What happens when a policy funding a Buy and Sell Agreement does not pay out?

Have you ever considered this scenario? A well-structured buy and sell arrangement, policies in place, valuations in place… and then, a shareholder passes away, and the claim is repudiated.

I never considered this, until I was asked a question: “What happens if a shareholder commits suicide?”. I wanted to answer immediately, but then I paused and thought about it a bit. I first wanted to do research specific to this question, but I quickly realised that the question does not really relate to suicide, but rather what if the policy that is meant to fund the buy and sell arrangement does not pay out at claim stage, for whatever reason.

My point of departure

As we well know, the policy is not the crux of a buy and sell arrangement. The contract is. I decided to obtain pro forma buy and sell agreements offered by various Life Assurance Companies. The purpose is to determine how these agreements deal with this specific scenario (the claim not being paid out). I studied three different agreements from three different Life Assurers. The names of the Life Assurers are not important and I will therefore not reference them by name. I will, however, highlight the differences I found, the implication of each and what needs to be considered when structuring a buy and sell agreements for different clients. When I refer to “the scenario” in the rest of the article, I am referring to the policy claim being repudiated.

The different clauses

Company A‘s contract had no clause dealing with the scenario. The contract only states that each shareholder confirms that they did not and will not withhold any information or make false statements or provide incorrect or limited information on any application form. This does not ensure that a claim will be paid. A shareholder can still commit suicide within the first 2 years of the policy’s commencement, resulting in no claim being paid. Based on the structure of the contract, the clause dealing with repayment of amounts in the event that the benefit payment was insufficient will apply. In essence, the valuation has been provided, R 0 was paid out form the policy and therefore the full valuation is payable in line with the agreed repayment terms. This means that either the surviving shareholder(s) must arrange alternative finance or they must buy the shares and make repayments, including interest, over the selected term. Now, if that term is only 12 to 24 months, then it can be a sizeable repayment. The contract stipulates that the shares will immediately be transferred to the purchasing shareholder(s), but that the shares must be ceded to the selling shareholder for security. The contract stands in the event that the policy claim is repudiated. This contract does not state that the remaining parties can renegotiate repayment terms where the policy proceeds are insufficient to cover the purchase price.

Company B‘s contract does deal with the scenario. It states that the deceased shareholder (represented by the executor) cannot enforce the contract against the remaining shareholders. However, the remaining shareholders can enforce the contract against the deceased shareholder. This means that the remaining shareholders have a choice now. And no one can force them to go ahead with the contract. They have limited time to inform the executor of their intention to enforce the contract. If they do not, then the contract lapses. The contract states that if the remaining shareholder(s) enforces the contract, then the payments must be made over a 12 month period, unless otherwise agreed to between all the parties. In this instance, the contract allows for new payment terms to be agreed to, which allows flexibility and better peace of mind, should the policy not pay out for whatever reason.

Company C‘s contract also deals with the scenario. The buyer will not be obliged to purchase the deceased’s (or disabled) shareholder’s shares. The buyer(s) will now have an option to purchase the shares “and on terms that are no less favourable┬áthan those that the Buyer would otherwise have enjoyed”. So very much the same as Company B’s contract. It does not, however, state that the contract will lapse should the buyer decide not to purchase the shares, but this can be inferred from the option given to the buyer, that if the buyer decides not to purchase the shares, then the contract will come to an end.

What you need to consider when structuring a Buy and Sell Agreement

Relying on “you should see your lawyer to help you draw up the contract”, is not a great strategy and it certainly does not relieve you from your responsibility to ensure the agreement is correctly structured and implemented.

In my experience, lawyers and other legal professionals think that a buy and sell agreement is the same as a shareholder’s agreement. Yes, some of the aspects are addressed in the shareholder’s agreement, but not to the extent that a focused buy and sell agreement does.

Your role as Financial Planner and Financial Adviser is to guide both the client and the legal professional assisting with drafting the agreement, through your expertise. You should explore the worst case scenario. Worst case scenario includes (but are not limited to):

  • Claim not successful, i.e. the policy does not pay out;
  • Simultaneous death of all shareholders (not impossible);
  • Partial claim payments (especially in the event of disability);
  • etc.

Explore these scenarios in detail and discuss possible solutions, obtain input from the client and from the legal professional. This will ensure clarity to all the parties involved. Better that they agree on terms now, than trying to negotiate with an executor or surviving spouse and children.

In closing

Have you ever come across a scenario like the one I am addressing in this article? What were the circumstances and importantly, the lessons learned from this? You are welcome to share your story in the comments below and if you can provide further insight, please share it below.

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