If you are thinking of selling your business to another company, we think you’re going to want to read this blog post. Because often times the selling owner will join the purchasing business as a member of its board of directors or as an officer. Usually this is part of the consideration, or payment, for the assets of the business being sold. And sometimes the purchasing business will pay a portion of the purchase price over time pursuant to a promissory note. That set of facts turned out pretty badly for one individual in a recent case decided by the Federal Court of Appeals in New York City.
It’s attractive to the person selling his or her business to work for the new business as a paid consultant, officer or director. But what if the purchasing business fails to make the payments on the promissory note, and the seller person wants to collect and the purchasing business can’t pay? This recent case means that you may never get paid all of what you’re owed, at least not from the purchasing company’s insurance company.
Let’s call the guy selling the business Bill. Bill developed some software for the security industry and built his company up. Bill then agreed to sell his business, ABC Company, to XYZ Company, for $1.5 million. XYZ Company agreed to pay him over time and executed a promissory note. Bill sat on XYZ Company’s Board of Directors for a period of time, and then resigned. Because he hadn’t been paid what he was owed under the promissory note, he sued XYZ Company and its directors for not paying them. He might’ve thought that XYZ Company’s officers and directors insurance policy would cover the claim. He might’ve held this hope because maybe XYZ Company and the directors were not swimming in cash. Well, the insurance company denied coverage, and Bill took what he could get from the directors ($300,000), against a judgment for 2 million and an agreement that he could go after the insurance company for the 2 million if he never tried to collect that balance from the directors. This is called a forbearance agreement. XYZ Company filed for bankruptcy, so it was protected from Bill’s claims.
Bill then sued the insurance company and lost. The insurance policy had an “insured versus insured” exclusion which meant that the insurance company did not have to pay any claim between directors unless it was related to employment. Bill wasn’t happy. You see even though the promissory note had nothing to do with him being a director of XYZ Company, his claim was by a director (him) against a director (the other defendants) and therefore the insurance company didn’t have to pay. There are other cases where this exclusion also protected the insurance company, such as here and cases where it didnt, here.
Officers and directors insurance policies are complicated reads. In addition to an insured versus insured exclusion, they often have exclusions that are particularly applicable to small family held businesses. A “family exclusion endorsement” is typically included in such policies ensuring private companies. This exclusion says that insurance company doesn’t have to cover a claim that’s made by one family member against another. And in a small family held business the family members are usually officers, directors or owners. Most likely the “insured versus insured” exclusion is also going to get the insurance company out of paying if all the family members are officers or directors.
The opinion has some unexciting language about interpretation of insurance policies, and the decision itself really doesn’t set new law. What the opinion does do is provide some guidance to attorneys representing people in Bill’s position. First, Bill probably should’ve gotten a security interest in exchange for the promissory note. Then he could’ve foreclosed on the security interest, to recover the money. Second, Bill probably should’ve gotten a copy of the insurance policy, before he gave up his rights against the directors (his attorney may have done that, it’s just not clear). And instead of being a consultant as an independent contractor, he should have been an employee. That way the insurance exclusion would do not apply.
It’s all well and good, and easy to Monday morning quarterback some other case. But it’s cases like these that help lawyers in the future, and make for great reading on a chilly, fall Saturday.