Frye estate ruling highlights risks in shareholder agreements
This story was originally published by Law360 Canada, (www.law360.ca) a division of LexisNexis Canada.
By: Charlie Kim and Matthew McGuigan
Shareholders’ agreements often include restrictions on the shareholder’s ability to transfer their shares without the approval of other shareholders. This is particularly common in the case of owner-managed and closely held corporations, where the shareholders are keen on preventing unwanted third parties from acquiring shares of the corporation. Shareholders’ agreements for these types of corporations therefore tend to limit the persons to whom, and circumstances under which, shares may be transferred.
Facts
As the court emphasized, Frye concerned feuding siblings vying for control in the family business corporation, George H. Frye Holdings Ltd. Five siblings — Cheryl, Jack, Donny, Bing and Cam — held an equal ownership interest in the Corporation. The letters patent of the Corporation stipulated that the shares of the Corporation could not be transferred without the express sanction of the board of directors. In 1991, the five siblings entered into a shareholders’ agreement, which placed further restrictions on the transfer of shares. The shareholders’ agreement contained the following provisions:
Part I, para. 7
APPROVALS REQUIRED
The following matters, in addition to the approval required by the bylaws of the Corporation and the Business Corporations Act, shall require the approval of at least three (3) of Bing, Cam, Cheryl and Jack. [Donny was a disabled adult. Bing, Cheryl and Cam were appointed Donny’s trustees for two trusts held in his benefit.]
. . . . .
(m) Any transfer of shares otherwise as provided in this Agreement…
Part I, para. 11
TRANSFER RESTRICTED
Each of the Signatory Shareholders agrees that he will not sell, assign, transfer, grant options in respect of or otherwise deal with any of his shares in the capital of the Corporation, except in accordance with the provisions of this Agreement…
In 2002, Cam passed away and, despite the transfer restrictions contained in the shareholders’ agreement, his shares of the corporation were bequeathed to Cheryl under his last will and testament. The validity of this transfer was challenged by Jack, who argued that it was in violation of the shareholders’ agreement.
Analysis
The Ontario Court of Appeal acknowledged that the letters patent and the shareholders’ agreement applied to a transfer of shares through a last will and testament. However, notwithstanding that the bequest of Cam’s shares to Cheryl was prohibited by the shareholders’ agreement, the court nonetheless held that this transfer was not void and did not need to be set aside.
In support of its decision, the appeal court distinguished Cam’s (and ultimately his estate’s) contractual obligation with respect to transferring his shares and his rights at law to bequeath his assets. The court held that the purported transfer gave rise to a breach of contract but did not affect the validity of Cam’s last will and testament itself, and therefore held that it could not invalidate the share transfer.
The court also relied on s. 67(2) of the Business Corporations Act (Ontario), which states that a corporation is to treat “the executor, administrator, estate trustee, heir, or legal representative of the heirs, of the estate of a deceased security holder as a registered security holder entitled to exercise all the rights of the security holder that the person represents.” (The court noted that the term “heir” was to be interpreted as s. 27 of the Succession Law Reform Act stipulates — unless a contrary intention is apparent in a will, “heir” means “the person to whom the beneficial interest in the property would have gone under the law of Ontario if the testator or other person died intestate.” Therefore, the court was not concerned with Cheryl qualifying as an “heir” in Frye because she was a beneficiary under Cam’s will and therefore, was not an “heir.”)
On this basis, the Court of Appeal held that legal title to the shares was transmitted by Cam’s last will and testament to the estate trustees, who were to hold the shares in trust for Cheryl. Therefore, the estate trustees were the registered owners of the shares, but Cheryl was the ultimate beneficiary entitled to the shares per Cam’s last will and testament. The estate trustees were nevertheless bound by the shareholders’ agreement and could not distribute the shares out of the estate to Cheryl until the requirements of the shareholders’ agreement and letters patent were met.
The Court of Appeal’s decision, however, severely limited the practical application of the transfer restriction clause in the shareholders’ agreement. Although Cheryl could not become the registered owner of the shares, she nonetheless held the beneficial interest and could direct the estate trustees, as her bare trustees, as to how to exercise all the rights associated with the shares. Essentially, the court permitted an indirect transfer of the shares in violation of the shareholders’ agreement.
When drafting the share transfer restriction clause in a shareholders’ agreement, the parties should be wary of the practical implications that could arise as a result of the court’s decision in Frye. Strategic drafting can help alleviate such risks — particularly by including the following in shareholders’ agreements:
(1) The shareholders’ agreement could include a clause that states that any transfer of shares in contravention of the shareholders’ agreement will constitute an event of default. Upon the occurrence of such event of default, the shareholders’ agreement should provide the non- defaulting shareholders with the right (but not the obligation) to buy out the defaulting shareholders’ shares. Oftentimes, such a buyout provision will provide for a buyout at a discounted price.
(2) Although not preventing a transfer of shares in contravention of the shareholders’ agreement, shareholders’ agreements may provide for specific remedies in the event of a breach of the agreement. For instance, the shareholders’ agreement may provide that to the maximum extent permitted by law, all rights attaching to the shares are suspended and are inoperative until the purported transfer is rescinded, including the right to vote and to receive dividends or other distributions.
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