The Tennessee Supreme Court recently addressed the interplay between the freedom of private parties in Tennessee to enter into contracts with each other and the role of public policy in determining the enforceability of such contracts.
In the case of Baugh v. Novak, in which the Supreme Court’s opinion was filed on May 20, what was at issue was a contract for the sale of an interest in a corporation and related indemnity agreements between the sellers and the purchasers.
The facts, although not overly complex, would take a while to recite fully, as the Court devotes about 4 pages to the factual background of the case.
In essence, the Baughs had originally purchased the corporation from the Millers, but had not paid the purchase price in full, instead financing the purchase with the Millers. As part of that transaction, the Millers required that the Baughs get their permission in order to transfer an interest in the company being sold and purchased.
Some time later, the Baughs entered into an agreement with the Novaks to sell a 50% interest in the company. The agreement between the Baughs and the Novaks was structured with the intent that the granting of permission of the Millers was not required. In connection with the sale of the corporate interest by the Baughs to the Novaks, the parties entered into indemnity agreements with each other that essentially provided that each party would be responsible for half of the debt payments to the Millers and on the company’s other debts.
After a number of years, the Mr. Baugh began paying the note to the Millers and a certain bank loan out of his own pocket. The bank loan was paid off, and the bank assigned its interest in the note to Mr. Baugh.
The Baughs sued the Novaks seeking enforcement of the indemnity agreement.
After a bench trial, the Chancery Court of Williamson County found in favor of the Baughs and awarded them a judgment of $201,715.50. The Court of Appeals reversed, finding on its motion that the indemnity agreement was unenforceable on public policy grounds because it undermined the purpose of T.C.A. Section 48-16-208, which authorizes restrictions on the transferability of shares of corporate stock and permits those restrictions to be enforced against the holder and transferee of the stock.
The Tennessee Supreme Court first noted that courts clearly have the authority to invalidate contracts on public policy grounds, although such authority requires courts to exercise “great delicacy.” The rationale for such judicial restraint is because of what the Court sees as tension between a court’s authority to invalidate contracts on public policy grounds on one hand and freedom of contract on the other hand.
The Court describes a three-part test, all of which prongs of the test must be satisfied in order for a court to invalidate a contract on public policy grounds: (1) the violation of public policy is clearly established; (2) the violation is inherent in the contract itself or the contract’s purpose taints it with illegality; and (3) a clear public detriment will probably occur as a result of the contract or the object of the contract tends to injure the public. In addition to the three-part test, the Court also notes that courts must be even more hesitant to invalidate a contract on public policy grounds when the party seeking such result has received the benefit of the other party’s performance.
Significant quotations from the Court show how difficult a burden it should be for a party seeking to have a contract voided on public policy grounds–courts should “wield a scalpel rather than a sledgehammer,” and courts “must, if possible, interpret contracts in a way that upholds their validity.” In addition, the Court stated that if provisions of a contract are legally severable, that should be done to uphold those provisions that can be upheld.
In holding that the indemnity agreement at issue was not void on public policy grounds, the Tennessee Supreme Court made several conclusions: (1) neither the public, the Millers, nor the Novaks were or will be harmed by any violation of T.C.A. Section 48-16-208; (2) it is not clear that the stock transfer agreement between the parties violated T.C.A. Section 48-16-208; (3) it is not clear that the Tennessee legislature intended to invalidate contracts such as the stock transfer agreement or the related agreements in question; and (4) the broad remedy of invalidating the indemnity agreement is not necessary since it would be easy to sever that agreement from the stock transfer agreement.
One can probably take a number of lessons from Baugh v. Novak. However, the main point may be that voiding a contract on the ground that it violates public policy is likely to be an uphill battle. In the end, that is a good thing, as this case reminds us of the importance of freedom of contract, and the deference that courts take to the bargains that private parties make with each other.