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LAYSTROM v. CONTINENTAL COPPER & STEEL INDUSTRIES

June 29, 1955

C.A. LAYSTROM ET AL.
v.
CONTINENTAL COPPER & STEEL INDUSTRIES, INC.



The opinion of the court was delivered by: Hoffman, District Judge.

This is an action brought by the former stockholders*fn1 of Quality Hardware and Machine Corporation to recover from the assignee of the purchaser of the stock an alleged balance on the price agreed to be paid for the stock.

The original contract for the sale of the stock was entered into on July 22, 1944, between substantially all the owners of stock of Quality Hardware and Machine Corporation, as sellers, and Chester A. Bolles, as buyer. The purchase price was fixed as a sum equal to the net worth of the Corporation plus 50% of the net profits for the next five years. Approximately $900,000 was paid to plaintiffs on July 31, 1944, for the net worth of the Corporation and more than $100,000 was paid to the plaintiffs for their share of the net profits for the last five months of 1944 and for the calendar years 1945 and 1946. The correctness of the amounts so paid is not in dispute. The plaintiffs, however, claim that there remains owing a substantial amount of money on account of profits in the calendar year 1948 and the first seven months of 1949. The defendant denies that any additional sum is owing, claiming that there were no profits in 1947, 1948 and the first seven months of 1949, but only losses.

Both parties are in agreement that there was no profit in the year of 1947 and that nothing is owed for that year. The books of account show for 1947 a net loss of $69,816.96, for 1948 a net loss of $355.54, and for the first seven months of 1949 a net loss of $248,400.43. It is the plaintiffs' position that certain liabilities entered on the books in 1948 and 1949 should have been recorded in 1947 so as to show for 1947 a net loss of $533,020.51,*fn2 and a net profit before income taxes for 1948 of $193,447.96, and for the first seven months of 1949 of $73,195.99. Plaintiffs allege they are entitled to one-half of these net profits for 1948 and the first seven months of 1949.

Resolution of the differences between the parties is dependent upon the construction to be placed upon the terms of the original contract of sale and of the assignment thereof. In pertinent part the original contract of sale provided:

    "2. * * * The purchase price for said shares of
  stock shall be * * *:
    "(a) A sum equal to the net worth of Quality as of
  July 31, 1944 as determined by an audit as herein
  provided * * *.
    "(b) Six (6) payments equivalent to fifty per cent
  (50%) of the net profits of the business of Quality
  computed as herein provided for the five years
  commencing August 1, 1944 and ending July 31, 1949;
  and * * *

"3. * * *

    "(b) The amounts payable under paragraph 2(b)
  hereof shall be paid by the buyer on March 14, 1945
  and

  March 15 of each succeeding year thereafter, the
  final of said payments to be made March 15, 1950. * *

"5. * * *

    "The net profits of the business for each of said
  periods are to be computed on the basis of the
  methods of accounting now employed by Quality."

In 1946 Chester Bolles, the purchaser of the stock under the original agreement, assigned the contract to the defendant.*fn3 Thereafter the plaintiffs and the defendant entered into an agreement dated April 11, 1946, which provided that as the remaining portion of the purchase price the defendant should pay to the plaintiffs (paragraph 7(a) thereof):

    "An amount equal to fifty percent (50%) of the net
  profits of the business of Quality computed as
  provided for in the contract of July 22, 1944, for
  the years 1946, 1947 and 1948, and the first seven
  months of 1949."

"Net profits" is a term having a well established meaning. The leading case defining the term is Thomas v. Columbia Phonograph Co., 1911, 144 Wis. 470, 129 N.W. 522, which was a suit by an employee whose compensation was to consist in part of a percentage of net profits. The employer in computing the amount to be paid had offset against losses in prior periods the gains in subsequent periods before making payment for such later periods. The court held this was proper, saying, 129 N.W. at pages 523-524:

    "* * * When the words `net profits' are applied to
  a course of dealing involving several successive
  transactions the idea of time is inseparably involved
  in the expression. For receipts and disbursements,
  gains and losses, in such case are never
  simultaneous, and some period is always meant at the
  end of which net profits may be ascertained. The
  words `net profits' unqualified * * * by other words
  in the contract, would naturally refer to the
  termination of the adventure. They may also refer to
  the expiration of a year or other fiscal period, at
  the end of which profits are to be computed, but
  which is a fraction of and within the period of
  adventure. But in this latter case if the business
  continues and covers several of such fiscal periods,
  and the period is for the purpose of computation
  only, and not for the purpose of terminating the
  adventure, losses and gains arising out of matters
  covered by an earlier fiscal period but occurring
  after ascertainment of the profits for that period,
  are carried into and increase or diminish the net
  profits in the next or some succeeding fiscal period.
  * * * It would be an entirely unreasonable
  construction of this contract to hold that during the
  period of service the plaintiff might select those
  months which showed a net profit, compute his
  percentage on this net profit, and reject all those
  months which showed a loss. The true construction of
  this contract is that the fiscal period for
  computation of net profits is the month, but that the
  real period to which net profits refers is the period
  of plaintiff's service and if by reason of net
  profits made during some months and losses incurred
  during other months of the period of plaintiff's
  service, there is at the end no net profit at all,
  the plaintiff has not earned anything by way of
  percentages upon net profits. * * *"

Numerous other cases hold that "net profits" cannot be said to exist in any period until the deficits of a prior period have been wiped out. As recently as last year our Court of Appeals so held. In Hamilton Mfg. Co. v. United States, 7 Cir., 1954, 214 F.2d 644, 647, the court said:

    "* * * We think it can be said reasonably only that
  by net profits is meant the net profits upon the
  business from its organization, and * * are not to be
  confined to one period and made synonymous with
  annual profits. * * *
    "* * * In the preceding years there were no net
  profits but only accumulated losses, to the reduction
  of which current earnings must necessarily be applied
  until the deficit is wiped out and net profits have
  actually come into existence."

The court quoted with approval the following language from Lich v. United States Rubber Co., D.C.D.N.J. 1941, 39 F. Supp. 675, affirmed per curiam, 3 Cir., 1941, 123 F.2d 145:

    "`* * * The term connotes the clear pecuniary gain
  remaining after deducting from the gross earnings of
  the business the expenses incurred in its conduct,
  the losses sustained in its prosecution, and the
  capital invested. [Citing cases.] It is a
  prerequisite to the existence of net profits that the
  assets of a corporation exceed the liabilities,
  including the liability on the capital stock. Where
  the capital is impaired, annual net earnings, if
  insufficient to offset the impairment, do not
  constitute net profits. [Citing cases.] The term net
  profits is not synonymous with the term annual net
  earnings. Annual net earnings may be productive of
  net profits, or, as in the instant case, reductive of
  the deficit.'"

The above definition of "net profits" is peculiarly appropriate in this case. The obvious reason for the provision in the contract of sale of the stock for a payment to the sellers of half the net profits for the next five years in addition to the net worth of the enterprise at the date of the sale as determined by an audit of its books was the recognition by both sellers and the buyer that the net worth as determined from the books did not reflect the full value of the business. In numerous respects the balance sheet of any business, compiled in accordance with current accounting practices, fails to reflect its current value as a going concern. Even when the books of the business, as here, are kept on an accrual basis, the carrying of inventory at cost, regardless of how much higher the market may be, often results in profits fairly attributable to an earlier period appearing only in later transactions. Moreover, the balance sheet usually excludes from book value the conjectural, but nevertheless real, value in the intangibles of a going concern such as the value to be attributed to the existence of an unusual organization of men talented businesswise or engineeringwise, or the manufacture of a particularly timely line of goods. Two businesses having identical book value may have the greatest divergence in revenue production because of the intangibles which accounting normally does not reflect in a balance sheet of net worth. The provision in a contract for a sale of an enterprise at net book value for a division of net profits for a subsequent five year period is a reasonable method of reflecting these intangibles in the sales price.

Because of the foregoing purpose of the provision for the division of net profits it could not be properly held that the plaintiffs may recover the net earnings for 1948 and 1949, where these admittedly were insufficient to offset the losses incurred subsequent to the plaintiffs' receipt of the net profits for 1944, 1945 and 1946. No reason exists for treating each of the six periods for calculating the profits and making periodic payments as separate units so that the losses of one period may be ignored in determining the profits for the subsequent periods. On the contrary, the intent of this contract, to assess fairly the value of the stock sold by plaintiffs and bought by defendant, requires that losses during the five year period be offset against gains without regard to any attempt to fix the annual period within the five year period during which any loss or gain was incurred. It should be sufficient that all parties agree that the losses occurred during the five year period. Whether plaintiffs are correct in their claim that the losses were incurred in 1947 or the defendant is correct in its claim that the losses were so spread over the three years as to offset in each period the earnings thereof, is not determinative. To hold that plaintiffs were entitled to recover the net annual earnings for 1948 and 1949, assuming they are correct that the losses were incurred in 1947, would be giving them as part of the purchase price a sum over and above the amount fairly agreed upon. In such an event, they would be receiving more than half of the profits for the five year period. At the same time the defendant would have for its part of the bargain obtained a business which did not produce revenues at the rate at which the defendant would be required to pay.

Although the foregoing construction of the contract renders it immaterial whether the defendant properly entered the liabilities reflecting the losses on its books in part in 1947, in part in 1948, and in part in 1949, instead of all in 1947, even on plaintiffs' construction of the contract the plaintiffs offer no plausible basis for recovery.

The plaintiffs argue first that under the contract the defendant was a fiduciary and as such has the burden of justifying its accounts. It is true that contracts whereby someone who has full control and possession of books of account of a business undertakes to share profits with one having no access or knowledge of the books, have sometimes been held to create a fiduciary relationship, e.g., Gauthier v. Dickerson, 1952, 41 Wn.2d 419, 249 P.2d 370, 371; Western Union Tel. ...


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