Check the Language of Your Agreements.

Owners of closely-held businesses, including family-owned companies, often agree to restrict the owners’ ability to later transfer their ownership interests to third parties. Such restrictions prevent one owner from selling his or her interest to a “stranger” with whom the remaining owners otherwise would not want to co-own or operate their business. These provisions also frequently require advance consent of the remaining owners before a sale to a third party or provide a right of first refusal through which the remaining owners may match the price offered for a departing owner’s interests before he or she sells to a third party. Transfer restriction clauses also sometimes provide exceptions for transfers to certain family members, such as an owner’s spouse or children, in order to provide continuity of ownership at least among the owners’ families. But what happens when a non-transferring owner does not want to do business with his departing co-owner’s children and refuses to acknowledge a transfer of ownership to them? A state appellate court in Illinois recently addressed such a situation in Kenny v. Fulton Associates, LLC.

According to the Court’s decision on appeal, Gerard Kenny, a businessman and contractor, and Eugene Callahan, a lawyer, had known each other for over 40 years, with Kenny describing Callahan as “almost like a brother.” They had operated several businesses together, including Fulton Associates, LLC, which owned a commercial building, and Canal Partners, which owned an adjacent parking lot. The operating agreement and partnership agreement for Canal and Fulton, from 1983 and 2001, respectively, each had provisions restricting the owners’ ability to transfer their ownership interest to any third party, other than to immediate members of their family, without the written consent of all owners.

Kenny was the named manager for Fulton, but Callahan managed its day-to-day operations and handled all the company’s legal matters. Callahan also represented Kenny and his family in other business and litigation matters. Kenny had signed a settlement agreement in 2002 with Cadlerock LLC and a separate mortgage in 2009 with Whoriskey LLC, which Callahan had helped negotiate. In those agreements, Kenny agreed that Fulton would not permit the transfOwnership Transferser of any ownership interest without the prior consent of Cadlerock or Whoriskey.

In 2009, Kenny sold his interests in Canal and Fulton to his two sons, Michael and Christopher. When Kenny asked Callahan to sign a consent to the transfer, Callahan refused and claimed that Kenny had not obtained Cadlerock’s or Whoriskey’s consents to the transfer. Callahan further refused to acknowledge the Kenny brothers as members or partners of the companies and thereafter did not seek or obtain their consent when taking any actions on the companies’ behalf. Instead, Callahan unilaterally appointed himself manager of Fulton and falsified articles of amendment in doing so, raised his own management fee, opened a bank account that only he could access, compensated his own law firm from company funds, and failed to notify Michael or Christopher that the sole tenant in Fulton’s building had not renewed its lease. In addition, Callahan and his son continued to run the day-to-day operations of Fulton’s building.

Kenny sold his interests to his two sons, Michael and Christopher. When Kenny asked Callahan to sign a consent to the transfer, Callahan refused…

Michael and Christopher sued Callahan for a declaration that they properly purchased Kenny’s interests in the companies under the terms of the relevant operating or partnership agreement and that they therefore were the rightful owners of 50% of each company. They also asserted claims for breach of fiduciary duty, based on his unauthorized conduct, and for an order that Callahan be dissociated as a member or partner of the companies as a result of his misconduct.

Callahan argued that Michael and Christopher did not properly acquire their interests in the companies because Kenny did not receive the consents to transfer required by the Cadlerock and Whoriskey agreements. The Court disagreed. Instead, the Court looked solely to the language of the companies’ operating and partnership agreements, which did not contain any condition on an owner’s transfer to an immediate family member. The Court further observed that, even if the separate Whoriskey and Cadlerock agreements prohibited Fulton’s members from transferring interests without consent, the language of those agreements did not “preclude or render void [Kenny’s] transfer, expressly permitted under the Operating Agreement.” The Court further noted that Whoriskey or Cadlerock may have had a basis to object to the transfers under the terms of their agreements, but Callahan could not advance those claims on their behalf by refusing to acknowledge a transfer, which the operating agreement otherwise permitted.

By looking at the plain language of the operating agreement, the Court noted that the parties agreed that a member may transfer his interest to immediate family members without prior consent, that Michael and Christopher were immediate family members, that the transfer of Kenny’s ownership interests was proper, and that Michael and Christopher had thus become owners of Fulton and Canal in Kenny’s place. The Court went on to affirm the trial court’s separate rulings that, through his unilateral and unauthorized activities, Callahan had breached the fiduciary duties he owed to Michael and Christopher as co-owners and, based on those breaches, that Callahan was dissociated as a member or partner of the two companies.

This decision provides at least three takeaways to consider when negotiating or implementing restrictions on ownership transfers. First, parties should consider whether an exception to consent requirements for transfers to immediate family members makes sense for their business or families. Even if owners know their co-owners’ family members, those family members still may not be desirable as business partners. Second, if there are agreements between a company or its owners and third parties that contain restrictions on ownership interest transfers, the owners would be well-served to reference compliance with the terms of those third party agreements as an additional condition to transfers permitted under the operating or partnership agreements. Third, and finally, if a permitted transfer has occurred, the non-transferring owner(s) and management should recognize the transferees as new owners and work in good faith to fulfill all fiduciary duties and other obligations owed to those new owners.