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 ). 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.”