A decision earlier this month by an upstate appellate court in a corporate dissolution proceeding called Matter of Stevens (Allied Builders, Inc.), 2010 NY Slip Op 05066 (4th Dept June 11, 2010), adds uncertainty to the already fuzzy array of precedents surrounding the question whether the filing of a dissolution petition triggers a mandatory buyback of the petitioner’s shares under the provisions of a right of first refusal (“RFR”) in the shareholders’ agreement.
I’ll first set the stage with some basics, then I’ll dig into Stevens.
What’s an RFR?
RFRs are most familiar in the real estate setting, e.g., a tenant’s right to match a third-party purchase offer during the lease term. Less well known is the use of RFRs in the close corporation setting as a stock transfer restriction found in shareholders’ agreements. This type of RFR requires each shareholder to sell his or her shares to the corporation and other shareholders before they can be sold to an outside buyer. The shareholder RFR primarily serves as a further deterrent to any sale of non-controlling interests which, for the vast majority of closely held corporations, are non-marketable unless very steeply discounted.
There are infinite variations on how to draft RFR trigger events and pricing mechanisms. A narrow version, analogous to the tenant’s right to match a third-party purchase offer, is triggered only by a bona fide third-party offer for the shares, which then must be offered back to the corporation or the other shareholders at the same price and on the same terms. The third-party sale can proceed only if the corporation or the other shareholders turn down the purchase opportunity.
Very frequently, however, a much broader RFR is used, with attributes more akin to a right of first offer, which mandates a stock buyback triggered by any event constituting a voluntary or involuntary transfer of shares. The broad-form RFR more often than not will fix share price at book value or use some other formula or pre-determined price unfavorable to the selling shareholder.
What’s the Issue?
When relations among fellow shareholders in close corporations deteriorate beyond repair, a petition for judicial dissolution may be the only effective remedy. The issue is whether the mere filing of a petition for judicial dissolution triggers the RFR.
Courts unquestionably will enforce an RFR triggered by the filing of a dissolution petition where the RFR expressly provides that the filing is deemed an offer to sell. The interpretive problem arises, as it did in the Stevens case, when the RFR contains no express reference to a dissolution petition, but only uses general references to “involuntary transfer” or to a shareholder who seeks to “otherwise dispose” of his or her shares.
What’s at Stake?
The consequences of triggering the RFR can be huge and, I daresay, with potential malpractice ramifications for the lawyer who files for dissolution without appreciating or advising his or her client of the risks.
If the RFR does not apply, an oppressed minority shareholder seeking dissolution under Business Corporation Law (“BCL”) § 1104-a can anticipate the remaining shareholders electing to purchase the shares for “fair value” under BCL § 1118. If the parties cannot agree on fair value the issue is determined by the court, which will not apply a minority discount. If the RFR does apply, the minority shareholder may decide to forgo dissolution rather than accept a fixed or formula buyout price that is substantially below fair value and may entail a long-term, unsecured payout.
The stakes can be equally high for 50/50 shareholders when one of them seeks dissolution based on deadlock under BCL § 1104 which, unlike its § 1104-a cousin, does not give the other shareholder the right to purchase the petitioner’s shares. If the RFR is not triggered, any eventual buyout must be negotiated. If it is triggered, the petitioner loses all negotiating leverage and must accept the RFR price and terms.
Prior Case Law
Prior to Stevens, the arc of appellate precedent is traced by three cases:
- The Brooklyn-based Second Department’s 1986 Doniger decision. In Doniger the court held that the dissolution petition triggered an RFR that included “any proposed passage or disposition of shares whatsoever” including “under judicial order [or] legal process.” Over the next 20 years, a handful of lower court decisions interpreted Doniger narrowly as requiring an express reference to share disposition by judicial process.
- The Manhattan-based First Department’s 2006 Johnsen decision. Johnsen enforced a buyout triggered by a judicial dissolution petition where the RFR applied to any shareholder seeking to “transfer or otherwise dispose of his stock in any manner whatsoever.” The court ignored the additional Doniger element of judicial process. (Read here an article I wrote with a colleague for the New York Law Journal analyzing the Johnsen decision.)
- The Rochester-based Fourth Department’s 2008 El-Roh decision. El-Roh enforced a buyout triggered by a dissolution petition where the RFR referred to any transfer of shares “including, without limitation, transfers that are voluntary, involuntary, by operation of law or with or without valuable consideration.” As in Johnsen, the court put no weight on the absence of express reference to judicial process. Also notable is the El-Roh RFR’s omission of the “any disposition whatsoever” language found in Doniger and Johnsen. (Read here my prior posting on the El-Roh decision.)
Whether you agree or disagree with these decisions, their unmistakable thrust is a liberal interpretation of general language in RFR provisions in favor of compelling buyout triggered by the filing of a dissolution petition. Now along comes Stevens with an opposite outcome.
What Happened in Stevens?
Stevens involved a corporate dissolution petition brought in 2008 by a 24.5% shareholder alleging minority shareholder oppression under BCL § 1104-a. The petitioner acquired his shares under a 10-year Option Agreement dated June 25, 1996 (click here to view) at the specified price of $240 per share. Section 7(a) of the Option Agreement contained the following stock transfer restriction:
. . . Purchaser shall not sell, transfer, assign, give, bequeath, hypothecate, pledge, create a security interest in, or lien on, encumber, place in trust (voting or other) or otherwise dispose of all or any portion of the shares of capital stock of the Corporation, or any interest therein, now owned or hereafter acquired, held or controlled by Purchaser, whether voluntarily or through any bankruptcy or other insolvency proceedings, adjudication of insanity, death or otherwise, and intending to apply to intershareholder, causa mortis, and transfers of any and every nature, kind and description [defined as “Transfer of Stock”] unless and until each of the terms and conditions of this Agreement shall have been met. [Emphases added.]
Section 7(c) prohibited Stevens from any Transfer of Stock without first giving the other shareholders 30-days written notice offering to sell the shares to them. Section 7(e) set the price at $240 per share subject to any future change in purchase price (which apparently never happened in the intervening 12 years before the dissolution proceeding).
After Stevens filed for dissolution, the other shareholders sought to dismiss the proceeding and to enforce their alleged Section 7 right to purchase Stevens’s shares for $240 per share on the ground that the filing of the petition was a Transfer of Stock as defined in Section 7(a). They also argued that Stevens was required to sell his shares at the same price under Section 8 of the Option Agreement giving them the option to purchase his shares upon the termination of his employment at any time within 10 years from the date of the Option Agreement. Although Stevens’s termination occurred more than 10 years after the Option Agreement, the other shareholders contended the term was extended by later amendments.
Significantly, unlike Section 7, Section 8(c) expressly provided that the filing of a dissolution petition under BCL § 1104-a:
shall be deemed to be an offer pursuant to this paragraph 8 to sell all shares of the Corporation then owned by the petitioner or subject to any option created hereunder.
In an unreported Decision and Order dated March 9, 2009 (read here), Monroe County Commercial Division Justice Kenneth R. Fisher ruled against the respondent shareholders on their Section 8 argument, finding that the 10-year term was never extended, but agreed with their argument under Section 7. Here’s the key passage, which includes a citation to my above-mentioned New York Law Journal article:
[R]espondents contend, and this court agrees, that the unambiguous language of §7 is invoked by the institution of a dissolution proceeding. Matter of El-Roh Realty Corp., 48 AD3d 1190, 1191-92 (4th Dept 2008); Hesek v. 245 Fourth Main St., Inc., 170 AD2d 956 (4th Dept 1991); Matter of Doniger v. Rye Psychiatric Hosp. Center, Inc., 122 AD2d 873, 876-77 (2d Dept 1986). The failure of §7 to explicitly enumerate as one of its triggering mechanisms the institution of a dissolution proceeding does not deprive §7 of its unambiguous effect on the petition in this case. This much is made clear in In re Johnsen v. ACP Distr., Inc., 31 AD3d 172, 177-78 (1st Dept 2006), and Peter A. Mahler & Michael A.H. Schoenberg, Outside Counsel: Dissolution Petition Can Unwittingly Trigger Stock Buyback, N.Y.L.J., vol. 236, July 21, 2006 at p. 4, col. 4 (under Johnsen, unambiguous language sweeps in commencement of a dissolution proceeding despite lack of specific reference to it in the RFR buyback provisions). Accordingly, application of §7, which does not have a 10 year term, is established on this record.
The petitioner appealed to the Appellate Division, Fourth Department, whose Memorandum and Order dated June 11, 2010, reversed the lower court’s order and reinstated the dissolution petition. The appellate court gave two reasons. First, it held that to construe Section 7 as applicable to the filing of a dissolution petition would render the explicit reference to dissolution in Section 8 “meaningless.” Second, it held that the language of Section 7, as a matter of law, did not encompass a dissolution proceeding. Here’s what the court said:
[S]ection 7 is not so broad as to include dissolution proceedings (see Matter of Pace Photographers [Rosen], 71 NY2d 737, 747-748). Respondents’ reliance on Matter of El-Roh Realty Corp. (48 AD3d 1190) is misplaced. In that case, the shareholders’ agreement “prohibited the transfer of any shares, including, without limitation, transfers that are voluntary, involuntary, by operation of law or with or without valuable consideration’ ” (id. at 1191). A dissolution proceeding pursuant to Business Corporation Law § 1104-a, however, is an involuntary transfer (see § 1104-a [b]), and section 7 (a) of the Option Agreement does not prohibit involuntary transfers except as explicitly listed, e.g., through bankruptcy.
Are the reasons given persuasive? You can decide for yourself, but let me offer some food for thought:
- Is it clear that Section 8, with its express reference to a dissolution petition, would be rendered meaningless if Section 7(a) is construed as including a dissolution petition? Isn’t it really just a question of divining the parties’ intent behind the more general language used in Section 7(a)? In other words, does the court’s point beg the question as to the scope of 7(a)?
- In distinguishing the RFR in El-Roh, the court appears to overlook the words, “or otherwise dispose of” in Section 7(a) of the Stevens RFR. It was those precise words that convinced the First Department in Johnsen to enforce the RFR.
- Section 7(a) does not expressly refer to the “involuntary” transfer or disposition of shares, but it does use the words, “or otherwise,” after listing several involuntary dispositions, to wit, “bankruptcy, . . . adjudication of insanity, [and] death . . .” Would the court have reached the same conclusion if the clause had referred generally to any “involuntary” disposition (as did the clause in El-Roh) and, if so, does the distinction withstand scrutiny?
As explained in the lower court’s decision, very early in the case the parties entered into a stipulation whereby, should the court determine that the RFR does not apply, the corporation shall be deemed to have elected to purchase the petitioner’s shares pursuant to BCL § 1118 for fair value. The stipulation further provided that fair value shall be determined either by the price fixed in Section 7(e) of the Option Agreement, if the court determines that it controls, or if not, by the court pursuant to a valuation hearing. I will be sure to report on any further case developments concerning the valuation question.
Not the Final Word
Trying to make sense of Stevens and its forebears has the feel of a talmudic exercise, in which a slight rearrangement of the words or punctuation can lead to diametrically opposed conclusions. The courts are not to blame. They didn’t write these RFR provisions. But it does add to the disquieting sense that these provisions are a trap for the unwary.
It’s a safe bet that there are many, many thousands of shareholders’ agreements (and, more recently, LLC operating agreements) out there containing RFR provisions not unlike the ones used in Stevens and the other cases mentioned above. The reason is not because they’re well drafted — I would describe them as legal gobbledygook — but because lawyers don’t want to charge, and clients don’t want to pay, for reinventing the wheel every time they prepare an agreement. So lawyers tend to use the same forms they or their colleagues used before. Even those lawyers that follow case law developments may have a hard time convincing all concerned to spend money amending their shareholders’ agreement to avoid what seems like a remote contingency. Thus, the odds are good we’ll be seeing more cases of this sort.