Many an article or blog post concerns minority shareholder rights, shareholder oppression or shareholder “freeze out”. As business and litigation lawyers, we are always mindful of the rights between and among business owners, what can and cannot be done in furtherance of those rights and the legal mechanisms applicable to the exercise of those rights. We frequently write on the strategies available to a minority shareholder such as examination of books and records, claims of breach of fiduciary duty and the potential for appointment of a corporate receiver or custodian.
This is not that article.
The fact is, being a minority shareholder means that, by definition, there are often things you simply cannot control. A shareholder or member in a business entity who possesses less than a controlling stake must have reasonable expectations as to the rights attendant to such ownership and understand the limits of such rights so as to make informed decisions concerning the investment of time, energy and money in pursuit of the collective enterprise.
Let’s start with who owns the remaining shares in the company. In the absence of an agreement to the contrary, the majority shareholder is free to transfer the majority (said another way; controlling) interest in the company without the consent of the minority. A transaction can result in a change in control such that the minority shareholder suddenly works for someone entirely new. While a minority shareholder can enjoy “dissenter’s rights”, such rights are applicable in very narrow situations specified by statute. In fact, in the absence of a prohibition, the stock in a business entity is readily transferrable, just like on an exchange, if a buyer and/or seller can be identified.
Internally, a minority shareholder can find it difficult to impact the direction of the business. Depending on the by-laws of the entity and, frankly, the will of the majority, a minority shareholder may or may not have a voice on the board of directors and thus may not possess a vote on material decisions such as the persons who will fulfill critical roles in the executive branch of the business such as the officers of the corporation. More importantly, a minority shareholder may not have input on the financial operations of the company including distributions, financing arrangements, major purchases of inventory, equipment or talent. All of which can dramatically affect the annual bottom line.
Even employment is not guaranteed to a minority in interest. In the absence of an agreement to the contrary, the employment of a minority shareholder may simply be at will in the same way as the sales force, the administrative assistants or the custodian. Certainly, terminating a minority’s employment could be one of the factors argued in a freeze out, but in the absence of other factors, termination of employment alone may not give rise to a cause of action. Certain courts have suggested continued employment may be implicit in a “founder” but those situations are few and far between and a plaintiff/minority shareholder must be prepared with more to argue than the end of employment if freeze out is alleged.
In business, like politics, being in the minority means sometimes you are powerless to immediately change the course of the company. Sometimes, a group of shareholders can band together to pool their collective influence for their mutual benefit. Other times, the best strategy is to become the majority even when the acquisition of additional shares comes at an unnecessary or unanticipated cost. Under any circumstances, rights afforded to the majority are not constrained solely because a minority shareholder does not agree with a particular course of action.
As a litigator, I am often contacted by minority shareholders who are frustrated by their lack of control or influence. While the law offers certain protection for holders of such minority interests, those remedies are factually limited and are often unsatisfactory even if granted in full after significant expense in litigation. Certainly an appropriate agreement outlining the respective rights and obligations can change the analysis. Business owners should consider, and plan for, what rights their stake in the company provides.
Thousands of businesses across the United States fall within the definition of what is commonly referred to as “small business”. Many of these small business are formed by two “friends” with compatible skill sets and both possessing knowledge of a particular industry. Business owners commonly refer to their co-owners as “partners”. As the business and its’ complexity grows, deficiencies in performance or capacity on the part of one partner may be exposed. Alternatively, the absence of immediate success can cause a less patient partner to seek other opportunities and abandon the work that is necessary for the collective good. What starts as a promising partnership can quickly turn sour. Here are a few tips on moving forward:
1. Agree on material issues ahead of time. It goes without saying that a written agreement which contemplates and addresses material issues benefits everyone. Terms frequently addressed in such agreements include the relative duties of the parties, corporate officers, duties of directors and financial matters. If shareholders/partners/members are required to devote substantially all of their time to the venture, the agreement must so state. Similarly, if shareholders/partners/members can be required to contribute capital to the business, the prevailing agreement must so state. Agreed upon rights and remedies upon abandonment of functions within the business by a shareholder/partner/member can provide the road map for resolution and expedite transition.
2. Change terms of employment. An option which may be available to a shareholder/partner/member is the exercise of corporate power to change terms of employment with respect to the non-performing shareholder/partner/member. While a founding shareholder/partner/member may arguably have certain rights to continued employment, such guarantees are limited and may not preclude a change in terms when faced with non-performance or abandonment. Exercise of corporate power does not come without risk and any change in employment terms is almost always alleged as part of a minority shareholder oppression claim.
3. Offer a buy-out. Certainly the cleanest and most efficient means to end an unproductive arrangement quickly is to acquire the non-performing shareholder/partner/member’s interest in the business by the payment of money. Of course, such an agreement is not always financially available. Moreover, a voluntary transfer necessarily implicates that that non-performing shareholder/partner/member agree. Issues of valuation, income streams, indemnification and restrictions against competition can complicate any potential buy-out.
4. Sell the business. Often the solution to a disagreement on partner performance is a sale of the business with a corresponding post sale employment agreement for the performing shareholder/partner/member. Money is a powerful motivator. A sale generates money in a lump sum which can induce a shareholder/partner/member to forego the ongoing income stream that results from future operations. Certainly, control over the sale process, including the legal right to effectuate a sale by virtue of agreement or corporate control, are essential factors for evaluation.
5. Dissolve and start something new. As a matter of last resort, dissolution of the entity may be the only way to gain freedom from a non-performing shareholder/partner/member. The Business Corporations Law provides a mechanism for dissolution. Provided the requirements can be met, a shareholders/partners/member may seek judicial dissolution of the entity essentially forcing a judicial sale. An important aspect of dissolution is relief from fiduciary duties owed to the business and minority owners. Dissolution can be a complicated and expensive proposition and very disruptive to ongoing business operations but remains a viable strategy when business owners can no longer work together but also cannot agree on separation.
One of the trickiest issues we deal with in business control disputes relates to the impact and management of personal guaranties on the part of the individual shareholders/members. A personal guaranty can be an impediment to a transaction among the shareholders consolidating ownership, an impediment to the withdrawal of a shareholder/member, or even a trigger of default under the terms of financing agreements in place between a business and its bank. Managing the impact and expectations of business owners as to a personal guaranty should be considered in the early stages of any potential transaction.
In nearly every small business banking relationship, the bank requires personal guaranties on the part of business owners. Personal guaranties, often even the more overbearing “spousal” personal guaranties, are the norm. Of course, the purpose from the bank’s perspective is to increase the level of security against repayment. The individual terms of the personal guaranty are governed by the language of the agreements.
The net effect of a personal guaranty is to, in effect, pierce the corporate veil and render the guarantor liable for the debt to the bank (or other creditor party to the guaranty agreement). In this way, not only does the bank obtain another source from which it can recover, but also dramatically impacts its practical bargaining power. Often we see shareholder agreements including and incorporating indemnification provisions which reference those situations in which a shareholder/member has guarantied an obligation to a lender. The value of such indemnification provisions is suspect given that the bank is always going to look to the path of least resistance to recover the extent of its obligation. In a guaranty the company is the primary obligor to the creditor. It is the primary obligor’s default which leads to exposure under a personal guaranty. In that instance, the company is not likely in a position to indemnify as its assets are likely devoted to the repayment of the primary guarantied obligation.
The best and most frequent approach to a personal guaranty in a business control dispute is to secure the release of the guaranty by the bank or other creditor as part of the transaction. Certainly, if the debt is retired in a third party sale, accounts are closed and the issue is moot. Not necessarily so in an ownership consolidation transaction involving a transfer among existing owners or members, or where one or more shareholders/members leaves the business. In that case, the business may continue and banking relationships may remain unmodified. The bank is not required to release the guaranty. Even further, under certain circumstances and agreements, a transaction may constitute an event of default of the credit arrangement. Management of the personal guaranty becomes an important part of the deal.
It is obviously always better to secure a release of a guaranty contemporaneous with a transaction. If that course of action is unavailable, indemnity is the only other option. In such cases, indemnification should flow from both the company and individuals as, if the guaranty is ever an issue, it is likely the Company’s ability to pay in the first place, which gives rise to creditor’s pursuit of the guarantor.