Court Invalidates Control-Shifting Stock Transfer Made in Violation of Corporation's Right of First Refusal
The right of first refusal (RFR) is a type of stock transfer restriction found in shareholder agreements of closely held corporations. Under the most common form of RFR, the shareholder seeking to transfer his or her shares to another person is required to submit sequentially to the corporation and, if the corporation declines, to the other shareholders the opportunity to purchase the shares on the same terms as are being offered by the proposed purchaser. The courts routinely enforce RFRs in recognition of the special partnership-like character of close corporations.
A recent decision by the Appellate Division, First Department, in Giaimo v. EGA Associates Inc., 2009 NY Slip Op 09277 (1st Dept Dec. 15, 2009), illustrates the mischief that can occur when the RFR is not properly spelled out in a shareholders' agreement but, instead, is set forth in abbreviated and incomplete form on the back of the share certificates. Giaimo also illustrates the paramount importance New York courts place on the fiduciary duties owed by majority shareholders and directors of close corporations to minority shareholders, arguably to the point of preempting the statutory scheme governing director's self-interested transactions.
EGA Associates Inc. (EGA) is a closely held New York corporation formed in 1961 to own and operate real estate. According to the complaint filed by Robert Giaimo (read here), the stock of EGA was held one-third each by Robert and his siblings, Edward and Janet. Edward died after a long illness in March 2007. Edward's will bequeathed his EGA shares in equal parts to Robert and Janet, which would have left them as equal 50% shareholders. Two weeks before his death, however, Edward sold one of his shares to Janet for $80,000, thereby giving her majority ownership upon Edward's death. Some months later, Janet gave notice of meetings of the shareholders and directors at which she obtained voting control of the board by electing herself and her lawyer as two of the three directors.
Robert's lawsuit sought declaratory and injunctive relief setting aside the sale of stock by Edward to Janet on the ground it violated the crude RFR printed on the back of the stock certificates issued to each of the three siblings, providing as follows:
Shares are not transferable without granting the corporation thirty (30) days written notice of sale of terms, involved parties and a first option to purchase said shares before transfer to other existing shareholders or to third parties, except in the case of transfers to immediate family (spouse and children only). Such restrictions shall not apply [sic]. Corporate first option preserved for all subsequent transfers.
Janet defended the stock sale by alleging that, before he died, Edward told her that, in his capacity as EGA's president, he had waived EGA's right of first refusal prior to the sale, although apparently the waiver was never separately documented. Janet also contended that Edward believed that Robert would sell his shares in EGA, and that he decided to sell one of his shares to Janet to ensure that EGA remained within the family and to prevent shareholder gridlock.
Robert moved for summary judgment canceling the sale and voiding the actions taken at the subsequent shareholder and director meetings. He argued that Janet's testimony relating Edward's statement concerning the company's waiver of the RFR was barred by the Dead Person's Statute, codified in Section 4519 of the Civil Practice Law and Rules. Robert alternatively argued that the sale was invalid under Section 713(a) of the Business Corporation Law which authorizes interested-director transactions upon appropriate disclosure and approval vis-a-vis disinterested directors and/or shareholders.
The trial court, in a decision by New York County Supreme Court Justice Marcy S. Friedman reported at 2008 NY Slip Op 32944(U) (Sup Ct NY County Oct. 28, 2008), denied Robert's motion. First, she ruled that the Dead Person's Statute did not bar Janet's testimony concerning her discussions with Edward at the pre-trial phase where there is other admissible, corroborating evidence including a bill of sale for the stock and a new stock certificate, both authenticated by Edward's personal assistant. Second, Justice Friedman ruled that Robert had not eliminated triable issues as to whether, as EGA's president, Edward had authority to waive the RFR without board approval. Third, she ruled that even if BCL Section 713 applied, Robert failed to eliminate triable issues as to whether the stock sale to Janet was fair and reasonable to EGA under subsection (b) of the statute, which would allow an interested-director transaction that otherwise fails to comply with the disclosure and approval requirements. As to the last point, the court cited Janet's contention that Edward's alleged desire to prevent shareholder gridlock constituted a "bona fide purpose" for the stock sale. Justice Friedman also cited testimony by EGA's accountant who suggested that the $80,000 paid by Janet over-valued the share of stock, at least compared to its book value.
Robert appealed the trial court's decision to the Appellate Division, First Department, which unanimously reversed the decision and entered summary judgment in Robert's favor voiding the stock sale and the subsequent actions taken at shareholder and directors meetings. The court's short decision expressly rejects Janet's argument based on Edward's alleged waiver of the RFR, holding that "[a]s the president of a closely held corporation, Edward lacked the power to act unilaterally against Robert's interest" and citing several precedents in which courts recognize the fiduciary duties owed by majority shareholders to the minority in closed corporations. The decision also rejects Janet's argument that the transfer restrictions on the stock certificates were invalid in the absence of other "corporate documents evidencing their approval," adding that "the three shareholders accepted these restrictions without objection and relied on them until after this litigation was commenced."
Notably absent from the appellate decision is any mention of Janet's argument, accepted by the trial court, that the company's alleged waiver of the RFR in an interested-director transaction, notwithstanding non-compliance with the disclosure and approval requirements of BCL 713(a), might be sustainable under BCL 713(b) as "fair and reasonable as to the corporation." I can think of at least two possible reasons for the omission. First, the stock sale apparently was never formally submitted to the board or the shareholders for a vote, so it's not clear by its terms that BCL 713(b) applies. Second, the waiver dispute in this case is linked inextricably to the predominant question of shareholder control of a closely held corporation, i.e., it is not primarily a question of what's fair and reasonable to the corporation which generally has no independent, cognizable interest in deciding who holds the reins of management. This second reason opens the door wide to the appellate court's elevation of fiduciary duty owed to minority shareholders as the deciding principle.
As mentioned above, a fully developed RFR provision in a shareholders' agreement likely would have avoided this dispute. Among other things, it would have required that the share be offered to the other shareholders in the event the company opted not to acquire the share. Such a provision would have enabled Robert to maintain his 50% interest.
One final footnote. In July 2007, Robert filed a separate petition to dissolve EGA pursuant to the deadlock dissolution statute BCL 1104, as well as under the oppressed minority shareholder statute BCL 1104-a (read petition here). Janet thereafter elected to purchase the petitioner's shares in lieu of dissolution. It appears that a valuation hearing was conducted in 2009, before the appellate ruling discussed above, but that there's been no valuation decision much less a consummation of the buyout. It will be interesting to see whether and how the appellate court's invalidation of the stock sale to Janet will affect the pending dissolution/buyout proceeding.
Beware Unreasonable Restraints on Alienation When Drafting Shareholder and Operating Agreements
Our English common-law heritage includes what's known as the rule against unreasonable restraints on alienation. Law students first encounter the rule in their property class, where they learn about the abolishment of the feudal "fee tail" which restricted the transfer of real property to a specific line of male heirs. Basically, our laws and public policy strongly favor the right of persons to freely dispose of their property both real and personal. Agreements that place ownership of property in the hands of one person and the right to alienate, i.e., sell or otherwise convey the property, in the hands of another, are unenforceable.
The rule is not absolute. It only prohibits unreasonable restraints on alienation. For instance, where a niece agreed to pay $15,000 to her uncle and aunt for a $100,000 farm that was in the family for generations on condition that, during the uncle's and aunt's lifetimes, the niece wouldn't mortgage the farm or convey it to her husband, a court enforced a reversion clause in the recorded deed giving the property back to her relatives when the niece placed mortgages on the farm that subsequently were foreclosed. The court found it reasonable to enforce the restraint to preserve family ownership of the farm for a limited duration. Moreover, the niece's interest in free alienation was outweighed by her agreement to the restraint in consideration for a drastically reduced price. (Example taken from Alby v. Banc One Financial, 128 P3d 81 [Sup. Ct. Wa. 2006].)
What's this got to do with shareholder and operating agreements?
As mentioned, the rule also applies to personal property. Certificated and uncertificated shares in a corporation are considered personal property as are membership interests in a limited liability company (see LLC Law Section 601). One of the main purposes of shareholder agreements for closed corporations and LLC operating agreements is to restrict the transfer of shares and membership interests. Sometimes the restrictions are designed to keep ownership in the family if it's a family-owned business. More generally, such restrictions emulate a partnership model in which the owners are actively involved in company management and therefore need to maintain control over the admission of new owners.
Restrictions that effectively prohibit share transfer are not enforceable. As New York's highest court stated in Wildenstein & Co. v. Wallis, 79 NY2d 641 (1992), factors in assessing reasonableness of the restriction include price, duration and purpose. For example, in Lam v. Li, 222 AD2d 290 (1st Dept 1995), the court invalidated a provision giving one party a perpetual option to purchase 50% of the corporation's shares for $10. In Rafe v. Hinden, 29 AD2d 481 (2d Dept), aff'd, 23 NY2d 759 (1968), a stockholder successfully invalidated a provision requiring him to get written permission from the other stockholder before selling to a third party where the other shareholder retained the arbitrary power to forbid a transfer.
The seminal New York case cited in support of stock transfer restrictions is Allen v. Biltmore Tissue Corp., 2 NY2d 534 (1957), where the court upheld a bylaw provision that gave the corporation the option to purchase the shares of a deceased shareholder at their original purchase price, which was below market value at the date of death. The court explained (citations omitted):
As the cases thus make clear, what the law condemns is, not a restriction on transfer, a provision merely postponing sale during the option period, but an effective prohibition against transferability itself. Accordingly, if the by-law under consideration were to be construed as rendering the sale of the stock impossible to anyone except to the corporation at whatever price it wished to pay, we would, of course, strike it down as illegal. But that is not the meaning of the provision before us. The corporation had its option only for a 90-day period. If it did not exercise its privilege within that time, the deceased stockholder's legal representative was at liberty to "dispose of said stock as he [saw] fit" (§ 30), and, once so disposed of, it would thereafter be free of the restriction. In a very real sense, therefore, the primary purpose of the by-laws was to enable a particular party, the corporation, to buy the shares, not to prevent the other party, the stockholder, from selling them.
Generally speaking, these restrictions are employed by the so-called "close corporation" as part of the attempt to equate the corporate structure to a partnership by giving the original stockholders a sort of pre-emptive right through which they may, if they choose, veto the admission of a new participant. Obviously, the case where there is an easily ascertainable market value for the shares of a closely held corporate enterprise is the exception, not the rule, and, consequently, various methods or formulae for fixing the option price are employed in practice e.g. book or appraisal value, often exclusive of good will, or a fixed price, or the par value of the stock. In sum, then, validity of the restriction on transfer does not rest on any abstract notion of intrinsic fairness of price. To be invalid, more than mere disparity between option price and current value of the stock must be shown.
The restriction upheld in Allen, triggered by the shareholder's death, is akin to a more general right of first offer found in many shareholder and operating agreements. These provisions require a shareholder or member who seeks to exit during his or her lifetime to offer the shares or membership interest back to the corporation/LLC, or to the other shareholders/members, before selling to a third party. The typical first offer provision requires the offerees to accept or decline the offer within a reasonable period (e.g., 30 to 60 days) and uses any of a variety of pricing mechanisms including fixed price, formula, or various appraisal procedures.
The right of first offer should not be confused with the right of first refusal, also commonly found in shareholder and operating agreements. Under the right of first refusal, a shareholder or member may solicit and accept a bona fide purchase offer from a third party, subject to the corporation's or LLC's (or their owners') pre-emptive right to acquire the interest at the same price. The right of first refusal generally is less susceptible to challenge under the rule against unreasonable restraints on alienation because the pricing necessarily is at market value.
A very recent example of a transfer restriction running afoul of the rule is found in Verderber v. Commander Enterprises Centereach, LLC, Short Form Order, Index No. 007691/09 (Sup Ct Nassau County Oct. 15, 2009), decided by Nassau County Commercial Division Justice Ira Warshawsky. Verderber involves a complicated fact pattern with multiple LLCs and operating agreements, in which the primary issue for pretrial decision was the applicability of an arbitration clause -- the court found that the clause applied but was waived by the parties' litigation conduct. Also at issue was the operating agreement's provision that, in the event any member desires to transfer all or any part of his or her interest, it must be transferred to the LLC at a price based on a specified multiple of the company's net operating income, less the current mortgage balance, payable over five years. The plaintiffs (husband and wife), who wanted to transfer their combined 20% membership interests to another LLC wholly owned by them, sought a declaration that the restriction violated the rule against unreasonable restraints on alienation. The defendants, who held the other 80% interests, asked the court for a preliminary injunction to prevent the transfer pending the litigation.
Justice Warshawsky denied the requested injunction on the ground that the defendants were unlikely to succeed in showing that the transfer restriction could overcome the rule against unreasonable restraints on alienation. Here's the pertinent part of the decision:
A provision in a certificate of incorporation requiring a shareholder to give a "first option" to the corporation or the other shareholders to purchase the stock, at an agreed price or then-existing book value, before offering it to outsiders is ordinarily enforceable (Allen v. Biltmore Tissue Corp., 2 NY2d 534, 541 [1957]). However, the option must be for a limited period. "[O]wnership of property cannot exist in one person and the right of alienation in another" (Id. at 542). "An effective prohibition against transferability itself" is not enforceable (Id.). A limited liability company bears resemblance to a close corporation, at least as to the limited liability feature. Thus, it appears that an operating agreement covering a limited liability company may contain a first option provision, but it may not prohibit a member from selling his interest to a third party. In any event, defendants have not shown a likelihood of success on the merits with respect to the enforceability of the provision restricting transfer of plaintiffs' membership interest.
The decision does not quote the defective provision, so it's not 100% clear what went wrong with it. The decision's language suggests that the transfer restriction contains an outright prohibition on a sale of membership interest to anyone other than the LLC. The court's reference to a time limitation also suggests that the LLC may have been able arbitrarily and indefinitely to delay purchase.
I'm aware of only one other decision, by a Georgia state court in a case called RTS Landfill, Inc. v. Appalachian Waste Systems, LLC, 598 SE2d 798 (Ct App Ga 2004) (written up by L. Andrew Immerman in the March 2005 Pubogram), applying the rule against unreasonable restraints on alienation to invalidate a transfer restriction involving an LLC membership interest. Keep in mind, Section 603 of New York's LLC Law states that an LLC membership interest may be assigned in whole or in part "except as provided in the operating agreement." Does the statute arguably trump the common law rule, such that an operating agreement could prohibit outright the transfer of a membership interest? Given New York case law developments applying other common law rules to LLCs such as derivative action and equitable accounting, and finding void as against public policy a waiver in the operating agreement of the right of judicial dissolution, one might predict a similarly victorious outcome for the pro-alienation common law rule. I'd love to see how Delaware Chancery Court would handle the issue under that state's LLC Act which expressly states, in Section 18-1101(a) and (b), that the "rule that statutes in derogation of the common law are to be strictly construed shall have no application to this chapter," and that "it is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements."
