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Monday, 26 July 2010 00:00

Buy – Sell Agreements: Be Sure to Say What You Mean; Keep Good Records

Recently, the Wisconsin Supreme Court issued an opinion in Ehlinger v. Hauser, 2010 WI 54 (June 25, 2010). This case provides us with important reminders of (1) why it is essential in a contract to say what you mean and mean what you say and (2) why it is necessary to ensure that you have adequate financial records to support your company’s financial statements.

The Facts

Briefly, the facts in Ehlinger were as follows: Two equal shareholders in a corporation signed a buy-sell agreement, which is a typical way to provide a means of business succession in the event certain agreed upon events come to pass. Here, the agreement provided that if one shareholder became completely disabled, the other shareholder could buy out the disabled shareholder. So far, so good.

However, also typical in these types of agreements, the parties provided a means to arrive at a buyout price. This is, generally, a good thing. Unfortunately, this particular agreement provided that the non-disabled shareholder was entitled to purchase the disabled shareholder’s shares at “book value.” Nothing more was stated regarding this term.

One shareholder did become disabled, and the non-disabled shareholder presented an offer to buy the disabled shareholder’s shares. What was the dispute about? You guessed it – each shareholder calculated “book value” in a different way. Each shareholder wished to include different assets and liabilities in the calculation and calculated the value of the assets and liabilities in a different way.

By simply stating that “book value” was to be used, the parties left open the interpretation of that term. It could mean anything from simple adoption of the company’s internally generated balance sheet, i.e., book value being the assets less the liabilities as stated, or a balance sheet generated after a full-blown audit by an outside CPA firm.

Before the trial court, a special magistrate with a CPA background was appointed in an attempt to determine if GAAP (Generally Accepted Accounting Principles) was correctly applied and if the company’s books and records were sufficient to allow a determination of book value. The special magistrate found that, due to poor record-keeping, 76% of the company’s assets and 90% of the company’s liabilities could not be verified through available supporting documentation.

The Supreme Court’s Holding in the Case

A divided Supreme Court determined that the agreement was unenforceable. As the majority opinion characterized it, the question was not “what is required under GAAP, but what is required to determine the parties’ rights.” The Court stated:

“Here, regardless of whether the parties intended assets and liabilities to be computed on a cost basis, a tax basis, a fair market value basis, or any other basis, the unavailability of [the company's] financial records prevents Ehlinger from exercising his right to examine the books in order to assess the accuracy of the buyout price. From both a practical and a legal standpoint, the unavailability of the records precludes this agreement from being enforced.”

Additionally, the Supreme Court reviewed the issue of the non-disabled shareholder using the company’s money to defend himself in the seven year old lawsuit. The non-disabled shareholder, who was running the business day-to-day, asserted that he had a right to be indemnified by the company for the legal expenses he incurred. The disabled shareholder objected.

The Supreme Court determined that the dispute was primarily between the two shareholders. It would have been proper for the company to indemnify the non-disabled shareholder for actions he took solely in his capacity as a corporate officer or if the company spent funds in its own legal defense. Neither circumstance was present here. Moreover, if the non-disabled shareholder did contend that he was acting as a corporate officer and wished to use the indemnity for corporate officers provided by the Wisconsin Business Corporation Law, he needed to follow the notice procedure outlined in the statutes. He failed to do so here.

What We Can Learn from this Case

Buy – Sell Agreements still have great value and should be used appropriately;

Use a means, method or formula to establish the buyout price that is precise and not subject to interpretation;

define it in detail;
and/oragree to appoint a neutral 3rd party to determine;

Maintain adequate financial and business records and retain for a sufficient period of time;

Review the Buy – Sell Agreement periodically to make sure the means, method or formula for the buyout is still relevant and ascertainable;

Provide in the Buy – Sell Agreement for payment of legal expenses in the event of a dispute, e.g., each party to pay one half or “loser” pays all, or provide for a mediation or arbitration mechanism in the event of a failure to agree and allocate the expense in that mechanism;

As a shareholder, be aware of when you act on your own behalf, and when you act on behalf of the company.

Based on the results of this case, even recently drafted Buy – Sell Agreements should be reviewed to determine if they adequately and precisely identify the means, method or formula for the buyout. Additionally, periodic review of your company’s financial statements is in order to ensure that the necessary supporting documentation and detail is available and can be used in the event a Buy – Sell Agreement is triggered.

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