Did you know that selling stock in exchange for an unsecured promissory note may be unlawful, void or voidable? In an area like Silicon Valley where stock may be worth a fortune from the second a company is born, companies might think to be creative in order to sell stock to a party that’s unable or unwilling to pay large sums for it immediately. One might think that a safe course is to sell the stock for a promissory note to pay for the stock later, such as when it’s worth more than the sum of the note.
However, a somewhat obscure law in California, which is echoed in other states, makes it unlawful for a corporation to sell or issue stock in exchange for a promissory note (a debt) that is not secured by property other than the stock itself. Section 409 of the California Corporations Code makes it unlawful for a California corporation to sell or issue stock for a promissory note that is not “adequately secured by collateral other than the shares acquired.” Thus, a company cannot sell or issue stock for a promissory note, even if the note is secured by the stock itself. So what consideration in a sale of stock is valid? The answer is money, services already rendered, valuable property received or a promissory note that is secured by property other than the stock itself.
Delaware corporations, which are not subject to this provision of California law, are nevertheless subject to a similar statute under Delaware law. Section 152 of Delaware’s General Corporation Law provides that “[t]he board of directors [of a corporation] may authorize capital stock to be issued for consideration consisting of cash, any tangible or intangible property or any benefit to the corporation, or any combination thereof.” While this statute is less clear on the issue than the California law, Delaware case law arguably supports a construction of the Delaware statute the same as the California law, and Section 152 itself implies the corporation must receive some actual benefit in exchange for the issuance of stock. Interestingly enough, the Delaware Constitution (Article IX, Section 3) used to expressly prohibit the issuance of stock “except for money paid, labor done or personal property, or real estate or leases thereof actually acquired by such corporation.” However, this provision was repealed in 2004, leaving the issue somewhat more ambiguous under current Delaware law. One would have to check the legislative history to understand why that section was repealed, but in any case the statutory provision remains, along with at least one case which cites both as a basis to consider the stock sale invalid. See Prizm Group, Inc. v. Anderson, 2010 Del. Ch. LEXIS 105, 2010 WL 1850792 (Del. Ch. May 10, 2010).
The legal implications of these statutes are potentially not good for anyone involved in the leveraged sale of stock – neither the company, its management nor the putative purchaser. Taking the last case first, the sale to the buyer is likely void or voidable as against the buyer, which means the corporation may rescind (cancel) the sale of stock arguably at any time the issue is raised, at least until proper consideration is received by the corporation, such as all money due on the debt that is at issue. (Note that the sale is probably not voidable by the buyer as against the corporation, and the note is almost certainly enforceable by the corporation against the debtor, the above notwithstanding.) As respects the company, an invalid sale of stock might expose the company to liability from other shareholders who might argue that their equity in the corporation has been unfairly diluted by a sale of stock without real value received in return. And officers or directors who approved the sale might also be exposed to action by the corporation and/or by other shareholders on a similar theory of liability, as might arise in the context of a shareholder derivative action (a lawsuit brought by one or more shareholders in the name of the corporation against officers and/or directors for mismanagement that harmed the corporation or its shareholders).
Turning to limited liability companies, it is much less clear and, at least for now, doubtful that the limitation on consideration for the sale of equity applies to LLC’s. The statutes cited do not apply to LLC’s – they are quite specific to corporations only. With that said, in principle, one could make the same policy argument in the context of LLC’s – that the sale of equity in exchange for an unsecured note does not provide actual value to the company and thus frustrates existing equity holders and creditors. However, the statutory and case law for LLC’s on this is thus far non-existent based on research done to date, so currently there is no known legal basis to support this policy rationale as applied to LLC’s, or other types of business associations for that matter.
However, corporations, their managers and purchasers would be wise to heed the law in California, Delaware and other states that generally bar an unsecured debt obligation as consideration for the sale of stock. Transactions violating these laws will be void or voidable, and the participants in such stock sales may be subjecting themselves to inadvisable risks and liabilities. So, as the saying goes, buyer beware.
To learn more about the author of this article, visit www.ihwlaw.com.
Could a company that wanted to grant equity in exchange for a promise of future payment instead grant options, or would section 409 also forbid options from being granted without satisfactory consideration?
Thanks for your question, Martin. A grant of options is different than an actual sale of stock, for various reasons, including that options are not actually stock but simply a right to purchase stock at a fixed price, a right that may not even be vested (and often is not vested) at the time of the grant. In addition, generally speaking, at the time of a grant of options, the grantee (recipient) does not transfer any value to the corporation. The grant may be a reward for services rendered or to incentivize future services, but generally the grantee does not transfer value to the grantor at the very time of the grant. So Section 409 would not apply to the grant of options. If, however, at the time of option exercise, the purchase price is “paid” with a promissory note, Section 409 would seem to apply to render the purchase voidable (for a California corporation, with a potentially similar effect under the Delaware statute cited). Again, this is referring to an unsecured promissory note or a note that is not secured by property other than the underlying stock.
Thanks for the info! Do you have any citations or authorities that tell us what the impact of non-compliance with 409 might be? Thanks!
Thanks for your question, Kate. The case law and secondary authorities suggest that non-compliance with the statute renders the sale of stock void or voidable. See, e.g., 78 A.L.R.2d 834 (“Construction and effect of constitutional or statutory provisions precluding issuance of corporate stock in consideration of promissory notes”).