North Carolina Business Litigation Report

NC Court of Appeals Interprets the "Purchase on Death" Provisions of a Shareholders Agreement

[Ed. note:  The following article was written by Mack Sperling before his unplanned leave.  Although releasing it today is less timely than is Mack's custom, the issues involved in the case are still of interest to businesses and business lawyers.  Any errors or shortcomings in the article are attributable to your substitute bloggers.]

 

On February 16, in Lynn v. Lynn, the Court of Appeals interpreted provisions of a Shareholders Agreement requiring the corporation to repurchase a shareholder's "restricted shares" upon his death, with the purchase to be funded by the proceeds of a life insurance policy on the shareholder.

The trial court had found the Agreement to be ambiguous, and had considered a variety of extrinsic evidence in determining the ownership of the shares in question.  The Court of Appeals found no ambiguity, ruled that it had been error to consider the extrinsic evidence, but it nevertheless reached the same result as to ownership.

Background

A father (James) and his two sons (Greg and Kenneth) formed a corporation, James Lynn & Sons, Inc. Eventually, the father owned 51% and the sons each owned 24.5% of the company's stock.

In 1993, the shareholders and their wives entered into a shareholders' agreement requiring that upon death, each shareholder would sell his "restricted" shares back to the corporation for an amount equivalent to the face amount of a life insurance policy on his life, with the face amount to be adjusted annually. The corporation was to own the policies.

The sons kept life insurance in place, paid for by the company, which increased over time from $75,000 to $375,000. The corporation paid the premiums, though the brothers had the policies issued in their names as opposed to them being owned by the corporation.  They named their wives as beneficiaries of the policies. The father didn't maintain insurance, due to expense, but upon his death in 1997 his executor sold his shares to the sons in a transaction referencing the Shareholders Agreement.

Later, the sons adjusted their ownership interests with Kenneth becoming the 55% majority owner and Greg holding a 45% interest.

Then it got interesting. Greg and his wife got divorced, and were involved in heated litigation over the equitable distribution of their property. Greg's wife sued Kenneth, as majority shareholder, to establish that the shares of the company were subject to equitable distribution.

Kenneth then died unexpectedly.  His shares went to his estate.  The insurance proceeds went to his wife.  Greg's ex-wife said that 100% of the shares were now subject to her equitable distribution claim.  Greg pretty much agreed with his ex-wife, and said that upon the payment of the life insurance proceeds to Kenneth's wife, he held 100% of the shares.

Kenneth's widow had a different point of view.  She said that the Shareholders Agreement only applied to "restricted shares," and that the shares held by her late husband did not fit that definition. She also said that the corporation hadn't complied with the life insurance provision given that it did not own the policies. She said she was entitled to both the insurance proceeds and the shares.

 

 

The Trial Court Ruling

The trial court ruled that the Agreement was ambiguous, because sometimes it referenced "restricted shares," sometimes it referenced plain 'ol "shares," and no shares had been denominated as being "restricted."

The trial court considered a wealth of extrinsic evidence on the meaning of "restricted shares," including testimony from the attorney who had drafted the Agreement, who testified that all of the corporation's shares were restricted notwithstanding the lack of any notation to that effect on the face of the shares. The trial court further considered evidence from the insurance company showing that the purchase of the insurance was to "fund a "Partnership Buy/Sell Agreement,'" along with testimony from the insurance agent and the company's accountant.

The trial court ruled that Greg was the owner of 100% of the stock. Kenneth's widow argued on appeal that the agreement wasn't ambiguous, that it applied only to "restricted shares," and that the trial court should not have considered extrinsic evidence.

The Court of Appeals Ruling

The Court of Appeals agreed with Greg's widow on the plain terms of the Agreement, ruling that "there is no ambiguity in the Agreement, and, more specifically, we find no ambiguity in the term 'restricted shares.' Accordingly, extrinsic evidence admitted solely for the purpose of defining 'restricted shares' under the Shareholders’ Agreement was improper."

The appellate court nevertheless reached the same result. It held that all of the corporation's shares fell within the meaning of "restricted shares." One factor in its decision was that there were extensive restrictions on the alienation of shares contained throughout the Shareholders Agreement designed to prevent shares from passing to outsiders. It said that restrictions of this type are "common in closely held corporations," and that all of the shares were in effect "restricted." It also observed that the provision requiring the use of the life insurance proceeds referred to the purchase of a shareholder's "interest." It said that "this evidences the intent that all shares owned by the decedent be covered."

The lack of any marking on the share certificates that the shares were restricted did not give the Court much pause. It said that this might have made a difference if the buyer had been a good faith purchaser without notice of the restriction; but that in this case the wives had both signed off on the Shareholders Agreement.

Additionally, the Court of Appeals affirmed the trial court's conclusion that the corporation complied with the requirement that life insurance be purchased to fund the Agreement.  Although the policies were owned by Kenneth individually at the time of his death, not by the corporation, the corporation paid the premiums.  There also was testimony from an insurance agent that the brothers purchased the policy in order to fund the buy-sell provision of the Agreement.  (According to the Court of Appeals, this was not improper extrinsic evidence regarding the interpretation of the Agreement, but rather was evidence necessary to determine whether the corporation complied with the requirement that life insurance be purchased).

The Court held that the parties' course of dealing established their clear intent that the policies in question be used to fund the buy-sell portion of the Agreement.  Kenneth's widow argued that the technicality of policy ownership entitled her to both the policy proceeds and the shares in the corporation; instead, the trial court and the Court of Appeals held she was entitled to neither.

Appellants' Brief

Plaintiff-Appellee's Brief

Third Party Plaintiff-Appellee's Brief

 

 

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Mack Sperling
Brooks Pierce, LLP
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