One of the pleasures of being a litigator is that we constantly learn. The pleasure multiplies as a law blogger, where articles we write inspire litigation arguments, and litigations we fight inspire articles. Recently, my blogging and litigation worlds merged, cross-inspiring one another in some interesting ways.
A client who came across one of my articles about her case engaged our firm to represent her and her late husband’s estate when the outlook seemed dire.
Then, an article from earlier this year by my co-blogger, Peter Sluka, germinated a legal argument in the case challenging enforceability of a stock transfer restriction in a shareholder’s agreement our opponent argued caused a 50% stock interest worth millions of dollars to be “forfeited” because the deceased shareholder attempted to bequeath the shares to his widow in violation of a transfer restriction limiting permissible bequests only to one’s “issue.”
Coming full circle, as I researched more about this niche area, the things I learned for the litigation are now the inspiration for this week’s article.
Two weeks ago, Bronx County Commercial Division Justice Fidel E. Gomez issued a Decision and Order in Worbes denying as “patently premature” our opponent’s pre-discovery motion for summary judgment, denied our clients’ cross-motion also on prematurity grounds, and granted our clients leave to allege several new counterclaims, including to challenge enforceability of the stock transfer restriction on public policy grounds. Our clients filed the amended pleading last week.
Arguing public policy to challenge enforceability of a stock transfer restriction might sound like a shaky proposition. But, as it turns out, there are several strands of interrelated New York case law invalidating stock transfer restrictions and buy-sell agreements on public policy grounds where the effect of the agreement is to cause “forfeiture” or “annihilation” of a valuable closely-held business interest for little or no consideration.
In the case Peter Sluka wrote about earlier this year, Atlantis Mgt. Group II LLC v Nabe (2022 NY Slip Op 30399[U] [Sup Ct, NY County 2022]), Manhattan Commercial Division Justice Jennifer G. Schecter ruled that a buy-sell provision in an LLC operating agreement triggered upon breach of “any provision” of the agreement, and forcing the sale of a member’s interest to the other for $1 — a “forfeiture for a dollar” — is a “draconian,” “grossly disproportionate, unreasonable, unenforceable penalty.” “By punishing any breach, however minor, with forfeiture of valuable interests in exchange for a mere dollar,” Justice Schecter ruled, “the intent of the provision is purely punitive” and unenforceable as against public policy.
Atlantis relied on case law outside of the closely-held business context (see e.g. Truck Rent-A-Ctr., Inc. v Puritan Farms 2nd, Inc., 41 NY2d 420  [liquidated damages provision in a truck lease agreement]; Beltway 7 & Props., Ltd. v Blackrock Realty Advisers, Inc., 167 AD3d 100 [1st Dept 2018] [loan agreement]). But there are several lines of case law akin to Atlantis in the closely-held business context.
First, the Court of Appeals has held that a stock transfer restriction absolutely prohibiting inheritance of a decedent’s stock without consideration to the deceased shareholder’s estate is void as against public policy. In Quinn v Stuart Lakes Club, Inc. (80 AD2d 350 [1st Dept 1981]), a corporation’s by-law provided that when a shareholder died, his stock “shall be considered void,” which the Court characterized as “survivorship lottery” prohibiting inheritance of a shareholder’s stock so “the last survivor shall fall heir to the corporation.” The Court ruled that such a restriction, prohibiting by-operation-of-law transfers upon death, “is not to be given effect.”
Affirming this holding, the Court of Appeals ruled, “We agree that article 9 of the corporation’s by-laws is void as an absolute restraint on the power of alienation violative of the public policy in this State” (Quinn v Stuart Lakes Club, Inc., 57 NY2d 1003 ).
Second, under New York law, a stock transfer restriction with terms so “onerous” it would result in “annihilation of property” is unenforceable (Lam v Li, 222 AD2d 290 [1st Dept 1995]; Rafe v Hindin, 29 AD2d 481 [2d Dept 1968], affd 23 NY2d 759 ).
In Lam, the Court explained, “In New York, certificates of stock are regarded as personal property,” and “the right of transfer is a right of property,” so “if another has the arbitrary power to forbid a transfer of property by the owner, that amounts to annihilation of property” (quotations omitted). Lam ruled that the “onerous terms” of an option for one shareholder to purchase the stock of another for just $10 “effectively prevent defendant from transferring the stock to anyone but plaintiff,” rendering the option “unreasonable” and “unenforceab[le].”
In Rafe, the Court found that “since no price is stated at which the plaintiff must sell” to defendant “and which the latter is required to pay to the plaintiff for the plaintiff’s stock,” the contract “may be construed as rendering the sale of the plaintiff’s stock impossible to anyone except to the individual defendant at whatever price he wishes to pay.” Rafe concluded, “The restriction is not only not reasonable, but it is against public policy and, therefore, illegal.”
Third, the Appellate Division has held that interpretation of a partnership agreement to “bestow a windfall” upon one business owner to the detriment of another violates the rule that a “contract should not be interpreted to produce a result that is absurd, commercially unreasonable, or contrary to the reasonable expectations of the parties” (In re Lipper Holdings, LLC, 1 AD3d 170 [1st Dept 2003]).
Under this principle, in Cole v Macklowe (99 AD3d 595 [1st Dept 2012]), the Court reversed a decision holding that a partner was automatically “divested” of his partnership interest by not exercising a buy-sell provision in the partnership agreement upon termination of employment, holding that Cole’s “failure to sell his interest did not divest him” automatically of the interest. “Not only is the agreement void of any language mandating this result,” held the Court, “the interpretation of the agreement urged by defendants—allowing them to acquire plaintiff’s partnership interest” for no “consideration” “represents a windfall to the defendants that is absurd, not commercially reasonable and contrary to the . . . intent of the parties.”
The words they use vary, but all of these cases essentially say the same thing: equity in a closely-held partnership, corporation, or limited liability company is valuable personal property.
Under this principle, a transfer restriction or buy-sell agreement that would impose a “forfeiture” (Atlantis), cause an ownership interest to become “void” (Quinn), result in “annihilation of property” (Lam and Rafe), or “bestow a windfall” (Lipper and Cole), is vulnerable to attack as unenforceable under public policy.