United States: Narrow Construction of New York Statute Results in Limitation of Rights Automatically Transferred to Purchaser of Security

In the recent decision Consolidated Edison, Inc. v. Northeast Utilities, 2004 WL 1105972 (S.D.N.Y. May 17, 2004), District Judge Koeltl ruled that where shareholders are third-party beneficiaries of a contract between the issuer of stock and a third party, the right to sue that third party for breach of the contract does not automatically transfer to a subsequent purchaser of the stock. Rather, it remains with shareholders who owned stock at the time of the breach, unless explicitly assigned to the subsequent holder.

This case arises out of the failed multi-billion dollar merger between Consolidated Edison, Inc. ("Con Ed") and Northeast Utilities ("NU"). Under the Merger Agreement, Con Ed had agreed to purchase all outstanding NU shares at a substantial premium above the market price. Shortly before the closing, Con Ed called off the merger and sued for a declaratory judgment that it had no obligations under the Merger Agreement. NU counterclaimed, seeking on behalf of its current and future shareholders the "lost premium" of the contemplated sale of stock. Following a ruling by the Court that NU shareholders were entitled to pursue the "lost premium" claim, a former shareholder intervened, seeking damages as a holder of NU stock on the date of alleged breach of the agreement. NU moved for summary judgment against the intervenor, claiming that he had assigned his rights to the merger premium when he sold his shares. The Court held that under New York law contract rights associated with stock ownership do not transfer when the stock is sold, unless explicitly indicated.

In reaching its decision, the Court noted that NU "made it clear that its claim to recovery on behalf of its shareholders, and its argument for the automatic assignment of the claims at stake, relies entirely on §8-302(a) [of the New York Uniform Commercial Code]."

The Court rejected NU’s interpretation of §8-302(a), finding that: (i) §8-302(a) does not define a claim against third parties as a "right in the security" nor does it explicitly codify the automatic transfer of all claims accrued while holding a security; and (ii) §8-302(a) relates to issues of ownership and title and is simply a mechanism for transferring such rights, which are granted to the transferee as against the issuer of the stock and other potential holders.

The case is one of first impression in its application of N.Y. U.C.C. §8-302 to the automatic transfer of stock-related contract claims against third parties. Section 8-302(a) provides, in relevant part: "[A] purchaser of a certified or uncertified security acquires all rights in the security that the transferor had or had power to transfer."

NU argued that, under its plain language, §8-302(a) operates to transfer accrued contract claims against third parties because it refers to "all rights" being automatically transferred without limitation. The Court, however, made a distinction between "all rights related to the security or accrued while possessing the security" urged by NU and "all rights in the security," reasoning that NU cannot rely on the plain language of §8-302(a) because the language itself does not control or define what are "rights in the security."

Rather, the Court stated that §8-302 is merely an expression of the "shelter rule," as it is characterized by the Official Commentary, and therefore simply ensures that a holder in due course gains clear title and may transfer his rights in the security as such. The Court stated that "the phrase ‘had or had power to transfer’ stands for the unremarkable proposition that people cannot transfer rights that they do not own or control."

The Court explained that the legislative history of Section 8-302 and the structure of Article 8 of the U.C.C. confirm that the provision, rather than defining what rights are in the security, merely involves the mechanism for transferring rights and applies "primarily to disputes over the quality of title and the competing ownership rights passed from transferor to transferee." The Court noted that "Article 8 as a whole ‘does not set forth general rules defining property rights that accrue to holders of securities’ and instead simply ‘sets forth rules relative to the transfer of the rights.’" Section 8-302 "deals with the rights and liabilities of successive holders of a security as between themselves."

The two cases relied upon by the Court are not directly on point, though they contain language supporting the exclusion of automatic transfer of claims against third parties under §8-302. The first case involves fraud claims, which do not run with the security. The Court noted the opinion does not distinguish those from the other claims against third parties, which it concludes do not automatically transfer under §8-302. The second case is an application of the shelter principle, in which the plaintiff was unable to recover under bonds given to him as a gift from someone who was not a bona fide purchaser and therefore could not transfer that status to him. The Court cited language in that opinion discussing §8-302, which states that the phrase "rights in the security" "concern[s] the transferor’s title, or ownership interest, in the security itself in relationship to the ownership interest of others."

Finally, the Court rejected NU’s argument that New York’s General Obligation Law §13-107, which provides for the automatic transfer of certain bondholder claims, is analogous to §8-302 and supports its claim. The Court noted that §13-107 does not apply sweepingly to all third-party claims, but rather only applies to all claims as against three specific parties. Further, the legislative history of §13-107 does not support NU’s claim that its automatic transfer provision was a codification of the common law. Rather, the New York rule is that causes of action are freely assignable, but that such assignments must be express, as codified by New York’s General Obligation Law §13-101.

While such an outcome may be surprising, the opinion is supported by the official comments to §8-302, its legislative history, and the scant case law applying §8-302(a), though it appears to be a narrow construction of the provision’s language. The Court certified its order, allowing NU to seek an interlocutory appeal before the Court of Appeals for the Second Circuit. Interestingly, the Court also certified for interlocutory appeal its earlier holding that the shareholders are third party beneficiaries under the Merger Agreement, the determination of which could render moot the question of who is entitled to such a claim.

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