The importance of buy-sell mechanisms in shareholder agreements

A properly prepared shareholder agreement will protect both your business and the rights of the shareholders, but sufficient attention must be paid to the buy-sell mechanism within the agreement.

It may feel a bit like the introduction of a prenup in the midst of wedding planning, but anticipating a future where relationships are soured and the tallying of assets is muddied is a critical step in safeguarding the long-term health of your business.

As demonstrated by the recent case of Leeder Automotive Inc. et al. v. Warwick, the buy-sell mechanism is a stand-alone contract in and of itself, which stipulates how a party’s share or shares of a business may be sold, and the procedure by which those shares are to be valued.

However, buy-sell mechanisms dependent upon a third-party valuation remain susceptible to litigation, because selling parties will still be prone to dispute the value determined; the selling parties often view themselves as aggrieved in the transaction, and are anxious to ensure they are receiving the full value of the sale.

Highlights of the case: Leeder Automotive Inc. et al. v. Warwick

• Minority shareholder Warwick decided to sell his shares of Leeder, triggering the buy-sell provision of Leeder’s unanimous shareholders’ agreement (USA).
• Leeder agreed to purchase Warwick’s shares, but conflict arose over their valuation for a number of reasons, including the assertion that the third party engaged to undertake the valuation did not conduct an audit that was independent and compliant with generally accepted accounting principles (GAAP).
• The relationship between Leeder and Warwick deteriorated. Warwick decided to retain his shares rather than sell; however, Leeder made an application to compel Warwick to complete the sale transaction.
• The application judge found that Leeder had breached the provisions of the valuation, and that Warwick could retain his shares, but the judge did not treat the buy-sell mechanism as a separate contract and considered the botched valuation as a repudiation of the share-purchase transaction, as part of the USA.

The appeal

The Court of Appeal agreed that Leeder had breached the provisions of the valuation and that Warwick could retain his shares, and dismissed the appeal.

However, the court declared the application judge to be in error in their interpretation of the role of the buy-sell mechanism, namely that:

• There can be no such thing as a partial repudiation — the transaction agreement alone, of the USA, cannot be repudiated.
• Instead, the buy-sell mechanism, as it requires both an offer and acceptance, has the necessary elements of a stand-alone contract, and as such, is capable of being wholly repudiated if the provisions are not met.

Key takeaways

• Executed correctly, the provisions of a buy-sell mechanism in a shareholder agreement can provide all parties with a cost-effective and efficient manner in which they can disentangle their business interest without litigation;
• To enforce the agreement, the provisions of the mechanism must be drafted with clarity and precision; and
• All parties must strictly adhere to the mechanism’s provisions. Failure to comply can result in a failed share-purchase transaction.

This article was originally published by The Hamilton Spectator.