October 17, 2017

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Definitions in Shareholder Agreements Matter When Transferring Family-Owned Business Stock

Owners of family-owned corporations often enter into shareholder agreements that spell out whether and to whom corporate shares can be transferred. Frequently, these agreements provide for rights of first refusal by the other stockholders or a stock repurchase by the company if a shareholder wishes to transfer shares during his or her lifetime.  These agreements also typically address whether shares may be transferred to any heirs upon a shareholder’s death.  Unless the language regarding permitted transfers is clear, claims may arise between generations of owners concerning the proper ownership of shares upon a shareholder’s death.

A recent California Court of Appeal decision – Saccani v. Saccani – is illustrative of the type of dispute that can arise between family members over a deceased owner’s shares.  Albert Saccani started Saccani Distributing Company in 1933.  According to the Court, Albert’s “desire was that the company would always be kept in the family.”  When he died, each of his sons – Donald, Roland, and Gary – received one-third of the company’s shares.

By 1991, the brothers had entered a shareholder agreement. That agreement provided for certain “Permitted Transfers” through which the brothers could transfer their stock (1) to each other, (2) to their respective descendants, and (3) to trusts for the benefit of their descendants.  As to any other lifetime transfers the brothers wished to make, they were required to give the company the right of first refusal to purchase any stock before seeking a third party purchaser.  The agreement also provided that, upon the death of any of the brothers, their estate representative would be deemed to offer to sell the shares back to the company, unless a Permitted Transfer would occur under a brother’s estate plan.

One of the brothers, Donald, transferred his shares in the company to a revocable trust. Donald and his wife had no children.  One of the provisions of the trust granted his brother Gary an option to purchase all of Donald’s shares in the company.  Donald died in 2007.  In 2012, Gary exercised the option and purchased all of the shares held in Donald’s trust.  As a result, Gary owned two-thirds of the company’s shares.

In 2013, the third brother, Roland, died and his sons, Todd and Antonio, together inherited Roland’s one-third interest in the company. Todd and Antonio then sued their uncle Gary claiming that he improperly acquired Donald’s shares from the trust.  Todd and Antonio sought a declaration from the trial court ordering that the shares be returned to Donald’s wife and then sold to the company.  If the shares were in fact sold back to the company, Todd and Antonio would then, together, own fifty percent of the company, instead of a minority stake.

The trial court rejected Todd and Antonio’s claims, ruling that “Donald’s granting of the option to Gary was a permitted transfer under the definition of transfer in the shareholder agreement.” On appeal, the Court of Appeal agreed, referring to the language of the agreement. The Court noted that the shareholder agreement broadly defined “transfer” as “gift, sell, pledge, encumber, hypothecate, assign or otherwise dispose of.”  The definition of transfer did not specifically identify the right to provide an option to purchase, as Donald’s trust provided to Gary.  Nonetheless, the Court noted that the ordinary meaning of the word “encumber” means “to burden or restrict free action.”  Donald therefore “encumbered” his shares by granting Gary an option to purchase them.  As such, the Court ruled that Donald “‘transferr[ed]’ his shares under the broad definition given to that term in the shareholder agreement when he granted an option to Gary to purchase the shares.”

This case serves as a reminder that definitions matter when parties are drafting shareholder agreements.

Todd and Antonio argued that the option was nonetheless invalid because the shareholder agreement only allowed Donald to make a lifetime transfer of his shares to Gary and that he was unable to do so after his death. They further argued that the only permissive use of a trust under the shareholder agreement would be to transfer shares to Donald’s descendants, which did not happen since Donald had no children.  The Court rejected these arguments, again referencing the broad definition of the term “transfer” in the shareholder agreement and noting that the agreement specifically allowed for a transfer between the brothers upon one brother’s death.  The Court thus concluded that the terms of the shareholder agreement “allowed Donald to transfer his shares to Gary (by granting the option) upon Donald’s death.”  As a result of this ruling on appeal, Gary retained his two-third ownership of the company, with Todd and Antonio together remained owners of one-third of the ownership interests.

In this case, the Court applied the plain language of the shareholder agreement in determining that the transfer at issue was permitted. The Court was able to do so because of the broad definition of the term “transfer” in the agreement.  Such a broad definition was likely thoughtfully drafted to include the widest range of possible ways in which the shares could be transferred at a later point in time.  Nonetheless, this case serves as a reminder that definitions matter when parties are drafting shareholder agreements.  Such definitions will guide a Court’s review of such agreements, perhaps many years later, and at a time when some or all of the original parties are no longer available to testify as to what transfers were intended to be permitted.

As a separate issue, it appears in this case that while the company founder intended that the company “always be kept in the family,” there was no requirement or provision that that the company always be owned equally by the founder’s sons’ families.  The brothers in this case can be presumed to have foreseen the potential for uneven concentration of shares beyond their generation of family ownership, since the shareholder agreement clearly provided for such a result.  Nonetheless, the nephews’ suit against their uncle seeking, effectively, to equalize share ownership between the surviving family lines demonstrates the risk of misunderstandings and misaligned expectations that may arise in connection with transfers to a third generation of family members or beyond.  In this case, the Court determined that the nephews were not entitled to any more of an ownership interest than they had inherited.  But this case shows that, in the context of multi-generational family-owned businesses, drafters of shareholder agreements would be well-served to try to envision, and address through careful drafting, possible claims that might arise decades after the agreement date and between family members who are not involved with the business, and may not even be born, when the agreement is entered.

© 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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