September 2008

In Praise of Share Transfer Restrictions

by Robert S. Klein

I had my first disappointing encounter with negotiable instruments when I was six years old. I had discovered a stack of blank business checks and a massive one-armed check-embossing machine in my father’s home office, and I decided to make my buddies rich. I made out business checks to Jimmy Strong for $10,000,000 and Harry McDermott for $15,000,000. There were whoops of joy on the playground when I handed out the checks. My father was not overjoyed when he found out.

Unrestricted corporate shares are easy to transfer, much easier than it was for me to pass my dad’s business checks.1 Unfortunately, the consequences of having freely tradable shares can be more troublesome for private corporations. Washington’s minimal organizational requirements2 ignore a hazard to the founders of close corporations — namely, the risk that unrestricted shares will be issued and will fall into the hands of antagonists. The lack of share transfer controls invites shareholder strife and other mischief.3 Why doesn’t the Washington Business Corporations Act (Act)4 offer founders an easy option for adopting share transfer controls?

The threat to the founder’s control will not come from strangers swooping in to gobble up the corporation’s shares. In truth, hostile takeovers are rare for close corporations. Outside investors have little appetite for unmarketable stock. No, the danger will come from or through business associates. The danger is that shares, once granted as a reward to employees or as payment to friends and family for their seed money, will someday be used against the founder and the corporation by a recently fired and vindictive ex-employee,5 or by an angry ex-spouse (who got the shares in a divorce), or by a deceased shareholder’s greedy children, or, after foreclosure, by an impatient local banker or an aggressive IRS agent. The close corporation needs an orderly way to buy out these adverse interests, but the buy-out price, attorneys’ fees, and potential litigation costs may be steep when share transfer controls are not already in place.6

At this time, a Washington close corporation’s only choice is to draft customized share transfer controls—typically in a shareholders’ agreement—to guard against unwelcome shareholders. Some close corporations fail to make this choice when they are organized. Either the founder is a do-it-yourself champion who uses simple Internet forms, or the founder wishes to save his working capital and won’t spend the money on an attorney to draft a shareholders’ agreement, or the founder does not anticipate having any business partners, or the founder does not appreciate the dispute prevention power of a well-crafted agreement. In any event, too many new close corporations are created without transfer controls.

Founding shareholders will insist on controlling their enterprises, whether they aspire to become the next Hewlett and Packard (who famously started their business in a garage) or hope that their child will someday take over the family store.7 This is more than a matter of personal inclination, it is a matter of financial necessity. Founders often depend on their close corporations for their livelihoods. 8

A founder will instantly understand that he can keep control of his close corporation by controlling who owns its shares — though, in Washington, he will have no idea how to formalize transfer restrictions without the help of an attorney. As we will see, even though the great majority of Washington corporations are privately held, Washington has chosen to omit a special close corporations statute that would establish share transfer restrictions. In some states, statutory transfer controls are automatically established if the incorporator (the founder or his attorney) elects close corporation status in the articles of incorporation.9 In Washington, the Act authorizes transfer controls, which the founder may create if he hires a lawyer to draft a restrictive article of incorporation, bylaw, or shareholders’ agreement.10

The Act’s omission makes it more likely that close corporation founders will face unwanted and potentially unhappy co-owners, or, worse, that the founders will be squeezed out of their corporations if ownership of a controlling block of shares falls into the hands of a serious adversary.11 This omission — the lack of elective statutory transfer controls — is too obscure a point to cause shareholders to lobby for legislative reform.

The precise scope of the problem is unknown, but the vast majority of Washington corporations are privately held and, therefore, may be at risk. We have statistics for three kinds of Washington corporations: public corporations that do not need transfer controls, professional service corporations  that have transfer controls whose shares are subject to statutory transfer controls,12 and venture capital-backed private corporations whose shares are subject to contractual transfer controls.13 The Washington Secretary of State’s Office reports that, as of September 30, 2007, there were 151,731 active for-profit corporations organized and existing under Washington law, including 7,992 professional service corporations (5.27 percent). Only 186 Washington corporations (0.12 percent) are public corporations.14 According to VentureSource’s records, there are 114 active Washington close corporations (0.08 percent of total) that have received at least one round of financing from venture capital firms.15 Using O’Neal and Thompson’s estimate16 as an additional guide, it is fair to estimate that at least 30 percent of the remaining 143,439 Washington corporations (43,032) are close corporations operating without transfer controls.

Adding elective transfer restrictions to the Act will suit the do-it-yourself founder, and they should eliminate some of the mischief flowing from unrestricted stock.17 Beyond the simple protection that statutory transfer controls would offer, practitioners will have the opportunity to help their clients by drafting more sophisticated transfer restrictions into the articles of incorporation.

Clients will like — or will need — restrictive articles, whether or not they adopt a shareholders’ agreement. There are three reasons favoring restrictive articles, besides the allure of reasonable attorney fees: speed, issue deferral, and failsafe protection. First, the press of events may force a new corporation to start operations immediately, with no time to negotiate a shareholders’ agreement. Restrictive articles should be uncontroversial and easy to adopt. Secondly, the new corporation may have just one shareholder, who does not need a shareholders’ agreement. Or, the key founder may wish to defer negotiations with his co-founders about sensitive issues (buy-sell, drag-along rights, etc.) until after the new corporation has been launched. The key founder may shy away from negotiating a sophisticated “buy-sell” agreement in the intoxicating early days of a new business enterprise. It may seem too much like negotiating a prenuptial agreement. Finally, practitioners should anticipate that their clients, if given the chance, will mistakenly issue freely tradable shares to their star employees or new investors without the benefit of a shareholders’ agreement or other transfer control. Or, a shareholders’ agreement, once adopted, may be terminated or become unenforceable, leaving the corporation with unrestricted shares unless a restrictive article is in place. To establish a failsafe against these troubles, include share transfer controls in the corporation’s articles of incorporation. Don’t expect clients to call you first — even if they promised!

The Act allows the restrictions to be set forth in the articles of incorporation, bylaws, or a shareholders’ agreement.18 Transfer restrictions adopted by amendment to the articles of incorporation will not bind shares that were issued before the amendment unless the holder of those shares votes to pass the amendment.19 The existence of the restrictions must appear on the face or back of the stock certificates.20 The Act imposes few limitations on transfer restrictions. Certain types of purchasers may be disqualified if the disqualification is not “manifestly unreasonable.”21 Restrictions may be imposed to preserve the corporation’s status, its tax elections, or for “any other reasonable purpose.” Washington courts have upheld share restrictions that are reasonable at the time they are imposed.22

What should a practitioner include in a restrictive article for a Washington corporation? Practitioners will have sharply different views about this. Here are the features I suggest:

• Transfers in violation of the restrictions should be void and should not be recognized on the corporation’s books.
• The restrictions should permit normal stock transfers such as estate planning gifts, employee stock grants, stock restriction agreements, stock option plans, and redemption agreements, including insurance-funded redemptions.
• Stock pledges should be allowed with the corporation’s consent. Eligible buyers at foreclosure sales should be restricted.
• The shareholders should be able to waive the transfer restrictions for specific transactions.
• Shareholders should be allowed to voluntarily transfer shares after giving fellow shareholders and the corporation a right of first offer.
• Certain occurrences should give rise to involuntary buy-out rights: the death of a shareholder, the award of shares to an ex-spouse in a divorce, a shareholder/employee’s separation from employment, a creditor’s judicial or non-judicial seizure of the shares, or an indirect transfer of shares by an entity.
• Shares in the hands of an involuntary transferee should temporarily become non-voting shares until the expiration of the right of first offer period.
• There should be a binding non-judicial procedure for pricing the shares at market value through an appraisal or a formula (e.g., book value or a multiple of EBITDA).
• The payment of the purchase price for shares should be extended over a sufficient term to avoid a liquidity crisis for the corporation and the remaining shareholders.
• The transfer restrictions should be integrated with statutory dissenters’ rights.
• The transfer restrictions should explicitly declare a reasonable purpose.23
• Independent transfer restrictions should be included in the Articles to guard against a violation of state and federal securities laws and to avoid blowing any subchapter S election made by the corporation.
• The transfer restrictions should provide a foundation for (and can be integrated with) a shareholders’ agreement that would offer more sophisticated transfer restrictions, including clauses for buy-sell, drag-along, tag-along, structured employment separation buy-outs, etc.

Restrictive articles will be helpful, perhaps even popular with clients. They will be easy to adopt and inexpensive. Restrictive articles will never be as protective or as sophisticated as a comprehensive shareholders’ agreement, but they are much better than nothing, because nothing is all the Act presently offers.24  

Robert S. Klein practices business and real estate law at the law firm of Short Cressman & Burgess PLLC in Seattle. He is a partner and the co-chair of his firm’s Business & Tax Practice Group. He can be reached at rklein@scblaw.com or 206-682-3333.

NOTES
 1. A corporation is obligated to transfer ownership of shares on its books if the transfer application is in proper form and no transfer restrictions apply to the shares. See RCW 62A.8-204, 8-401; and RCW 23B.06.270.
 2. RCW 23B.02.020. The Washington Secretary of State’s website offers an abbreviated do-it-¬yourself form of articles of incorporation. See www.secstate.wa.gov/corps/registration_forms.aspx.
 3. An improvident transfer could disqualify a close corporation’s S-corporation tax election or could violate state or federal securities laws.
 4. RCW Title 23B. The Act is a modified version of the Model Business Corporations Act.
 5.A minority shareholder-employee will have a claim for being squeezed out of his corporation. Robblee v. Robblee, 68 Wn. App. 69, 841 P.2d 1289 (1992); Scott v. Trans-Sys., Inc., 148 Wn.2d 701, 709, 714, 64 P.3d 1 (2003); and see, e.g., O’Neal and Thompson, Close Corporations and LLC’s: Law and Practice (Revised 3d ed.), §9.3; O’Neal and Thompson, Oppression of Minority Shareholders and LLC Members (Revised 2d ed.).
 6. Minority shareholders may be squeezed out through a reverse stock split (RCW 23B.13.020(1)(d)) or other squeeze out techniques. O’Neal and Thompson, supra, §9.3. The corporation may dilute minority shareholder by issuing or granting new shares to others for fair value, especially if there are no preemptive rights. Each of these solutions is expensive and may provoke an action for corporate dissolution (RCW 23B.14.300(2)(b)) or other litigation.
 7. Andrew Carnegie was once asked the secret of his success. He replied: “Concentrate your energies, your thoughts and your capital. The wise man puts all his eggs in one basket and watches the basket.”
 8. O’Neal and Thompson, supra, § 7.2, page 7-4 through 7-6.
 9. More than 20 states have enacted special supplements for close corporations. This may have the advantage of providing standard transfer restrictions that remove the need and expense of having the founders draft a customized share transfer restriction. See, e.g., Wis. Stat. §§180.1801 through 1837 (2007); and see O’Neal and Thompson, Close Corporations, supra, § 1:15, page 1-99, and §1:19.
1 0. Generally, see RCW 23B.06.270; RCW 23B.02.020(6)(a). Washington’s Official Legislative History observes that RCW 23B.06.270 is intended to “guide practitioners” in the use of transfer restrictions. See Official Legislative History, Senate Journal 51st Legis. 3006-07 (1989).
 11. See O’Neal and Thompson, Close Corporations, supra, §§ 1:9, 1:15.
 12. RCW 18.100.110, RCW 18.100.116.
 13. Venture-capital-funded private corporations are subject to significant controls over the transfer of shares. See the model legal documents published by the National Venture Capital Association at www.nvca.org.
 14. Reference USA, www.referenceusa.com. (custom search parameters: Washington, public company). A search of the SEC’s EDGAR database using 10-K Wizard found that 121 public Washington corporations filed annual reports with the SEC during calendar 2006. www.10kwizard.com.
 15.VentureSource lists 285 venture-backed companies headquartered in Washington, without regard to the state of formation. 118 are Delaware corporations. The VentureSource list was checked against the Secretary of State’s corporate database to determine the number of Washington corporations. VentureSource offers a comprehensive database of venture-backed companies and their investors. www.venturesource.com.
 16. O’Neal and Thompson estimate that considerably more than one-half of all close corporations have adopted transfer controls. Id. at § 7.2, fn. 1.
 17. The Model Statutory Close Corporation’s Supplement provides standardized statutory provisions for close corporations, including transfer restrictions and repurchase of shares upon a shareholder’s death. See Volume 4, Model Business Corporation Act Annotated, Section of Business Law, American Bar Association, (3rd Edition, 2005 Supplement).
 18. RCW 23B.06.270(1); RCW 23B.02.020(6)(a).
 19. RCW 23B.06.270(1).
 20. RCW 23B.06.270(2).
 21. RCW 23B.06.270(3) and (4); and see the Official Comments of the Corporate Act Revision Committee, 1989 Journal of the Washington Senate, pp. 2983–3110; Landefeld and DeJong, Washington Business Entities: Law and Forms (2nd Edition, 2006), §11.07(c).
 22. In re West Water Way Lumber Co., 59 Wn.2d 310, 317, 367 P.2d 807 (1962); Rogers Walla Walla, Inc. v. Ballard, 16 Wn. App. 81, 91, 553 P.2d 1372, 1378 (1976). No Washington cases opine on RCW 23B.06.270. Some state courts have struck down transfer restrictions as unreasonable restraints on the alienation of property, though the majority of state courts have upheld transfer restrictions that are reasonable. See the cases collected in Volume 1, Model Business Corporation Act Annotated, Section of Business Law, American Bar Association, §6.27 (3rd Edition, 2005 Supplement). The fourth edition is due in January 2009.
 23. See Landefeld and DeJong, supra, §11.07(c), pp. 11–23.
24. I thank my law firm’s librarian, Patricia Pi, for her research help. I thank my law firm’s associate John Crosetto and my law partner John Sullivan for their advice and editing.