Editor’s Note: The following article by Elaine M. Cohen was published as part of the Business Law Section Newsletter Vol. 42, No. 2 – February, 2019, which is distributed to members of the Business Law Section. To learn more about joining a section of the New Jersey State Bar Association, email us at [email protected].
A certainty of life is that it ends in death. However, the demise of a business can occur in many different ways, including, for example, a sale, a merger, the retirement or disability of one of the principal owners, insolvency, and a possible stalemate by the owners on management and operational decisions. Any business that is established with more than one owner needs to address these situations. The optimal time to address succession planning issues is at the time the entity is organized. However, it is never too late to address the issues that may arise. In fact, all businesses should review their buy-sell agreements periodically based on changes to circumstances and the law. Through a series of examples, this article focuses on some practical drafting concepts that should be incorporated in most shareholder and operating agreements.
Use of Internet Forms—How it Can All Go Wrong
Two internal medicine doctors are longtime acquaintances, each with their own medical practices. They decide to merge practices and form a new professional company. The doctors are resourceful and frugal, so they prepare their own operating agreement. Their intent is to provide that if one physician passes away, the other physician will purchase the deceased physician’s membership interest for $2 million. Each physician secures a $2 million life insurance policy on the life of the other physician. The online operating agreement used by the physicians only provides that upon death of a member the company will purchase the membership interest within 30 days after the death using the life insurance payable to the estate of the deceased member. Without understanding the redemption obligation by the company under the agreement they prepare, the doctors each personally guarantee the obligation to purchase. What could go wrong? It’s only a death obligation and they have full insurance coverage. Unfortunately, due to either the stress of the job or mental illness, one doctor takes his own life within five months of the merger.
An initial issue the surviving physician and company must face is whether the ownership of the life insurance policy matches the party that is obligated to purchase under the buy-sell agreement. Was the agreement they entered into set up as a cross purchase or redemption obligation? Buy-sell agreements generally may be drafted as redemption, cross purchase or a hybrid of both. In a redemption format, the company is the owner and beneficiary of the life insurance policy that insures the owners. In a cross purchase format, each owner is the obligor and should be listed as the owner and beneficiary of the life insurance policy naming the other owner as the insured.
In the example above, the physicians executed a buy-sell agreement with a redemption obligation, and thus the company was obligated to purchase the membership interest of the physician. Such obligation should have been secured by life insurance coverage on the doctor owned by the company. Instead each doctor purchased the life insurance coverage on the other doctor (cross purchase). It is imperative to confirm that the insured, the owner, and the beneficiary match what the agreement requires. If these items do not match the agreement, the party required to buy out the deceased’s estate may not have insurance proceeds available to do so.
The second issue raised in the above hypothetical makes the first issue academic. One doctor committed suicide. Generally, life insurance policies are void if the insured commits suicide within the first two years after the policy has been issued. The other doctor is now in a pickle, so to speak, because his form operating agreement obligates him, individually, to purchase the deceased doctor’s interest and he has no insurance proceeds to pay for the membership interest. He personally guaranteed the payments. The buy-sell agreement did not address what happens if insurance proceeds are not available. It might have provided, for instance, that if there are no or insufficient insurance proceeds payable, then the purchaser will pay the purchase price over a term of years utilizing a promissory note at a certain rate of interest (hypothetically, in five or 10 years). It is crucial that the parties to a buy-sell agreement think about the terms for buying out a deceased member that make sense for the business—both if insurance is available and if it is not.
Life Insurance Ownership
What happens to the company-owned life insurance policy when a person leaves the business? The author recommends that at the very least the company retain the policy until the member is fully bought out. The buy-sell agreement should address the issue of who has the right to the ownership of the life insurance policy. Does it matter whether the member who leaves is terminated based on voluntary withdrawal, disability, or retirement?
If and when the company decides to cancel the life insurance policy of a former owner, it is good practice to include language in the agreement requiring written notice to the insured former member and an offering of the life insurance policy for sale to the insured at its interpolated terminal reserve value (or if it is a term policy, for the prorated portion of the paid annual premiums).
Disability—Buy-out vs. Disability Income Continuation
A comprehensive buy-sell agreement also will address the disability of a member or shareholder. Some agreements may contain a mandatory purchase triggered upon permanent disability, with an accompanying salary continuation for a period of time. If the company purchased a disability income policy, monthly amounts are payable to the disabled member or shareholder to replace the income he or she was receiving. An alternative to a disability income policy is a disability buy-out policy. The latter policy will pay a lump sum payment to the company after a waiting period, and the company uses the funds to purchase the disabled owner’s equity interest.
Pursuant to their agreement, the company in the above example purchased disability buy-out insurance on each physician based on a buy-out value of $500,000 per doctor. Each doctor is working under the belief that if one of them becomes disabled, the disability policy will pay out a lump sum of $500,000 to the company, which will fund their buy-out. One of the doctors suffers a permanent disability; he is unable to work and the company is obligated to purchase his interest.
Unfortunately, many disability buy-out policies that pay a lump sum contain a provision that depending upon when one becomes disabled, the lump sum benefit may decrease. Therefore, the doctors will be surprised because at age 64, when the disability arose, the policy may only pay a lump sum of $200,000, not the $500,000 they thought was going to be paid. Many disability policy buy-out arrangements only guarantee a full lump sum payment until age 60, and then decrease. Practitioners should review the coverage to make sure their clients’ ‘fully funded’ disability policy is indeed fully funded.
Dispute Resolution
As discussed at the beginning of this article, it is important to address at inception business differences that could become irreconcilable. It is also important to set forth in agreements among equity holders the mechanism to deal with issues that may arise down the road. In the prior example of the medical practice that consists of two members, what would happen if the doctors (each owning 50 percent) could not agree on a major business decision relating to the operations of the medical practice? Does their agreement contain a well-drafted dispute resolution paragraph? This can include a range of options, including mediation, arbitration, and a tie-breaker provision. In a small business, some parties have found that designating a trusted third-party advisor as the tie breaker is a less costly and more efficient means to resolve a dispute.
Conclusion
Business attorneys assist clients at all stages, from organization of an entity through growth and expansion, day-to-day operational matters, management decisions, business succession planning, and liquidation and termination of the business entity. The goal is to act as the quarterback; to work hand in hand with a client’s other professional advisors, including accountants, financial advisors, and insurance agents, to create a professional team of counselors. A properly drafted shareholder or operating agreement is imperative. The pitfalls of a poorly thought out form agreement or no agreement in the 21st century are self-evident.
Elaine M. Cohen is an associate of Witman Stadtmauer, P.A. in Florham Park, admitted in NJ, FL and AZ. Her practice focus is business organization, M&A, general business planning and contract preparation.