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OFFICIAL PUBLICATION OF THE CALIFORNIA NEW CAR DEALERS ASSOCIATION

Pub. 7 2025 Issue 1

Manning Leaver Legal Lane: The Importance of Shareholder Agreements

Shareholder agreements play a key and often crucial role in governing relationships among shareholders of a corporation and can be a very effective means to protect shareholders, including with respect to transfer of shares, voting rights and decision making. Shareholder agreements also provide a way to supplement or vary the default rules set forth in applicable law. Thus, a well-thought-out shareholder agreement can address many issues that may arise in the future, helping to prevent disputes and avoid costly litigation. This article highlights some of these important issues, and while it pertains to shareholder agreements, many of the same considerations are equally applicable to operating agreements of limited liability companies.

Restrictions on Transfer of Stock

By default, and subject to compliance with securities laws, generally stock of corporations may be freely transferred. However, particularly in small, closely held corporations with only a limited number of shareholders, the existing shareholders may desire to restrict who may become a shareholder of the corporation to limit the shareholders to persons known to the existing shareholders. There are a variety of ways a shareholder agreement can restrict the transfer of stock, including (i) prohibiting the transfer of stock without the consent of the other shareholders, (ii) providing other shareholders with a right of first offer or a right of first refusal if a shareholder desires to sell or transfer his or her stock, and (iii) prohibiting shareholders from encumbering their stock, such as by prohibiting a pledge of stock as collateral for a loan. When such restrictions on transfer are in place, there are often specified exceptions that would not require the consent of other shareholders or trigger rights of first offer or first refusal, such as transfers to a shareholder’s family trust or to other existing shareholders.

Buy-Sell Provisions

Shareholder agreements often contain put and call rights and may address the sale of stock upon the death, disability or termination of employment of a shareholder. For example, a minority shareholder may be granted a put right, namely the option to require other shareholders or the corporation to purchase the minority shareholder’s stock at a set price or pursuant to a specified formula, thus giving the minority shareholder a way to exit the corporation. Conversely, a shareholder or the corporation may be granted a call option, giving them the right to purchase the stock of a shareholder at a set price or pursuant to a specified formula. The right to exercise a call option is often triggered by a default by the selling shareholder under the shareholder agreement or another agreement or, if the selling shareholder is an employee of the corporation, by the termination of employment. Similarly, put or call rights may be granted to the corporation or shareholders with the trigger being the death or disability of a shareholder. Such rights may allow a disabled shareholder or the estate of a deceased shareholder to sell the stock so that liquid funds are available, allow the other shareholders or the corporation to prevent heirs or devisees of the deceased shareholder from becoming a shareholder, or allow removal of a shareholder that can no longer contribute to the business of the corporation.

Drag-Along and Tag-Along

Shareholder agreements can address issues that may arise if the corporation is to be sold through a stock sale. For example, if a majority of shareholders (usually a supermajority) agree to sell their stock as part of a stock sale of the corporation, drag-along rights allow them to force the remaining shareholders to sell their stock on the same terms. This protects the majority by preventing a minority holdout from stopping a stock sale of the corporation. As a protection to minority shareholders, a minority shareholder may be given the right to tag-along with the sale of stock by a majority of shareholders on the same terms. This protects the minority by not allowing the majority to sell their stock at a premium, potentially leaving minority shareholders behind or requiring them to sell at a lower price if they want to sell.

Protection of Minority Shareholders

Shareholder agreements can help safeguard minority shareholders’ rights and interests, such as by including provisions that prevent majority shareholders from making decisions that disproportionately benefit the majority shareholders at the expense of minority shareholders. In close corporations, this is especially important as the risk of majority shareholders exploiting their position is higher. As discussed in the following list, some topics a shareholder agreement may cover in this regard are preemptive rights, the right to appoint a director, dividend policies, supermajority approval requirements for certain matters and tag-along rights.

  • Preemptive Rights: To protect shareholders against dilution of their holdings in the corporation, a shareholder agreement may grant the corporation’s shareholders the right to have the first opportunity to purchase shares in the corporation’s future stock issuances.
  • Board of Directors: Bylaws typically specify the number of directors a corporation may have, and a shareholder agreement could specify who will serve on the board or give certain shareholders the right to designate a director. For example, sometimes a minority shareholder who does not hold enough shares to select a director by vote may be given a right to designate a director. A shareholder agreement may also specify when such a shareholder would lose the right, such as if their ownership percentage falls below a certain threshold.
  • Dividends: A dividend policy setting forth, among other things, when and under what circumstances dividends must be paid, can be included in a shareholder agreement to give minority shareholders some certainty as to payment of dividends.
  • Super Majority Approval: A shareholder agreement could require a super majority vote for approval of certain actions or transactions. For example, a shareholder agreement could require super majority approval, such as a two-thirds vote, for the sale of the corporation’s stock or all or substantially all of the assets of the corporation, for the issuance of additional stock, or to take specified actions outside of the scope of the corporation’s normal day-to-day operations. 
  • Tag-Along Rights: Tag-along rights are another means of protecting minority shareholders, and this is discussed under the Drag-Along and Tag-Along heading of this article. 

Confidentiality

If there is a need for shareholders to keep certain information confidential, such as trade secrets and proprietary business information, including customer lists, a shareholder agreement can set forth the confidentiality obligations of shareholders.

Non-Compete and Non-Solicitation

State and federal laws often limit or restrict non-competition and non-solicitation provisions. However, even where such laws exist, there may be exceptions allowing a non-compete provision in connection with the sale of a business, including the sale of stock of a corporation, or restricting solicitation that would use the corporation’s intellectual property. When admitting a new shareholder to a corporation, whether such provisions are appropriate or permitted should be considered and could be included in a shareholder agreement to the extent allowed.

Deadlock

Particularly if there are two 50% shareholders or another combination of shareholders where there is a possibility of a deadlock due to a 50-50 vote, the shareholder agreement may contain a provision on how such a dispute would be resolved. Common approaches to deal with deadlock include designating a third party to cast a tie-breaking vote outside of legal process, requiring arbitration or allowing one shareholder to buy out another shareholder.

Delegation of Management Rights; Simplified Corporate Procedures

When permitted, a shareholder agreement may transfer the powers of the board of directors to shareholders so that they can manage a corporation directly, and it may, in other ways, simplify corporate procedures by removing formalities such as requirements to hold director and shareholder meetings. For example, a California close corporation, meaning a California corporation whose articles of incorporation include a provision that all of the corporation’s issued stock may not be held by more than 35 shareholders and the statement “This corporation is a close corporation,” may contain such provisions. In very small, closely held corporations where management practices are often informal, this can be an important part of a legal compliance strategy as the shareholder agreement can set forth corporate requirements that comport with how the corporation will actually be run.

S-Corporations

If a corporation is an S-corporation, a shareholder agreement can contain provisions to help ensure that S-corporation requirements stay satisfied.

The previous issues are illustrative of important matters to consider when determining whether to enter into a shareholder agreement and what to include in it. However, there is no one-size-fits-all approach. Each jurisdiction has its own laws that may limit which and to what extent the foregoing issues can be addressed and when default statutory rules for corporations can be varied by a shareholder agreement. Moreover, whether certain minority or majority protections are appropriate for a particular group of shareholders will vary depending on the totality of the circumstances, and there are other issues that could be addressed in a shareholder agreement that are not discussed above. Accordingly, it is important to consult with counsel familiar with the applicable state laws and the needs of the corporation and its shareholders to determine what should be included in a particular shareholder agreement. It is also advisable to have a tax and accounting advisor and estate planning counsel review the agreement for possible tax, accounting and estate planning issues. At times, a short-form shareholder agreement addressing only a very limited number of issues may be sufficient and appropriate, and in other circumstances, a long-form agreement addressing many potential issues would be the best approach.

Particularly when admitting a new shareholder, it is very important to consider whether a shareholder agreement should be entered into. Even in existing corporations where there is no shareholder agreement, the shareholders may want to consider entering into a shareholder agreement to address future issues. If a shareholder agreement exists but was entered into many years ago or when different shareholders were in control of a corporation, it can be a worthwhile endeavor to carefully review it to see if the prior agreement is still a good fit for the shareholders. 

Manning, Leaver, Bruder & Berberich LLP is a Los Angeles law firm that practices throughout California and has been in existence for over 100 years. It has a strong automobile dealer practice covering all areas related to the automobile dealer industry, including dealership buy-sells, real estate transactions, business and consumer litigation, regulatory compliance, dealer association law, new motor vehicle board matters and franchise law. See manningleaver.com for more information and areas of practice. Nothing in this article may be considered as legal advice. Contact legal counsel for legal advice.

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