Penalising the under insured

With thanks to co View Legal director Patrick Ellwood, this week’s post looks at a situation we had recently under an insurance funded buy sell arrangement where the parties were wanting to craft the agreement in order to penalise a business owner if they were under insured.

In particular there was a desire to ensure that the agreement discounted the purchase price that was otherwise payable under the agreement if the insurance payout was less than the market value of the interest in the business at the relevant date.

For a number of reasons we recommended against this approach, including:

1.   The overall aim of any business succession agreement is to achieve as smooth a transition of the business as possible.  If a party to the transaction believes that they are not getting fair value then the prospects of a smooth transmission are significantly decreased.

2.   The exiting owner (or their estate) will still be required to pay tax on the transfer of the interest at full market value (even though the price under the agreement would be less than market value) due to the way in which the market value substitution rules under the Tax Act operate.

3.   Practically, if the exiting party had sold their interest the day before the triggering event, they would have received market value.  It is arguably inequitable for an owner to be disadvantaged because of a sudden involuntary exit event, as opposed to a planned voluntary exit.

4.   Generally most agreements (ours included) cater for any shortfall in insurance funding by ensuring that the remaining owners are still required to pay the difference but have an extended period of time (for example, three years) to repay the difference.

Until next week.