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., 74 AD3d 815, 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.
Update May 2, 2011: As it turned out, the impact of the stock allocation on the proceeding was not very significant, but the valuation itself turned out to be a real humdinger. Read here my post highlighting the valuation hearing referee’s massive report and the court’s decision confirming it, involving complex issues of real estate appraisal and discounts for lack of marketability and taxes on built-in capital gains.