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Bar News - June 12, 2009

How “Freely Transferable” Are Those Minority Interests?


Daniel W. Sklar
One of the most important characteristics of a corporation is the fact that it has "freely transferable shares." This feature means that any stockholder, whether she holds a minority or majority interest, can, at least theoretically, monetize her investment by selling some or all of her stock. Because of "free transferability" most of us advise our clients, when forming a closely held corporation, to enter into what has become a fairly standard form of stockholder agreement. These agreements deal with a variety of issues form board membership to the death or disability of a stockholder. Additionally, they almost always contain a "right-of-first refusal" which runs first to the corporation and then to the other stockholders.

Specifically, the standard provision provides that if a stockholder actually receives a bona fide written offer to purchase his/her stock, which he/she intends to accept, the selling stockholder must present that offer to the corporation and subsequently to the non-selling stockholders and afford them the opportunity to match the offer within a prescribed period of time. What’s interesting is the fact that while I have drafted or reviewed dozens of these agreements, until this year I have never actually seen a minority stockholder attempt to sell stock under these or any other circumstances. More importantly, that recent experience has demonstrated the practical deficiencies that exist in the form agreement that is apparently being issued by a great many practitioners.

Think about what a minority stockholder actually needs in order to sell her stock for something close to its actual fair market value. More particularly, what will the potential buyer want to examine? The answer is the normal list of items found on any experienced buyer’s standard "due diligence list." For example, that due diligence list will request, inter alia, three to five years of financial statements, year-to-date statements, budgets, business plans, leases, intellectual properties, key contacts, employment agreements, employment files, a list of key or major customers, financial projections, technology descriptions, accounts receivable aging and tax returns, to list but a fraction of the total number of items requested and produced by a seller in even a relatively small corporation acquisition. In the absence of a specific contractual provision obligating the corporation to use its best efforts to respond to reasonable due diligence requests, what can the selling stockholder do to get the requested and required information? Unfortunately, not much.

In order to get any information from a corporation, the selling stockholder must look to RSA 293-A:16.02, Inspection of Records by Shareholder. That section provides in pertinent part as follows:

      (a) A shareholder of a corporation is entitled to inspect and copy, during regular business hours at the corporation’s principal office, any of the records of the corporation described in RSA 293-A:16.01(e) if he gives the corporation written notice of his demand at least five business days before the date on which he wishes to inspect and copy.

     (b) A shareholder of a corporation is entitled to inspect and copy, during regular business hours at a reasonable location specified by the corporation, any of the following records of the corporation if the shareholder meets the requirements of subsection (c) and gives the corporation written notice of his demand at least five business days before the date on which he wishes to inspect and copy:
1. excerpts from minutes of any meeting of the board of directors;
2. accounting records of the corporation; and
3. the record of shareholders
     (c) A shareholder may inspect and copy the records described in subsection (b) only if:

1. his demand is in writing, and is made in good faith and states a proper purpose;
2. he describes with reasonable particularity his purpose and the records he desires to inspect; and
3. the records are directly connected with his purpose.
The New Hampshire Supreme Court has not been called upon to interpret or apply this statute. However, Delaware has a number of decisions and, assuming that the New Hampshire Court would, like most state supreme courts, at least consider the Delaware precedents, one can readily conclude that the statutory right to information is not going to come close to getting the selling stockholder the necessary information.

First the selling stockholder has to satisfy the requirements of subsection 16.02(c) which states that in order to obtain any information she must have a "proper purpose;" that she describe that purpose in writing and that the information requested is directly connected with her purpose. Id.

Confronted with this specific situation, the Delaware courts have held in several cases, that the paramount facts in determining whether a stockholder is entitled to inspect the corporation’s books and records is the propriety of the stockholder’s purpose in seeking such inspections. See CM&M Group, Inc. v. Carrol, 453 A.2d 788 (Del. 1982); Kortum v. Webasto Sunroofs, Inc., 769 A.2d 114 (Del. Ch. 2000). According to the CM&M court, a "proper purpose" is one which is reasonably related to such person’s interest as a stockholder and the court determines whether a stockholder’s purpose is properly based on the facts of each case. Id. The Court went on to hold that once a proper purpose has been established, any secondary purpose or ulterior motive of the stockholders becomes irrelevant.

Consequently, the Court ruled that the stockholder’s stated purpose of "valuing one’s shares" was a proper purpose and therefore constituted the valid basis for a request to inspect the corporate book and financial records. Similarly, the Court also concluded that the concurrent intent to complete that valuation in connection with a desired sale of the stock remained a legitimate purpose despite that "secondary" purpose or motive. Therefore, in order to satisfy the requirements of §16.02(c), the selling stockholder must submit a written demand listing the records to be inspected and describing the purpose for the request as being a desire to conduct a valuation of the stock and, secondarily, to assist in her effort to market and sell the same.

Once the stockholder overcomes the foregoing hurdle of establishing a "proper purpose," the statute then rewards that accomplishment by limiting the scope of the available information. First, §16.02(c)(3) provides that the requested records must be "directly connected with this purpose." Given that the "purpose" is to complete a valuation, one can readily imagine the intensity of the disputes that can originate around that limiting provision. Similarly, §16.02(c) further provides that regardless of §16.02(c)(3), the requesting stockholder can only inspect and copy " . . . the records described in subsection (b)." Subsection (b) provides that a stockholder who meets the requirements of subsection (c) may inspect and copy: " . . . (1) excerpts from minutes; (2) accounting records; and (3) the record of shareholders."

Based on the foregoing, most of the due diligence information will have to come under §16.02(b)(2). The simple reference to "accounting records" probably won’t be sufficient or broad enough to provide the selling stockholder with all of the information she actually needs in order to realize the full fair market value of her stock.

To add "insult to injury," once you get information from the corporation, that doesn’t necessarily mean you can disseminate it freely among the universe of potential buyers. The corporation may seek to impose certain restrictions upon the selling shareholder’s ability to use or release the information. At the very least, management will want to ensure that each recipient executes a non-disclosure or confidentiality agreement before receiving copies. By demanding the use of an onerous confidentiality agreement, the corporation can effectively limit or completely eliminate the stockholder’s ability to market her stock.

There may not be much we can do about existing stockholder agreements. Going forward, however, there is a great deal that we can do on behalf of passive investors and minority stockholders:
  • First, there should be a stockholders agreement to deal with the transferability issue. The issues can also be dealt with in the by-laws, but by-laws can be amended by the majority, while the agreement cannot.
  • Second, the corporation must be a party to the agreement. Third, the agreement should provide that in the event a stockholder wishes to sell his or her shares, then upon the receipt of written notice to that effect, the selling stockholder shall be entitled to inspect and copy all of the materials specifically listed on a schedule to the agreement or all of the materials certified by an independent investment banking firm as being necessary and customary for a transaction of that size and type.
  • Finally, the corporation should agree that the due diligence materials produced to the selling stockholder can be released to potential buyers after they execute and deliver to the corporation an NDA (non-disclosure agreement) in a form substantially similar to the one attached to the agreement as an exhibit.
Once those provisions are put into effect, the minority stockholders will actually own "freely transferable" shares if you agree that included within that term is the ability of a seller to actually realize the fair value of her stock as opposed to having to give it away.

Daniel Sklar is an attorney with Nixon Peabody in Manchester. He has been a member of the NH Bar since 1978.

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