Close Corporations - Planning

Stock – transfer limitations
 Goals: Maintain control over ownership, both identity and size

Third Party
Shareholder
Shareholder
Corporation
Shares are freely transferable
Shareholder

Third Party
Shareholder
Shareholder
Corporation
Transfer restrictions transferable
Shareholder

Transfer Restrictions
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May appear in charter, bylaw, or separate agreement.
MBCA § 6.27(a); DGCL § 202(b)
Requirements:
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Must be noted conspicuously on stock certificates
Must be “reasonable”
Types (MBCA § 6.27(d); DGCL § 202(c))
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Options (right of first refusal, right of first offer)
Buy-sell
Prior approval or consent
Prohibitions 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”?

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“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.”

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

Enforcing SH Agreements
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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?
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Enforcing SH Agreements
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Title of shares transferred to a trust
Agreement forming the trust gives trustee power to vote the shares
Disadvantages?
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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]
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Enforcing SH Agreements
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 other
SHs’ rights
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Enforcing SH Agreements
b) Irrevocable Proxies
 Proxies are usually revocable, but can be made irrevocable if attached to an interest
[MBCA §7.22(d)]
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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 is ancillary to a voting agreement
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Enforcing SH Agreements
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]
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Enforcing SH Agreements
McQuade v. Stoneham
[N.Y., 1934]
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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
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Enforcing SH Agreements
McQuade v. Stoneham
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McQuade lost Stoneham’s favor & was fired
McQuade sues for specific performance
Court:
 BoD must exercise independent business judgment on behalf of all SHs
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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?
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Enforcing SH Agreements
McQuade v. Stoneham
 McQuade seems to offer a bright line rule
Constrain
Shareholder
Judgment
 But the rule is not so bright
Void
Constrain
Director/Officer
Judgment
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Enforcing SH Agreements
Clark v. Dodge
[N.Y., 1936]
Clark knows a valuable secret formula.
Dodge contributes money. They form two drug companies.
C and D sign an agreement:
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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?
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Enforcing SH Agreements
Clark v. Dodge
 C discloses secret formula. D eventually fires C.
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Enforcing SH Agreements
Clark v. Dodge
≠
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Clark sues. Dodge claims SH agreement is void.
Apply the reasoning in McQuade to this case.
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Enforcing SH Agreements
Clark v. Dodge
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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)
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Enforcing SH Agreements
Clark v. Dodge
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 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)?
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Enforcing SH Agreements
McQuade
Turning Clark …
… into McQuade
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Enforcing SH Agreements
McQuade
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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
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The terms are reasonable (i.e., minority SH should not object)
The minority SH does not object
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Enforcing SH Agreements
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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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