P.C., No. 1160683 [Ala. Sup. Ct. Apr. 27, 2018], involves yet another dysfunctional buy-sell provision — this time contained in the by-laws of a professional corporation — where, like the Troser case mentioned above, the source document for valuation purposes — in Troser, the original Certificate of Value; in Lynd, a shareholders agreement — never existed.
The by-laws were adopted upon the P.C.’s formation in 1978 when it was a single shareholder medical practice. In 2013, the founding owner sold the practice to four other physicians including the plaintiff Lynd who left the practice a year later to care for her ailing mother in another state.
It was not disputed that, upon exiting the practice, Lynd was entitled to be paid for her share of the value of the practice. The by-laws provided for the shares to be valued by the method provided in the shareholders agreement in lieu of book value as provided in the Alabama default statute in effect at the time the by-laws were adopted.
As succinctly observed in the Alabama Supreme Court’s opinion, “The difficulty presented here is that there is no stockholder agreement.”
In the lower court proceedings, Lynd argued that she was entitled to receive the statutory “fair value” of her shares in the sum of $230,000. The lower court disagreed and granted summary judgment in favor of the P.C.’s argument that Lynd was required to accept book value of $6,275.
The Alabama Supreme Court reversed and remanded, finding that the by-laws unequivocally rejected valuation based on the Alabama statute’s default provision in effect in 1978 using book value. But the court also rejected Lynd’s argument that the superseding statute using the fair value standard should apply, finding that Lynd failed to establish as a matter of her licensure that she was a “disqualified” person entitled to invoke the statute. The court also rejected Lynd’s alternative argument that the fair value standard should apply as a matter of equity even if she was not a disqualified person under the statute.
Where this case is headed is anybody’s guess. If Lynd can’t squeeze herself within the current fair-value statute as a disqualified person, the court’s opinion offers no guidance how to resolve the valuation dispute given the non-existent shareholders agreement which, according to the by-laws, was supposed to provide the answer.
Did someone drop the diligence ball? Although they should have been, the opinion does not shed light on whether Lynd and her co-owners were aware of the by-laws and the non-existence of a shareholders agreement when they bought out the founder. It also is silent whether they attempted to enter their own shareholders agreement with buy-sell provisions concurrent with their acquisition of the practice or afterward.
Hat Tip: I caught sight of the Hornberger and Lynd cases in a recent issue of BVWire, a weekly e-zine featuring current events in the world of business appraisal including recent court decisions involving valuation disputes. If you’re a business appraiser or business divorce lawyer, and you haven’t already subscribed to BVWire (it’s free!), do so today.