Precautionary Measures for Companies who Issue Stock to Employees

By Benjamin Jensen
(801) 365-1017
ben@snjlegal.com

 

Utah companies can encounter shareholder disputes when they issue stock to an employee in exchange for services that are never performed or only partially performed. If the company issued the shares to the employee before the services were performed, the company will have little hope of recovering the shares in the absence of certain legal protections. In this article, I outline two legal protections that can act as precautionary measures for Utah companies that issue stock to employees[1].

Place Restrictive Legends on Shares.

Whether the business is a corporation or another form of entity, issuers of stock can protect themselves by adding restrictive legends to their issued shares. Restrictive legends are notices to third parties that prevent the free transfer of shares until certain regulatory and/or contractual obligations are met. Employee-shareholder agreements should be drafted jointly with restrictive legends that condition a corporation’s obligation to register issued shares on fulfillment of the agreement’s terms. In the hypothetical below, I discuss the legal effect of a generic restrictive legend on an
employee-shareholder’s ability to register shares for sale and provide a counter example of a restrictive legend that tailors the sale of shares to terms of an employee-shareholder agreement.

Mike’s Pizza

Suppose Mike’s Pizza decides to bring its supply chain in-house. After purchasing a dairy farm, Mike hires his friend Jeff, a longtime dairy farmer, to manage the dairy’s operations. The employee-shareholder agreement grants Jeff 1,500,000 shares of Mike’s Pizza common stock and pays Jeff $500,000 annually to manage the dairy’s daily operations over a 10-year period. The restrictive legend on the shares reads as follows: 

These securities have not been registered under the securities act of 1933, as amended. They may not be sold, offered for sale, pledged, hypothecated or otherwise transferred in the absence of an effective registration statement as to the securities under said Act or an opinion of counsel or other evidence reasonably satisfactory to the company that such registration shall no longer be required.

Jeff operates the dairy for four years, but then decides to resign from his position and retire before fulfilling the full term of his contract. Jeff attempts to register the shares for sale, but counsel for Mike’s Pizza refuses to write an opinion letter approving registration of the shares on the grounds that Jeff failed to fulfill the terms of his employment contract. Is the language on the restrictive legend sufficient to prevent
transfer of the shares?

No. Jeff can freely register his shares for sale because there is no specific language on the restrictive legend tying Jeff’s transfer of the shares to his fulfillment of the agreement.  Jeff only needs to properly fill out share transfer paperwork and receive an opinion letter from an independent attorney stating that the transfer would comply with applicable securities laws. There is nothing Mike’s Pizza can do to prevent registration of the shares.

Now consider a similar scenario, but this time the restrictive legend on Jeff’s shares includes the following language: 

These securities have not been registered under the securities act of 1933, as amended. They may not be sold, offered for sale, pledged, hypothecated or otherwise transferred in the absence of an effective registration statement as to the securities under said Act or an opinion of counsel or other evidence reasonably satisfactory to the company that such registration shall no longer be required. The Sale or other Transfer (whether voluntary, involuntary or by operation of law) of the shares of stock represented by this certificate is subject to the restrictions on transfer set forth in the Employee-Shareholder Agreement dated January 1, 2023, between Mike’s Pizza and the holder. A copy of the Employee-Shareholder Agreement may be obtained from the Corporation

When Jeff attempts to register his shares for sale, any purchaser or transfer agent will be notified that the shares are restricted pursuant to the terms of the employee-shareholder agreement. The notice provided by the restrictive legend allows Mike’s Pizza to refuse registration of the shares for trade, and the two parties can reach a compromise regarding the fulfillment of the agreement and registration of the shares. 

Special Protection under the Utah Business Corporations Act.

Absent any restrictive legends, issuers that incorporate in Utah have statutory protections that, if followed, authorizes corporations to take special acts to deal with employee-shareholders who fail to fulfill their part of the employee-shareholder agreement. Under the Utah Business Corporations Act, a Utah corporation can place shares in escrow and apply credits to an employee-shareholder account until the employee-shareholder fulfills the agreement’s terms. Upon completion of the services, the shares can be released in exchange for the accrued credits. If the employee fails to
provide such services, then the shares can be cancelled or rescinded unilaterally by the corporation.

The old saying that “possession is nine-tenths of the law” is especially true of laws regulating investment securities. For a variety of reasons, corporations that allow employees to hold unearned stock in their name face an uphill battle cancelling or preventing the free trade of unearned shares. The process I’ve described prevents employee-shareholders from possessing the shares, and provides a statutorily-authorized means by which a corporation can unilaterally cancel shares that were issued in exchange for services. It is a panacea for corporations who don’t want to waste time litigating securities issues down the road.

If you have any legal questions about the rights of employee-shareholders, or the status of shares issued pursuant to an employee-shareholder agreement, please contact the law offices of Skoubye Nielson and Johansen to consult with one of our attorneys. 

 

By Benjamin Jensen
(801) 365-1017
ben@snjlegal.com


[1] In this article,
the phrase “employee-shareholder agreements” is intended to include both
employment agreements and associated stock purchase agreements.

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