Baugh v. Novak

• Decision Date: 07 June 2011
• Citation: 340 S.W.3d 372
• Parties: Wendell P. BAUGH, III et al.v.Herman NOVAK et al.
• Court: Tennessee Supreme Court

340 S.W.3d 372

Wendell P. BAUGH, III et al.

v.Herman NOVAK et al.

Supreme Court of Tennessee, at Nashville.

Oct. 6, 2010 Session.May 20, 2011.Rehearing Denied June 7, 2011.

Stephen C. Knight and Nader Baydoun, Nashville, Tennessee, for the appellants, Wendell P. Baugh, III and Laura W. Baugh.Paul R. White and Keith Turner, Nashville, Tennessee, for the appellees, Herman Novak and Faith Novak.

OPINION

WILLIAM C. KOCH, JR., J., delivered the opinion of the Court, in which CORNELIA A. CLARK, C.J., JANICE M. HOLDER, GARY R. WADE, and SHARON G. LEE, JJ., joined.

This appeal raises the issue of whether a contract for the sale of an interest in a corporation and related indemnity agreements are unenforceable because they are contrary to public policy. The sellers of the corporate interest filed suit against the purchasers in the Chancery Court for Williamson County seeking damages for the purchasers' alleged breach of their indemnity agreement. The purchasers counterclaimed asserting, among other things, that the sellers had fraudulently induced them to purchase the interest in the corporation. Following a bench trial, the trial court awarded a $201,715.50 judgment to the sellers and dismissed the purchasers' counterclaim. On appeal, the Court of Appeals, on its own motion, invalidated the stock purchase agreement and the related indemnity agreements on the ground that they were contrary to the public policy reflected in Tenn.Code Ann. § 48–16–208 (2002). Baugh v. Novak, No. M2008–02438–COA–R3–CV, 2009 WL 2474714 (Tenn.Ct.App. Aug. 13, 2009). We granted the sellers' Tenn. R.App. P. 11 application for permission to appeal and now find that the Court of Appeals erred by finding that the agreements at issue in this case were contrary to public policy. We have also determined that the evidence fully supports the trial court's decision to dismiss the purchasers' counterclaim for fraudulent inducement.

I.

In June 1992, Wendell P. Baugh, III and Laura W. Baugh acquired Precision Services, Inc. from Ronald C. and Gayla J. Miller for $340,000. Precision Services was in the business of aligning large pieces of industrial machinery and printing presses to increase their efficiency. The Millers agreed to finance the transaction. Following the sale, Mr. Baugh managed the day-to-day operations of the company. Ms. Baugh did not play an active role in the business.

Three details of this transaction are relevant to the issues in this case. First, the Baughs personally guaranteed the note executed by the corporation that purchased Precision Services's assets and the right to use its name. Second, Ms. Baugh pledged the stock of the corporation that purchased Precision Services's assets to the Millers as security for the note.¹ Third, the loan agreement contained an explicit limitation on the right of the acquiring corporation to transfer or issue stock.² Following the completion of the transaction, the Baughs changed the name of their corporation to Precision Services, Inc.

Herman and Faith Novak were friends and neighbors of the Baughs. Mr. Novak was an electrical engineer who had been employed by General Motors and Alcoa. When Alcoa asked Mr. Novak to move back to Detroit, Mr. Novak talked with Mr. Baugh about finding some business opportunities in Nashville because he and his wife were not eager to move. In May or June 1994, Messrs. Baugh and Novak purchased Penske Plastics, Inc., a manufacturer of polyurethane fiberglass reinforced composite board, for $800,000. Each party owned fifty percent of the company ³ and were, by contractual agreement, jointly and severally liable for the company's debts and obligations. Messrs. Baugh and Novak also agreed to share equally in the profits from the company's operations.

Both Messrs. Baugh and Novak maintained offices at Penske Plastics's plant in Mount Juliet. Following the purchase of Penske Plastics, Mr. Baugh moved the office of Precision Services to the Penske Plastics's plant. Mr. Novak was aware that Mr. Baugh was carrying on Precision Services's and Penske Plastics's businesses at the same time.

In late 1994 or early 1995, Mr. Baugh offered to sell one-half of Precision Services to Mr. Novak because he believed that the company would benefit from Mr. Novak's engineering expertise. Following some negotiations in February or March 1995, Mr. Baugh agreed to sell Mr. Novak a fifty-percent interest in Precision Services, and Mr. Novak agreed to pay Mr. Baugh a purchase price equal to one-half of Precision Services's net annual profit. Because the amount of Precision Services's net annual profit would not be known until later in 1995, they agreed that Mr. Novak would pay Mr. Baugh $50,000 and that he would pay the balance later in the year once the business's net annual profit was calculated. Mr. Novak also agreed to assume one-half of Precision Services's liabilities, including the liability to the Millers.

Because of the limitation on the transfer of Precision Services stock contained in the June 1992 loan agreement with the Millers, Mr. Baugh requested the Millers' permission to sell one-half of the company to Mr. Novak. While the Millers did not refuse permission, they requested detailed information regarding Mr. Novak's personal finances and the terms of the agreement between Messrs. Baugh and Novak. By this time, Mr. Novak was aware of (1) the stock transfer restriction in the June 1992 loan agreement with the Millers, (2) the fact that the Baughs had pledged the Precision Services stock as security for the Millers' loan, and (3) the Millers' request for additional information regarding his personal finances and the terms of the agreement between Messrs. Baugh and Novak regarding Precision Services.

Because Mr. Baugh had found the Millers difficult to deal with in the past, he requested his attorney to structure a transaction that would enable Mr. Novak to acquire a one-half interest in Precision Services without the Millers' approval. Mr. Baugh's attorney drafted documents, including a stock purchase agreement, to enable Mr. Novak to acquire a right to one-half of the stock of Precision Services without the Millers' approval. These documents also contained an indemnity agreement in which the Novaks agreed to indemnify and hold the Baughs harmless for fifty percent of any payments they were required to make on the Millers' note and Precision Services's other debts.

On March 5, 1995, Mr. Novak gave Mr. Baugh a check for $25,000 containing the notation “ 1/2 of cash for 50% of Precision Serv., Inc.” In late April 1995, the Baughs and the Novaks met in the office of Mr. Baugh's attorney and signed the stock purchase agreement and indemnity agreement. ⁴ On April 26, 1995, Mr. Novak gave Mr. Baugh a second check for $25,000 containing the notation “Final Payment for Half Ownership of Precision Services.” Shortly after the completion of the transaction in April 1995, Mr. Novak requested the Baughs to provide him with an indemnity agreement regarding Precision Services's obligations similar to the one that the Novaks had provided to the Baughs. Mr. Baugh obliged by providing an agreement indemnifying the Novaks that was substantially identical to the agreement that the Novaks had provided the Baughs.

On September 29, 1995, following the end of Precision Services's fiscal year and the calculation of the company's net profits, Mr. Novak gave Mr. Baugh a check for $17,000 marked “50% of Precision Paid in Full.” Precision Services's federal tax returns from 1995 through 2003 stated that both Messrs. Baugh and Novak owned fifty percent of the company. Messrs. Baugh and Novak were joint borrowers on loans to Precision Services from the Bank of Nashville and First State Bank. As late as October 2004, Mr. Novak prepared “financial summaries” valuing his interest in Precision Services at $125,000.

From 1995 through June 2005, Messrs. Baugh and Novak managed and operated both Penske Plastics and Precision Services. Penske Plastics's business grew and flourished; however, Precision Services's business did not. In 1999 or 2000, Precision Services lost one of it largest customers, accounting for sixty to seventy percent of its annual revenue. In Mr. Baugh's words, Precision Services's business “just kind of slowly died” because the industry changed and its “services were no longer in demand.” Penske Plastics became the “golden egg” for Precision Services because revenues generated by Penske Plastics were frequently and regularly used to pay the obligations of Precision Services.

The Penske Plastics plant sustained significant damage by fire on June 2, 2003. One piece of equipment was heavily damaged and the building was filled with acidic smoke and soot. The soot damaged the remaining equipment and infiltrated into the offices. Many of the papers that Mr. Baugh kept in open banker's boxes in his office were so damaged that they were discarded. Among these papers were the original signed copies of the documents the Baughs and the Novaks had executed in April 1995. The companies' insurance policies were not sufficient to cover all the damage caused by the fire.

In mid–2005, Messrs. Baugh and Novak sold Penske Plastics to Alcan Baltec. The new owner did not require Mr. Baugh's services, and so Mr. Baugh physically left the premises in June 2005 to pursue a new career as a commercial real estate broker. Mr. Novak remained with Penske Plastics. Up until the time of the closing of the sale of Penske Plastics, the loan obligations of Precision Services continued to be paid using revenue from Penske Plastics.

By mid-December 2005, the financial status of Precision Services was precarious. In an email to Mr. Novak dated December 13, 2005, Mr. Baugh suggested ways “to limit our losses” and professed that he did “not understand your attitude towards [P]recision Services[.] [Y]ou seem to believe that it doesn't exist and that you have no liability for the Miller debt.” Mr. Novak responded...