How Can Founders Enforce First Refusal Rights?

Introduction

Founding stockholders may seek to prevent a co-founder from transferring shares to a direct competitor. The usual contractual device is a right of first refusal, which gives the corporation or the remaining stockholders the first opportunity to purchase the shares before they are sold to an outside buyer.

In Philippine law, however, a right of first refusal is enforceable only when it is properly created, clearly documented, and exercised according to the agreed procedure. A stockholder cannot ordinarily rely on a general expectation that co-founders must first offer their shares to one another.

What Is a Right of First Refusal?

A right of first refusal is a contractual right allowing a stockholder or the corporation to purchase shares before the selling stockholder transfers them to a third person. It is different from an unrestricted prohibition on transfer because the selling stockholder may generally sell to an outside buyer if the right-holder does not exercise the option within the prescribed period.

The Supreme Court has recognized that a right of first refusal over shares is a property right of the parties who agreed to it. In Summit Holdings, Inc. v. Court of Appeals, et al., General Register No. 124293, 2005, the Court upheld mutual rights of first refusal under a joint venture agreement and treated the right as distinct from the corporation’s ownership of land.

The decision also confirms that an agreement granting a first-refusal right over shares does not, by itself, violate constitutional restrictions on land ownership. The relevant inquiry is whether the eventual exercise of the right results in a legally prohibited transfer or ownership structure.

Governing Rule for Close Corporations

Section 97 of the Revised Corporation Code of the Philippines recognizes restrictions on the transfer of shares in a close corporation. Such restrictions must appear in the corporation’s articles of incorporation, bylaws, and the certificate of stock. If they do not, the restriction will generally not bind a purchaser in good faith.

The restriction must also be reasonable. It cannot be more burdensome than granting the existing stockholders or the corporation an option to purchase the transferring stockholder’s shares under stated terms, conditions, and period.

If the existing stockholders or the corporation fail to exercise the purchase option within the agreed period, the selling stockholder may sell the shares to a third person. This statutory mechanism is stated in Republic Act No. 11232, Section 97.

When Is the Restriction Binding?

For a transfer restriction to bind a purchaser in good faith, it should be consistently reflected in three places:

• the articles of incorporation;
• the bylaws; and
• the stock certificate.

The restriction should also identify the persons entitled to exercise the right, the triggering event, the required notice, the valuation method, the period for accepting the offer, and the consequences of noncompliance.

A clause appearing only in a founders’ agreement may still support a contractual claim against the co-founder who violated it. It may not, however, be sufficient to bind an innocent third-party purchaser who had no notice of the restriction and acted in good faith.

How Should a Founder Exercise the Right?

The first step is to determine whether the transfer clause has been triggered. A sale, proposed sale, assignment, donation, exchange, pledge, or transfer to an affiliate may be treated differently depending on the wording of the agreement.

The selling stockholder should then be required to give written notice containing sufficient information about the proposed transaction. The notice should ordinarily state the number and class of shares, the proposed buyer, the price, payment terms, closing date, and other material conditions.

The right-holder must respond within the contractual period and in the manner required by the agreement. A timely written acceptance is ordinarily preferable to an informal discussion, board resolution, or oral objection.

If the right-holder accepts the offer, the parties should document the resulting sale and tender the purchase price or comply with any conditions specified in the agreement. If the right-holder does not timely accept, the selling stockholder may proceed only within the limits of the original offer and the agreement.

Can the Co-Founder Sell to a Competitor?

Not necessarily. If a valid right of first refusal applies and the selling stockholder failed to make the required offer, sold before the expiration of the response period, or transferred the shares on terms more favorable than those offered to the right-holder, the transaction may be challenged.

The agreement should also address whether the shares may be sold to a direct competitor. A right of first refusal gives the existing stockholders or corporation an opportunity to buy; it does not automatically create a permanent prohibition against a competitor becoming a shareholder.

If the founders intend to absolutely prohibit transfers to competitors, that restriction must be carefully drafted and tested against the statutory requirement that transfer restrictions in a close corporation must not be more onerous than the permitted option-to-purchase mechanism. An absolute ban without a reasonable purchase option may be vulnerable to challenge.

Effect of the Revised Corporation Code

Section 97 of Republic Act No. 11232 requires restrictions on the transfer of shares to be properly stated in the corporation’s governing documents and stock certificates. It also preserves the selling stockholder’s ability to sell to a third person if the corporation or existing stockholders do not exercise the purchase option within the stated period.

The provision should be distinguished from the preemptive right under Section 38 of the Revised Corporation Code. Preemptive rights generally concern the right to subscribe to new issues or dispositions of shares by the corporation, while a right of first refusal concerns a stockholder’s proposed transfer of existing shares to another person.

Section 38 provides that stockholders enjoy preemptive rights in proportion to their holdings unless the right is denied in the articles of incorporation or a statutory exception applies. It does not, by itself, establish a right of first refusal over every private sale of existing shares.

Can the Right Be Waived?

Yes. A right of first refusal may be waived expressly or, depending on the circumstances, impliedly. In Florete, Sr., et al. v. Florete, Jr., et al., General Register No. 223321, 2018, the Court recognized that stockholders may waive compliance with transfer restrictions through express consent or conduct showing knowledge of the transaction and failure to object.

Accordingly, a founder who knows that shares were transferred in violation of the agreed procedure but remains silent or treats the transferee as a shareholder may later face difficulty in asserting that the transaction is invalid.

Waiver is ordinarily fact-specific. Parties should therefore avoid informal conduct that may be interpreted as approval, including recognizing the transferee’s voting rights, accepting dividends for the transferee, or recording the transferee as a shareholder without reservation.

What Remedies May Be Available?

Depending on the agreement and the circumstances, the aggrieved founders or corporation may seek one or more of the following:

• specific performance of the right of first refusal;
• an injunction to prevent registration or completion of the transfer;
• damages for breach of contract;
• rejection or suspension of the transfer in the corporate records, where legally justified; and
• declaration that the transfer is ineffective against the corporation or the protected stockholders.

The remedy will depend on whether the purchaser had notice of the restriction, whether the transfer was completed, whether the corporation accepted the transferee, and whether the right-holder timely exercised the purchase option.

What Must Be Proven in a Dispute?

A founder seeking to enforce the right should establish the existence of the agreement and its applicability to the disputed transfer. The relevant documents may include the articles of incorporation, bylaws, stock certificate, founders’ agreement, shareholders’ agreement, board records, written notices, and communications with the proposed buyer.

The claimant should also prove compliance with the exercise requirements. A valid claim may fail if the right-holder did not make a timely and unconditional acceptance, did not tender the required consideration, or attempted to impose terms different from those specified in the offer.

Conversely, the selling stockholder may defend the transaction by showing that the restriction was not properly stated, the period to exercise the right had expired, the right was waived, or the buyer acted in good faith without notice of the restriction.

Illustrative Scenario

Assume that a founders’ agreement provides that a selling founder must first offer the shares to the corporation and the other founders for 30 days. The agreement is also reflected in the articles, bylaws, and stock certificates. The founder instead transfers the shares to a competing company without notice.

The remaining founders may demand compliance with the first-refusal procedure and seek to prevent recognition of the competitor as a shareholder, subject to the specific terms of the documents and applicable procedural rules. Their position is stronger if they promptly object, demonstrate financial capacity to purchase, and make a timely written exercise of the right.

If the founders knew of the transfer, accepted the competitor’s participation in shareholder meetings, and waited for an extended period before objecting, the selling founder may argue that the restriction was waived.

Drafting Points for Founders

A well-prepared transfer restriction should expressly cover the following matters:

• the persons or entity entitled to purchase;
• the transactions that activate the right;
• the form and content of the required notice;
• the valuation and payment method;
• the period for exercising the right;
• the treatment of partial exercises by several stockholders;
• the effect of a sale on terms different from those stated in the notice; and
• the consequences of transferring shares to a competitor without compliance.

The documents should avoid vague language such as “the other founders shall have priority.” They should state whether the right belongs to the corporation, the other stockholders individually, or both, and whether the right is exercised pro rata or through a specified allocation process.

Important Limitations

A right of first refusal should not be confused with the corporation’s power to disregard a valid transfer. The corporation must examine the governing documents, the purchaser’s knowledge, the requirements for registration, and the applicable rules on certificates and corporate records.

Likewise, a contractual restriction cannot be used to defeat mandatory rules or constitutional limitations. In Summit Holdings, Inc. v. Court of Appeals, et al., General Register No. 124293, 2005, the Supreme Court explained that the separate juridical personality of the corporation remains relevant when assessing the legal effect of share transfers and ownership restrictions.

Conclusion

Founding stockholders can better protect the company from an unwanted transfer to a direct competitor by placing a clear right of first refusal in the articles of incorporation, bylaws, stock certificates, and shareholders’ agreement. The restriction should provide a reasonable purchase option rather than impose an unsupported absolute prohibition.

When a violation occurs, the protected stockholders should promptly review the transfer documents, send a written objection, exercise the purchase right if available, preserve evidence of notice, and consider appropriate judicial relief. Early action is important because silence, delay, or recognition of the transferee may support a finding of waiver.

The enforceability of the restriction ultimately depends on the exact language of the corporate documents, the parties’ conduct, and the purchaser’s good faith. A review by Philippine corporate counsel should be obtained before the transfer is recorded or the competitor is allowed to exercise shareholder rights.

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