How do you draft transfer provisions in a shareholders’ agreement or by-laws?

As part of the formation of a corporation, it is essential to prepare by-laws which set forth how the corporation will operate.

Where there are multiple shareholders, it is also a good idea to state how the shareholders will work together within the corporation, how they may vote their shares and how they may transfer their shares, among many other important provisions. These provisions can be set forth in a shareholders’ agreement which will govern the relationship between and among the shareholders and the corporation.

An essential component of either the by-laws or the shareholders’ agreement – wherever you see best to include the same – is a provision governing the transfer of shares. A transfer provision enables the shareholders to provide continuity in the management and policies of the corporation by restricting the disposition of stock by the shareholders and by ensuring that all sales of stock in the corporation are transacted according to the provisions agreed upon the shareholders. Such provision helps avoid uncertainty and disputes arising from, e.g., the sudden departure of a shareholder and the ensuing scramble to determine the procedure for their exit from the corporation.

The transfer provision ought to state that any transfer other than pursuant to the terms set forth in the transfer provision is null and void. This will prevent a non-conforming transfer, whether inadvertent or deliberate, from taking any legal effect.

The transfer provision ought to provide for the following scenarios:

(i) Involuntary Transfer

(a) Triggering Events

(b) Sale Terms and Procedures

(ii) Voluntary Transfer

(iii) Insurance

(iv) Estate Provisions

(v) Endorsement

An involuntary transfer may arise in several ways: the death of a shareholder, a shareholder’s breach of fiduciary duty to the corporation, a shareholder may file for bankruptcy, etc. The shareholders may set forth in the agreement what they agree would be an involuntary transfer event. The agreement should also set forth the steps for how to notify the outgoing shareholder of the event, and the steps the parties must take subsequently.

In most cases, except in the event, e.g., the outgoing shareholder owes a debt to the corporation, the outgoing shareholder will need to be compensated for his or her shares. The corporation can provide for its right of first refusal to buy the shares back, a procedure in the event it does not wish to do so, and how the price of the stock will be calculated, e.g., by the appointment of a neutral appraiser to determine fair market value, or otherwise. Having such procedures in place prior to the arise of such involuntary transfer events provides for the ability of the corporation to continue in its operations without disruption.

In the event of a voluntary transfer, where such shareholder decides on his or her own to part ways with the corporation, the same procedures – right of first refusal and valuation - can be put into effect without delay.

Another sub-section of the transfer provision to consider including is insurance. In order to assure that all or a substantial part of the purchase price for the shares of any shareholder will be available, the corporation may (but should not be obligated to) procure and purchase life insurance for a shareholder. For example, upon the death of an insured shareholder, the corporation – which would be the sole owner of the policy – would collect the proceeds of the policy payable by reason of such shareholder’s death and would pay as much of the proceeds as necessary to buy back any shares of stock at the purchase price, and would keep the excess.

The transfer provision may also include a section providing for the indemnity of the corporation by the estate of the deceased shareholder holding the corporation harmless from costs and expenses necessitated by securing court orders, etc., to enable the estate to transfer the shares to the corporation.

Finally, a transfer provision ought to include a statement calling for all certificates of shares to be endorsed with the notice that the transfer or encumbrance of such certificate is subject to the terms of the shareholders’ agreement, and may only be transferred upon proof of compliance therewith. This will serve to enforce the first paragraph of the transfer provision, that any transfer other than pursuant to this agreement will be null and void.

For more information about this article or other issues, please contact us The Bachman Law Firm PLLC at judith@thebachmanlawfirm.com or 845-639-3210.