Careful crafting of buy-sell provisions avoids later disagreement over personal guarantees

Careful crafting of buy-sell provisions avoids later disagreement over personal guarantees
Shareholder, partnership, and joint-venture agreements invariably contain provisions that allow investors to disengage from one another if their relationship later turns sour.

One such provision — the so-called buy-sell provision — allows an aggrieved investor to set the price at which it is willing to sell its investment to co-investors, or alternatively, to purchase their investments from them.

Often negotiated at a time when the investment vehicle has no outstanding debt, sometimes the buy-sell provision contemplates only a disengagement of the parties’ equity interests, but fails to cover off adequately other “investments” that may be made by investors on behalf of the business.

For example, not long after a new business is commenced, shareholders may be asked to provide personal guarantees of the corporation’s indebtedness to a third-party lender. On the subsequent exercise of a buy-sell provision relating to the business, the selling shareholder will expect not only to be paid out on his equity investment, but also to be released from potential liability under his personal guarantee.

Whether that expectation will be met or not depends on the precise wording of the buy-sell provision. This was emphatically brought home to the parties in the recent decision of the British Columbia Supreme Court in Smeland v. Montgomery.

In Smeland, the buy-sell provision expressly covered each party’s equity investment in the corporation, as well as any shareholder debt owed to the parties by the corporation. Notably, the buy-sell provision also covered “any [other] right or claim a Shareholder may have against the Company as a Shareholder . . .” (emphasis added).

Unfortunately, neither the buy-sell provision, nor the remainder of the shareholder agreement, specifically contemplated the release of the selling shareholder’s personal guarantees on closing of the buy-sell transaction. And, while the buy-sell provision did permit the inclusion of additional conditions to closing, the buy-sell offer failed to require a release of the selling shareholder’s guarantee as a specific condition of closing.

Naturally enough, the selling shareholder in Smeland refused to close the buy-sell transaction without a release of his personal guarantee. Initially, an arbitrator ruled in his favour, holding the buy-sell provision covered all aspects of the selling shareholder’s claims against the corporation, including importantly the claim the selling shareholder would acquire against the corporation if the selling shareholder were required to pay out on his personal guarantee.

In the arbitrator’s opinion, the selling shareholder’s guarantee (and the related claim against the corporation) arose as part of the selling shareholder’s capacity qua shareholder, and therefore fell within the scope of the buy-sell provision, as drafted. The selling shareholder was thus justified in refusing to close the transaction without a release of his personal guarantee.

The B.C. Supreme Court strongly disagreed with the arbitrator, holding any claim the selling shareholder might have against the corporation upon payment on his personal guarantee would not arise in the selling shareholder’s capacity qua shareholder. Instead, the claim flowed from equitable principles entitling a guarantor to be subrogated to the claims of its payee, and as such, the selling shareholder’s claim was one founded only in debt and nothing more.

In short, the claim would not arise in the selling shareholder’s capacity qua shareholder, and therefore was outside the ambit of the buy-sell provision in this instance. Accordingly, the selling shareholder was wrong in refusing to close the buy-sell transaction.

Not surprisingly, the Supreme Court was somewhat irked by the selling shareholder’s failure in the buy-sell offer to make the closing of the buy-sell transaction conditional upon a release of his personal guarantee. Specifically, in relation to this failure, and perhaps to moderate possible criticism of the court’s strict interpretation of the buy-sell provision here, the court offered up a concluding explanation: “It was [the selling shareholder’s] use of the agreement that leads to an unpalatable result . . . not the agreement itself.”  

The Smeland case serves as an important reminder to counsel engaged in drafting shareholder (and similar) agreements that not only should shareholder agreements deal with investor equity interests, but just as importantly, they should also deal with personal guarantees given on behalf of the business.

Indeed, the inclusion of express provisions in the shareholder agreement will serve to remind counsel of the need to obtain appropriate releases during the initial hurly-burly of the buy-sell transaction. And if for some reason on later review, express provision has not been built into the shareholder agreement, counsel should at least include an appropriate condition in the buy-sell offer.

Failure to adequately consider these issues may result in counsel being later confronted by an unsympathetic interpretation of his or her agreement, not to mention by an unhappy client as well.

Jim Shanks is a partner in the financial services group at Gowling Lafleur Henderson LLP.

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