Does Your Buy-Sell Agreement Render Your Company "Worthless"?

By William C. Hussey, II

A recent change in financial account - ing standards might render your company worthless if the equity interests (including stock, partnership interests, and membership interests) in the business are subject to mandatory repurchase at a future date.

As a result of the corporate scandals that now litter the business landscape, a little-publicized change made by the Financial Accounting Standards Board (FASB ) that goes into effect in December 2004 may inadvertently eliminate the entire equity of many closely-held, private businesses in which all of the equity

ownership interests are subject to a mandatory redemption or buyback by the business upon the occurrence of certain events (typically, the retirement or death of the equity holder). There is no time like the present for business owners and advisers to re-examine their current equity compensation plans and business operating agreements to make sure they are current and consistent with this new accounting standard.

In January 2004, the FASB reaffirmed guidance originally issued by it in May 2003 as Statement of Financial Accounting Standards No. 150 (FAS 150), which dramatically affects the financial reporting of certain stock and other ownership interests in business entities. The stated purpose of the changes made by FAS 150 is to "assist investors and creditors in assessing the amount, timing, and likelihood of potential future cash flows and equity share issuances." In short, FAS 150 requires that certain Mandatorily Redeemable Financial Instruments (or MRFI) be reclassified as a liability on the balance sheet of the business entity including corporations, partnerships and LLCs. For many closely-held business entities, this can mean that the entire equity investment in the entity will be restated separately on the balance sheet as a debt of the business. Such change may also inadvertently and adversely impact provisions under other agreements to which the business is a party, including by way of example, debt-equity ratios and other covenants under loan and other financing arrangements.

Under FAS 150, an MRFI includes stock and other financial instruments issued in the form of shares that directly or indirectly embody an unconditional obligation requiring the issuer to redeem the shares by transferring assets, including money, at a specified or determinable date or upon an event that is certain to occur. A closer look at this definition of an MRFI reveals the extent to which FAS 150 may adversely impact many closely held businesses.

First, the term shares as used in FAS 150 includes various forms of ownership that may not take the legal form of stock or other securities. FAS 150 specifically cites partnership interests and therefore, both LLC member and partnership interests may come within the scope of FAS 150 if they are subject to mandatory redemption. Moreover, an unconditional obligation to redeem the MRFI may be contained in either the terms of the financial instrument itself or in a separate agreement. For example, a shareholders agreement or an LLC operating agreement may contain the unconditional obligation of the business to redeem the shares.

Second, an MRFI is considered to be mandatorily redeemable if it embodies an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date (or dates) or upon an event certain to occur. An event that is certain to occur includes the death or termination of employment of the individual holding the shares, since both events, like taxes, are a certainty of life. Thus, FAS 150 reaches ownership interests that are governed by the buy-sell provisions in many typical shareholders and other operating agreements for closely-held entities. Those agreements typically include provisions that may provide, in whole or in part, that the shares must be redeemed upon the death or termination of employment of the holder. Such arrangements are sufficient to require that the ownership interests be classified as an MRFI.

On the other hand, FAS 150 does not affect certain financial instruments, including convertible bonds, puttable stock or shares that are conditionally redeemable (e.g., stock subject to a right of first refusal). If the obligation to redeem is conditional, than the instrument will only become a MRFI upon the occurrence of the event or if the event becomes certain to occur. Thus, the financial reporting requirements can change with respect to an ownership interest if the rights with respect to that interest change over time.

For example, if a financial instrument is subject to both a put option (e.g., held by the holder of the shares) and a call option (e.g., held by the issuer of the shares), the shares are not a MRFI because the redemption is conditioned upon the exercise of the respective options. Upon exercise of either option, however, the shares must be restated as an MRFI on the companys balance sheet. Contingently redeemable shares and call and put options will be revisited in later phases of the FASB project. Therefore, the treatment of such conditionally redeemable shares may yet change and may be classified by the FASB as an MRFI that is subject to treatment as a liability of the company from the date of issuance of the shares.

FAS 150 will also not affect the accounting treatment of certain employee stock ownership compensation, and corporate shares held in an ESOP. However, actual shares received by an employee for example, shares received in a stock grant or upon the exercise of a stock option that are subject to mandatory redemption pursuant to a shareholders agreement come within the scope of FAS 150.

Once again, for shares that are classified as an MRFI, the shares must be classified as a liability on the balance sheet of the business. For some businesses, this will not pose any problems. Many others, however, will have to assess the full impact of the change by reference to other agreements to which it may be a party.

As previously mentioned, this accounting change may have a material adverse effect under commercial loan documents that have debt-equity or other ratios that must be maintained by the borrower, but which do not account for the classification of MRFIs as a liability under FAS 150. In addition, if the redemption price of an MRFI is measured by book value, then annual changes in such book value must be recorded on the statements of income (loss) and cash flow of the business entity. It seems clear that special scrutiny to shareholders and other operating agreements, balance sheets, and income and loss statements will be warranted when reviewing these documents in order to ascertain the true financial position of a business, and whether FAS 150 has or will adversely affect that financial condition.

For most businesses that are privately held entities, the change will not be effective until December 15, 2004 and will affect their financial statements for the first fiscal year after such date (e.g., the fiscal year beginning January 1, 2005 for those businesses using the calendar year for financial reporting purposes). Accordingly, the owners and advisers of closely-held entities, and those banks and other institutions that deal with these businesses on a regular basis, must be aware of the accounting treatment mandated by FAS 150 to properly account for it when negotiating, drafting or amending agreements that are impacted by these changes.

We suggest that every business with a reason to believe that its ownership interests are or may become subject to mandatory redemption upon the occurrence of a later event should review, or have their attorneys examine such arrangements. Such review can insure that the equity side of the balance sheet is not adversely affected by FAS 150, and will allow sufficient time to take appropriate steps to address the required accounting changes in their legal documents if their financial reporting would be adversely affected.

Bill Hussey practices in the Business Department where he focuses on taxation issues. He can be reached at 215-864-6257 or husseyw@whiteandwilliams.com.