Close Corporations - Planning. Stock – transfer limitations Goals: Maintain control over...

Close Corporations - Planning

Stock – transfer limitationsGoals: Maintain control over ownership, both

identity and size

Shareholder

Corporation

Shares are freely

transferable

Shareholder Shareholder

Third Party

Shareholder

Corporation

Shareholder Shareholder

Third Party

Shares are freely

transferable

Transfer restrictions may limit

freedom

Transfer RestrictionsMay appear in charter, bylaw, or separate

agreement. MBCA § 6.27(a); DGCL § 202(b)Requirements:

Must be noted conspicuously on stock certificatesMust be “reasonable”

Types (MBCA § 6.27(d); DGCL § 202(c))Options (right of first refusal, right of first offer)Buy-sellPrior approval or consentProhibitions on transfer

The SRA Transfer Restriction

“No Stockholder shall sell, assign, transfer (whether by merger, operation of law or otherwise), dispose of or encumber any of the Stockholder’s Shares or any interest therein except as specifically provided in this Agreement. Any purported or attempted sale, assignment, transfer, disposition or encumbrance of Shares or any interest therein not in strict compliance with this Agreement shall be void and shall have no force or effect.”Is this

restriction “reasonable

”?

The Delaware Court interpreting such a restriction

“The Delaware courts have been reluctant to invalidate stock restrictions because they are unreasonable.”

“The policy of restricting the number of record shareholders to avoid public company reporting and filing requirements is clearly a valid purpose….”

“Likewise, the Delaware Supreme Court expressly found that the alignment of the employees’ interests with those of the company is a legitimate policy.”

“It is reasonable to conclude that CGC’s purposes would not be achieved if the stock was transferable.”

Shareholder Agreements in a Close Corporation

Goals: Maintain control directly, not through ability to elect and vote out directors

Copyright © Amitai Aviram. All Rights Reserved9

Enforcing SH AgreementsWhy is this an issue?

SHs in a close corp sign a SH agreement obligating them to vote in favor of a specified slate of directors Directors favor expanding into the widget market

Some SHs renege on the agreement; vote for directors who refuse to expand into widgets As a result, Acme does not expand into widgets

Other SHs sue for breach of the agreement What are the damages? How easy is it to prove them? How can you make the agreement easier to enforce?


Enforcing SH Agreements1. Voting Trust

Title of shares transferred to a trust Agreement forming the trust gives

trustee power to vote the shares Disadvantages? Statutory restrictions

Some statutes limit the duration of voting trusts [MBCA §7.30: 10 year limit, but renewable]

Some states require the voting trust to be made public [DGCL §218]


Enforcing SH Agreements2. Contractual Enforcement

a) Specific performance MBCA §7.31(b) states that voting agreements are

specifically enforceable DGCL §218(c) allows voting agreements –

implicitly allows for specific performance Court may refuse to enforce in cases

of oppression or violation of otherSHs’ rights



b) Irrevocable Proxies Proxies are usually revocable, but can be made irrevocable

if attached to an interest [MBCA §7.22(d)] Being a party to a voting agreement is considered an

interest [MBCA §7.22(d)(5)] So, the proxy tends to be an

enforcement mechanism that isancillary to a voting agreement



c) Is the SH agreement valid? Constraining discretion that isn’t subject to FDs

E.g., appointing directors Voting agreements generally permissible [DGCL §218(c); MBCA §7.31]

Constraining discretion that is subject to FDs Actions that are typically in the domain of directors/officers

E.g., appointing officers Does it impermissibly constrain BoD’s discretion? [McQuade/Clark]


Enforcing SH AgreementsMcQuade v. Stoneham [N.Y., 1934]

Stoneham owned a majority of the stock of the NY Giants

McGraw (the Giants’ manager) & McQuade (a city magistrate) bought a small amount of stock from Stoneham

The three signed a SH agreement in which they agreed to do their best to elect each other as directors & appoint each other officers at specified salaries


Enforcing SH AgreementsMcQuade v. Stoneham

McQuade lost Stoneham’s favor & was fired McQuade sues for specific performance Court:

BoD must exercise independent business judgment on behalf of all SHs

If directors agree in advance to constrain BoD’s judgment, SH will not receive the benefits of their independence

Therefore, agreement is void as against public policy

Protection in the SH agreement didn’t save McQuade How can he protect himself from being fired?


Enforcing SH AgreementsMcQuade v. Stoneham

McQuade seems to offer a bright line rule

Valid Void

But the rule is not so bright

ConstrainShareholder Judgment

ConstrainDirector/Officer

Judgment


Enforcing SH AgreementsClark v. Dodge [N.Y., 1936]

Clark knows a valuable secret formula.Dodge contributes money. They form twodrug companies.

C and D sign an agreement: C agrees to disclose his secret formula D agrees to invest the required money C receives 25% of profits (salary & dividends) D would vote, both as SH & director, to

assure that C would be a director &General Manager as long as his performance was faithful, efficient and competent.

Why does C need the agreement? Why does D?


Enforcing SH AgreementsClark v. Dodge

C discloses secret formula. D eventually fires C.

Clark’s lesson…



Clark sues. Dodge claims SH agreement is void. Apply the reasoning in McQuade to this case.

≠



Clark court: Minority SH are not harmed by a commitment to keep someone as an officer “as long as he is faithful, efficient and competent” I.e., SH agreements are valid if SH merely agree to do as directors what

they could do validly anyway

This does not explain the holding in McQuade Also, SHs may be harmed by an obligation not to fire without cause

(e.g., downsizing; better/cheaper candidate)



Clark court: McQuade was designed to protect minority SH who were not parties to the agreement In Clark, all SHs are parties to the SH agreement

Clark creates an exception to McQuade when all SHs are parties to the SH agreement

How can Dodge avoid the SH agreement (reach a McQuade outcome)?


Enforcing SH Agreements“Homemade McQuade”

The homemade McQuade

Turning Clark…

… into McQuade


Enforcing SH Agreements“Homemade McQuade”

Preempting the “Homemade McQuade” The company can prevent a “Homemade McQuade” by creating

constructive knowledge of the agreement – incorporating it in the AoI, or printing a reference to the agreement on all stock certificates.

Another obstacle for Homemade McQuades – Galler v. Galler In Galler, the court held that a SH agreement is valid even if not all SHs

are parties to it, if: The corporation is closely-held The terms are reasonable (i.e., minority SH should not object) The minority SH does not object


Enforcing SH AgreementsCase Law Summary

McQuade: SH can commit to how they vote as SH, but cannot constrain their judgment (or others on their behalf) as directors

Clark: SHs can constrain their judgment as directors, if all SH are parties to the SH agreement

Galler: SHs can constrain their judgment as directors even when some SHs aren’t parties to SH agreement, if terms of agreement are reasonable and fair to those SHs (& those SHs don’t complain)

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