What Is an Involuntary Transfer?
In defining an involuntary transfer, let's first look at what it isn't. It (obviously) isn't a voluntary transfer (one where you have made a choice to sell, gift, or otherwise transfer ownership of your business interest to another party). Instead, an involuntary transfer is probably not on your top-10 list of choices for treatment of your property, and it might be the result of judicial action. The following table provides examples of voluntary and involuntary transfers:
*Owner's decision to dispose of personal interest **Often resulting from judicial action
What Does It Have to Do With Your Buy-Sell Agreement?
Your Business May Be Your Largest Asset
Very often, the business itself is an owner's largest asset, and the chance exists that you or your co-owner may want or need to pledge your individual interests as security. Although pledging the interest may be a voluntary act, a foreclosure on the pledged stock is probably not something you volunteered for. Careful planning can ensure that you don't suddenly find yourself in business with your co-owner's creditors.
Your Business May Be Part of Community Property
In community property states (presently Alaska (which has an optional system), Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington, and Wisconsin) and Puerto Rico, spouses normally own half of all property owned by the couple, essentially making your spouse your co-owner. As a result, your business interest could be subject to claims of your spouse's creditors, and without careful preparation, you could find yourself in business with your spouse's creditors. In addition, without careful planning, your spouse could leave half of the business interest to a third party through will provisions.
Tip: In community property states, the death of a spouse is often specified in the buy-sell agreement as a triggering event to the buyout.
Tip: In community property states, each owner's spouse should sign and agree to be bound by the provisions of the buy-sell agreement.
In a divorce situation, the court could award a portion of an owner's interest to the spouse as part of the settlement. This means it is all too possible that you could find yourself in business with your co-owner's spouse. In a family business where children are active in the business, you might find yourself stuck with your ex-son-in-law or ex-daughter-in-law as a co-owner (suddenly the business interest as wedding gift seems like a terrible idea). In the event that you become divorced, you could find that your ex-spouse (who never showed any interest in your business) is now your co-owner (and is suddenly full of ideas about how to run it).
Without Specific Language, Your Buy-Sell Agreement May Not Cover Involuntary Transfers of Your Business Interest
Most buy-sell agreements cover the necessary bases in terms of restricting voluntary transfers such as sales, exchanges, or gift transfers. The terms of the agreement are often drafted to establish a process of transferring an owner's interest in the event of death, disability, retirement, or a desire to withdraw from the business. What many agreements often fail to include is specific language covering involuntary transfers, such as those arising from a court action (e.g., a foreclosure or a divorce settlement). It is important to note that general restrictions on sales and transfers (which are usually considered by the courts to be voluntary) are not enforceable for involuntary transfers such as those resulting from judicial action.
Example(s): Hal, Mark, and Tom are the co-owners of a business and are bound under a buy-sell agreement. The agreement includes a provision whereby no current owner can sell or gift (voluntarily transfer) an interest to an outsider without offering it to the business or the other co-owners first. Mark and his (now ex-) wife, Lisa, just got a divorce, and the court awarded Lisa one-half of Mark's interest in the business as part of the divorce settlement (an involuntary transfer, not Mark's choice). The buy-sell agreement has been examined to determine if it can prevent Lisa from retaining the shares awarded to her by the court. The buy-sell agreement specifies that it applies to "both voluntary and involuntary transfers" and states that the current owners have the option to purchase any shares subject to an involuntary transfer. Lisa signed the agreement when it was drafted, as did all the other spouses. Consequently, the current owners have the option under the agreement to buy Lisa's share of the business.
Tip: The best way to make sure your agreement covers involuntary transfers is to make sure it specifically says so.
A Properly Drafted Buy-Sell Agreement Can Lay the Groundwork for Buying Back Any Shares Subject to Involuntary Transfer
Your buy-sell agreement probably won't prevent the courts from awarding pledged assets to creditors, and it probably won't stop the divorce courts from granting a spouse a portion of an owner's interest in the business. However, your buy-sell agreement can set a framework allowing for a smooth (and fair) buyout of the shares that might be awarded. It can provide a mechanism allowing the business entity, you, or your co-owners an orderly and efficient manner of buying back the interest awarded through involuntary transfer, thus preventing the situation of the unwanted partner.
Tip: Make sure your buy-sell agreement clearly states who has the option and/or the obligation to buy back shares subject to involuntary transfer.
How Can You Make Sure Your Buy-Sell Agreement Helps Keep Outsiders From Becoming Owners?
Include a Clause Covering Involuntary Transfers
Most buy-sell agreements restrict the ability of the parties to make voluntary transfers of their interests to a party outside the agreement. However, you or your co-owners could become involved in an involuntary transfer situation resulting from the actions of personal creditors or the divorce of an owner in the business. If your buy-sell is drafted to expressly include involuntary transfers in addition to the standard general sale and transfer restrictions, it should prevent distribution of the stock to an outside party such as a creditor or former spouse.
Tip: Make sure that the language in the agreement includes the phrase "involuntary transfers" and that the agreement broadly defines the term.
Make Sure the Buy-Sell Agreement Specifies an Action Plan for Handling Shares Subject to Involuntary Transfer
It isn't enough for your agreement to state that shares subject to both voluntary and involuntary transfer are subject to the terms of the agreement. The agreement should also specify what options and obligations arise should an involuntary transfer occur. For example, your buy-sell agreement has been drafted to include involuntary transfers, and your co-owner has been forced into personal bankruptcy. Under the terms of your buy-sell agreement, you and your two solvent co-owners have the option to purchase the shares of your co-owner that are subject to transfer resulting from the bankruptcy of your co-owner. The agreement further states that any shares not bought by the remaining co-owners must be purchased by the business itself.
Caution: Be aware that obligating the shareholders or the business entity to buy shares subject to an involuntary transfer (as opposed to providing an option) could represent a contingent liability unacceptable to the corporation or its shareholders or creditors and may represent a continuing threat to the company's capital structure.
Make Sure Spouses Sign the Buy-Sell Agreement (Awareness Equals Fairness)
It is a good idea for the spouses of all parties under the agreement to sign the agreement. The purpose is for the spouses to acknowledge that they have read the agreement and agree to be bound by it. By acknowledging they have read the agreement, they can't later claim that they were unaware the agreement existed.
Tip: It is a good idea to have separate legal counsel for the spouses of the buy-sell agreement parties.
Consider Including These Clauses
Right of First Refusal
The right of first refusal clause can be used to grant the owners or the business entity itself the right to buy (or refuse to buy) any interest in the business awarded through an involuntary transfer using a price or formula set in the buy-sell agreement. In the event the business owners or the entity choose not to buy the transferred interest, the transferee under the award would then be free to keep it or sell it to any willing buyer.
For example, your co-owner has just gone through a divorce. As part of the settlement, the court awarded his now ex-wife half of his share in the business. Under the terms of the buy-sell agreement, he has the right to buy back the shares subject to transfer. If he doesn't buy them, the agreement states that you have the right, as a current owner, to buy the shares. He doesn't buy the shares from his ex, but you do, thus keeping the ownership group intact (although at different percentages than before).
The mandatory buyout clause can be used to obligate the owners or the business entity to buy an interest in the business from a transferee in the event of an involuntary transfer, although it is generally not used for involuntary transfers. This clause can be beneficial in a family business when a son-in-law or daughter-in-law has been granted an ownership in the business as a result of the family association. Should the child in the family business become divorced, the mandatory buyout clause can provide for a buyout of the interest of the former son- or daughter-in-law.
For example, let's say that you granted an ownership interest in the family business to your son-in-law when he married your daughter. Now your daughter and your son-in-law are divorcing. Under the terms of your buy-sell agreement (of which the son-in-law is a party), the business entity itself is obligated to buy back the shares held by the soon to be ex-son-in-law, thus keeping the business in the family.
Tip: Make sure that all the owners of the business are bound under the agreement.
Caution: Obligating the shareholders or the business entity to buy shares subject to an involuntary transfer (as opposed to providing an option) could represent a contingent liability unacceptable to the corporation or its shareholders or creditors and may represent a continuing threat to the company's capital structure.
How to Make Sure the Restrictions Will Be Enforceable
Restrictions Pursuant to Divorce Must Be Fair
You can't set restrictions in your buy-sell that could be considered by the court system as unfair to the spouses. The buy-sell transaction can't use a price that is unreasonably low. One way to provide for a price that the courts will accept as fair might be to use the same value or valuation method that would be used for a lifetime withdrawal from the business (such as retirement or the desire to leave the business before then).
Each state has its own statutes governing family law, and community property states have rules concerning property rights. Work with your attorney to make sure your agreement complies with the laws in your state and will be considered fair.
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