Conflicts between the owners in closely held businesses are common and very disruptive. Indeed, the closely held corporation structure itself often leads to the abuse of minority shareholders. This is primarily due to the fact that owners of a closely held business are often its primary decision makers, but the backgrounds and qualifications of ownership in a closely held business rarely reflect the depth of knowledge and expertise that a large corporation’s elected board of directors possess. Owners may include early investors, old friends, family members and/or longstanding employees, and frequently the owners are also the executives. As a consequence, the owner of a closely held business typically has more vested, personally and financially, than the traditional corporate decision maker.
Yet, the balance of decision-making authority in a closely held business commonly rests in the hands of a majority owner, or a few acting in concert, leaving those with a non-controlling interest – minority owners – subject to the discretion of the controlling majority. This results in shareholder oppression, which is rooted in several different legal theories, and more broadly addresses the evolving concern that majority shareholders in a corporation should not use their control to oppress a minority by employing mechanisms that disrupt the minority shareholders’ reasonable expectation in the value of their shares.
Minority Shareholder Oppression
Minority shareholder oppression can take many forms. Two terms, squeeze-out and freeze-out, are often used interchangeably to describe the tactics most commonly employed by majority shareholders. These tactics may involve efforts by the majority to diminish the value of a minority shareholder’s interest in the business. This can include terminating the minority shareholder’s employment, voting the minority off the governing board, voting to divert resources to prevent dividends, and diverting resources toward the salaries and benefits of those shareholders still under the employ of the business. Controlling shareholders may also attempt to eliminate a minority shareholder’s interest altogether, typically through mechanisms established by statute, such as dissolution and reacquisition of the business, reverse stock splits and cash-out mergers.
If these minority shareholder oppression issues arise, it is essential for both majority and minority owners to evaluate the risks and consequences of any action before taking it. Navigating the options requires an understanding of established common law and any governing statutes.
Common Law Remedies
Courts in many states impose a heightened fiduciary duty on majority shareholders. This duty owed to the minority by the controlling majority is similar to duties owed in a partnership or joint venture. A breach of this duty arises when the majority leverages control to its own advantage without providing the minority with the opportunity to benefit, absent a legitimate business purpose. Such a breach, in turn, gives rise to a cause of action by the individual minority shareholder. See, e.g. Crosby v. Beam, 47 Ohio St. 3d 105, 109 (Ohio 1989) (holding that majority shareholders have a fiduciary duty to minority shareholders, and noting that when majority shareholders in a closely held corporation utilize their majority control to their own advantage, without providing minority shareholders an equal opportunity to benefit, such breach, absent legitimate business purpose, is actionable). Filing suit against the majority under a breach of fiduciary duty theory is difficult, expensive and lacks certainty, but offers one option in combating oppressive conduct by majority shareholders.
Many states have also developed a statutory right of appraisal for minority shareholders in a corporation in the event the majority employs a cash-out merger. See Ohio Revised Code Section 1701.85. The right of appraisal establishes a procedure by which courts can ensure a fair cash value is received for shares being forfeited by the minority shareholders. In the proper context, cash-out mergers still serve a valid purpose, and the right of appraisal functions as a step in the process. In the context of cases involving minority shareholder oppression, however, the right of appraisal can function as a shield against squeeze out or freeze-out tactics to protect the financial expectations of minority shareholders.
Some states preclude the right to challenge a cash-out merger through claims of minority shareholder oppression on the basis that the right of appraisal serves as a sufficient safeguard to protect minority shareholders in closely held businesses. Other states, such as Ohio, allow a minority shareholder to bring actions for both, albeit separately. See Armstrong v. Marathon Oil Co., 32 Ohio St. 3d 397, 422 (Ohio 1987). Where actions for both can be brought, minority shareholders have an added advantage, while the possible consequences facing the majority are compounded.
Minority shareholders may also attempt to force a dissolution of the corporation through the courts, either as a tactic to bring the majority to the bargaining table or to force a liquidation. Generally, the courts perceive this as a drastic action and are hesitant to dissolve a corporation at the insistence of an unhappy minority shareholder. However, some state statutes, in following the Model Business Corporations Act, have expressly granted courts the authority to dissolve a corporation upon a finding of minority shareholder oppression. Compare Colorado Revised Statutes Section 7-114-301(2)(b) (“[a] corporation may be dissolved in a proceeding by a shareholder if it is established that . . . those in control of the corporation have acted, are acting, or will act in a manner that is illegal, oppressive, or fraudulent”), with Ohio Revised Code Section 1701.91(A) (not providing oppression as a means for dissolution). In states that provide the courts with this discretion, the relative position of majority shareholders to settle on favorable terms is further exposed.
Proper planning is the best way to avoid lawsuits involving minority shareholder oppression issues. Owners can enter into a buy-sell agreement or employment contracts, and can implement call provisions, transfer restrictions or arbitration procedures, among others, in the organizing documents to help avoid conflicts that may lie ahead by determining what will happen if problems arise. Perhaps most importantly, proper planning will instill a sense of certainty and confidence that your closely held business will be prepared and protected. The best time to plan is before problems arise, because business owners can usually agree to reasonable terms when times are good.
If the time for planning has passed, no matter which side of the table you are on, the law can provide avenues intended to address and help navigate thorny squeeze-out or freeze-out situations. If you or your closely held company are facing these issues, or decisions that may give rise to them, you should consider consulting with counsel prior to taking any action that could jeopardize the company and/or your equity interests.-