By: Justin Banford
A corporation is a separate legal entity that has been created through a registration process established by statue. A corporation has legal rights of its employees by statue. A corporation has legal rights and liabilities that are distinct from the rights of its employees and shareholders. Despite not being human beings, corporations, as far as the law is concerned, are legal persons, and have many of the same rights and responsibilities natural people do. A corporation is, at least in theory, owned and controlled by its principals. In a jock-stock company the principals are known as shareholders. A shareholder’s ownership-his or her management participation, control and claim to profits-reflects this stock ownership.
Thus, a person who owns a quarter of the shares of a joint -stock company owns a quarter of the company, is entitled to a quarter of the profit (or at least a quarter of the profit given to shareholders and dividends) and has a quarter of the votes capable of being cast at general meetings. Often a quarter of the votes, or any minority of interests, offers the shareholder very little influence. In their roles as a shareholder, shareholders have very little rights with the respect to management of the corporation. Shareholders primarily elect the Board of Directors and do little else. Unless modified by the Articles of Incorporation or bylaws, the “directors are elected by a plurality of the votes cast by the shares entitled to vote in the election at a meeting at a meeting at which a quorum is present.” Va. Code 13.1.669. In practice, for close corporations this means that a minority shareholder with less than 50% of the outstanding shares) has little say in the management of the corporation.
Shareholder oppression occurs when the majority shareholders in a corporation take action that unfairly prejudices the minority. It most commonly occurs in close corporations, because the lack of a public market for the shares leaves minority shareholders particularly vulnerable. The minority shareholders cannot escape mistreatment by selling their stock and exiting the corporation (a Buy-Sell Agreement under a share holders agreement may help). The majority shareholders may harm the economic interests of the minority by refusing to declare dividends or attempting a squeeze out. The majority may physically lock the minority out of the corporate premises and even deny the minority the right to inspect corporate records and books, making it necessary for the minority to sue every time they want to look at them. An important concept in law pertaining to shareholder oppression is the “reasonable expectations” of the minority shareholder. The “fair dealing” standard is also sometimes used by courts. Adoption of the Business Judgment Rule and notions of majority rule have enhanced the shareholder majorities’ ability to misuse the minority’s investment. Both defer to majority control by directing that courts not override management decisions of the majority provided the majority has not breached any of the triads of their fiduciary duty- good faith, loyalty or due care. This is a high bar. Courts will not second guess business decisions.
What can a minority shareholder do? Imagine you started a company with your longtime colleague on a handshake. He put in two-thirds of the start-up capital and, therefore, you agreed he should have two-thirds of the stock, but that your salaries would be equal. You do not have shareholders Agreement or an Employment Agreement. Years later after a disagreement, he uses his majority of the shares to upset the Board of Directors, naming himself CEO. HIs first order of business as CEO is to fire you. The board then suspends any future dividends and gives new CEO a healthy raise. Because the company is an S-corp, you receive a K-1 every year but no tax distributions causing you to go out of pocket to pay taxes on non-distributed profit. You ask for financial information and business records, which you are entitled to under Va. code 13.1-770; your old friend refuses and you have to sue for access just to see the records. You cannot sell your interest because shareholders showed the corporation’s directors oppressed minority shareholders by (1) using the directors’ control of dividends to retaliate against the shareholders, in bad faith, (2) keeping share value artificially low to minimize the directors’ estate taxes, (3) giving the directors large pay raises and bonuses while reducing dividends, (4) being dishonest with shareholders wishing to sell shares to the company, and (5) favoring the directors’ immediate family while denying employment to minority shareholders. The case was the culmination of decades of family fighting in court. The Colgate decision is note worthy because it provides a ray of light to minority shareholders that the nuclear option is available. Dissolution is decisive if nothing else. (Of course, as Colgate is a trial court ruling-not an appellate court decision-it’s value as precedent is limited. In other words, it is interesting but not binding.)
The Hope in filing suit is two-fold: to win the prayed for relief (money damages, injunctive relief, and/or involuntary judicial dissolution), but, more pointedly, to force the majority to offer a reasonable buyout. This is sometimes successful, sometimes not. First, the company is paying the legal costs of the majority, making litigation less painful. Second, in close companies it often becomes a matter of principle. You cannot and should not depend on the other side to act rationally. Remarkably, people do cut off their proverbial business nose to spite their face.