Stock Repurchase Agreements

I’ve never thought very hard about the remedy of specific performance.  That means ordering a party to a contract to perform its contractual obligations.

But the ability of the Court to order specific performance was front and center in the Business Court’s decision Wednesday in Hilco Transport, Inc. v. Atkins, 2015 NCBC 44.  The Defendants, shareholders of the Plaintiff corporation, argued that the Court could not order specific performance compelling them to sell their shares to the corporation.

One of the Hilco shareholders had the right under the Buy-Sell Agreement to require the family members of his brother, upon the brother’s death. to sell their shares to the corporation.

All of the shareholders were subject to the term of a Buy-Sell Agreement which said in Section 10.1 that "[t]he Stockholders and their successors and assigns shall . . . be entitled to specific performance and injunctive relief to enforce the provisions of this Agreement."

The Buy-Sell Agreement did not specifically give the right of specific performance to the corporation.

When the Defendant shareholders received written notice from the corporation stating that it was exercising its option to purchase their shares, they  refused to allow the redemption.  The corporation sued, demanding specific performance.

The Defendants moved to dismiss, relying on the Latin phrase expressio unius est exclusion alterius.  If your fluency in Latin is fading, that means "the expression of one thing is the exclusion of another," (Order Par. 22).  Given that Section 10.1 of the Buy-Sell Agreement gave the right of specific performance to the shareholders, without mentioning the corporation, the shareholders contended that the corporation did not have that right.

Judge Gale didn’t buy that argument.  He looked at the opening sentence to the paragraph giving the surviving brother the right to buy his deceased brother’s family’s Hilco shares.  The Judge found the language "[n]otwithstanding anything contained in this Agreement to the contrary . . . ." to be significant.

I don’t know if I would have viewed that clause as being determinative, but this observation by Judge Gale about the "special rules" for "interpreting stockholder agreements that limit share transfers" is instructive:

‘restrictions on alienation or transfer of stock are not favored and consequently are strictly construed.’  Averitt v. Ledbetter Roofing & Heating Co. v. Phillips, 85 N.C. App. 248, 251, 354 S.E.2d 321, 323 (1987).  However, such agreements can be upheld where the language is clear, because ‘[w]hile both option contracts and restrictions on the alienation of property interests are strictly construed, the clear intent of the parties as expressed on the face of the contract controls.  Lee v. Scarborough, 164 N.C. App. 357, 360, 595 S.E.2d 729, 732 (2004).

Op. ¶19.

If you think that this ruling means that the Defendants have to tender their shares to the corporation, you are wrong.  There are at least a couple of issues yet to be resolved.  The Defendants are challenging the valuation of their shares, which the Buy-Sell Agreement said was to be the stock’s fair market value as determined by a specified accountant.  There is also a challenge to the validity and enforceability of the Buy-Sell 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.

 

 

Continue Reading NC Court of Appeals Interprets the “Purchase on Death” Provisions of a Shareholders Agreement

Plaintiff was entitled to specific performance of a Shareholders’ Agreement requiring the Defendant, a terminated employee, to tender his shares back to the Plaintiff.  The repurchase was ordered even though the Defendant claimed that his termination was wrongful. 

The Court granted a Motion for Judgment on the Pleadings, and held:

Specific performance is appropriate when monetary damages are inadequate. Whalehead Properties v. Coastland Corp., 299 N.C. 270, 282, 261 S.E.2d 899, 907 (1980) (citing In Trust Co. v. Webb, 206 N.C. 247, 250, 173 S.E. 598, 600 (1934)). Viewing the material facts in the light most favorable to Defendant, the Court finds that Defendant’s employment was terminated (Compl. ¶ 9; Def.’s Ans. ¶ 9) regardless of the alleged wrongful or proper nature of the termination, Plaintiff tendered an amount to Defendant to purchase Defendant’s shares (Compl. ¶ 11; Def.’s Ans. ¶ 11), and Defendant failed to tender those shares to Plaintiff (Compl. ¶ 12; Def.’s Ans. ¶¶ 10, 12). If Defendant Barnette has a cause of action for wrongful termination, his damages may include losses resulting from his forced sale of shares. He therefore has an adequate remedy. Plaintiffs do not have an adequate remedy at law for his failure to sell his shares and are entitled to equitable relief. Only transfer of the shares at issue pursuant to the Shareholder Agreement would be an adequate remedy for breach of the Shareholder Agreement.

Full Opinion

Brief in Support of Motion for Judgment on the Pleadings

Brief in Opposition to Motion for Judgment on the Pleadings

Reply Brief in Support of Motion for Judgment on the Pleadings

Defendant, a terminated employee, owned one third of the outstanding stock of Classic Coffee Concepts. The issue 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 at trial.  Defendant would have been entitled to a multi-million recovery under two of them. The first, prepared pre-litigation for the accounting purpose of conducting a goodwill impairment, 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.

For purposes of the litigation, the company obtained a hypothetical appraisal 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. Yet 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 apply the first hypothetical ESOP appraisal, because that was "the only evidence of value that attempts to honor the parties’ agreement." The Court ruled that the establishment of the ESOP was not a condition precedent excusing performance by both parties, because conditions precedent are not favored in the law and also because neither party had argued the point at trial.

The Court also found that the company had materially breached the Stockholders Agreement by failing to redeem defendant’s shares within sixty days of the date of the termination of his employment, and that the pledging of defendant’s stock as collateral did not excuse it from having to do so. In a small victory for the defendant, the Court held that the company could not invoke its right to pay for defendant’s stock over a sixty month period, but that it was required to make an immediate, lump sum payment.

Full Opinion

Plaintiff’s Trial Brief

Defendant’s Trial Brief

 

Defendant, who was a director, shareholder and former employee of the corporate plaintiff, moved to disqualify the corporate plaintiff’s counsel. He argued that he reasonably believed that the law firm had represented him with regard to the agreements at issue and a guaranty agreement. He also argued that disqualification was appropriate because the corporation’s lawyers had "responsibilities" to him as a shareholder and director of the company.

The Court denied the motion. It found that although the law firm had represented defendant with regard to the guaranty agreement, the former representation was not substantially related to the claims before the Court so as to warrant disqualification under Rule 1.9 of the Rules of Professional Conduct. The Court also found that the law firm had not obtained any information in the course of that representation that would advance its defense of the corporation in the case before it.

Considering multiple factors, it determined that defendant could not have reasonably believed that the law firm was representing him in his individual capacity. On the argument regarding "responsibilities," the Court held that a corporation can be represented by its regular corporate counsel when the corporation is adverse to one of its constituents.

The Court dismissed the defendant’s counterclaim that the Stockholders Agreement requiring him to tender his shares back to the corporation was unconscionable, finding that the claim failed under either North Carolina or Delaware law.

Before reaching this issue, the Court expressed doubt about whether the choice of law provision specifying North Carolina law in the Agreement was enforceable, given that the corporation was a Delaware corporation and in consideration of the internal affairs doctrine.

The Court expressly refused to apply North Carolina law to plaintiff’s claim for dissolution, "because a claim for judicial dissolution goes to the very core of a corporation’s internal affairs [so] it is properly governed by the law of the state of incorporation." If North Carolina law had been applicable, however, the Court held that dissolution would not be appropriate.

Defendant’s claim that he had reasonable expectations of continued employment was belied by the terms of his employment agreement, which provided for termination at any time after twelve months, without cause.

Full Opinion

Plaintiff sought to enforce the stock repurchase provisions of a shareholders agreement with two former employees, the defendants. The Court found, however, that the price to be paid ($5 for stock with a book value of more than $36,000), and the circumstances under which the defendants had signed the agreement, rendered the transaction unconscionable. The Court further found, however, that there was no mandatory buyback obligation of the plaintiff.

The Court granted summary judgment on plaintiff’s claims that the defendants had violated fiduciary duties through their post-termination activities. As low level employees, defendants had no fiduciary duties as a result of their employment.

Nor had defendants violated any trade secret obligations by bidding on a contract where bidding was open to the public.

Full Opinion

The Court enforced mandatory buy-sell provisions in a shareholders agreement, noting the importance of such provisions to closely held businesses, and found that adjusted book value had been properly determined. It further found that the price to be paid was not unconscionable, after discussing both procedural and substantive unconscionability. Although the fair market value of the corporation’s equipment was substantially higher than its book value, that did not require an adjustment.

The Court rejected the shareholder’s argument that the termination of his employment was designed to obtain his stock at a favorable price. It found that if a terminated employee could make out a prima facie case of an improper motivation for the termination, that the employer would then have to show a legitimate business reason for the termination and the timing of the termination. The employee would then have to show that the proferred reason was a pretext.

Full Opinion

An agreement requiring a shareholder in a closely held corporation to sell his shares back to the corporation upon termination of his employment is valid and enforceable, as a closely held corporation is entitled to determine who will participate in its business. Book value is a typical and accepted means of determining a purchase price.

Full Opinion

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

Continue Reading Valuation Formula In Coffee Company’s Stockholders Agreement Enforced