The controlling shareholder—i.e., the shareholder with a majority of the voting power— in a closely-held corporation has significant influence over the corporation’s management and affairs. As a result, minority shareholders—i.e., those without a controlling number of shares—in a closely-held corporation face unique risks from the controlling shareholder, such as oppression and unfair treatment. This blog post discusses the nature of shareholder oppression claims and the steps controlling shareholders can take to prevent them.
Shareholder Oppression Claims
Closely-held corporations typically have few shareholders, all of whom normally participate in the management of the corporation, and no available market for the corporation’s shares. See, e.g., Donahue v. Rodd Electrotype Co., 328 N.E.2d 505, 511 (Mass. 1975) (discussing the common features of a closely-held entity). As a result, unless the corporation has supermajority or cumulative voting requirements, the controlling shareholder appoints the entire board of directors. Consequently, because the controlling shareholder “controls” the board, this shareholder risk liability if its behavior is deemed “oppressive” to minority shareholders. See, e.g., Kiriakides v. Atlas Food Sys. & Servs., Inc., 541 S.E.2d 257, 267 (S.C. 2001).
Among other things, oppressive conduct includes refusal to declare dividends, diversion of corporate earnings to the controlling shareholder through high compensation, and termination of the minority shareholder’s employment. See Donahue, 328 N.E.2d at 513. However, these tactics normally must be used together for the controlling shareholder’s conduct to be deemed oppressive. Subsequently, once the minority shareholder’s investment in the corporation looks indefinitely bleak, a common tactic is for the controlling shareholder to propose that it purchase the minority shareholder’s shares (albeit, for a very low price). See id. at 515. Accordingly, because there is no market for a closely-held corporation’s shares, the minority shareholder often reluctantly agrees. See id.
This type of behavior often results in a claim of shareholder oppression. Depending on the jurisdiction, there are two predominant methods a minority shareholder may use to obtain relief. First, some courts have held shareholders in closely-held corporations owe each other fiduciary duties, like those of partners in partnerships. Id. This means a controlling shareholder may not use its power to obtain a special advantage at the expense of the minority shareholders. Id. at 518. Any benefit or opportunity a controlling shareholder gives itself must be given to minority shareholders as well. As a result, the oppressed shareholder may bring a claim for breach of fiduciary duty. However, many jurisdictions—including, most notably, Delaware—hold shareholders do not owe fiduciary duties merely because they are in a closely-held corporation and, thus, do not require controlling and minority shareholders be afforded the same opportunities. See Riblet Prods. Corp. v. Nagy, 683 A.2d 37, 39 (Del. 1996); Nixon v. Blackwell, 626 A.2d 1366, 1381 (Del. 1993).
Second, many states allow any shareholder, regardless of the number of shares he or she owns, to petition for the corporation’s involuntary dissolution. Specifically, for states that follow the Model Business Corporation Act (“MBCA”), a court may liquidate and dissolve a closely-held corporation if the directors or the controlling shareholder acted or will act in a manner that is illegal, fraudulent, or oppressive. Model Bus. Corp. Act § 14.30 (Am. Law. Inst. 2006). Indeed, courts in MBCA jurisdictions will dissolve a corporation when the conduct of those in control frustrates the “reasonable expectations” of the minority shareholders. See, e.g., Meiselman v. Meiselman, 307 S.E.2d 551, 573 (N.C. 1983). Alternatively, if the controlling shareholder did not already purchase the minority shareholder’s shares at a discounted price, a court may order the petitioning shareholder’s stock be purchased by the corporation or another shareholder (typically, the controlling shareholder). See Model Bus. Corp. Act § 14.34 (Am. Law. Inst. 2006).
Preventing Claims of Oppressive Behavior
Precautionary contractual measures are common methods used by shareholders to prevent claims of shareholder oppression. First, shareholders can require supermajority or cumulative voting structures. Supermajority voting schemes require fundamental transactions, such as dissolution and mergers, be approved by two-thirds of the corporation’s shareholders. Further, some states (e.g., New York and Ohio) even require supermajority voting for fundamental transactions by statute. Alternatively, cumulative voting schemes allow minority shareholder representation on the board if the minority shareholders are willing to combine their votes.
Additionally, shareholders can include a buyout provision in the corporation’s bylaws or a separate shareholder agreement to prevent claims of oppression. Buyout provisions generally require the corporation or other shareholders to purchase a shareholder’s stock if some event occurs, such as the individual’s death or incapacitation, or in the event of a deadlock. Further, shareholders can include provisions in the corporation’s bylaws that compel dividends or protect salaries. Shareholders also can include mandatory arbitration or meditation provisions in the bylaws or the corporate charter.
Unfortunately, the practical realities of personal relationships in closely-held corporations often prevent shareholders from sufficiently negotiating the terms of the corporation’s bylaws. See, e.g., Meiselman, 307 S.E.2d at 558. Nonetheless, not all protections must be contractual. Most states—including, Delaware and Florida—give shareholders who dissent from the approval of a fundamental transaction the right to receive the fair value of their shares. However, while appraisal rights are incredibly valuable for minority shareholders, there are numerous procedural requirements to enforce them. Therefore, advising minority shareholders who dissent to a fundamental transaction of the procedures they must follow could be a valuable way to prevent an oppression claim.
A controlling shareholder in a closely-held corporation has an enormous amount of power to dictate the entity’s management and affairs. However, a controlling shareholder must either bargain for contractual provisions that will prevent shareholder oppression claims or be very conscious of the impact its decisions will have on the corporation’s other shareholders. Regardless, it is imperative for controlling shareholders to understand the nature of shareholder oppression claims so they may properly avoid or defend them.
By: Charles B. Jimerson, Esq. and Daniel L. Buchholz, JD Candidate