Failure To Follow Corporate Formalities – Fatal To Breach Of Contract Claim
Posted Oct 28, 2020
By Washington State Business and Real Estate Lawyer David C. Tingstad
No two closely held business are alike. In a corporate setting, following corporate formalities is critical for a host of reasons, including to maintain the separateness of the corporation from the shareholders. A recent Washington decision, Nelson v. Vetter, Inc., No. 80144-9-I, 2020 WL 6036825 (Wn. App. Oct. 12, 2020), reminds us of the need to comply with corporate formalities in a timely manner.
In 2001, Plaintiff Nelson became employed by defendant Vetter, Inc. (the “Company”) pursuant to a written employment contract. The contract provided that the Company would issue 15% of the stock in the Company to Nelson in a series of transactions in exchange for his services beginning two years of employment. Nelson proceeded to work for the Company for 18 years, but never received a stock certificate.
In 2008, the Company started paying dividends to the Company president, Vetter. Then, in 2009, Vetter stepped down and hired a replacement, Appleby. Upon hiring Appleby, Vetter transferred 5% of his stock to Appleby.
The Company’s bylaws provided:
The capital stock of this corporation shall be represented by stock certificates signed by the President and attested by the Secretary. All certificates shall be numbered consecutively in the order in which they are issued. On the stub of each certificate issued shall be entered the name of the person owning the shares thereby represented, with the number of shares and the date thereof. All certificates exchanged or transferred to the corporation shall be canceled, and no new certificates shall be issued in lieu thereof until the old certificate is canceled.
Transfers of stock shall be made upon the books of the corporation upon the written request or assignment of the holder, filed with the corporation, on the surrender of the certificate for such stock.
Appleby immediately began receiving distributions after the transfer, but Nelson received nothing. Again in 2015, Vetter transferred additional shares to Appleby. Then, in 2018, Appleby and Vetter sold all of the stock to a third party. Upon learning of the sale, Nelson demanded 15% of the sale proceeds. The Company refused and Nelson filed suit for breach of contract. The Company defended on the grounds that Nelson’s claim was barred by the statute of limitations.
Stock Transfers and Certificates
In Washington, the statute of limitations to bring an action for breach of a written contract is six years from the time of breach. The question for the appellate court was when was the employment contract breached? Nelson argued that breach occurred in 2018 when the Company failed to pay Nelson 15% of the sale proceeds. The Company argued that breach occurred in 2003 and 2004 when Nelson should have first received stock certificates for his shares, and again in 2008 when the Company failed to make distributions to Nelson.
In resolving this issue, the appellate court examined whether Nelson ever actually received shares under the RCW 23B, Washington’s Business Corporations Act, and the Company’s bylaws. RCW 23B.06.260 governs the issuance of stock certificates as a representation of actual shares owned. Notably, RCW 23B.06.260 does not require issued shares to be represented by stock certificates:
Unless the articles of incorporation or bylaws provide otherwise, the board of directors of a corporation may approve the issuance of some or all of the shares of any or all of its classes or series without certificates. The approval does not affect shares already represented by certificates until they are surrendered to the corporation.
The court focused on the key language of “unless the…bylaws provide otherwise.” In this case, the Company’s bylaws did in fact provide otherwise. The court noted that “the bylaws clearly state that [the Company’s] stock ‘shall be represented’ by stock certificates, that certificates ‘shall be issued’ after the old certificate is cancelled, and that stock transfers will take place only ‘on the surrender’ of the old certificate.” As such, Nelson never actually received any stock pursuant to his employment agreement. Therefore, the employment agreement was breached when Nelson failed to receive stock in 2003 and 2004, and then again in 2008 when the Company failed to make distributions to Nelson. Nelson failed to bring suit to enforce the terms of his written employment agreement within six years from 2003 or 2008. As a result, the appellate court affirmed the trial court’s dismissal.
Every closely held entity, whether a corporation, partnership, or limited liability company is unique. Many corporate statutes begin with the assertion: “Unless the articles or bylaws provide otherwise ….” Our LLC Act regularly states “Unless otherwise provided in an LLC agreement …” In Nelson, there is no question that the employee was entitled to stock in the corporation. However, no stock certificates were ever issued to him as required by the bylaws. Without compliance with the Company’s bylaws, Nelson never became a shareholder.
It is true that many corporations do not issue stock certificates. However, many corporations’ articles of incorporation or bylaws require stock certificates. Careful compliance with corporation’s governing documents is required for a host of issues, as is compliance with the relevant statues. Because every closely held entity is unique, having a complete understanding an entity’s governing documents is essential.
Adding further complexity for LLCs, in Washington (as in many other states), LLC agreements may be oral or written. How does one know the terms of the complete LLC agreement when the agreement can be partially oral and partially written? No one ever said it was easy, but stay tuned as these issues will continue to evolve.
For more Washington business entity law considerations, refer to this blog every Wednesday at 12 PM, noon.
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