Buy-Sell Agreements: Unreasonable Restrictions on Alienation

In general, a buy-sell agreement is a contract between the owners of a company and the company which both restricts the transfer of ownership and facilitates the sale of an ownership interest. A buy-sell agreement provides a mechanism for an owner to sell his or her ownership interest in a closely held corporation or family company in which no public market for the ownership interest exists. It also protects the company and the remaining owners from an unwanted or disruptive third-party becoming an owner by placing restrictions on the sale of an ownership interest.

While a buy-sell agreement can restrict the transfer of ownership, an ownership interest in a company is personal property and therefore unreasonable restrictions on the transfer of awnership interest are void. A common and enforceable restriction includes requiring a selling owner to first offer his or her ownership interest to the company and the remaining owners before selling to a third party (rights of first refusal or option rights). Depending on the terms of the buy-sell agreement, the company or the remaining owners can then purchase the ownership interest at a price set by the buy-sell agreement or under the terms of the proposed sale to the third party. Such provisions allow the company and the remaining owners the opportunity to purchase the ownership interest and to control who becomes an owner of the company.

While rights of first refusal or option rights are generally enforceable as a matter of law, an absolute prohibition on the transfer of ownership is not, as it would unreasonably restrict the ability of an owner to sell his or her ownership interest. It is less clear whether provisions less restrictive than absolute prohibitions but more restrictive than rights of first refusal are enforceable. The North Dakota Supreme has provided some guidance on how it will analyze transfer restrictions and has shown some leeway in imposing restrictions more severe than just rights of first refusal.

Under North Dakota law, a transfer restriction is enforceable if it is “not manifestly unreasonable under the circumstances.” N.D.C.C. § 10-19.1-70. Although this statutory language appears lenient, North Dakota courts will construe provisions restricting an owner’s right to transfer his or her ownership strictly and disfavor such provisions. Sorlie v. Ness, 323 N.W.2d 841, 844-45 (N.D. 1982). Yet, this does not mean that transfer restrictions are unlikely to be enforced: North Dakota courts recognize the importance of protecting a company and the remaining owners from “undesirable influences” and will not disregard buy-sell provisions merely because they impose a hardship on the selling party. Id. The Sorlie court, for example, recognized that transfer restrictions allow a company and the remaining owners to preserve harmonious owner relationships and refused to strictly construe provisions making transfer restrictions applicable to sales after an owner’s death. Id. at 843-44 & 848-49. Instead, the Sorlie court held that the transfer restrictions survived an owner’s death and continued to govern the successors-in-interest’s sale of the ownership interest to a third party. Id. As Sorlie illustrates, the courts will look to the circumstances and purpose of the restriction and weigh the protection the restriction provides against the “general policy against restraints on alienation,” rather than just strictly construing all transfer restrictions. Id. at 845 (quoting Fayard v. Fayard, 293 So.2d 421, 423 (Miss. 1974)).

In Fayard, which the North Dakota Supreme Court cited approvingly in Sorlie, the court identified seven factors to be considered in determining the reasonableness of a transfer restriction:

  • Size of the company
  • Degree of restraint on the power to alienate
  • Time the restriction is to remain in effect
  • Method used in determining the transfer price
  • Likelihood of the restrictions contributing to the attainment of company objectives
  • Possibility that a hostile owner would injure the company
  • Likelihood of the restriction promoting the best interest of the enterprise as a whole

Fayard, 293 So.2d at 424.

Throughout these factors, the general theme is that the more protection the restriction provides to the company and the remaining owners, the more reasonable the restriction will appear to be. While the fairness of the restriction, such as determination of price or the length of time the restriction is effective, are considered, the factors mainly focus on the benefit the restriction provides to the company compared to the severity of the limits it places on an owner’s right to sell his or her ownership interest. The greater the protection achieved by the restriction, the more likely a highly restrictive provision will be enforced.

As the circumstances surrounding a transfer restriction will weigh heavily in determining whether it’s reasonable, there is no bright line rule to gauge the enforceability of an unusual transfer restriction. However, the factors identified in Fayard and the North Dakota Supreme Court’s balancing of the protection afforded by the restriction against its severity provide guidance in anticipating whether it will be enforced. When drafting buy-sell agreements and including transfer restrictions beyond a simple right of first refusal, the specific protection provided by the restriction should be identified and the above seven factors should be considered to evaluate whether the provision is too restrictive or whether it could be made more restrictive to provide greater protection to the remaining owners and the company.

Needless to say, a buy-sell agreement can not only be complicated, but if properly written, an extremely valuable document for business owners. If you feel your company could benefit from a buy-sell agreement, contact Steve Welle, an experienced business attorney at O’Keeffe O’Brien Lyson Foss in Fargo.  Steve can be reached at 701-235-8000 or toll free at 877-235-8002.

 

 

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