1. Close Corporations - Planning

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

3. Shareholder Corporation Shares are freely transferable Shareholder Third Party

4. Shareholder Corporation Shareholder Third Party Shares are freely transferable Transfer restrictions may limit freedom

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

6. 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”?

7. 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.”

8. Shareholder Agreements in a Close Corporation Goals: Maintain control directly, not through ability to elect and vote out directors

9. Copyright © Amitai Aviram. All Rights Reserved 9 Enforcing SH Agreements Why 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?

10. Copyright © Amitai Aviram. All Rights Reserved 10 Enforcing SH Agreements 1. 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]

11. Copyright © Amitai Aviram. All Rights Reserved 11 Enforcing SH Agreements 2. 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 other SHs’ rights

12. Copyright © Amitai Aviram. All Rights Reserved 12 Enforcing SH Agreements 2. Contractual Enforcement 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 is ancillary to a voting agreement

13. Copyright © Amitai Aviram. All Rights Reserved 13 Enforcing SH Agreements 2. Contractual Enforcement 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]

14. Copyright © Amitai Aviram. All Rights Reserved 14 Enforcing SH Agreements McQuade 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

15. Copyright © Amitai Aviram. All Rights Reserved 15 Enforcing SH Agreements McQuade 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?

16. Copyright © Amitai Aviram. All Rights Reserved 16 Enforcing SH Agreements McQuade v. Stoneham McQuade seems to offer a bright line rule ValidVoid But the rule is not so bright Constrain Shareholder Judgment Constrain Director/Officer Judgment

17. Copyright © Amitai Aviram. All Rights Reserved 17 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: 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?

18. Copyright © Amitai Aviram. All Rights Reserved 18 Enforcing SH Agreements Clark v. Dodge C discloses secret formula. D eventually fires C. Clark’s lesson…

19. Copyright © Amitai Aviram. All Rights Reserved 19 Enforcing SH Agreements Clark v. Dodge Clark sues. Dodge claims SH agreement is void. Apply the reasoning in McQuade to this case. ≠

20. Copyright © Amitai Aviram. All Rights Reserved 20 Enforcing SH Agreements Clark v. Dodge 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)

21. Copyright © Amitai Aviram. All Rights Reserved 21 Enforcing SH Agreements Clark v. Dodge 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)?

22. Copyright © Amitai Aviram. All Rights Reserved 22 Enforcing SH Agreements “Homemade McQuade” The homemade McQuade Turning Clark… … into McQuade

23. Copyright © Amitai Aviram. All Rights Reserved 23 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

24. Copyright © Amitai Aviram. All Rights Reserved 24 Enforcing SH Agreements Case 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)