Insolvency is not an Excuse for Failing to Adhere to Contractual Buy-Sell Procedures

Often, corporate by-laws, shareholder agreements, operating agreements and employment agreements contain provisions requiring a mandatory redemption or sale of an equity interest upon the occurrence of specified events such as termination of employment, death or incapacity, or divorce.  These are generally known as ‘buy-sell provisions,’ and they often include specified notice and valuation procedures.  As with all contractual matters, the devil is in details and the consequences of failing to follow those details may be catastrophic.  A recent case from the Michigan Court of Appeals emphasizes those risks in the employee-shareholder termination context.  

In Turner v J & J Salvik, Inc., Case No. 313936 (April 15, 2014) (unpublished), the Michigan Court of Appeals held that an employee’s equity interest was not redeemed upon the termination of his employment because the procedures required under the stock restriction and redemption agreement were not followed.[1]  The stock restriction and redemption agreement required that employee’s equity interest be redeemed upon the termination of his employment with a closing to occur 30 days after the determination of the fair market value[2] of the equity interest.[3]  Unfortunately, the company did not follow the procedures set forth in the stock restriction and redemption agreement because it believed that the equity interest had no value since the company’s liabilities exceeded the value of its assets[4] and ‘law does not require the doing of useless act.”[5] The lower court agreed with the company, concluding that ‘there was no need for the company to cut a check for zero dollars to redeem the equity interest;’[6] however, the Court of Appeals took a different view. 

The Court of Appeals concluded that the buy-sell provisions remained effective despite the company’s apparent insolvency and the individual’s equity interest was not redeemed absent compliance with the procedures set forth in the stock restriction and redemption agreement.  The Court of Appeals reasoned that the company was still bound by the valuation procedure in the redemption agreement even if it was insolvent on the date that the employee was terminated.[7] It found that the parties’ agreement did not contain an exemption from the valuation and closing processes for equity interests having negative or no value.[8] Further, the Court of Appeals found that because the valuation procedures were not followed, there was no evidence that the employee’s shares were actually worthless.[9]  Thus, it concluded that since the redemption procedure was not followed and no closing of the proposed redemption occurred, the former employee continued to own his equity interest in the company after his employment relationship ended.[10]

Because the relationship between a business and its equity interest holders is often complex – particularly where the relationship is ending – businesses and their equity interest holders should consult with sophisticated legal counsel prior to entering into or triggering an agreement that contains a mandatory redemption or sale provision.  Schafer and Weiner, PLLC has substantial experience preparing, defending and litigating complex corporate documents relating to business entities, their equity interest holders and valuation provisions.  We look forward to helping you navigate through the complexities of corporate contracts, charting a heading to your desired location.