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Sell-buy agreements - a form of financial instrument.

What disclosures are required for these financial instruments?

The FASB has issued a number of statements in recent years requiring additional disclosures about financial instruments. Although buy-sell agreements meet the definition of a financial instrument, their very nature does not trigger most of the disclosure requirements. What's the nature of the disclosures for these agreements, that could have a significant impact on the liquidity of an entity?

Buy-sell agreements are frequently used for dealing with a variety of business and estate planning situations involving closely held businesses. A "buy-sell agreement" is typically a single document; however, "buy-sell" provisions are found in articles of incorporation, bylaws, and employment contracts. Used in its broadest sense, a buy-sell agreement represents the total of all agreements between owners of a closely held business regarding control, identity of shareholders, transferability of ownership, and a variety of other business and financial matters.

Traditional reasons for using buy-sell agreements are to establish a degree of certainty regarding the continuing ownership of a business, to provide a market for closely held shares, to provide certainty as to the value of shares for estate tax purposes, and to provide restrictions regarding operational matters, e.g., voting control, protection of S corporation status (if elected), tax accounting methods, and payment of dividends.

Types of Buy-Sell Agreements

One of the major features of any buy-sell agreement is the identification of the purchaser, either the corporation or individual shareholders. Whether or not disclosure is necessary depends upon whether the agreement involves a cross purchase or a stock redemption. In a cross-purchase agreement, the purchaser of the stock is one or more of the other shareholders. If the agreement obligates the shareholder(s) to purchase, the enterprise is not a party to the agreement and normally no disclosure is required. If the agreement calls for a stock redemption, the corporation is typically obligated to buy all of the shares held by the shareholder.

A third possibility would be a buy-sell agreement that obligates the remaining shareholders to purchase a shareholder's shares in the event of death or if the shareholder desires to terminate the investment. If the other shareholders determine they do not wish to purchase the shares, the corporation may then be secondarily liable for the share purchase.

The Buy-Sell Agreement as a Financial Instrument

In oversimplified terms, a buy-sell agreement is a conditional obligation, one of the basic building blocks of financial instruments. The obligation of one party to sell and the other to buy is conditional on the occurrence of a pre-specified, uncontrollable event, such as the death of the first party.

A buy-sell agreement is similar to a forward contract in which the purchasing entity promises to exchange an unknown, but determinable, amount of cash for an equity interest in an enterprise held by the seller. The selling entity promises to exchange an equity interest being held for an unknown but determinable amount of cash when the specified event occurs. Because the precise timing of the event that triggers the transaction is unknown and uncontrollable, either party could be required (an obligation) to execute the transaction under unfavorable circumstances or, conversely, either may be able (a right) to execute the transaction under favorable circumstances.

The FASB in its Statement No. 105, Disclosure of Information About Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk (SFAS No. 105), requires additional disclosures in essentially all financial statements prepared in accordance with GAAP when financial instruments are present. The Statement provides the following definition of a financial instrument:

A financial instrument is cash, evidence of an ownership interest in an entity, or a contract that both -

* imposes on one entity a contractual obligation to 1) deliver cash or another financial instrument to a second entity or 2) exchange financial instruments on potentially unfavorable terms with the second entity, and

* conveys to that second entity a contractual right to 1) receive cash or another financial instrument from the first entity or 2) exchange other financial instruments on potentially favorable terms with the first entity.

The contractual rights and obligations in the above definition encompass both those that are unconditional and those that are conditioned on the occurrence of a specified event. Clearly, the rights and obligations to buy and sell that exist within a buy-sell agreement are included in this definition, and a buy-sell agreement, whether standing alone or included within another instrument, is a financial instrument.

With an obligation to purchase, at a time as yet unknown, comes risk - risk that the enterprise may be obligated to pay cash that it may not have available. This type of risk, identified as liquidity risk, was included in the scope of the exposure draft on financial instruments. The Board, however, concluded the best way to address the various issues contained in the exposure draft would be to do so in phases. Consequently, SFAS No. 105 addresses market and credit risk only. Subsequent standards to be issued by the Board are to focus on disclosure of information relating to liquidity risks associated with financial instruments.

A buy-sell agreement that contains a specific price for the purchase of shares would have market risk and be covered by SFAS No. 105. The buy-sell agreements as defined here do not have market risk. All buy-sell agreements, however, have an element of liquidity risk. Such risk should be disclosed in the financial statements using the guidelines in SFAS No. 105 pending issuance of further standards.

SFAS No. 105 Disclosure Requirements

SFAS No. 105 requires disclosure of the nature and terms, including, as a minimum, a discussion of the credit and market risk of financial instruments with off-balance-sheet risk. Disclosure can be made either in the body of the financial statements or in the notes, and should include the face or contract amount as well as a narrative of the nature and terms. The narrative should include a discussion of credit risk and market risk, the cash requirements for the financial instruments with off-balance-sheet risk, and the accounting policies associated with the instruments.

If the financial instrument has off-balance-sheet credit risk, two additional disclosures are required: The potential loss the entity would incur if the counter-party to the financial instrument does not perform, and information about collateral similar to that required for all financial instruments with concentrations of credit risk.

Off-balance-sheet risk refers to the credit and market risk that exceeds the amount recognized, if any, in the statement of financial position. This risk exists when the amount of loss from an instrument is not reflected on the balance sheet because the item is not recognized as an asset or liability.

Credit risk of financial instruments is the risk a loss will occur because parties to the instrument do not perform as expected.

Market risk of a financial instrument is the possibility that changes in market prices will make the instrument less valuable or more burdensome.

Two major purposes of disclosure identified by the Board include 1) providing a useful measure of unrecognized items and 2) providing information to help investors and creditors assess risks and potentials of both recognized and unrecognized items. SFAS No. 105 develops the idea in this way:

For conditional items,...information disclosed might include the contract amounts or describe the reasons the entity engaged in those transactions and the conditions that would cause the entity to have an advantageous or disadvantageous result.

Buy-Sell Agreement Disclosures

What information is needed to help investors and creditors assess the risks and potentials of buy-sell agreements? Some answers are suggested by raising further questions: Who is a party to the agreement? What is/are the conditional event(s) that call for the firm to purchase outstanding shares? Is there any credit, market, or liquidity risk associated with the obligation? What is the extent of the firm's obligation under the agreement? What provisions have been made to meet the obligation when it becomes due?

Parties Under the Agreement. Who is a party to the agreement? The answer depends upon whether the agreement is a stock redemption or a cross-purchase. Depending on the circumstance that triggers a purchase under the agreement, the purchaser may not have an obligation to purchase but merely an option to do so. Typically, shareholders do not want to obligate their personal estates for stock purchase obligations, especially where the price (although determinable) is unknown at the time the agreement is entered into. When this is the case, shareholders generally have an option to purchase the shares of a decedent or withdrawing shareholder and, if not exercised, the corporation has an obligation to purchase these shares.

Most buy-sell agreements restrict life-time and death transfers within a desired ownership group. The desired ownership group may be limited to existing shareholders and, in the case of an S corporation, to the number of shareholders limited by tax law. Admitting a new shareholder outside the existing shareholder group usually requires the consent of the other shareholders. Absent consent of the other shareholders, a corporation is usually required to redeem any available shares.

Events Triggering a Buy-Sell Agreement. What events call for shareholders to sell and the corporation to purchase? The selection of the particular "trigger" events are influenced by a number of factors that involve tax, personal, and economic considerations.

Agreements typically provide that, upon the death of a shareholder, there is an obligation for the deceased shareholder's estate to sell and the corporation to purchase the deceased shareholder's stock. The average age of the shareholders who are parties to the agreement and any notable health risks may be useful items of information in a financial statement.

When a shareholder is also an employee, disability is an important triggering event. A buy-sell agreement usually provides for redemption of the disabled employee's shares, thus providing cash to the family of the disabled shareholder. When disability is a triggering event, the number of shareholder/employees and the relative risks of their activities should be discussed.

Typically, purchase of stock by a key employee (a nonfamily member employee) is coupled with a mandatory buy-back agreement upon termination of employment at a formula price. This gives the minority shareholder both an incentive to enhance the value of the corporation while employed and the protection of knowing his investment will be liquidated upon termination. Adequate disclosure should include both the number of employee/shareholders and their average length of employment.

A contemplated voluntary transfer by a shareholder is also a common triggering event. In this event, the agreement usually provides for the corporation and/or the remaining shareholders to have an option (not an obligation) to purchase the shares. Normally, the requirement is that all (and not less than all) of the shares must be purchased to protect the selling shareholder. Any provisions that obligate the corporation to redeem shares should be disclosed.

It is not uncommon for a buy-sell agreement to include an option for the corporation to repurchase its shares if they become subject to an involuntary transfer, e.g., a transfer to a trustee in bankruptcy or a guardian upon a shareholder's incompetency. A provision might also be included for an option to purchase in the event the shares are subject to an involuntary transfer in connection with a marital dissolution. Information regarding these terms should be included in footnote disclosures.

What Is the Obligation? In any circumstance that triggers a purchase under a buy-sell agreement, consideration must be given to the question of whether the corporation is obligated to purchase or merely has an option to purchase. An option to purchase does not represent any risk to the corporation and therefore need not be disclosed. However, any event in which the corporation has an obligation to purchase does represent a liquidity risk, and disclosure of the nature of the triggering event should be made. As stated earlier, there normally would be no credit or market risk. There could be, however, market risk if the pricing of the purchase obligation is measured on an historic basis and does not properly reflect changing conditions.

Disclosure of Funding Sources. One of the most important aspects of a buy-sell agreement is the source of funding for the obligations created by the agreement. At the core of the funding issue is the corporation's cash-flow capabilities. The firm's cash flow is affected both currently (to fund accumulations or pay for insurance premiums) and in the future at the time of the triggering event, e.g., death, disability. Disclosures in the financial statements should include the amount of funding for stock redemptions set aside in the period, the total to date set aside and/or the amount paid in insurance premiums this period with the face value of the policies, and the potential difference between purchase price if a triggering event occurred at the statement date and the funds that would be available for the purchase.

Although life insurance will often resolve the future funding problem of purchasing a deceased shareholder's stock, and disability insurance may be available for future purchase in the event of a permanent disability, insurance proceeds are not typically available in most lifetime purchase situations, e.g., retirement, termination of employment, voluntary or involuntary transfer. Other noninsurance methods of funding and payment must then be employed to adequately meet the major needs of the parties.

If insurance was unavailable or unaffordable when the agreement was drafted, a corporation may have been given the right to pay all or part of the purchase price in installment payments by giving a promissory note. Proper disclosures should then include the annual rate of interest, or method for calculating interest, on the promissory note, the length of time stipulated for payment, any requirements for security for the note, and any restrictions to be placed on the operation of the business while the note remains unpaid. Since deferral of payment permits the corporation to fund the purchase price out of future earnings, liquidity risk to the firm may have to be disclosed.

A buy-sell agreement might provide that the purchase price be payable in full on the date of the purchase, even if there is no insurance or other source of funds. This anticipates the corporation will be able to arrange to borrow the funds needed to satisfy the cash obligation. If this clause is present in the agreement, the length of time between the triggering event and the closing of the transaction, and the risks imposed on the corporation to borrow funds at a potentially unfavorable time, should be disclosed.

A variation found in buy-sell agreements, referred to as "hybrid funding," occurs when an agreement provides that cash will be paid at the closing to the extent of insurance proceeds (or up to a specified percentage of the purchase price if there is no insurance) with the balance payable over a period of time evidenced by a secured promissory note. In this instance, proper disclosures should contain all the information discussed earlier concerning disclosures about the adequacy of insurance or funding, terms of the note, and liquidity risk to the firm.

Footnote Example

An example of the wording that could be found in footnote disclosures in the financial statements of a closely-held corporation that is a party to a buy-sell agreement is illustrated below:

The Corporation is a party to an agreement among its shareholders, where, in the event of death, disability, or retirement of one, it is obligated to purchase the interest of that individual at its fair value at time of purchase.

(Additional Disclosures Depending Upon Funding Method)

The Corporation maintains life insurance and/or disability buyout insurance that will provide proceeds payable to the corporation to fund this obligation. The annual cost to the corporation of the insurance is $X.

The obligation will be payable by the Corporation equally over a five-year period with interest at X% per annum. This obligation is collateralized by a pledge of the repurchased stock.

The Corporation will be required to fund this obligation when it is determinable.

The exact wording to be used in footnote disclosures will depend upon provisions in the buy-sell agreement.

Jeanne Sylvestre, PhD, is with the University of South Alabama. Caroline Strobel, PhD, CPA, and Bruce W. Hadlock, CPA, are with the University of South Carolina.
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Author:Sylvestre, Jeanne; Strobel, Caroline; Hadlock, Bruce W.
Publication:The CPA Journal
Date:Aug 1, 1995
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