Buy-Sell Agreements in a Succession Plan

You are in business with one or more business ‘partners’. Most likely all of the business owners
are involved in the day to day running of the business. But what happens if you or they die or
retire from the running of the business? Here we set out some of the problems you may encounter unless you have a proper business succession document (often called a Buy/Sell Agreement). We also set out some of the options and issues in putting in place a proper Buy/Sell Agreement. These issues are the same regardless of whether your business is run via a company, unit trust or partnership.

Common Problems
These are some of the common problems business owners can encounter when one of the above events occurs: disputes between the continuing owners and the incoming owner of the business (the incoming owner may acquire his or her interest under the will of the deceased former owner). This often occurs as the new owner does not understand the business or does not have the respect of the other business owners; in a private business the sale of a portion of the business to an outside party is often not possible (i.e. there is limited external liquidity). So really there can only be sales between business owners. However, without an agreement:the incoming owner (under a will) cannot force the other business owners to buy his or her portion of the business; and the remaining business owners cannot force the sale of the deceased business owner’s portion of the business; even if all of the owners want a sale to occur there is not sufficient funding to allow this; the owners who still work in the business become disgruntled with having to pay ongoing returns to the new passive owner (i.e. the estate of the deceased owner); and concerns about the continuity and viability of the business, including from employees, customers, bankers, suppliers and creditors who may leave or discontinue support (particularly where the owners are in dispute).

Buy/Sell Agreements
Putting in place a Buy/Sell Agreement can avoid some of the above and provide certainty for
business owners. In simple terms a Buy/Sell Agreement provides a framework under which business owners can sell their interest in the business or buy the interest of a co-owner. For tax purposes (see below) Buy/Sell Agreements usually use options to buy or sell on a defined trigger event (e.g. death of an owner). Usually: the owners not subject to the trigger event have a right but not an obligation to buy the exiting owner’s interest in the business (Call Option); the owner subject to the trigger event has a right but not an obligation to make the remaining owners buy his or her interest in the business (Put Option).

As an alternative, a buy back/redemption agreement could be considered. Under such arrangements the trading entity (e.g. company) rather than the other owners buys back the exiting
owner’s shares (note there are Corporations Act requirements which apply to share buy-backs).
Another alternative is to have a sale of the whole business on a trigger event occurring. We don’t
look at these two options in this paper. We now look at some of the issues you need to
consider and resolve to ensure you meet your needs.

Events
You need to work out the trigger events or conditions which lead to a sale of a business interest. These are often tailored to and limited by funding available for any purchase (see below). There are two broad trigger event categories being: involuntary or insurable trigger events (death, critical illness, and total permanent disability); and voluntary or uninsurable trigger events (retirement, resignation or lawful termination of employment).

Call Options are generally granted on the happening of both involuntary and voluntary trigger events. Put Options are generally granted on the happening of involuntary trigger events. As insurance is not available for involuntary trigger events you may need to consider price reductions or payment over time (vendor finance provisions).

Price
The price at which an exiting owner’s interest in the business is to be sold should be fixed under
the Buy/Sell Agreement and reviewed at agreed intervals. Alternatively the parties should agree to an appropriate valuation methodology and/or an expert valuation process. Careful thought should be given to any scenarios that might justify a reduction of the price payable. For example, a reduction might be appropriate in the case of Put Options for voluntary trigger events as mentioned above (say if an owner is forced out for breaching a Shareholders’ Agreement or their employment is terminated for fraud). A reduction might also be appropriate in circumstances where an exiting owner fails to maintain an insurance policy as required under the Buy/Sell Agreement or otherwise invalidates an insurance policy.

Funding
A Buy/Sell Agreement is often fully or partly funded by insurance policies. For tax purposes generally ‘principal ownership’ is used (meaning each owner of the business owns their own
insurance policy). There are other options for insurance policy ownership but these can have
adverse tax consequences (including Capital Gains Tax outcomes on the payment of the
insurance policy proceeds). There may also be tax differences in the treatment of insurance
premiums. So tax advice is critical on these issues.

As an alternative, the owners may decide to use their own capital, borrow money to finance the
sale, and/or enter into a vendor finance arrangement. However, it is difficult to predict if at the time a sale is required the owners will have the funds available to make the purchase. Parties should consider the timing of the payment (up front lump sum or paid over time by way of installments). If payment is to be made over time by way of installments (vendor finance), security (e.g. a mortgage) and interest should also be considered.

Capital Gains Tax
Care must be taken when drafting Buy/Sell Agreements. Options should be used to avoid unintended Capital Gains Tax (CGT) consequences. The entry into of virtually any agreement can be a CGT event. However, a Buy/Sell Agreement using options without consideration will not trigger any CGT liability at the time of signing. Rather, the CGT event and resulting CGT liability will occur on the exercise of the options (i.e. when an unconditional agreement to buy and sell an interest in the business comes into force).

Likewise, where a business succession agreement (including a Buy/Sell Agreement) does not use options but makes the sale of a business interest conditional on an event occurring, the CGT event will not occur on signing but on that condition being satisfied. If the Buy/Sell Agreement includes vendor finance CGT must be carefully considered. Otherwise, a seller will incur the CGT and liability in one year but may only receive the sale price over a number of years.

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Universal Banking – Answer For The Best Banking Design?

1.1 INTRODUCTION

In recent years, universal banking has been growing its popularity in Indonesia. Mandiri Bank, for example, has taken strategy to become Indonesia’s universal bank; this bank has also initiated to develop an integrated financial risk system in terms of sounding financial performance and increasing shareholder value. In Germany, and most developed countries in Europe, universal banks have initiated its operations since nineteen century. There is mounting evidence that in those countries, universal banks have taken an important part in the development of real sectors and the financial system. In those countries, the growing numbers of universal banking practices are really supported by the regulation of central of bank.

Despite, in The United States, they are strict to regulate universal banks by blocking commercial banks from engaging in securities and stock markets practices. They argued that the practice of universal banking might be harmful for the financial system. ((Boyd et.al, 1998) cited in Cheang, 2004) The “risk” might be the key reason why the central bank of The U.S is worried about the universal banking system. Since, if the central of bank allowed banks to adjust their operation to be universal banks, the relationship among, banks, financial and stock markets would be closer. Consequently, this would give an uncertainty to the banks condition and performance. For example, if there were a disaster in stock market, banks would get problems in their financial positions. Thus, they would tend to be insolvent.

In addition universal banks would also threaten the market share of other specialized institutions, because more customers would choose universal banks that offer more option to their investment. Hence, more specialized institutions are likely to be ruined in the U.S financial industry.

One majoring factor, which is triggering a bank to be universal bank, is to increase the profit by enlarging their market share. According to João A. C. Santos (1998) universal bank itself can be defined as the financial institution, which enlarges its service range in terms of offering a variety of financial products and services in one site. Thus, by operating universal banking, banks could get a greater opportunity to expand to another financial area, such as : financial securities, insurance, hedge funds and etc.

Although the trend of banks has recently tended to universal banks, it is undoubtedly true that universal banks would also face further risks because a wide range of financial services is strongly associated with increasing risks and escalating monitoring costs. These are the major concerns why banks have to implement more advance technology in terms of financial risk management. Moreover, the practices of universal banks would cause significant risks to economy’s payment system. Since, the operation of universal banks connects closely to the financial and stock markets that are very fluctuate in a short term.

To win in the tight competition among financial institutions, banks have to alter their maneuver to lead in the market. Universal bank could be the wise choice for the bank manager, because they can attract more customers with a wide range of services. Furthermore, by altering their operation to the universal banking system, banks would get benefits from the efficiency and economies of scale.

In order to understand about the universal banking practices, this paper would examine the exclusive matters, which related to the risks and benefits in a universal bank. Moreover, this paper would also focus the whole impact of this institution to the financial system and the economy as a whole.

1.2 PROFITS AND COSTS IN UNIVERSAL BANKING: IMPLICATIONS FOR INDIVIDUAL BANKS

General problem related to financial intermediation, include universal banks and another type of banks, is about asymmetric information . It is the main problem that causes costs to increase and influence the performance of financial institutions. In Universal banks, the problems that would increase are slightly different with specialized banks; they are similar in that they should cope the risks problem associated with their financial position. Although, in universal banks, the risks are more bigger due to the wide range of financial instruments that they organized. Therefore, banks have to increase their spending on monitoring costs that are more complicated than specialized institutions or conventional banks.

Possible answer why more banks sacrifice to the escalating risks and transform it operation into the universal banking is that they want to compete and expand their market share, in order to seek a greater opportunity profits by serving more choices to their customers. Many banks has experienced a great performance after they alter their operation, the main concerns are that they could reach better economies of scale which can reduce the amount of spending in operational costs and also a greater opportunity to get more profits. The research finding which was conducted by Vender, R. (2002, cited in Cheang, 2004) about the efficiency of revenue in financial conglomerates and the level of both profit and cost in universal banking, has proved that both financial conglomerates and universal banking contain good performance in several indicators of bank profitability. His finding also suggests that the sustained expansion of financial conglomerates and universal banking practices may increase efficiency in the financial system.

This opinion is strengthen by another experts, like : George Rich and Christian Walter (1993). They state that universal banks which posse benefits over specialized institutions, are able to take advantage of reduction in the average cost of production and scope in banking. It is essential for banks that operate on a international level and in order to fulfill customer needs with a variety of financial services. They also mention a classic example how universal banks in some countries, such as : Switzerland, Germany and more European countries has experienced benefits by operating universal banking. In addition, they also state that the fear if universal bank would threaten specialized institutions has not proven. In Switzerland and Germany, for example, specialized institutions could achieve a better improvement in terms of cooperating with big banks. Universal banks are one of potential market channel which can sell their products directly to the customers, so specialized institutions also get additional return due to the increases in the number of universal banks. Therefore, this proves that universal banks do not threat other institutions; in fact, they support specialized institutions to market their products.

According to Fohlin, universal banking would lead to a bank’s concentration due to the increases the number of branch. Based on Germany’s experience, such branching-based expansion has led to the efficiency in banking because it could increase economies of scale in advertising and marketing, and open an enormous opportunity to enhance diversification and steadiness for banks.

A universal bank has unique position to tackle asymmetric information. As stated by Joao A. C. Santos (1998), that a universal bank has potential benefits on the reduction of agency cost and acquires profits due to information advantages. Although in other sides, universal banking also face problems related to the cost, conflict of interest and safety and soundness. But the default risk, which is generally happened in financial intermediation, would decrease substantially because universal banks are easier to control over their customers. Most of lenders in universal banks are their customers, so they can understand about the capacity of the customers from the information that they gather.

Nicholas Cheang (2004) also points out how universal banks could reduce a crucial problem in financial institution, asymmetric information. He argued that they could preserve a close relationship with their borrowers, by gathering more relevant information to make an important decision for investment. Their advantageous positions also vital to optimize the distribution of fund allocation, because banks have already known which investment that would give more margins to them. So, they don’t need to worry too much about the risk.

1.3 UNIVERSAL BANKS AND THE STABILITY IN THE FINANCIAL SYSTEM

Financial institution plays a vital role in terms of mobilizing funds in the economy. Consequently, stability in financial system is really important to manage by government in order to prevent wider implications to the real sectors. Financial disasters which happened in most countries in Asia in 1997 are the classic examples how importance to save banks to recover the economy.

As the financial supermarkets, which are handling a variety of financial instruments, they must face a greater risk than specialized institutions. As a consequence, this institution needs to be monitored closely in order to prevent more implications to the economy. According to Benston (1994), the escalating risks in universal banking would lead to a great problem because it can cause generous distress in the financial system. Hence, it will greatly increase the risk to the economy’s payment system. In another term, Rime and Strioh (2001) who examine the financial system in Switzerland in which universal banking are becoming more important in this country, state that difficulty in monitoring large universal banks is a major concern. This is the reason why universal bank has to spend more money in monitoring cost and develop an advanced system in information technology. In other words, it could say that the consequence of inefficient monitoring could lead to financial instability. (Cheang, 2004)

A wider range of universal banks in financial system makes the fund channels of banks to the customer are larger than specialized institutions. So, the economy will improve because universal banks will support more funding. This can be seen by the fact that a universal bank practice in Germany has triggered the progress of some enterprises performance in this country. (Stiglitz, 1985). It is understandable that when the allocation of fund can distribute widely and effectively to the potential enterprises, the economy will improve. In this context, universal banks have played as the key institution which mobilize fund to the potential lender.

Edwards (1996), has also proved that a universal bank is not just significantly contributed to economy from the external funds that they provide, but also from the improvement of the information flows. (cited in Cheang, 2004) Therefore, this proves that universal banks have played a significant role in terms of reducing the default risk by providing important information about the lender or customers. Furthermore, the safety of the financial system would be improved by the existence of universal banks.

1.4 CONCLUSION

The development of universal banks has to in line with the policy direction of central bank, because it is important to keep the stability of financial system and the economy as whole. There are three important areas that must be concerned related to universal bank operations, such as : the strengthened of capital and advanced risk management system. Consequently, in order to manage universal bank, people need to be aware about the unique of the risk type in universal banking. Furthermore, policy maker must also consider about the implication of universal banks in financial system.

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