A Closely Held Corporation Sought To Repurchase 25 Percent O

A Closely Held Corporation Sought To Repurchase 25 Percent Of Its Outs

A closely held corporation sought to repurchase 25 percent of its outstanding shares from one of its shareholders. The corporation and the shareholder agreed that the corporation would purchase all of the shareholder’s stock at a price of $500,000, payable $100,000 immediately in cash and the balance in four consecutive annual installments. The state’s incorporation statute provides: “A corporation may purchase its own shares only out of earned surplus but the corporation may make no purchase of shares when it is insolvent or when such purchase would make it insolvent.” At the time of the repurchase of the shares, the corporation had an earned surplus of $250,000. What are the arguments that the repurchase of shares satisfied the incorporation statute? What are the arguments that the repurchase of the shares did not satisfy the incorporation statute?

Paper For Above instruction

The legal question surrounding the repurchase of shares by a closely held corporation hinges on whether such a transaction complies with statutory requirements pertaining to the use of earned surplus and solvency. In this case, the corporation intends to purchase its shares from a shareholder for a total price of $500,000, using a combination of immediate cash and installment payments over subsequent years, while having an earned surplus of only $250,000 at the time of repurchase. This situation presents a nuanced statutory analysis, centered on the statutory provisions that restrict share repurchases to those out of earned surplus, and prohibit such transactions if they would render the corporation insolvent.

Arguments Supporting Compliance with the Statute

Proponents of the view that the repurchase satisfies the statutory requirements often argue that statutory language allows a corporation to purchase its shares out of earned surplus, which, at the time, was $250,000. They may assert that since the purchase price ($500,000) exceeds the current earned surplus, the corporation could potentially consider reserve accounts or other surplus related accounts in its overall financial resources. However, most statutes explicitly restrict a repurchase to the limits of earned surplus, not including other reserves or unrestricted retained earnings.

Because the corporation's earned surplus was only $250,000, which is half of the repurchase price, some may argue that to satisfy the statute, the corporation would need additional lawful sources of funds beyond earned surplus, such as contributed capital or surplus explicitly authorized for buy-backs. Since the corporation’s only available resource was $250,000 of earned surplus, arguments can be made that, strictly speaking, the repurchase exceeded the amount permissible out of earned surplus, thus violating the statute.

Additionally, some may argue that the installment payment plan indicates an intent to ensure the corporation’s continued solvency after the transaction. Under this view, the corporation’s financial position was sufficiently protected because the bulk of the purchase was deferred, allowing earnings to grow or covered by ongoing operations, thus potentially avoiding insolvency. Advocates might also contend that because the corporation was not insolvent at the time of the agreement, and the transaction could be structured in a way that does not impair its capacity to meet liabilities, the statutory restriction is not violated.

Arguments Against Compliance with the Statute

Conversely, opponents of the transaction argue that the statutory language clearly prohibits a corporation from repurchasing shares when it does not have enough earned surplus to cover the purchase price. Since the corporation's earned surplus was only $250,000 at the time, and the total purchase price was $500,000, the transaction exceeds the available lawful source for share repurchase under the statute.

Moreover, the statute explicitly states that a corporation "may make no purchase of shares when it is insolvent or when such purchase would make it insolvent." Since the purchase price exceeds the current earned surplus, the transaction is arguably expectant to cause or contribute to insolvency or at least violate the restriction concerning the outflows of surplus funds. The plan to pay on installments over subsequent years does not necessarily mitigate this violation, as the obligation to pay the remaining balance could impair the corporation’s financial stability, especially if earnings do not materialize as projected or if other liabilities overshadow the residual surplus.

Finally, critics may argue that the transaction seeks to transfer value from the corporation to a shareholder beyond what is statutorily permissible, effectively funding a buy-back that exceeds the limits of earned surplus, thereby contravening the statutes aimed at protecting creditors and the integrity of corporate financial management. This could be viewed as an abuse of corporate law, risking insolvency or damaging creditors’ interests, and is therefore deemed inconsistent with statutory requirements.

Conclusion

In conclusion, the arguments in favor of the transaction’s compliance focus on the structure of installment payments and the corporation's solvency, suggesting that the transaction might be permissible if structured properly and if no insolvency occurs. Conversely, the arguments against emphasize the statutory requirements limiting repurchases to earned surplus, which the corporation’s current surplus of $250,000 does not meet given the $500,000 purchase price. These conflicting perspectives underscore the importance of strict adherence to statutory provisions designed to safeguard corporate and creditor interests during share repurchase transactions.

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