Formulas for Success

Ehlinger v. Hauser and the Importance of Clarity in Drafting Buy-Sell Agreements in Wisconsin and Beyond:

 

All businesses with more than one owner should have a buy-sell agreement.  A buy-sell agreement is an arrangement between the owners of a business under which, upon the occurrence of a specified event—such as an owner’s death, disability or desire to leave the business, permits the remaining owners to purchase the interest of the deceased, disabled or dissociating owner.  When entering a buy-sell agreement, it is paramount that business owners know what the agreement says and how its terms will be applied.  This concept may seem simple, but a vague or unenforceable buy-sell agreement carries potentially harmful, and even disastrous, consequences for both the owners and the business itself.

 

An illustration of the importance of a clear buy-sell agreement is the recent Wisconsin Supreme Court decision in Ehlinger v. Hauser and Evald Mouldling, Inc.  In that case, Ehlinger and Hauser were joint and equal owners of Evald Moulding, Inc. (“Evald”).  In 1992, Ehlinger and Hauser entered a buy-sell agreement which contained a provision stating that if one shareholder became “totally disabled” for a specified period, the other shareholder would have the first right to purchase all or part of the stock owned by the disabled shareholder.  The agreement fixed the purchase price of the stock at “$350,000.00 or Book Value, whichever is greater.”  Ehlinger and Hauser never updated or revised the agreement.

 

In December 2000, Ehlinger told Hauser that he had lost interest in the business and asked Hauser to make an offer to purchase his stock in Evald.  Shortly thereafter, Hauser sent Ehlinger a letter invoking the disability provision of the buy-sell agreement (Ehlinger had contracted Parkinson’s disease years prior) and stating that, based on Evald’s most recent fiscal year-end statement, Hauser had calculated the book value of Ehlinger’s shares to be $431,400.  Hauser further stated that he would pay the first installment “immediately upon acceptance of the purchase offer.”  Ehlinger did not accept the offer, and instead called a meeting at which he moved to have Evald’s books audited to determine the value of the business.  Hauser did not second the motion.

 

After other unsuccessful attempts to resolve the dispute, Ehlinger filed a lawsuit seeking a judgment that the buy-sell agreement was “unenforceable for lack of essential terms,” including the definition and manner of determining “book value.”  Ehlinger also alleged that even if the agreement was enforceable, determining the book value of his stock was impossible due to Evald’s poorly kept financial records.

 

The circuit court found that Ehlinger was “totally disabled” within the meaning of the buy-sell agreement, but refused to order a buyout due to the vagueness of the term “book value.”  Instead, the court ordered the parties to submit their own definitions of “book value” to a court-appointed special magistrate who would determine Evald’s book value according to generally accepted accounting practices (“GAAP”).  Ehlinger and Hauser agreed that “book value” equaled Evald’s “assets minus liabilities,” but disagreed on how to determine which assets and liabilities should be included in the calculation, and on what degree of verification was necessary.

In the course of his inquiry, the special magistrate found it impossible to verify Evald’s available financial records, which consisted mostly of periodic summaries, for which supporting financial documentation had been discarded or were otherwise unavailable.  Thus, the special magistrate determined that calculating Evald’s “book value,” regardless of how that term was defined, was impossible.

 

Following the special magistrate’s finding, Ehlinger renewed his request that the court find the buy-sell agreement unenforceable.  After allowing the special magistrate more time for investigation, the court held that the agreement was unenforceable because the term “book value” was indefinite.

 

On Hauser’s appeal to the Wisconsin Court of Appeals, that court affirmed the circuit court’s decision, but, instead of deeming “book value” to be indefinite (i.e., incapable of interpretation), concluded that the term was merely ambiguous and that the circuit court had resolved the ambiguity by reasonably determining that Ehlinger and Hauser intended book value to be calculated by GAAP.  However, the court noted, since the special magistrate could not apply GAAP to determine Evald’s book value, the buy-sell agreement could not be enforced.

 

On further appeal, the Wisconsin Supreme Court agreed that the buy-sell agreement was unenforceable, but declined to conclude whether the term “book value” was indefinite (i.e., incapable of interpretation), ambiguous (thus necessitating a trial on Ehlinger and Hauser’s intended meaning of the term), neither, or both.  Specifically, the court noted that even if a trial were held and the meaning of “book value” determined, Wisconsin law affords Ehlinger, as the owner of the interest being purchased, the right to examine Evald’s books, records and files which might reflect its book value.  However, as demonstrated by the special magistrate’s findings, the unavailability of Evald’s financial records prevented Ehlinger from exercising that right.  Accordingly, the court stated, “the unavailability of the records precludes this agreement from being enforced.”

 

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Unfortunately for Ehlinger and Hauser, the failure to draft a buy-sell agreement that could be enforced by applying well-defined terms and clearly stated provisions resulted in over seven years of costly litigation and the appointment of a receiver for Evald’s assets.[1]

 

The Ehlinger case exemplifies the importance that co-owners of businesses not only enter into a written buy-sell agreement to determine how issues such as death, disability, bankruptcy or a co-owner’s desire to exit the business will be resolved with respect to ownership of the business, but also that owners discuss the meanings of the agreement’s key terms and conditions and reach a mutual understanding of how the agreement will be applied.  Ehlinger does not mean that business owners cannot agree that a buy-sell transaction will be for “book value;” only that such a term should be clearly defined, agreed upon and supported.

 

Drafting a buy-sell agreement and achieving a mutual understanding of its terms will often require business owners to sit down with their legal and accounting professionals, both at the commencement of a business venture and throughout its existence, and discuss difficult issues and scenarios.  Periodically revisiting buy-sell agreements will remind owners not only of the need for clarity, but also of the need to revise and update their agreements in light of any change in circumstances (personal, business or otherwise) that could affect applicability or enforceability.

 

While business owners cannot always guarantee their companies’ growth, longevity or financial success, with careful drafting, open discussion and prudent monitoring, they can likely ensure successful buy-sell transactions.