Legal Update: June 2024
Watts v. Smith–Long-Term Means Long-Term
In the business valuation world, valuators attempt to consider a benefit stream into perpetuity, which is a very long time. Sadly, many business owners have difficulty grasping long time periods as they execute agreements dealing with multi-generational ownership and family relationships. In Watts v. Smith, 2023 Ky. App. (Unpub.) (Ky. Ct. App. September 8, 2023), the children and grandchildren of a family business’ founders learned just how long stock agreements can last and the lengths to which courts will go to enforce them.
In the business valuation world, valuators attempt to consider a benefit stream into perpetuity, which is a very long time. Sadly, many business owners have difficulty grasping long time periods as they execute agreements dealing with multi-generational ownership and family relationships. In Watts v. Smith, 2023 Ky. App. Unpub. LEXIS 535 (Ky. Ct. App. September 8, 2023), the children and grandchildren of a family business’ founders learned just how long stock agreements can last and the lengths to which courts will go to enforce them.
Background
During the 1940s, B.L and Sylvia Smith built a very successful business distributing alcoholic beverages. In the early 1970s, B.L and Sylvia, looking to transfer the business to the next generation, incorporated Smith Brothers Distributing Company (SBDC) and divided the shares equally among their eight children. In 1972, they executed a stock restriction agreement (the “1972 SRA”). In general, the 1972 SRA provided that shareholders could freely transfer their shares to another family member, but other than that, they were required to give SBDC and the other shareholders preference. Apparently the 1972 SRA operated successfully for several decades. By the twenty-teens, when this dispute erupted, SBDC had acquired and retired half of the original shares. The remaining 104 shares were held in four equal blocks. One of those blocks consisted of the children of the founders’ oldest son. In 2016, he transferred his shares to his seven children (collectively the “Rapier Group”) pursuant to a gift trust (the “2016 Agreement”), and one of them advised the other family members that she wanted to sell her shares.
The 1972 SRA contained the following, relevant terms:
- Paragraph 1 allowed any stockholder to transfer all or a portion of their stock by gift to an immediate family member “without the written consent of all other stockholders.”
- Paragraph 2 required that to transfer their shares to anyone other than an immediate family member, the stockholder must provide SBDC and the other shareholders with 40 days’ notice of the intent to sell the stock. During the notice period, SBDC needed to determine if it desired to acquire some or all the shares that the individual was offering. To the extent SBDC declined to purchase all the shares available for sale, the other shareholders could purchase the shares in proportion to their existing ownership. If neither SBDC nor the other shareholders elects to purchase the seller’s shares, the seller is free to sell as they wish.
- Paragraph 6 allowed that if, after complying with Paragraph 2, a seller does not sell the stock to an outsider, the seller has a put option to sell the shares to SBDC at the price specified in Paragraph 7. “If the corporation does not then buy the stock back, the corporation dissolves. This destruction provision is part of the clear theme of the SRA for the stock to stay in the family whether held by the corporation of [sic] the family members who hold the stock.”[1]
- Paragraph 7 established an initial purchase price for the stock at $100 per share through July 1975, “when a new value will be determined if all shareholders of the Corporation’s outstanding stock agree thereto. If the shareholders do not agree th[e]n the Stock Restriction Agreement terminates in accordance with Paragraph 13 hereof.”[2]
- Paragraph 13 provided that the 1972 SRA would “continue in full force and effect” until terminated by a unanimous agreement of the shareholders or by dissolution or bankruptcy of the company.
Unsurprisingly, the shareholders never set a new stock price after the initial three-year period specified in Paragraph 7 expired.
In October 2021, SBDC, through two of the founders’ sons who were members of the Board of Directors, filed a petition seeking declaratory judgment that the 1972 SRA provisions concerning transferability of the stock remained in force.
In November 2021, the other two directors, including one who belonged to the Rapier Group, filed a motion to dismiss the petition because it had not been authorized by a majority of the company’s four-member Board of Directors. One of their arguments was that the 2016 Agreement superseded and abrogated the 1972 SRA.
In December, the original two directors filed a response to the motion to dismiss and a cross-claim that the 1972 SRA binds the shareholders irrespective of the 2016 Agreement.
Court Findings
Initially, the trial court addressed the apparent efforts of the parties to mix legal principles (contract interpretation) with equitable principles of fairness. “First ‘equity follows the law.’ In other words, if the rights of the parties are governed by legal principles, such as the law relating to contract interpretation, then equity should not be applied routinely to change the rights of the parties.”[3] The parties each sought to apply the doctrine of unclean hands, claiming that, in prior stock transactions, the terms of 1972 SRA were applied or ignored as suited the individuals’ desires at the time. The court concluded, instead, that the most appropriate equitable doctrine to this case was that “equity aids the vigilant, not those who slumber on their rights.”[4] Ultimately, the trial court determined that legal principles were sufficient to adjudicate the respective positions of the parties.
“Under contract law, the law looks for the intent of the parties as they stated it. Every word should be considered. The Court should not add or subtract words. The Court must look at every provision in context with the entire agreement being considered together.”[5]
The cross-claim respondents, claiming the 1972 SRA had expired and seeking to enforce the terms of the 2016 Agreement, argued that the failure of the shareholders to agree to a new stock price in 1975 (as stated in Paragraph 7 of the 1972 SRA) triggered a termination of that agreement. The trial court, on the other hand, noted that such an interpretation would require the court to ignore the remainder of the relevant sentence, which states, “If the shareholders do not agree [to a new price] then the Stock Restriction Agreement terminates in accordance with Paragraph 13 hereof.” Paragraph 13 provided that the 1972 SRA would continue in “full force and effect until terminated by the mutual agreement of all of the parties hereto, or by voluntary or involuntary dissolution of the Corporation, or upon adjudication of the Corporation as a bankrupt, whichever event occurs first.” Had the founders intended the failure to set a new share price to be a triggering event, Paragraph 7 would have stopped with “the Stock Restriction Agreement terminates” or would have included that failure to reach an agreement on the stock price as a triggering event in Paragraph 13.
The respondents were, in effect, arguing that absent a fixed price for the shares, a buy-sell provisions of the 1975 SRA were meaningless and the agreement itself was unenforceable. The court, again, viewed the situation differently. The 1972 SRA established a process to affect the will of the founders—to keep the company within the family. As the appellate court held, in affirming the trial court’s ruling, “the language of Paragraph 7 did not require or mandate that the shareholders establish a new value by the first Monday in July 1975.”[6]
Addressing the appellant-respondent’s contention that an agreement without a price is meaningless and unenforceable, the appellate court ruled that a provision material to one contract may not be material in another contract. The appellate court agreed with the trial court’s conclusion that the objective of the 1972 SRA was to establish a process to keep ownership of the company within the Smith family. The provisions of the contract focused primarily on that objective. The price, left until fairly late in the agreement, was incidental to the process established in the document.
Conclusion
As often happens, both the trial and appellate courts went to great lengths to enforce a valid contract even though it was more than four decades old and, apparently, had been observed over the years more in breach than in compliance. It was valid for purposes of establishing a process for a shareholder to sell their shares even absent a specific price at which the shareholder could trigger the last resort put option.
[1] 2023 Ky. App. Unpub. LEXIS 535 at *4, emphasis added by court.
[2] Ibid.
[3] Ibid. at *8, emphasis in opinion.
[4] Ibid., quoting Williams Coal and Coke Co. v. Spears, 277 Ky. 57, 125 S.W.2d 745, 748 (Ky. 1938).
[5] Ibid. at *11.
[6] Ibid at *17.
Michael J. Molder, JD, CPA, CFE, CVA, MAFF, applies 30 years of experience as a Certified Public Accountant and litigator to help investigate and analyze cases with complex financial and economic implications. He has acted as both counsel and accounting expert in pending and threatened litigation as well as participating in internal investigations of financial misconduct. As a litigator, Mr. Molder helped co-counsel understand complex financial and accounting issues in dozens of cases. In 2006, Mr. Molder returned to public accounting applying his unique skills to forensic engagements. He has also performed valuations of business interests in a wide variety of industries.
Mr. Molder has served as valuation expert for both plaintiffs and defendants in commercial litigation matters and owner and non-owner spouses in matrimonial dissolutions. He has participated in the valuations of businesses in a wide variety of industries, including: food service, wholesale and retail distribution, literary development and production, healthcare, manufacturing, and real estate development.
Mr. Molder has also investigated and valued damages in a wide variety of litigation contexts ranging from breach of contract claims to personal injury cases, and from employment disputes to civil fraud. He has consulted on many matters which have not involved the issuance of a report for litigation or resulted in deposition or trial testimony. Accordingly, the identity of these matters is protected by attorney client privilege.
Mr. Molder has also lectured widely on a variety of accounting and litigation related topics including business valuation, financial investigations in divorce proceedings, accountant ethics, financial statement manipulation and “earnings management.”
Mr. Molder can be contacted at (610) 208-3169 or by e-mail to Molder@lawandaccounting.com.
