Business Court Interprets "Cookie-cutter" Partnership Agreement

In a case decided Tuesday by the Business Court, the parties were at loggerheads over how the assets of a partnership were to be valued upon the dissolution of the partnership or the withdrawal of a partner.  Judge Jolly granted the motion for summary judgment by EHP Land Company, the withdrawing partner of HPB Enterprises, which was the developer of a resort community on 750 acres of land in Perquimans County.  EHP Land Co., Inc. v. Bosher.

The partnership agreement said that EHP was entitled to the book value of its interest, to be adjusted based on the fair market value of  "any inventory owned by the partnership."  The critical word for construction by Judge Jolly was "inventory," which was undefined in the agreement and as to which there was a huge difference of opinion between the parties regarding the meaning of the word.  To  the plaintiff corporate partner it included all the developed and undeveloped real property owned by the Partnership, "as well as development amenities such as the golf course, pro shop, clubhouse, restaurant and marina."   Op. ¶21. 

The defendant partners had a much more limited view, arguing that the term was ambiguous and therefore void.  In the alternative, they contended that "inventory"  was limited to assets developed and held for sale, which would not have included much of the property owned by the partnership.

Given the lack of any evidence regarding the intention of the parties as to the construction of the undefined word, Judge Jolly determined that it had  a "natural and ordinary meaning."  Op. ¶52.  Looking to dictionary definitions, he concluded that undeveloped lots to be developed in the future were within the scope of the "inventory" of the partnership.

The Court recognized testimony that the partnership had not discussed the term at the time the partners entered into the agreement and that there was no draftsman who could testify as to the meaning of the undefined word. The lawyer who had drafted the agreement testified that the partnership agreement was the "standard, 'cookie-cutter' Partnership Agreement that [he] used for partnerships at that time."  Judge Jolly said:

It is not uncommon for contracts to be form-based and not created from "scratch."  Indeed, one reason the use of form contracts is beneficial is because terms may acquire meaning from continual use over time.  The very fact that the term“inventory” appears in the Partnership Agreement weighs in favor of according it specific meaning; that is, the term was chosen not haphazardly without thinking, but was chosen for inclusion in a form contract precisely because it carries meaning. 

Op. ¶50.

I can't end without saying that my partner John Buford deserves a public thank you for running this blog very well during the many months (since February) I have not been working or writing on this blog due to a stroke.  He did a great job and only gave the blog back somewhat unwillingly when I asked for it a few days ago.  I hope to be back to work in a few months but will start keeping up the blog now.  I'll leave it to you whether you preferred John over me.  Please don't hurt my tender feelings.  I appreciate all of you who wrote to me while I was in the hospital.  Thank you for reading and for noticing that I was missing.



Minimizing Windfall: Dissolution Valuation by Royalty

Valuing a closely held business is often a debate over hypothetical dollars, particularly when the company's sole asset is unproven technology.  The Business Court confronted such a situation recently in Vernon v. Cuomo.

The company in question developed a new technology with potential widespread medical application:  silicone-free syringes, which would enable syringes (especially of high-priced medicines) to be pre-filled without risk of contamination.  The potential of the technology, however, was not enough to keep the company together.  Two shareholders asserted dilution and self-dealing claims against the other shareholders.  After a bench trial, the Court concluded that the defendants engaged in self-dealing and breached their fiduciary duty to the plaintiffs.  The Court ordered the judicial dissolution of the company to protect the interests of the complaining shareholders pursuant to N.C.G.S. § 55-14-30(2)(ii).  (Mack wrote about the bench trial opinion last year).

In lieu of dissolution, the defendants exercised their statutory option to purchase the plaintiffs' shares at fair value under N.C.G.S. § 55-14-31(d).  That statute neither defines fair value nor specifies the procedures for a court to use in arriving at it.  In Vernon, Judge Tennille followed a procedure similar to two previous valuation cases, Garlock v. Hilliard and Royals v. Piedmont Electric Repair Co.:  solicit the opinion of an independent appraiser, "but also [take] into account other equitable and practical considerations based on the arguments and submissions of counsel and matters of record."

The added complication of Vernon was that, with the only asset an unproven technology, there was a high risk of windfall on both sides:  "One of the key problems faced by the Court in this valuation process has been how to protect against a windfall by the majority shareholders if the technology proves to be extremely valuable while not requiring the majority to pay an initial price that may be too high if the technology is not adopted widely in the industry."

The Court approved of the methodology of the appointed appraiser, who had extensive IP valuation experience.  The appraiser's methodology included:

  • the discounted future economic income method to discern fair value
  • Latin Hypercube simulation algorithms to generate income estimates
  • a Fisher Pry model to project a market adoption rate for the technology
  • Monte Carlo simulation methods to consider uncertainties in the company's underlying earnings potential

However, because of the uncertainties and the windfall risk, the Court concluded that a royalty sharing arrangement would best capture the value of the technology for both sides.  The Court found that the plaintiff's shares were worth a specific amount, plus a royalty sharing arrangement of a specified percentage.  (The amounts themselves are redacted in the public version of the Court's opinion).  The Court ordered the closing to take place within 20 days, with 50% of the purchase price paid at closing and the balance paid in two annual installments with no interest.

Recognizing the novelty of the approach (and the appellate courts' distrust of novelty), the Court also reached a backup conclusion of the total fair value of the plaintiffs' shares, which would take effect if an appellate court struck down the royalty sharing arrangement.



[The photo of the syringe is from Zaldylmg's photostream on Flickr, some rights reserved.]

Valuation Of Railroad Company's Shares Presented Issues Of Material Fact

This Business Court case concerns the valuation of shares of the Aberdeen and Rockfish Railroad Company, a North Carolina short-line railroad.  Judge Jolly granted in part, and denied in part, the Defendants' Motion for Summary Judgment, on May 20, 2008, in In The Matter Of The Ruth Cook Blue Living Trust.

The shares at issue were held by a Trust.  The Trust Agreement provided that upon the death of the settlor (Mrs. Blue), the shares were to be offered to the members of her family "at the value established by the accounting firm engaged by the Railroad as of December 31 of the year preceding my death."

The Trustees (the Plaintiffs) and the family members entitled to buy the shares (the Defendants) were at odds about their value.  The Court ruled, on summary judgment, that the word "value" meant "'fair market value' of the Railroad shares as the same would be viewed by the Trust, as prospective seller, and the Blue family, as prospective purchasers."  The term "value" did not mean the fair market value of the shares if they had been offered to the general public.

The Defendants argued that a valuation report done by the Railroad's accounting firm shortly before Mrs. Blue's set the value for the shares.  The Court noted, however, that this report had been prepared "for the limited purpose of determining the fair market value between a willing buyer and a willing seller in the general marketplace of a minority interest of a share of the Railroad's common stock for gift and estate tax purposes."   The Court found that there were material issues of fact whether this valuation, which incorporated a significant discount for the lack of marketability of the shares, reflected the intent of Mrs. Blue.  (There were similar issues raised by the Classic Coffee Concepts case earlier this year.)

The Court granted summary judgment, however, on the issue of whether the accounting firm issuing the report was in fact the proper firm to perform the valuation.  It found that it was.  Then, the Court rejected an argument by the Plaintiffs that they were entitled to challenge the methodology of the accounting firm.   It held "the court notes that since Ruth Cook Blue is deemed to have embraced the expertise of [the accounting firm] by virtue of paragraph 8.01 of the Trust Agreement, it is likely that criticism of [the accounting firm's] valuation methodology would be of limited probative value, if it would be admissible at all."

The Court also allowed an amendment to the Complaint which, if not allowed, might have been determinative of the valuation  issue.   

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Valuation Formula In Coffee Company's Stockholders Agreement Enforced

Classic Coffee Concepts v. Anderson, 2008 NCBC 1 (N.C. Super. Ct. January 31, 2008)(Diaz)

Defendant, a terminated employee, owned one third of the outstanding stock of Classic Coffee Concepts. The issue in this case was the price to be paid for the stock, which the corporation was obligated to repurchase under a Stockholders Agreement. The Agreement said that the price would be determined by looking to the fair market value of the stock as determined by an independent appraisal of the Employee Stock Ownership Plan. But no ESOP had ever been established. 

A variety of conflicting appraisals were presented to the Court. Defendant would have been entitled to a multi-million recovery under two of them. The first, prepared pre-litigation to address an accounting issue involving goodwill, set the company's "fair value" at $12,500,000. A "fair value" appraisal ignores discounts in value that are typical for closely held corporations, like those for lack of marketability and lack of control. Defendant's shares would have been worth $4 million if this appraisal applied. A second appraisal factored in the discounts applicable to closely held corporations, and concluded that the corporation had a value of $8,390,000. If this appraisal had controlled, defendant's shares would have been worth more than $2.7 million. 

The company obtained a hypothetical appraisal for purposes of the litigation which valued the company as if the ESOP required by the Agreement was in place. The value placed on defendant’s shares under this approach was markedly lower, only $120,000. Another appraisal assuming the existence of the ESOP valued defendant's shares at $192,000, and the last of the many appraisals before the Court valued them at zero.

After analyzing this thicket of conflicting appraisals, the Court held that it would

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