June 18, 2014

Minority Shareholder Beware

BACK TO KNOWLEDGE CENTER

Corporate law is designed to address the needs of large publicly held companies like Nike. It would be unworkable to allow a shareholder, with 100 Nike shares, to participate in management and decide on the next Air Jordan shoe. Corporations are run by the board of directors that is elected by a majority of the voting shares of the Corporation. The outvoted shareholder has no say in how the business is run. However, stock in a public company is freely transferable and so the unhappy shareholder in Nike has the ultimate vote; she can call her broker and sell the stock.

Closely-held corporations are fundamentally different. Shareholders are typically family members, friends or close acquaintances and typically the shareholders participate in managing the corporation as board members or employees or both. In most cases the decision to invest is based primarily on the understanding that the shareholder will participate in management. Except for the wall street financier, most people who buy stock in Nike or IBM do not expect to be appointed the board.

When dissension occurs among shareholders in a closely held corporation, the minority may find the majority managing the corporation in unexpected ways. The corporate norms of majority rule and centralized management can provide opportunities to "squeeze-out" the minority shareholder.

Take a common example of two friends who incorporate a business with each contributing their life's savings. One receives 51% of the stock (Mr. Majority) and the other receives 49% (Mr. Minority). Both work in the business in senior executive positions, draw a good salary and are on the board. Like many small corporations profits are distributed through bonuses not dividends.

One day Mr. Majority decides he no longer wants Mr. Minority in the business and so he calls a shareholder meeting and votes his controlling interest to remove Mr. Minority from the board and then, using his control of the board, he fires Mr. Minority and terminates all his benefits. Although this may not seem fair, these actions are authorized under the basic principles of corporate law.

Mr. Minority, who is no longer drawing a salary, requests that the corporation begin paying dividends. Mr. Majority, who continues to receive a return on his investment in the form of salary and other benefits decides to continue to reinvest profits rather than declare dividends. The decision not to declare dividends is generally protected under corporate law by the business judgement rule. This decision forces Mr. Minority to reinvest his share of the earnings in the corporation, even though he no longer can participate and has no say in running the business.

At this point Mr. Minority is probably thinking about selling his stock, but there is no market for closely-held corporation stock. Realistically, the only possible buyer is Mr. Majority. However, Mr. Majority has no incentive to buy the stock, except at a bargain price, because he is getting the use of Mr. Minority's capital for free. And, to make matters worse, the situation can continue indefinitely because corporations have perpetual existence. Mr. Minority faces the prospect of being "frozen out" of the benefits of his stock but "locked in" to the investment in the corporation forever.

The above example illustrates a common "squeeze out" situation, which can be accomplished by a majority shareholder exercising his rights under corporate law. As a result of these abuses in closely held companies, the courts and the legislature have provided protection for minority shareholders. In closely held corporations the courts have found that the majority shareholder owes a fiduciary duty of good faith, fair dealing and full disclosure to the minority shareholders. Under ORS 60.661 the courts can provide equitable relief if the majority shareholder has acted in an "oppressive manner."

The problem with relying on these rules is that they are difficult to apply and are expensive to prove. Furthermore courts in Oregon are still very reluctant to interfere in intra-corporate disputes. For example, the Oregon supreme court in one case refused to grant relief when a 33% shareholder was removed from the board of directors; in another case the court refused to grant relief for failure to declare substantial dividends after a shareholder left his employment with the corporation.

Resorting to litigation to protect the minority shareholder is also bad for business. The cost, both financial and emotional, is high and in many cases the parties are no longer able to remain in business together. (It is no wonder that the majority of cases end up with the majority buying out the minority or vice versa.) Therefore whenever possible, a party who wants to invest in a corporation as a minority shareholder should insist upon modifications to the statutory norms of corporate control. These modifications can be in the form of restrictions in the articles and bylaws or in a separate contractual agreement.

The corporate form of legal entity has allowed the development of this country's greatest business enterprises. Without the corporate form, many of the country's most successful businesses could not exist. It is difficult to imagine a 747 being manufactured by a partnership of aeronautical engineers and metal workers. However, the same rules that allow a multi-billion dollar corporation with thousands of shareholders to function does not work for a closely held corporation. The shareholders in a closely held corporation need to address the deficiencies in the law or face the possibility of being "squeezed out."

For more information on this topic, please contact marketing@jordanramis.com or call (888) 598-7070.

 


Back to Top