A New Jersey Appellate court has upheld use of a buyout formula in a partnership agreement, despite the fact that it left the deceased partner's estate with a mere fraction of fair market value. In Estate of Cohen v. Booth Computers (Appellate Division, July 13, 2011), the estate of Claudia Cohen appealed a judgment awarding the estate $178,000 for Claudia's 50 percent share in the Booth Computers partnership, even though the partnership's fair market value had been estimated at approximately $23 million. Booth Computers, created in 1978, is a family-owned partnership originally comprised of three partners: Claudia, Michael and James Cohen. The partnership's assets consist of three real estate properties whose value has grown exponentially over time.
The Booth Computers partnership agreement provides that, in the event of the death of any one partner, the surviving partners must purchase the shares of the deceased partner according to a specific formula. The parties had also agreed that the value of a deceased partner's interest would equal his or her own proportionate share of the partnership's net worth plus $50,000. Net worth was defined as the net book value of the company as shown on the most recent partnership financial statement, which pegged the value of the company based on the costs of its assets and did not reflect increases or decreases in asset values. Thus, under the partnership agreement, a surviving partner would benefit from increases in asset value over time.
When Michael died in 1997, James and Claudia invoked the buyout provision and Michael's estate was paid $34,503.08 for his one-third interest in Booth Computers. When Claudia died in 2007, James once again attempted to rely on the buyout provision. Due to the large disparity between the net book value and fair market value of the partnership, Claudia's estate filed a lawsuit seeking to recover one-half of the partnership's fair market value. At trial, the trial court rejected the estate's arguments that fair market value was the proper methodology to utilize and awarded a judgment based on the partnership's book value.
The estate subsequently filed an appeal with the Appellate Division in which it contended that the trial court erred in enforcing the buyout provision because (1) the term "net book value" is sufficiently ambiguous to encompass fair market value, (2) the judge failed to utilize the gap filling provisions of the Uniform Partnership Act, and (3) the buyout price was unconscionable given the gross disparity between the cost approach utilized and the fair market value. The Appellate Division rejected the notion that net book value and fair market value are synonymous. Net book value was clearly defined in the partnership agreement as the value of the company based on its book value as set forth in the partnership's financial statements (which utilized a historic cost approach). The court next upheld the trial court's decision not to apply the Uniform Partnership Act (UPA). Where a partnership fails to set a buyout formula, the UPA will require a buyout price based on the partnership's "fair value" The Appellate Division reasoned that there was no need to "fill the gap" here because the partnership agreement set forth a specific fair value formula in the event of a buyout. Finally, the court rejected the estate's argument that the buyout provision should be disregarded altogether because it is unconscionable. The court noted its reluctance to make an unambiguous contract better for either of the contracting parties simply because, in one party's view, changed circumstances had made that agreement disadvantageous. The Appellate Division held that a disparity in price between book value and fair market value, where a buyout provision is clear on its face, did not mean the agreement was unconscionable.
Cohen demonstrates that a partnership agreement's buyout formula will be strictly construed by New Jersey courts even if it leads to a very unfair result. There are common sense reasons why "net book value" provisions continue to be used in such agreements, including the partners' desire not to require the sale of the business by the survivors in order to pay a substantial sum for the buy-out of a deceased partner. On the other hand, partners should recognize that valuations based on book value could provide a windfall to a sole surviving partner if the partnership's assets appreciate in value over time and if that appreciation is not reflected in the partnership's financial statements.
There are a number of practical ways to address these issues. The parties can agree to periodic re-assessments of value. The parties can also provide that they will purchase insurance policies that can fund the purchase by the surviving parties of the deceased partner's share and still continue the business. However, where the parties have clearly chosen net asset value as the basis for value, Cohen shows that the courts will respect those agreements.
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