Opinion
NO. 01-16-00029-CV
02-14-2017
GERARDUS J. SMITH, Appellant v. J. DARRELL BREWER, Appellee
On Appeal from the 215th District Court Harris County, Texas
Trial Court Case No. 2014-68579
MEMORANDUM OPINION
After Gerardus J. Smith sold his interest in several companies to J. Darrell Brewer, Smith sued Brewer alleging that Brewer was required to indemnify him for "tax losses" he incurred because of the sale. Smith and Brewer filed cross-motions for summary judgment, each alleging that their interpretation of the indemnity provision was unambiguous and required judgment in their favor. The trial court granted Brewer's motion and denied Smith's motion. Smith brings this appeal, contending that the trial court erred in concluding that the indemnity provision did not cover his alleged losses. We affirm.
BACKGROUND
In 2011, Smith and Brewer formed two oilfield service companies—Pro Oilfield Services, LLC and Pro Oilfield Services Holding, LLC [collectively, "Pro Oilfield"], which they jointly owned with others. Smith and Brewer then formed two additional oilfield service companies—Max Oilfield Services, LLC ["Max"] and COT Oilfield Services, LLC ["COT"]. Collectively, we refer to all four companies as "the LLCs". All of the companies are taxed as partnerships, so partnership tax law applies to any analysis of the parties' interests therein. See 26 C.F.R. § 301.7701-3(b)(1) (West 2017) (for federal tax purposes, an LLC with more than one member treated as partnership unless it elects to be taxed otherwise).
Smith acted as the Chief Financial Officer of the LLCs, and, in 2012, he was appointed President of them. Smith did not contribute any capital to the companies when acquiring his equity interests, but he did make loans to the companies and personally guaranteed substantial amounts of their debt. Smith made a $1.25 million loan to one of the companies, and personally guaranteed $19,377,874 in recourse debt and $4,007,565 in nonrecourse debt on loans to the LLCs by Community Trust Bank and Coastal Commerce Bank. Thus, at the time relevant to this dispute, Smith had guaranteed $23,385.439 of the LLCs' debt. Brewer also guaranteed his share of the LLCs' debt.
Smith's calculations in other places uses the number $23,366,128, and Smith in his briefing acknowledges that he "is not certain what accounts for the discrepancy." For purposes of this opinion, we will use the figure above because it is also the figure used by Brewer in his briefing and analysis.
From 2011 through 2013, the LLCs suffered substantial losses. These losses had two effects. First, because Smith made no capital contributions to the LLCs, the LLCs' losses gave Smith's capital account in them a negative balance of $13,748,802. Second, he deducted his share of these losses on his tax returns. In 2012, Smith deducted $10,624,497 in losses, and, as a result, paid zero in personal income taxes. In 2013, Smith deducted $3,589,191 in losses, and, as a result, paid $169.
"[A] capital [account] deficit may be created by the charging of losses against a partner's capital account as well as by the withdrawal of funds by a partner." Park Cities Corp. v. Byrd, 534 S.W.2d 668, 673 (Tex. 1796); see also Partnerships—Taxable Income; Allocation of Distributive Share; Capital Accounts, "General Maintenance Rules," TAX MANAGEMENT PORTFOLIOS, BUREAU OF NATIONAL AFFAIRS, 712-3rd, at A-43 (explaining that capital accounts can have a negative value when losses and distributions exceed contributions and income).
In 2013, Smith decided that he wanted to leave the company, and he and Brewer began negotiating a buyout of Smith's equity interests. In October 2013, Smith and Brewer signed a document entitled "Equity Sale Agreement" ["ESA"], through which Brewer acquired all of Smith's interests in the LLCs. In exchange, Smith received (1) $4.5 million in cash; and (2) a complete repayment of Smith's $1.5 million dollar loan to Pro Services, plus interest.
The ESA contained the following indemnity provision that relates to the outstanding debt:
9. Indemnity. Brewer ("Indemnitor") shall indemnify and hold harmless Smith ("Indemnitee") from all losses , including but not limited to suits, actions, causes of actions, claims, investigations, losses, damages, fines, penalties, tax liability arising out of the forgiveness or cancellation of Debt , third-party claims, or liability of any character , type or description, including, but not limited to, attorneys' fees and costs, arising out of or relating to Debt , third-party claims, or any other liabilities of the Companies regardless of type and WHETHER ATTRIBUTABLE, IN WHOLE OR IN PART, TO ANY ACT, OMISSION OR NEGLIGENCE OF INDEMNITEE OR INDEMNITOR; any failure by Indemnitee or Indemnitor to comply with federal, state, or local law, statute, ordinance, regulation, rule, or administrative decision; or any failure by Indemnitor to otherwise perform its obligations pursuant to this Agreement. Notwithstanding anything to the contrary in this Agreement, the indemnification and requirement to hold Indemnitee harmless shall not extend to any acts or omissions of fraud, willful misconduct, or gross negligence committed by Indemnitee, or tax consequences arising as a result of Indemnitee's receipt of the Purchase Amount under this Agreement. Indemnitor shall be required to reimburse Indemnitee all reasonable and necessary legal fees and costs to be incurred by Indemnitee arising from any claim asserted against Indemnitee that is the subject of this Indemnity. (emphasis added).
The ESA defines "Debt" as follows:
"Debt" refers to debt from Community Trust Bank personally guaranteed by Smith and incurred on behalf of Pro Oilfield Services, LLC, Pro Oilfield Services Holding, LLC, and Maxx Oilfield Services, LLC (along with COT Oilfield Services, LLC, collectively
referred to as the "Companies") and debt from Coastal Commerce Bank personally guaranteed by Smith and incurred on behalf of COT Oilfield Services, LLC. Smith is not personally liable for any other obligations of the Companies." (emphasis added).There is no evidence that the Debt has gone unpaid by the LLC's. or that demand has been made upon Smith for payment.
As a result of the sale, Smith reported a taxable gain of $19,616,491. Smith arrived at this figure employing the following formula: Proceeds (cash + debt for which seller will be indemnified) - Basis = Taxable Gain. According to Smith's brief, he arrived at this number in the following manner:
Proceeds: $29,256,841 (4,500,000 in cash, 1,390,713 in repaid loan, and 23,366,126 in indemnified debt)
Minus
Basis: $9,639,515 ($23,385,439 in liabilities guaranteed by Smith minus $13,748,802 in Smith's portion of company losses)
The parties agree that Smith correctly reported this amount on his 2013 tax return. After applying net operating losses and capital loss carry-forwards to offset this taxable gain, Smith paid $169 in income taxes for 2013.Equals: $19,639,515 in Taxable Gain
Brewer alleges that the repayment of Smith's $1.25 million dollar loan and interest to Pro Services should not have been included as part of Smith's taxable gain, but nonetheless conducts his analysis with that amount included because Smith did so on his 2013 tax return.
Thereafter, Smith sued Brewer, alleging that he had "suffered liabilities, losses, costs, and damages arising out of and relating to the Debt and certain other liabilities of the [LLCs]" and seeking breach-of-contract damages for Brewer's failure to indemnify him for said losses. Smith then filed a partial motion for summary judgment on liability, asserting that Brewer breached the indemnity provision of the contract. Specifically, Smith alleged that the indemnity provision required Brewer to reimburse Smith for "the loss of valuable tax assets like [net-operating losses] and carry-forwards to offset a taxable gain and thereby eliminate the tax liability flowing from that gain." Essentially, Smith seeks the value of the net-operating losses and carry-forwards that Smith used to offset his taxable gain on the sale. Brewer filed a cross-motion for summary judgment, alleging that, as a matter of law, he did not breach the indemnity provision.
The trial court granted Brewer's motion for summary judgment, denied Smith's partial motion for summary judgment, and dismissed Smith's claims with prejudice. This appeal followed.
PROPRIETY OF SUMMARY JUDGMENT
In several related issues on appeal, Smith contends "[t]he Trial Court erred in ruling on summary judgment that Mr. Smith's losses are not covered by the broad and unambiguous indemnity language in Paragraph 9 of the [equity sale agreement]." Specifically, Smith argues that the indemnity paragraph of the ESA requires Brewer to indemnify him for the value of net operating losses and carry-forwards that he can no longer use to offset taxable gain on future tax returns. Essentially, Smith contends that, when he used the net-operating losses and carry-forwards to negate his tax liability on the sale, he suffered a "loss" covered by the indemnity provision of the ESA. Thus, even though Brewer assumed liability, by way of the indemnity clause, for Debt previously guaranteed by Smith, Smith contends that he retains the right to use any net operating losses associated with that Debt in the future.
Standard of Review and Applicable Law
We review de novo the trial court's ruling on a motion for summary judgment. Mann Frankfort Stein & Lipp Advisors, Inc. v. Fielding, 289 S.W.3d 844, 848 (Tex. 2009). In a traditional motion for summary judgment, the movant must establish that no genuine issue of material fact exists and the movant is thus entitled to judgment as a matter of law. TEX. R. CIV. P. 166a(c). When reviewing a summary judgment, we take as true all evidence favorable to the non-movant and resolve any doubts in the non-movant's favor. Valence Operating Co. v. Dorsett, 164 S.W.3d 656, 661 (Tex. 2005); Provident Life & Accid. Ins. Co. v. Knott, 128 S.W.3d 211, 215 (Tex. 2003).
Traditional summary judgment is proper only if the movant establishes that no genuine issue of material fact exists, and that the movant is entitled to judgment as a matter of law. TEX. R. CIV. P. 166a(c). The motion must state the specific grounds relied upon for summary judgment. Id. A genuine issue of material fact exists if the non-movant produces more than a scintilla of probative evidence regarding the challenged element. See Ford Motor Co. v. Ridgway, 135 S.W.3d 598, 600 (Tex. 2004); see also Forbes Inc. v. Granada Bioscis., Inc., 124 S.W.3d 167, 172 (Tex. 2003) ("More than a scintilla of evidence exists if it would allow reasonable and fair-minded people to differ in their conclusions."). A defendant moving for traditional summary judgment must either (1) disprove at least one element of the plaintiff's cause of action or (2) plead and conclusively establish each essential element of an affirmative defense to rebut the plaintiff's cause. Khan v. GBAK Props., Inc., 371 S.W.3d 347, 352 (Tex. App.—Houston [1st Dist.] 2012, no pet.) (citing Am. Tobacco Co. v. Grinnell, 951 S.W.2d 420, 425 (Tex. 1997)).
If the trial court's order does not specify the grounds for its summary judgment ruling, we affirm the summary judgment if any of the theories presented to the trial court and preserved for appellate review are meritorious. Provident Life & Acc. Ins. Co. v. Knott, 128 S.W.3d 211, 216 (Tex. 2003).
When both parties move for summary judgment and the trial court grants one motion and denies the other, the reviewing court should review both parties' summary judgment evidence and determine all questions presented. Mann Frankfort Stein & Lipp Advisors, Inc. v. Fielding, 289 S.W.3d 844, 848 (Tex. 2009). The reviewing court should render the judgment that the trial court should have rendered. See Myrad Props., Inc. v. LaSalle Bank Nat'l Ass'n, 300 S.W.3d 746, 753 (Tex. 2009); Mann Frankfort, 289 S.W.3d at 848.
The summary-judgment motions require us to interpret the indemnity provision of the ESA. When reviewing a contract, our goal is to determine the parties' true intentions as expressed in the instrument. See Coker v. Coker, 650 S.W.2d 391, 393 (Tex. 1983). We do not read any provision in isolation, but consider each provision with reference to the whole. See id. If the contract's language can be given a definite legal meaning or interpretation, it is not ambiguous and we will construe the contract as a matter of law. See El Paso Field Servs., L.P. v. MasTec N. Am., Inc., 389 S.W.3d 802, 806 (Tex. 2012) (citing Italian Cowboy Partners, Ltd. v. Prudential Ins. Co. of Am., 341 S.W.3d 323, 333 (Tex. 2011)). A contract is ambiguous if, after applying the principles of contract construction, it is subject to more than one reasonable interpretation. See Plains Expl. & Prod. Co. v. Torch Energy Advisors Inc., 473 S.W.3d 296, 305 (Tex. 2015). An ambiguous contract will not support summary judgment because it creates a question of fact about the parties' intent. See id. Here, neither party argues that the contract at issue is ambiguous; instead each argues its interpretation is the correct one.
With regard to indemnity contracts, courts may not expand the parties' rights or responsibilities beyond the limits defined in the indemnity contract. DBHL, Inc. v. Moen Inc., 312 S.W.3d 631, 635 (Tex. App.—Houston [1st Dist.] 2009, pet. denied); Hong Kong Dev., Inc. v. Nguyen, 229 S.W.3d 415, 458 (Tex. App.—Houston [1st Dist.] 2007, no pet.).
Analysis
Smith argues that the indemnity provision covers all "losses" arising out of or relating to the "Debt," and that "[w]ithout the discharge of the Debt and the non-Recourse Liabilities, [he] would not have incurred a taxable gain at all (he instead would have sustained additional losses that could be carried forward), and [he] would not have used and thus "lost" the [net-operating losses] and carry-forwards to offset the taxable gain." Smith ignores the corresponding negative capital account value carried by the LLC's that was eradicated by the sale and formed part of the calculation of the cost basis in computing any gain.
Brewer responds that the value of the net-operating losses and carry-forwards that Smith used to offset his taxable gain are not "losses" or "tax liability arising out of the forgiveness or cancellation of Debt" within the meaning of the indemnity clause. Brewer agrees that, while Smith was entitled to, and, in fact, chose to use those net-operating losses and carry-forwards to offset his taxable gain on the sale, Brewer "certainly did not agree to reimburse Smith for the value of [net-operating losses] Smith may have been able to deduct in the future had he not used them to offset his gain on this sale."
While we agree with Smith that net-operating losses and carry-forwards are "valuable tax assets," Smith did not "lose" the value of those assets, he "used" them. There is nothing in the language of the indemnity clause to suggest that Brewer agreed to pay the taxes on the gain that Smith realized on the sale by categorizing Smith's use of net-operating losses and carry-forwards to offset such gain as an indemnifiable "loss." Smith's interpretation of the indemnity provision stretches beyond reasonable interpretation; courts will not enforce an unreasonable construction of an indemnity provision. See Vill. Place, Ltd. v. VP Shopping, LLC, 404 S.W.3d 115, 129 (Tex. App.—Houston [1st Dist.] 2013, no pet.) (stating that appellate courts "avoid constructions that would lead to absurd results.").
Additionally, whether net-operating losses and carry-forwards have value in the future depends on whether any gain exists against to which apply them. If Smith had no future gains, then net-operating losses and carry-forwards have no value and, again, Smith has suffered no loss to be covered by the indemnification clause.
Brewer also argues, and again we agree, that this case presents no "tax liability arising out of the forgiveness or cancellation of debt," which would be explicitly covered by the indemnity clause. The record conclusively establishes that there has been no forgiveness or cancellation of the Debt because the Debt was never forgiven by the creditors. See U.S. Cent. Sav. Bank FSB, 499 U.S. 573, 581 n.6, 111 S. Ct. 1512 (1991) (stating that "discharge" occurs "only if the creditor cancels or forgives a repayment obligation"). Smith's tax returns do not report any cancellation or forgiveness of debt. Thus, the trial court properly concluded that there was no "forgiveness or cancellation of debt" to trigger the indemnity provision.
Smith's purported "loss" of the tax loss carry-forwards do not arise out of the gain recognized in the assumption of his Debt, but are attributable to his negative capital account at the time of the sale. Without the debt, the taxable gain to Smith remains the same. For example:
The parties refer to this as a "without" calculation, so we will do the same here.
Proceeds: $ 5,890,713 ($4,500,000 in cash and $1,390,713 in repaid loan)
Minus
Basis: Smith's negative $13,748,802 capital account
Equals: $19,639,515 in Taxable Gain
Smith's gain on the sale is the same regardless of whether the Debt is included in the calculations, thus the existence of the Debt did not create a liability or loss triggering the indemnity clause. The negative balance of Smith's capital account is the cause of his large taxable gain.
Smith and his expert try to avoid this inevitable conclusion by performing a "without" calculation that removes reference to the Debt from the sale proceeds, but leaves it in Smith's basis for calculating the gain on the sale of his interests. Smith's "without" calculation compares Smith's proceeds with the indemnity promise against the proceeds without the indemnity promise, while leaving the entire amount of the Debt in Smith's basis. However, under the indemnity clause in this case, the issue is not whether Smith has a loss "arising out of or relating to" the indemnity promise; the issue is whether Smith has a loss "arising out of or relating to" the Debt. In other words, the indemnity provision requires a loss relating to the Debt, not merely the indemnity promise. Thus, a proper "without" calculation will necessarily remove all references—both in the taxable gain and the basis—to the Debt to determine whether the existence of the Debt is a factor in Smith's taxable gain. Because Smith's taxable gain is the same under the "with" calculation and the "without" calculation, the "Debt" was not a factor in Smith's taxable gain.
Because Smith's use of net-operating losses and carry-forwards to offset taxable gain are not, as a matter of law, "losses" or "tax liability arising out of the forgiveness or cancellation of debt," as this indemnity agreement defines them, and the "loss" Smith complains of is not "arising out of or relating to" the Debt, the trial court properly granted Brewer's motion for summary judgment and denied Smith's partial motion for summary judgment and motion for reconsideration.
Accordingly, we overrule Smith's issues on appeal.
CONCLUSION
We affirm the trial court's judgment.
Sherry Radack
Chief Justice Panel consists of Chief Justice Radack and Justices Jennings and Bland.