November 20, 2017

November 20, 2017

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Corporate Formalities Matter in Transfer of Shares of Family-Owned Businesses

Shares in family-owned businesses are often transferred between family members, whether through a sale or gift during a shareholder’s lifetime or through inheritance after an owner’s death. The parties to such a transfer should make sure it is properly documented to reflect the intention to transfer the shares. Typically, this is done through the transferor’s delivery of a signed share transfer instrument and the company’s issuance of a share certificate in the new holder’s name. In the absence of proper documentation, the transferee may not have a valid claim to the share ownership. Even worse, the company may find itself in the middle of an ownership dispute if the transferee has attempted to acquire the shares through fraud or deceit.

A California Court of Appeal recently faced such a situation in Patel v. Clocktower Inn, Inc. The company owned a hotel in California. The hotel was managed by members of the Patel family, who originally had emigrated from India. Bhikhubhai “BC” Patel owned 12 of the shares of the company’s stock, equaling 50%, while three of his nephews, collectively, owned the other 50%. BC’s two sons, Bharat and Suresh, worked for the company but did not own any shares. BC was in his late seventies and did not read English. Instead, he relied upon Bharat to explain company matters to him in his native Indian dialect. The Court also noted that “formal corporate procedures were rarely used [and] [b]usiness decisions were often made orally and without formal board of directors meetings.”

BC either told his sons or led them to believe that BC’s shares in the company would pass to them upon his death. According to the Court, however, “[a]pparently, Bharat and Suresh were unwilling to await BC’s death, or wished to solidify their claim to at least some of the Clocktower stock in advance of BC’s death.” In order to do so, the sons caused the company to hold a shareholders’ meeting pursuant to signed waivers and a notice of consent. The minutes created in connection with that meeting stated that the shareholders “were informed” that BC had agreed to transfer three shares each to his two sons “as a gift” and instructed the company’s secretary to issue new shares to Bharat and Suresh and to reflect a reduction in BC’s holdings on the company’s records. BC signed the shareholder meeting minutes at Bharat’s urging but without reading or understanding its contents.

The company’s by-laws required an endorsement to effect a transfer of any company shares. It was undisputed, however, that BC never signed any stock transfer certificate. Instead, when BC finally learned from Bharat that six of his shares were being transferred, BC objected and refused to make any transfer. Nonetheless, based upon the supposed transfer, Suresh and BC’s nephews, now ostensibly holding a majority of the company’s shares, took over the management of the company. BC then filed a declaratory judgment action against Suresh, BC’s nephews, and the company, asserting that he never intended to transfer any of his shares and that the claimed transfer to his sons was therefore ineffective.

The court rejected the defendants’ contention that the shares were effectively transferred through the statement in the shareholder meeting minutes…

At trial, the court rejected the defendants’ contention that the shares were effectively transferred through the statement in the shareholder meeting minutes that BC had transferred the shares “as a gift.” The trial court also noted that, “[b]eing gratuitous and without consideration, the intention stated in the minutes could not constitute an enforceable contract.” Instead, BC “remained free to change his mind until the transfer was completed.” Where BC never signed any transfer certificate and stated that he never intended to transfer the shares to his sons during his life, the transfer was never completed. The trial court thus entered declaratory relief in BC’s favor, providing specifically that the minutes did not alter the share ownership and that the allocation of shares remained as it had been before the minutes were created, with BC continuing to own 50% of the company’s shares.

On appeal, the defendants argued that the trial court erred in concluding that the minutes were not an enforceable contract. The Court of Appeal rejected this argument outright, stating that it would not disturb the trial court’s findings: that BC could not read the minutes nor were they translated for him before he signed the minutes; that BC never agreed to transfer his shares to anyone during his lifetime; and that Bharat deceived BC into signing the minutes of the shareholder meeting.

The defendants also argued that “the endorsement requirement in Clocktower’s by-laws was not binding because the corporation was a closely-held family business that did not follow or adhere to corporate formalities.” The Court of Appeal disagreed, again noting that the trial court found that BC never formed the underlying intent to make the gift of shares to his sons and thus the endorsement issue did not even come into play. Alternatively, the Court noted, even if BC had initially intended to make a gift of the shares to his sons, he never completed the gift because he did not endorse or deliver the shares. Either way, the Court did not accept the defendants’ argument that the endorsement and delivery of shares was excused simply because the company was operated informally.

The Clocktower case serves as a reminder that corporate formalities matter when transferring shares of family-owned businesses. If the by-laws or other governance documents require delivery of specific signed documents to the company in order to effect a transfer, both the company and the transferee should make sure the transferor has signed and delivered all such documents. Also, while children of family-business owners may wish to speed up their expected inheritance of certain shares in the company, they should not try to avoid the required corporate formalities for a transfer through deception or other maneuvers designed to give the appearance of a present intent to transfer where none exists. Such misconduct will increase the risk that the supposed transfers will be deemed invalid if later challenged by the shareholder of record. It is also entirely likely that, in the face of such misconduct, the shareholder will reconsider his or her estate plan and disinherit the offending heirs entirely.

© Copyright 2017 Murtha Cullina

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About this Author

Michael P. Connolly, Murtha Cullina, Shareholder Agreements Lawyer, Business Valuations Attorney
Partner

Michael Connolly is a partner in the firm's Litigation Department. He represents owners and managers of family-owned businesses and closely-held businesses in connection with disputes between business owners under LLC operating agreements, shareholder agreements, and partnership agreements; claims against directors and officers concerning company management and operations; and other internal disputes concerning business valuations, corporate distributions, and access to company information.

Mr. Connolly also has an active business litigation...

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