Re: Closed Co., Ltd.; Shareholder Agreement; Sale of Shares
Summary of Facts
This matter arises from a dispute between two brothers concerning enforcement of a shareholder agreement for a closed, family-owned corporation, Closed Co., Ltd, (“the Company”). The two brothers, Tim and Tom, are the last remaining family owners of shares of stock to the corporation. Other shares of stock are currently held by a trust created by Tim’s and Tom’s late sister, Abby. Abby created the trust in 2011, naming herself as beneficiary of the trust. She subsequently died in 2012. Abby’s minor child is now the beneficiary of that trust with Tom and his wife, Sally, being co-trustees.
Per the terms of the shareholder agreement, upon the death of a shareholder, or the death of a primary beneficiary of a trust which is a shareholder, the Company shall have a thirty day option to purchase the decedent’s shares. If the Company does not exercise its option, then a shareholder or shareholders shall have a thirty day option to purchase the decedent’s shares in accordance with that shareholder’s proportional interest in the Company. And, finally, if neither the Company nor a shareholder exercises an option to purchase the decedent’s shares, then the Company MUST purchase all of the decedent’s shares pursuant to yet another thirty day option period.
To date, the shares in the trust created by Abby naming her as beneficiary have not been sold to either the Company or the remaining shareholders, hence the dispute. Tim wishes to enforce the terms of the shareholder agreement with either the Company purchase of the trust’s shares, or both Tim and Tom individually, and equally, purchase the trust’s shares. It is unclear what Tom’s wishes are, although he seems to believe erroneously that as trustee the shares in the trust already belong to him.
Discussion
Restrictions on Shares of Stock
As a general rule, restrictions upon the right to transfer shares of corporate stock are permissible provided that those restrictions are reasonable and not contrary to any law or public policy. Rench v. Leihser, 139 Ill. App. 3d 889, 890, 487 N.E.2d 1201, 1202, 1986 Ill. App. LEXIS 1821, (1986), citing People ex rel. Rudaitis v. Galskis, 233 Ill. App. 414, 420 (1924). Moreover, because clauses for stock purchases in a shareholder agreement constitute a restraint on the otherwise free alienation of the parties’ shares, they must be strictly construed. Id., citing Vogel v. Melish, 31 Ill. 2d 620, 624-25, 203 N.E.2d 411, 413 (1964).[1]
Applying these two standards can often times have harsh results. In Rench, the shareholder agreement expressly provided that it would terminate if a shareholder sold his or her stock in the corporation. The court found the plain meaning of the language of the shareholder agreement conclusive even though the parties carried on for twenty years as though the agreement was in effect. Rench at 891. In the instant case, the language is no less clear or unambiguous as to the terms and obligations of the agreement.
The Trust
Abby is one of the original signatories of the shareholder agreement. She is also, by the terms of the agreement, Section 1.2(i), a member of the family. By the terms of the agreement, Abby would be a permitted transferee. Thus, when she created the trust naming herself as beneficiary, the trust clearly was a “Qualifying Trust” under Section 1.2(d).
On the other hand, once Abby passed, and left the trust to her minor daughter, the trust ceases to be a Qualifying Trust as her daughter does not meet the criteria set out in the agreement as a permitted transferee under Section 1.2(c). Section 1.2(c) provides that only a Shareholder[2], a Party to the agreement, an Eligible Shareholder or a Qualifying Trust may be transferred shares.[3] Simply put, taken as a whole from the language of the shareholder agreement, the transfer was a prohibited transfer.
Prohibited Transfer
Section 2.1 of the agreement provides that when a transfer violates any terms of the shareholder agreement that the transfer will not be recognized by the Company and shall be null and void. Here, the transfer of the trust violated the terms of the shareholder agreement because the beneficiary of the trust is not now a Shareholder, a Party to the agreement or an Eligible Shareholder. Accordingly, since a shareholder agreement must be strictly construed, the transfer to the minor daughter need not be recognized by the Company or other shareholders because it is null and void. Rench at 891. Presumably, those shares will remain in limbo until they are purchased under the terms of the shareholder agreement.
Death of a Party
The remaining shareholders held a meeting on June 30, 2016. In attendance were Tim, Tom, Tom’s wife, Sally, and Attorney Less. Surprisingly, Attorney Less expressed the opinion that while the terms of the shareholder agreement provided that the Company must purchase the shares in the trust, the trust was under no obligation to sell those shares.
As discussed above, the transfer of shares within the trust is a prohibited transaction because Abby’s minor daughter is not a permitted transferee. This renders the transfer null and void, leaving the shares in Abby’s estate. It also exposes Tom and Sally, as Co-Executors of Abby’s will, to liability as Abby’s shares must be sold to either the Company or the shareholders per the terms of the shareholder agreement.
Illinois statute expressly lists the executor of a deceased shareholder as a person against whom a restriction against transfer may be enforced and is not an abandonment of the requirement that a shareholder’s agreement regarding transfer restrictions be strictly construed. 805 ILCS 5 6.55. (See, Phillips v. McCullough, 278 Ill. App. App. 3d 442, 447 (1996); shareholder agreement enforceable against testamentary transfers.) Obviously, were it to come to litigation, Tim and the Company could sue Tom and Sally personally to compel enforcement of the shareholders agreement.
Specific Performance
Specific performance is an equitable remedy which is available for cause of action involving agreements on the sale or transfer of shares of stock where the shares are not available on the open market. Butler v. Kent, 275 Ill. App. 3d 217, 227, 655 N.E.2d 1120, 1126 (1995). Generally, specific performance requires a heightened standard of proof to establish a claim without assistance of extrinsic evidence. Id.
Here, there is no need for extrinsic evidence. A fair reading of the shareholder agreement shows that the shares must be sold to either the Company or the shareholders. If they are not sold to either the Company or the shareholders, then the Company must purchase the shares. Thus, no extrinsic evidence is needed. Tim can compel specific performance.
Fiduciary Duty to Abby’s Daughter
Tom and Sally also owe a fiduciary duty to Abby’s minor daughter as co-executors of Abby’s will and guardians. This is outside the scope of the problem presented. However, it should be noted that as Abby’s brother, Tim, was given power of attorney to make health and property decisions for Abby while she was still alive if she could not make those decisions. Clearly, Abby trusted Tim. It is not out of the realm of possibilities that Tim could bring suit on behalf of his niece to enforce a sale of Abby’s stock.
Conclusion
Terms in a shareholder agreement which restrain transfers of shares must be strictly construed. In this shareholder agreement, there are restraints on transfers of shares which prohibit transfers to those who are not shareholders or eligible shareholders. Further, per the shareholder agreement, a prohibited transfer is null and void.
The transfer to Abby’s daughter is a prohibited transfer by these criteria. Thus, the transfer is null and void. As a result, the Company must purchase the shares. And, as co-executors of Abby’s will, Tom and Sally must sell those shares.
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[1] Questioned in Phillips v. McCullough, 278 Ill. App. 3d 442, 663 N.E.2d 47 (1996) on the issue of whether a shareholder agreement will survive a death of one of the parties.
[2] Here, “Shareholder” means someone who presently owns shares.
[3] Section 1.2(a) of the agreement provides that an “Eligible Family Employee” must be a descendant of the family, attained a bachelor’s degree from an accredited four-year university, and been employed for a continuous twenty-four months in a profession or business. Further, under Section 1.2(b) an “Eligible Shareholder” must have been employed by the Company for twelve months and be an Eligible Family Employee.
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