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  • WisBar News
    July 08, 2010

    Deficient financial records preclude contract enforcement, supreme court holds

    InvestmentBy Joe Forward, Legal Writer, State Bar of Wisconsin

    July 8, 2010 – The unavailability of supporting documents to determine the “book value” of a shareholder’s shares in a corporation precluded enforcement of a buy-sell agreement, the Wisconsin Supreme Court recently held in Ehlinger v. Hauser, 2010 WI 54 (June 25, 2010).

    In addition, the court held that a corporation cannot indemnify a corporate officer/shareholder for litigation expenses where the officer/shareholder does not follow proper procedures to apply for indemnification under Wisconsin’s corporation statutes.

    In 1992, the parties – William Ehlinger and Jon Hauser – entered a buy-sell agreement as equal shareholders in Evald Moulding, Inc., a Watertown corporation. The agreement included a disability clause. In the event of one’s “total disability,” the non-disabled shareholder could buyout the disabled shareholder’s shares for “book value.”  Shortly after the agreement was signed, Ehlinger developed Parkinson’s disease.

    In 2001, Hauser invoked the disability clause, and calculated the book value of Ehlinger’s shares at nearly $432,000 for the end of fiscal year 2001. Ehlinger did not accept the offer, and his attempt to audit Evald’s books and records to determine book value failed.

    A lawsuit was commenced. The circuit court appointed a special magistrate (accountant) to determine the book value of the shares.

    As the supreme court explained, both parties agreed that the term book value meant “assets minus liabilities” but could not agree on “which assets and liabilities should be computed in the calculation, and what degree of verification was needed.”

    Because some of the records underlying the corporation’s financial statements had been unintentionally discarded or were otherwise unavailable to calculate book value, the circuit court held the buy-sell agreement unenforceable as “indefinite” because the term “book value” could not be cured using generally accepted accounting principles (GAAP).

    The appeals court affirmed, but stated that the term book value was “ambiguous” under contract law. Application of GAAP resolves the ambiguity, the appeals court held, but GAAP requires supporting documentation as a necessary component of a book value computation. Such supporting documentation was not available.

    Contract unenforceable

    The supreme court held that regardless of whether book value was an “indefinite” or “ambiguous” term under contract law principles, the unavailability of records to determine a book value made the contract unenforceable because Ehlinger could not examine the books to validate the accuracy of a book value computation.

    Ehlinger would be entitled to examine Evald’s books to determine the accuracy of a book value calculation, whatever accounting method was employed to reach it, the court explained. That is, the “unavailability of Evald’s financial records prevents Ehlinger from exercising his right to examine the books in order to assess the accuracy of the buyout price,” the court wrote.

    Because Ehlinger could not validate book value, the “contract cannot be enforced regardless of how the term could be defined,” the court wrote, and contrary to Hauser’s argument, book value “is not just any value that may be arbitrarily entered upon the books of a company.”

    Cross-exam of magistrate

    The supreme court also held that the circuit did not erroneously exercise its discretion when it denied Hauser an opportunity to fully cross-examine the special magistrate, and offer an expert witness in rebuttal. Hauser argued that the special magistrate was an expert witness.

    The circuit court appointed the special magistrate to determine book value, clarifying that the special magistrate “was to receive and report evidence only.” That is, there was to be no advocacy and no ex parte communication.

    The supreme court found that both parties and the court understood the role of the special magistrate to be analogous to a referee or master, who determines “matters of account,” not an expert witness, and the circuit court has broad discretion to outline the master’s role.

    Hauser, the court found, did not assert a right to cross examine or depose the special magistrate until two days before trial, and did not assert a right to present his own expert witness until the trial began. Under those circumstances, the court explained, Hauser “forfeited his right to object to the procedures specified by the court” regarding the special magistrate.

    Hauser’s litigation expenses

    During the proceedings, Ehlinger learned that Hauser was directing the corporation to pay his litigation expenses. Against Ehlinger’s objection, the circuit court allowed it. Hauser argued that indemnification from the corporation was appropriate because such expenses were incurred on his behalf as a corporate officer.

    Recognizing the issue as one of first impression, the court held that Hauser was not entitled to litigation expenses because he did not “follow any of the formalities” required by Wis. Stat. section 108.0855 to apply for corporate indemnification.

    In the alternative, Hauser argued that litigation expenses were incurred in defense of the corporation, noting that Evald was named as a party. However, the court explained that litigation expenses are not available in usual corporate dissolution proceedings.

    No exceptions apply here, the court wrote, “because the corporation does not have an interest in whether Ehlinger remains a shareholder.” The corporation “may not militantly align itself on the side of Hauser, one of two equal, discordant shareholders, by paying for expenses incurred by Hauser in defense of his actions as a shareholder,” the court concluded.

    Thus, the court held that the circuit court erroneously exercised its discretion by allowing Hauser to charge the corporation for litigation expenses.

    Notes

    Justice Patience D. Roggensack filed a concurring opinion. Justice David T. Prosser and Justice Annette K. Ziegler filed a separate opinions concurring in part, dissenting in part. Justice N. Patrick Crooks did not participate.

    Justice Prosser did not agree with the majority’s ruling on Hauser’s litigation expense, stating that the majority’s opinion “overlooks critical facts and results in a mistaken interpretation of the indemnification provisions of the Wisconsin corporation statutes.”

    Justice Ziegler was concerned about the circuit court’s appointment of a special magistrate, arguing that the parties were “deprived of the opportunity to fully develop evidence and make a complete record.”  She also disagreed with the majority’s conclusion that it need not decide whether the buyout agreement was indefinite or ambiguous under contract principles.

    Attorneys

    Gary Ahrens, Daniel Vaccaro, and Monica Rierderer of Michael Best & Friedrich LLP, Milwaukee, and Kristin Hauser of Evald Moulding Inc. represented Evald Moulding, Inc. and Jon Hauser.

    Timothy Feeley and Sara MacCarthy of Hall, Render, Killian, Heath & Lyman P.C., Milwaukee, represented William Ehlinger.



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