It's a fact that the great majority of multi-owner, closely held business entities are run by working owners. In many if not most instances the working owners realize the financial benefits of ownership primarily in the form of salary. Sometimes the working owners realize the financial benefits of ownership primarily in the form of distributions. And sometimes the working owners realize the financial benefits of ownership with a mix of regular salary plus distributions from excess funds as they become available during the year or at year end. Choice of entity and tax considerations often influence the choice.
If the business is fortunate enough to prosper for many years, at some point one or more of the working owners will die, become permanently disabled, resign, or retire. A typical owner agreement, be it a corporation, LLC, or partnership, addresses each of those events in any one of a number of different ways. Death and disability being unpredictable, involuntary events to which every owner is susceptible, owner agreements usually provide for buyout on more-or-less reasonable terms when either one of those events occurs.
Addressing the working owner who voluntarily stops working can be a trickier proposition when drafting the owner agreement. One common technique is to distinguish between working owners who stop working before or after a defined retirement age. The agreement may provide for book value, return of capital, or some other below-market, dis-incentivizing buyout formula for the owner who stops working pre-retirement age, and a formula more akin to market value for the owner who stops working at or after the defined retirement age.
When a working owner voluntarily stops working, whether it's in the context of serious dissension among the owners or simply because the owner desires to pursue other business or personal pursuits, the owner agreement's provision dictating the disposition (or not) of the owner's equity takes center stage. The dynamics are even more conducive to litigation when the remaining working owners resent sharing profits with the departed owner who's no longer contributing time and effort to the business.
That is pretty much what happened in the recently decided case of Martin v Abrams Family Trust, where the Appellate Division, First Department, upheld a summary judgment ruling by Manhattan Commercial Division Justice Andrea Masley, declaring that the plaintiff was not required to forfeit her shares in the subject management company upon her voluntary retirement and that she remained entitled to receive her equal share of distributions.
Background. The corporation involved in Martin is a small management and financial planning firm servicing individuals and entities in the entertainment industry. The plaintiff started working for the company as a secretary in the late 1970s and eventually worked her way up to co-CEO. Starting in 2013, plaintiff and the other co-CEO began negotiations with the company's then-four shareholders to bring them on as non-voting 10% shareholders. A series of draft agreements were prepared but never executed. The proposed deal structure changed in 2015, leading to an executed shareholders agreement in 2016 by which plaintiff and the other co-CEO for $500,000 each, acquired from the departing founder in equal shares his 50% of the company's voting shares, making them co-equal with the two other 25% shareholders.
Plaintiff Retires. In 2021, by which time plaintiff's 25% interest was fully vested, announced her intention to retire after 43 years working for the firm. Plaintiff and the other shareholders attempted to negotiate a buyout of plaintiff's shares but failed to reach agreement on price. In the course of negotiations plaintiff maintained that she had the right to retire and maintain her 25% equity interest absent an acceptable buyout. In response, the three other shareholders took the position that if plaintiff retired without an agreement to sell her shares, under the 2016 Agreement she forfeited her shares.
The 2016 Agreement's Provisions. The 2016 Agreement included articles requiring buyout of a shareholder's equity upon death or disability, but not upon retirement. The defendant shareholders instead relied on section 1.5.2 of the 2016 Agreement providing that "[f]or as long as [plaintiff] is a shareholder of the Corporation, [plaintiff] shall serve as the Chief Executive Officer–East Coast Office, Vice-President and Treasurer of the Corporation."
The Plaintiff Sues and Wins Summary Judgment. The Plaintiff filed suit against her co-shareholders in 2022 seeking a declaratory judgment that upon her voluntary retirement she possessed the rights to retain her 25% equity interest and to continue receiving her pro rata share of profit distributions. The defendants argued that under section 1.5.2, the plaintiff forfeited her shares upon the termination of her services as CEO. Defendants also relied on parol evidence, inter alia, concerning the negotiations that commenced in 2013 leading up to the reconstituted 2016 Agreement, to argue that the parties held the common expectation that no shareholder who left the business should continue receiving profits off the backs of the remaining, working shareholders. Justice Masley's May 2024 Decision and Order rejected defendants' interpretation of section 1.5.2 and granted summary judgment for plaintiff, finding that the 2016 Agreement "is silent on retirement and forfeiture," that section 1.5.2 "does not say that [plaintiff] is a shareholder as long as [plaintiff] is CEO," and that [plaintiff] is entitled to shareholder distributions even though she is no longer CEO." Justice Masley added that the outcome would be no different even were the proffered parol evidence to be considered, based on the inclusion of explicit stock forfeiture provisions triggered by retirement in the parties' 2013 and 2014 draft agreements that were dropped in the 2016 Agreement.
The Appellate Division Affirms. The Appellate Division's decision last week rejected the defendants' appeal essentially on the same grounds cited in Justice Masley's ruling, writing (citations omitted):
Supreme Court properly found that plaintiff is not required to forfeit her 25% of the closely held corporation upon her retirement, based on the plain language of the 2016 agreement between the parties, and, in particular, the provision governing plaintiff's employment. That provision does not provide for forfeiture of shares in the event of retirement, although the 2016 agreement contains express share buyback provisions in the event of death or disability elsewhere in the agreement. Defendants' interpretation of the provision at issue would have effected a forfeiture against plaintiff. To constitute a forfeiture, the provision would have had to contain "clearly expressed" language of forfeiture, but it did not.
The court expressly did not rely on parol evidence because it found the 2016 agreement unambiguous. In any event, such evidence, including the parties' use of a forfeiture provision in a prior, abandoned draft agreement, and the deposition testimony, supported the court's determination.
Planning for Shareholder Retirement. In the situation faced by the parties in Martin, when a working owner of a small company seeks to retire, there normally is a strong, mutual interest in achieving a buyout of the exiting owner. The exiting owner normally prefers to cash in their equity rather than depend on the vagaries of future distributions over which they no longer have any meaningful control or influence. The exiting owner also likely will have limited ability (or desire) to police company management and finances. The remaining working owners understandably chafe at the prospect of toiling to grow the company and increase profits when a significant portion goes into the pocket of the retired owner. The fact that plaintiff and the other shareholders in Martin attempted to negotiate a buyout of the plaintiff's shares soon after plaintiff announced her intention to retire underscores that strong, common interest. Frankly, it's hard to understand why either side in Martin intentionally would have negotiated a shareholder agreement silent on the subject of buyout upon retirement. The lesson for others is simple: when drafting an owner agreement for a closely held company, (a) be sure to address retirement and other voluntary resignation scenarios; (b) include clear provisions governing the formal process and timeline for an exiting owner; and (c) fashion a buyout that's fair to all parties, i.e., one that reasonably approximates the value of the departing owner's equity and allows the remaining owners to finance the buyout without impeding company operations and growth prospects.
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