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Share transfer restrictions in closely held corporations: shareholders' protection and exit strategies

MRÁZOVÁ, Ž.: Share transfer restrictions in closely held corporations: shareholders‘ protection and exit strategies. Právny obzor, 105, 2022, special issue, pp. 29-43

Share transfer restrictions in closely held corporations: shareholders’ protection and exit strategies. Share transfer restrictions represent a typical characteristic of closely held corporations and family businesses. Default provisions of Slovak law on share transfer in limited liability companies creates a broad scope for drafting individual types of restrictions in a most creative variety of manners. When opting for a specific share transfer restriction, shareholders should not only focus on the primary interest of maintaining a stable personal structure of the company with a view of protecting the business from the entry of unwanted third parties, but also take into account potential exit scenarios which – in closely held corporations – often are the only possibility to resolve an ongoing conflict of interests between the shareholders. Therefore, when forming a company, the author assumes it is important to carefully and precisely draft the selected type of share transfer restriction in the corporate contract or  shareholders’ agreement to properly resolve potential conflicts among shareholders and allow smoothly exit of affected party. Also, shareholders should not neglect to consider the occurrence of situations when statutory restrictions affect the share transfer, and vice versa, when a stipulated share transfer restriction may be unlawful or unenforceable.

Keywords: share transfer restrictions, close corporations, limited liability company, articles of association, contractual freedom, pre-emptive rights, shareholders´ agreements

"Had we only considered it in the beginning..."
is a phrase we often hear in practice when it comes to a deadlock, or incurable differences among the shareholders. When forming a company, prospective shareholders mostly concentrate on the economic side of business and, when determining the management and governance, focus on the allocation of property and voting rights, often neglecting to consider efficient mechanisms to resolve potential intracompany conflicts. Overconfidence, overoptimism and initial excitement for doing business prevents the parties from eliciting thoughts about the methods of resolving future conflicts of interests and exit strategies.
In addition, increased transaction costs associated with the setting-up of an additional corporate right might lead to a contracting passivity of the prospective shareholders, even in situations where the negotiation of the business parties would be more efficient and improve their position in the legal relationship. Therefore, shareholders often rely on the statutory ready-made standards that - although being intended to fill contracting gaps - are often insufficient and inadequate to resolve the case at hand.
Yet a careful consideration of rules agreed beforehand (ex ante) has a significant influence not only on maintaining the company's primary ownership structure, but also on a smooth and efficient procedure of a shareholder's exit as one of the potential solutions to a conflict between the shareholders.
While by definition, free transferability of shares is the one of the defining feature of corporations,
various share transfer restrictions are typical for closely held corporations and family businesses, as stipulated in the articles of association or shareholders' agreement.
Closely held corporations are characterised by a small number of shareholders who live in the same geographic region, are bound by a family bondage, or know each other well, and all or at least as much as the majority of them are represented in the company's bodies, or are key employees.
Personal and family relationships, that underlie the cooperation between the shareholders in closely held corporations, are beneficial for a stable functioning of the company. It is also applied that how closely the corporation is held, may be modified within statutory limits. An appropriately chosen type of share transfer restriction may not only suitably protect the corporate ownership structure from the entry of unwanted third parties, but also provides for a shareholder not being locked in the company for good without a possibility of exit.
In the process of company formation, it is therefore advisable to pay reasonable attention to a careful drafting of share transfer restrictions, their anchoring in the respective document, depending on whether it is intended to be of contractual or corporate nature, and, last but not least, the possibilities of their efficient application in specific situations,
i. e
. in the event of share transfer to other persons or handover to the next generation or legal successors. Share transfer restrictions shall always be considered and appropriately arranged so as the interests of both the exiting and the continuing shareholders in a closely held corporation, and the interest of the business organisation itself, are protected.
The most common ground for a share transfer restriction in closely held corporations is kinship, loyalty and mutual trust between the shareholders.
In practice, share transfer restrictions are utilized as a tool for protecting the interests of the shareholders, the company, and the creditors. Their importance lies in safeguarding the stability of ownership and they serve as control over the composition of the circle of shareholders. Thus, restrictions fulfil the protective function where the ownership structure is meant to be bound to specific individuals. On the one hand, their purpose might be to prevent a discretionary share transfer to persons outside the initial ownership structure; on the other hand, to frustrate the exit of a key shareholder, at least for a certain limited period. Another purpose of restriction arrangements might also be the protection against the strengthening of the position of one of the shareholders to the detriment of the other (minority) shareholders or against the forming of a blocking majority. Any of the named reasons follows a different interest that primarily should be considered when drafting a specific rule restricting share transfers.
Individual methods of restricting transferability of shares may be laid down in corporate contracts (memorandum of association, articles of association), shareholders' agreements or other sideletters. As we will discuss later, share transfer restrictions may be even directly imposed by law. Our further attention will be primarily centred on the interpretation of share transfer restrictions in a limited liability company (
spoločnosť s ručením obmedzeným
) as the most commonly used form of business organisation for small and medium-sized enterprises in Slovak jurisdiction.
1. Transferability of shares and its restrictions
The Slovak law on limited liability companies provides for different requirements for share transfers among the shareholders and the transfer to a person outside the company. While the transfer of a share to another shareholder is allowed with the consent of the general meeting,
the transfer of a share to
is prohibited by default provisions,
unless explicitly allowed by the articles of association, while it may still be subject to the consent of the general meeting.
Although the Slovak Commercial Code explicitly establishes (intracompany transfer) or admits (external transfer) a share transfer restriction by consent of the general meeting and articulates the consequences of a dissent (transfer not effective towards the company),
it does not explicitly provide as to whether it is also possible to restrict the transfers by other means, or whether a transfer to another shareholder may be completely excluded. However, relying on the fundamental principle of the autonomy of shareholders' will, we assume that in a limited liability company, shareholders can stipulate a wide variety of terms and rules that either restrict any transfers, or even exclude them completely.
a) Types of share transfer restrictions and their legal limitations
Although the only restriction the law provides with respect to a limited liability company is the consent of the general meeting (which will be discussed in more details further below), the default nature of Section 115 of the Slovak Commercial Code allows to draft various forms of share transfer restrictions.
Individual methods of restricting share transfers include the
prohibition clauses
, that both prohibit share transfers in general (transfer exclusion), or subject the transfer to certain
time requirements
(such as the articles of association providing that within five years from the company formation, the shareholder must not transfer its share to another shareholder or a third party), or
personal requirements
on potential acquirers (such as transfer prohibition applying to all persons, except for relatives, the transfer is permitted to existing shareholders only, or the prospective acquiring shareholder is subject to other restrictions relating to education, expertise or kinship). Moreover, the transfer of a share might be subject to the provision of specific terms and rules (such as prohibition to donate the share, admissibility of transfer only upon the settlement of the entire shareholder's contribution, etc.). Shareholders may also be bound by certain conditions only on selected transfers (such as transfer for value to a person other than relatives). The articles of association may further stipulate the terms of transfers in the form of information obligations of the transferring shareholder with respect to other shareholders/company or as an obligation set for (each) acquirer to accede to the shareholders' agreement. Individual restrictions may be drafted as positive or negative requirements. Since a proof of having fulfilled the abovementioned terms of transfer may prove to be difficult in practice, it is recommended to leave the review of their fulfilment to a company body.
We further distinguish
consent clauses
, namely clauses requiring the consent of the general meeting or other corporate boards, specific shareholders with the right to overrule the decision (shareholders with veto right), or of third parties. In our opinion, the transfer of a share in the company may also be restricted by requirement of the consent of a person outside the company (bank, father of a family whose sons are shareholders). The transferability of share may also be restricted by utilizing various forms of pre-emptive right, such as the right of first refusal, the right of first offer, or options (call option, put option). Other share transfer restrictions include the tag-along right, the drag-along right, and the sh
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