Share transfer restrictions in close corporations as mechanisms for intelligible corporate outcomes.

AuthorLeacock, Stephen J.
  1. INTRODUCTION II. HISTORICAL PERSPECTIVE III. OBJECTIVES OF RESTRICTIONS IV. CONTRACTUAL BASIS FOR ENFORCEMENT OF CORPORATE SHARE TRANSFER RESTRICTIONS V. DRAFTING CHALLENGES A. The Setting 1. Drafting B. Proper Remedy for Enforcement C. Specific Applications of Share Transfer Restrictions 1. Rights of First-Refusal/Buy-Sell Agreements 2. Testamentary Dispositions 3. Involuntary Transfers Generally VI. RIGHT OF ALIENATION AND CONCEPTIONS OF REASONABLENESS VII. COURT INTERPRETATION OF REASONABLE RESTRICTIONS IN ACTION A. Voluntary Transfers 1. Strict Construction 2. Pledge of Stock 3. Legal Impact of Size and Business Activity of the Corporation B. Involuntary Transfers 1. Operation of Law 2. Strict Construction of the rule of reasonableness 3. Pledge of Stock 4. Other Specific Operation of Law Contexts i. Divorce and Marriage Dissolution ii. Bankruptcy iii. Insolvency VIII. CONCLUSION I. INTRODUCTION (1)

    "[T]he most likely purpose for share transfer restrictions in close corporations is to prevent outsiders from purchasing shares and potentially damaging the company." (2)

    Analysis, evaluation, and synthesis of legally valid share transfer restrictions3 in the corporate documents (4) of close corporations (5) are intriguing. Actually, share transfer restrictions (6) tend to be included within a corporation's bylaws, (7) rather than in its articles of incorporation. (8) Nevertheless, subject to any statutory preconditions, (9) the legal validity of such restrictions is transcendent whether located in one or both (10) of these two corporate documents. (11)

    Corporate share transfer restrictions are often drafted as rights of first refusal granted to the corporation, to the current shareholders, or to both. Therefore, drafting ingenuity, creativity, and, above all clarity, are at a premium. (12) Moreover, the most significant substantive legal basis for enforcement of share transfer restrictions is contractual. (13)

    However, the location of any share transfer restriction in controversy is not legally significant. Share transfer restrictions located in corporate bylaws or elsewhere are binding on the stockholders of the corporation based upon orthodox contract principles. (14) This binding contractual effect is legally indistinguishable from agreements between shareholders, which do not become a bylaw of the corporation. The fundamentally binding contractual effect is essentially equivalent in legal impact and outcome. (15) Such agreements between the shareholders of a corporation may often require 100% of the shareholders of the particular corporation to be signatories to each pertinent agreement. Thus, notwithstanding the fact that the provisions of such agreements might not become an actual bylaw of the pertinent corporation in which the shares are held, nevertheless, the applicable legal principles coincide. The contractually restrictive effect is legally valid whether the provision in controversy is in a bylaw, in a buy-sell agreement between the shareholders, in the articles of the corporation, or elsewhere.

    In order to be treated by the courts as legally valid, share transfer restrictions must be judicially determined to be reasonable. (16) Share transfer restrictions are subject to the entire array of ordinary contract law principles. (17) It must therefore be proven that each party allegedly bound by a particular share transfer restriction is contractually a party to the agreement which embodies the critical terms of the applicable share transfer restriction. (18)

    Thus, the rights conferred by valid share transfer restrictions upon the recipients of such rights are subject to contract law fundamentals such as waiver and estoppel principles. (19) For example, if a stock transfer restriction empowers a corporation to redeem the shares of any deceased shareholder, the corporation must strictly adhere to all specific time constraints included in the agreement. (20) Therefore, failure by the corporation to completely honor the express time constraints required for the valid exercise of its rights will have legal consequences. This failure can be legally fatal to retention of those rights by the corporation. It can legally nullify them. Therefore, in appropriate circumstances, a corporation (21) may substantively forfeit such rights based upon valid proof that the corporation waived them. (22) Each controversy depends upon the facts and circumstances of the specific case. (23)

    Of course, subject to a finite number of specific conditions precedent, (24) corporate bylaws that explicitly but reasonably restrict share transfers tend to be judicially interpreted as legally valid. (25) Moreover, the sentiments expressed by one commentator (26)--in the context of conflicts of interest within the firm--also resonate harmoniously with the quest to resolve conflicts addressed by share transfer restrictions in close corporations. (27)

    In some instances, the retention of a particular legal status (28) by a close corporation may also depend upon the enforcement of share transfer restrictions in its corporate bylaws. (29) Furthermore, where the share transfer restrictions have been included in the corporation's bylaws expressly or impliedly for the corporation's benefit, the corporation itself can waive the pertinent share transfer restrictions. (30)

    However, disputes that arise under share transfer restriction agreements cannot be mandatorily resolved by arbitration per se. On the contrary, unless a valid express agreement has restricted the resolution of such disputes to arbitration as the dispositive legal mechanism, (31) orthodox court resolution of these disputes is the norm.

    This article examines judicial approaches to the interpretation and enforcement of share transfer restrictions in close corporations in the dynamic context of individual fact controversies. The article discusses and determines whether or not share transfer restrictions in close corporations have genuinely assisted the courts, the corporate community, and business society on the whole in reaching intelligible corporate outcomes.

    The introduction in Part I sets the stage for analysis of these restrictions, which may also be referred to as buy-sell agreements. Part II provides a relatively brief historical perspective of share transfer restrictions and traces the evolution of judicial approaches to them. This section explores how this evolution in judicial thinking developed concomitantly with judicial assessment of the impact of the emerging power of corporations on societal development. Part III analyzes the objectives of share transfer restrictions and provides the transition to the substance of Part IV.

    Part IV explains the contractual basis enunciated by the courts as the substantive instrument for enforcement of share transfer restrictions. This serves as the connection to Part V, which analyzes the drafting challenges faced by those who make use of share transfer restrictions as mechanisms to reach chosen corporate objectives. Part V discusses some of the significant hurdles that drafters have to surmount in order to attain these selected goals. This section also identifies the preferred remedy sought from the courts in order to achieve specific enforcement of the terms agreed upon in the particular share transfer restrictions. Additionally, it analyzes the prospects of success in persuading the courts to grant the preferred remedy.

    Part VI interprets more fully the right of alienation. Next, it analyzes and discusses the unavoidable legal impact on share transfer restrictions of conceptions of reasonableness. Then, it explains that conceptions of reasonableness determine whether or not the court will enforce each share transfer restriction in controversy.

    Part VII analyzes the substantive characteristics of share transfer restrictions as the courts construe them in the specific cases selected for examination. Additionally, it evaluates and synthesizes the judiciary's interpretation of these restrictions in determining whether the particular restriction in issue meets the challenge of judicial scrutiny. It also explains the foundation of applicable legal criteria developed by the courts as lenses through which to conduct this judicial scrutiny. Distinguishing voluntary transfers from involuntary ones is used to assist in the task of understanding the judiciary's enforcement philosophy in action. The conclusion in Part VIII closes the discussion with the observation that clearly and unambiguously drafted share transfer restrictions have been for the most part quite effective in meeting the drafters' and business community's goals. It also observes that corporate law experience relating to the use of such restrictions has successfully allayed judicial and societal concerns as well.

  2. HISTORICAL PERSPECTIVE

    A very brief historical perspective relating to corporations generally, (32) and to share transfer restrictions in close corporations in particular, generates dividends. It provides a more complete picture of the progressive development of the law in this context. It also highlights pivotal turning points in their legal evolution. It explores the continuum of the development of judicial approaches to share transfer restrictions over time. It also shows that, based upon analysis and reflection, the judiciary has proceeded from reluctance--or even hostility to enforcement of such restrictions on the alienation of property rights in general--to a more rational approach. This approach involves a factual and contextual determination by the courts of the reasonableness of each specific restriction. (33)

    Applying this approach over time, courts have concluded that proof of full and complete compliance with the standards that they have developed earns enforcement of the particular share transfer restriction in controversy. This outcome is sensible. It is valid because it is intelligible in light of its fundamental grounding in fair and...

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