Shareholders have a fundamental right to transfer their shares. This right was also recognized as a general expectation of all shareholders under the former shareholder oppression doctrine. The right continues to be enforceable through the common-law tort of conversion. However, that right may be modified by contract. In closely-held corporations, the shareholders frequently desire some control over who their business partners will be. Partners in a general partnership have that power, but corporate shareholders ordinarily do not, unless that power is created contractually through restrictions on transferability. The most common types of such restrictions are agreements that provide a veto power by the corporation or other shareholders on any proposed transfer or "buy sell" agreements that may create rights of first refusal that obligate the shareholder to sell to the corporation or other shareholders on the same terms and conditions offered by a third-party or a requirement to first offer the shares to the corporation or other shareholders at a set price or one determined by an appraiser prior to seeking a third-party buyer.
An agreement, often coupled with transfer restrictions, is the buy-sell agreement, which grants an option to the corporation or to the shareholder or to both to either buy or sell the shares to the corporation or the other shareholders at a predetermined price or one set by an appraiser upon the happening of certain events—typically, death, termination of employment, divorce, bankruptcy, involuntary or unapproved transfer etc. Sometimes such provisions may be invoked at will as a means to resolve oppression disputes among the shareholders by providing an exit to a minority shareholder.
In order to be enforceable, section 21.210 of the Business Organizations Code requires that the transfer restrictions be imposed by the certificate of formation, the bylaws, a written agreement among two or more shareholders and/or the corporation. The restriction must be consented to by the shareholder, either expressly by signing the agreement or voting for the provision in the certificate or bylaws, or implicitly by purchasing stock already subject to such restrictions and with notice of the restrictions. However, the Code also provides that such restrictions are not enforceable if they are not reasonable. Very little case law exists to define what types of restrictions would be “unreasonable,” and the plain language of the statute indicates that most such restrictions would be reasonable. In all likelihood, restrictions that resulted in a forfeiture in which the shareholder received essentially no consideration for the loss of his shares or that otherwise impose a penalty on the transfer would be deemed unreasonable.
Buy sell agreements may be an effective way to prevent or mitigate minority shareholder oppression. Thoughtful shareholders may enter into an agreement at the outset of the venture that provides for fair dispute resolutions and creates a mechanism for an unhappy shareholder to exit the venture or for the corporation to redeem the shares of a minority shareholder who is acting contrary to the best interests of the corporation. The terms of such a "buy" or "sell" are agreed in advance and can be structured to incentive the parties to be fair and reasonable. We have created a bylaws template that includes such a mechanism, and we advocate its use in most closely-held corporations.
Unfortunately, most shareholders are not thoughtful and do not structure buy sell agreements with fairness in mind. At the beginning of the venture, shareholders are usually in a "honeymoon" phase, trust each other, and cannot imagine a dispute that could be resolved only through a buy-out. Where shareholders think to execute a buy sell agreement at all, they typically provide for a buy-out only in cases of death, disability, divorce, and termination of employment. Usually, they utilize an old form agreement from the corporate attorney's file, which was drafted not with the purpose of resolving disputes and protecting shareholder interests but solely for the purpose of protecting the corporation. Almost universally, these agreements are mandatory on the shareholder but voluntary on the corporation--meaning that an oppressed shareholder has no contractual right to cash out and exit the corporation when he is being oppressed, but the majority has a mechanism to squeeze out the minority shareholder when ever he wants. Very often, these agreements price the buy-out based on book value of the corporation, which is always far less than the fair market value of any successful enterprise--other than a real estate holding company. In such a case, the buy-sell is not a solution for shareholder oppression but becomes a tool to execute such oppression. When dissension among the shareholders arises, the m
ajority shareholder will often terminate the minority shareholder's employment, triggering the buy-sell option, and pays the minority shareholder book value--a tiny fraction of the real value of the shares. In this situation, the minority shareholder has only two options: (1) challenge the buy sell as "unreasonable" under the Business Organizations Code (almost always a loser), or (2) challenge the corporation's use of the buy sell as being in bad faith and a violation of the duty of impartiality through the breach of trust cause of action.
|About the author: Houston Business Lawyer Eric Fryar is a published author and recognized expert in the field of shareholder oppression and the rights of small business owners. Eric has devoted his practice almost exclusively to the protection of shareholder rights over the last 25 years. Learn more||
This post represents our opinion regarding the relevant shareholder oppression and minority ownership rights law. However, not everyone agrees with us, and the law is changing quickly in this area. This page may not be up to date. Be sure to consult with qualified counsel before relying on any information of this page. See Terms and Conditions.