Shareholder agreements for closed corporations frequently prohibit lifetime stock transfers, except pursuant to a right of first refusal (RFR) that gives the corporation and the remaining shareholders the option to acquire the selling shareholder’s interest at the same price and on the same terms of any bona fide purchase offer by a third party. Such RFRs have limited  practical value for the simple reason that, generally speaking, there are few if any outside buyers for a non-controlling interest in an owner-operated, non-dividend paying close corporation.

A recent post-trial decision by Suffolk County Commercial Division Justice Elizabeth Hazlett Emerson in M.H. Mandelbaum Orthotic & Prosthetic Services, Inc. v. Werner, 2012 NY Slip Op 32080(U) (Sup Ct Suffolk County May 30, 2012), addressed an interesting twist on the usual RFR scenario: Does a provision in the RFR, requiring that any third-party buyer agree to be bound by the shareholders’ agreement, also require the third-party buyer to assume the selling shareholder’s job duties specified elsewhere in the shareholders’ agreement?

The case involves a company located in Port Jefferson, New York, that sells orthotic and prosthetic devices. The company, called M.H. Mandelbaum Orthotic & Prosthetic Services, was founded in 1987 by Martin Mandelbaum as 100% owner. In 1991, Mandelbaum hired Marc Werner. Three years later, Mandelbaum sold Werner a 5% stock interest in the company with an option to acquire an additional 25%. According to Mandelbaum, his intention was to eventually offer the corporation for sale to Werner upon Mandelbaum’s retirement.

The Shareholders’ Agreement

Mandelbaum and Werner entered into a shareholders’ agreement including the following, key provisions:

  • Section 3, entitled Shareholder Employment, specified each shareholder’s employment responsibilities including Werner’s as Vice President with administrative duties and requiring his active participation in the company’s clinical and orthopedic practice. Section 3 also provided that each shareholder had the right to terminate his employment on 60 days notice and must cooperate in hiring and training a new employee to fill the departing shareholder’s position as employee.
  • Section 4, entitled Restrictions on Disposition of Shares, prohibited Werner from selling or otherwise disposing of his shares except with Mandelbaum’s prior written consent or as specifically authorized by the shareholders’ agreement.
  • Section 5, entitled Lifetime Disposition of Shares, included an RFR authorizing Werner to sell his shares to a bona fide third-party purchaser but only after giving the company and Mandelbaum respective first and second options to acquire the shares for the same price and on the same terms. In the event neither option was exercised, Werner could consummate a sale to the third-party buyer provided the latter “agreed to be bound by the same terms of this Agreement as Marc Werner.”
  • Section 14, entitled Covenant Not to Compete, included non-compete and confidentiality provisions that, among other things, prohibited Werner from competing with the company within a 15-mile radius for two years after ceasing to be a shareholder.

Werner’s Resignation and Stock Transfer

In March 2009, Werner simultaneously gave notice of his resignation and the proposed sale of his 5% stock interest to his father, Carl Werner, for $30,000, subject to the company’s and Mandelbaum’s exercise of their RFR options.The company offered Werner $20,000, which he rejected. Mandelbaum did not elect to purchase the shares. Werner left to start his own orthotic and prosthetic device business. In June 2009, Werner’s father, who was employed by an electronics company, paid Werner $30,000 pursuant to a stock purchase agreement. The father also signed an Adherence Agreement promising to be bound by the shareholders’ agreement.

After a series of inconclusive communications between Mandelbaum and Werner’s father, in January 2010, the company’s counsel sent a letter to the father asserting the company’s refusal to recognize the stock transfer as valid, stating:

Because it is clear that Carl Werner refuses to perform Marc Werner’s responsibilities under the Shareholders’ Agreement (i.e., Carl Werner will not devote his full time and best efforts to the corporation and cannot actively participate in the clinical and orthopedic practice), the purported transfer of shares from Marc Werner to Carl Werner violates Section 5(f) of the Shareholders Agreement . . ..

The Lawsuits

A flurry of litigation followed Marc Werner’s departure from the company, including a suit by the company against Marc Werner for breach of restrictive covenants; a suit by the company against both Werners to declare invalid the stock transfer from son to father; and a suit by Carl Werner against the company to enforce the stock transfer.

The Framed Issue Hearing

In January 2010, the court denied the company’s request for a preliminary injunction against Marc Werner for alleged violation of his non-compete and other restrictive covenants (read decision here). In October 2011, with all three cases before her, Justice Emerson conducted a framed issue hearing on the validity of the stock transfer from Marc Werner to his father.

Carl Werner testified at the hearing that, although he had no prior experience or training in the field of orthotics and prosthetics, he would retire from his current employment and go to work for Mandelbaum if they negotiated a new employment agreement. Mandelbaum testified that, consistent with his understanding of the shareholders’ agreement, he expected the father to perform the identical duties performed by Marc Werner.

The Post-Trial Arguments

In his post-hearing brief, Mandelbaum argued that, under the shareholders’ agreement, the father’s assumption of his son’s job duties was a condition precedent to the valid transfer of shares from son to father, and that the father’s inability and refusal to assume the son’s duties rendered the transfer invalid.

The father’s post-hearing brief argued that Mandelbaum initially confirmed by email that the father was the new owner of the shares; that the father was ready, willing and able to work for the practice; and that, six months after the shares should have been delivered to the father, Mandelbaum asserted a new argument, claiming that the father wanted only to be a passive investor which allegedly put him in violation of the shareholders’ agreement.

Justice Emerson’s Decision 

Justice Emerson’s discussion of the controlling law initially reviews the principles governing contractual condition precedents, defined as “an act or event, other than a lapse of time, which, unless the condition is excused, must occur before a duty to perform a promise in an agreement arises.” Further, she writes, “[t]o make a provision in a contract a condition precedent, it must appear from the contract itself that the parties intended the provision to so operate.”

Applying these principles, Justice Emerson concludes that the father’s admitted inability to take on his son’s employment responsibilities defeats the son’s attempt to transfer his shares to his father.  Here’s what the decision says:

Here, the express condition precedent appears in the Shareholders Agreement, Section 5(f), and makes specific reference to the purchaser, in this case Carl Werner, being bound by the same terms of the Shareholders Agreement as the seller, Marc Werner, which means that Carl Werner would step into the shoes of Marc Werner as an employee of the corporation. Although Mandelbaum was prepared to accept Carl Werner as a shareholder, Carl Werner was not capable of undertaking Marc Werner’s duties and responsibilities in the corporation, to wit, serving as the Vice President of the corporation, and actively participating in the clinical and orthopedic practice of the corporation by getting referrals, providing in-service training to physical therapists, seeing patients in the office, and visiting patients in hospitals, clinics and nursing homes. In addition, Carl Werner conceded that he was not an orthotist or a prosthetist. Carl Werner’s failure to assume Marc Werner’s duties and responsibilities upon the purchase of Marc Werner’s shares relieved Mandelbaum and the practice of any obligation to close under the Shareholders Agreement.

Justice Emerson also rejects, as contrary to the literal intent of Section 5(f), the father’s argument that the shareholders’ agreement contemplates share transfer to someone who, even if not qualified at the outset, could eventually become a qualified employee, writing as follows:

In any event, the intent of the Shareholders Agreement was not followed literally, thereby invalidating the sale. The Shareholders Agreement initially provided Marc Werner with an incentive to remain with the corporation. Thus, it can be said that Mandelbaum’s intent in the instant Shareholders Agreement was to maintain a long term relationship with Marc Werner, who was a valued and productive employee. It, therefore, follows that the Shareholders Agreement provided that only employees could be shareholders, or to admit as a shareholder another qualified individual who could fulfill Marc Werner’s role. Carl Werner asserts that the Shareholders Agreement should allow for shareholders to eventually become employees. Even assuming, arguendo, that Carl Werner began to work for the corporation, he conceded that he could not, upon hire, be the valued and productive employee that Marc Werner had been unless and until he obtained the necessary training and certifications within five or ten years, a result not contemplated in the Shareholders Agreement. Mandelbaum’s testimony supports the joint creation by him and Marc Werner of an express condition precedent which provided that any new purchaser of the shares would have the same experience and training in orthotics and prosthetics as the selling shareholder. It is, thus, clear that Marc Werner failed to follow the Shareholders Agreement literally. His purported transfer of the shares to Carl Werner violated Section 5(f) in the Shareholders Agreement. [Citations omitted.]

The court accordingly rules invalid the sale of stock by Marc Werner to his father, and declares that Marc Werner remains the owner of 5% of the corporation’s shares. In a separate, concurrent order in the suit brought by Carl Werner to enforce the stock transfer (read here), Justice Emerson similarly rules that he is not entitled to issuance of stock, dividends, an accounting or damages.

Marc Werner nonetheless managed to eke out at least a temporary victory in the separate injunction suit brought against him by the company, with Justice Emerson denying the company’s renewed application for a preliminary injunction and compelling further deposition of Martin Mandelbaum (read here).

A Few Closing Thoughts

  • I’m in no position to speculate as to the Werners’ reasons for the attempted stock transfer, although it wouldn’t be unreasonable to assume that by doing so, the son sought to start the running of the two-year period of his non-compete covenant under Section 14 of the shareholders’ agreement. Does Justice Emerson’s invalidation of the transfer mean that Marc Werner remains subject to the non-compete, even more than two years after he left the company? The question appears to be reserved for trial in the company’s injunction action against Werner.
  • As noted at the outset, RFR provisions in a shareholders’ agreement rarely give a non-controlling shareholder a realistic opportunity to sell his or her shares for anything approaching fair value. Where, as in the Mandelbaum case, the agreement also requires that any  third-party buyer must assume the job responsibilities of the selling shareholder, the opportunity to realize fair value by sale to an outsider practically vanishes.
  • That being said, a minority shareholder entering into a shareholders’ agreement with an RFR — especially if the agreement also contains employment provisions — will want to expressly exclude any of his or her personal performance obligations from the standard provision requiring the third-party buyer to be bound by the shareholders’ agreement.

Update December 30, 2013:  Marc Werner’s problems continue. In a decision dated December 13, 2013 (read here), Justice Emerson granted the company’s request for summary judgment of liability for soliciting company clients in breach of the shareholders’ agreement and also granted the company’s request for a preliminary injunction,