Texas law governing minority shareholder rights is complex and full of traps for the unwary. Texas lawyers get it wrong every day--frequently exposing their clients to further liability. Here are ten mistakes never to make.
1. Advising clients that Shareholder Oppression law is dead.
Many Texas lawyers believe that the Ritchie v. Rupe opinion, in which the Texas Supreme Court eliminated the shareholder oppression doctrine as a legal remedy, declared open season on minority shareholders, and these lawyers mistakenly advise majority shareholders that there is no legal penalty for oppressive conduct or dissuade minority shareholders from bringing valid claims. These lawyers simply have not read the opinion very carefully. The Texas Supreme Court overruled the Shareholder Oppression doctrine, not because minority shareholders had no rights, but because the doctrine was deemed unnecessary. During the 150 years preceding the advent of the shareholder oppression doctrine, Texas courts had developed robust legal protection for minority shareholders. All of those cases are still good law. Beginning in late 1980s, Texas appellate courts distilled the legal principles in those earlier cases into a single doctrine combined with a forced buy-out remedy. That doctrine was overruled but not the legal rights and duties on which it was based.
2. Advising clients that the exercise of majority rule makes an action legal.
Many lawyers simply do not understand that the power to do something in a corporation is not the same as the right to do that thing. In a corporation, the majority rules, which means that the majority has enormous power over the corporation and can abuse that power to harm minority interests. But that is not the end of the story. The power to do something does not mean the right to do it. Officers, directors, and majority shareholders have the fiduciary duty to use their uncorrupted business judgment solely for the benefit of the corporation as an entity and the shareholders collectively (all of them). The Texas Supreme Court in Ritchie v. Rupemade very clear that the interests of the corporation are not the same thing as the interests of majority. Therefore, the mere fact that the decision was validly made by a majority tells you nothing about whether the decision violates the law.
3. Advising (or allowing) majority shareholders to deny the share ownership of a minority shareholder
Many lawyers think that it is necessary to possess a stock certificate in order to be a shareholder. Wrong, wrong, wrong. Texas law has been clear for more than a century that the certificate is merely evidence of ownership; it is not the stock itself. A person becomes a shareholder when he performs whatever consideration was required by the agreement under which he was to acquire shares. This is true even if the ownership is not recorded and no formal act of issuing shares is ever performed. If the corporation has ever acknowledged the share ownership, in its records, by permitting attendance at shareholder meetings, by reporting ownership on Form K-1 of a federal tax return, then the person is a shareholder—no take backs. Not only is the wrongful denial of stock ownership incorrect as a legal matter, taking that position in a lawsuit actually results in additional liability. The wrongful denial of stock ownership is an act of conversion and may make the corporation and the majority shareholder liable for the value of the plaintiff’s shares.
4. Withholding corporate records in response to a valid inspection request.
Texas law gives shareholders broad rights to inspect corporate records and to have knowledge of what is going on in their own company. There is almost never a legitimate reason not to be forthcoming with information to a shareholder, so long as the shareholder agrees to the protection of legitimate trade secrets. Majority shareholders usually want to withhold information out of spite or ego. Lawyers representing majority shareholders can certainly waste the corporation’s money delaying and fighting the disclosure of corporate information. They almost always lose, and subject the corporation to not only the expense of a hopeless fight but also the statutory penalty of paying the plaintiff’s attorneys fees as well.
5. Advising action by non-unanimous consent
When there is discord among shareholders, the majority shareholder very frequently has no interest in a formal meeting and is advised by his attorney to take corporate actions, such as removing the minority shareholder from the board of directors, by executing a written consent in lieu of shareholders’ meeting. Texas law permits action by shareholders through execution of a written consent when the consent is unanimous and signed by all shareholders, but a non-unanimous consent, even if signed by a majority, has no effect unless the power is granted in the corporation’s Certificate of Formation—not its bylaws. Most corporations use the standard form of Certificate of Formation prepared by the Texas Secretary of State, which does not include a non-unanimous consent provision. Action taken by a non-unanimous written consent, when the certificate does not authorize it, is ulta vires and may subject the majority shareholder to liability.
6. Advising the corporation to pay for the majority shareholder's defense.
When there is a fight among shareholders, the majority shareholder's lawyer generally gets paid by the corporation. Texas law permits a corporation to indemnify legal expenses of officers, directors, and shareholders when their actions are taken in good faith, and most corporations adopt indemnification provisions that provide protection to the fullest extent permitted by the law. However, the right to indemnification only kicks in after the lawsuit is over. The payment of attorneys’ fees as they are incurred is not indemnification, but “advancement.” Texas law permits advancement only
- where the corporation has provided for it in its certificate or by-laws,
- where it has been approved by a majority or directors or shareholders who are not benefiting from the advancement, and
- where there is a prior written undertaking to pay the money back if the court determines that there was no right to indemnification.
Where the corporation advances legal fees to the majority shareholder without both proper authorization and a prior written undertaking, the majority shareholder is simply stealing corporate funds for his own benefit and may be subject to liability.
7. Permitting the use of the corporation’s lawyer to defend a derivative action.
When a minority shareholder brings a lawsuit against an officer, director, or majority shareholder for breach of their fiduciary duties, the lawsuit is actually brought on behalf of and for the benefit of the corporation—a derivative suit. Although the majority shareholder controls the corporation and has the power to direct the corporation’s attorney, the corporation is the true plaintiff in the lawsuit and any lawyer representing (and being paid by) the corporation, has ethical and legal obligations to protect the best interests of the corporation, not the majority shareholder. In these types of lawsuit, the corporation and its counsel are required to remain neutral. Having the corporation’s lawyer represent the majority shareholder individually in a derivative suit is a conflict of interest and may result in disqualification and even liability. The same is true when the corporation’s attorney actively defends the action, even if the majority shareholder has individual representation. No attorney-client privilege attaches to conversations with the corporation’s attorney that relate to the defense of the majority shareholder against the derivative claims.
8. Majority shareholder communications with the corporation’s counsel when the plaintiff is a director.
In many closely-held corporations, all of the shareholders are also directors. There is no attorney-client privilege as to any director of the corporation regarding communications with the corporation’s attorney. Any discussions that the majority shareholder has with the corporate counsel regarding his dispute with a minority shareholder who is on the board must be disclosed. The only way around this is to have the board form a special committee that does not include the plaintiff and to retain counsel to advise the committee, not the company.
9. Believing that an interested director cannot vote on a self-dealing transaction.
Any transaction with the corporation that benefits a director is by definition a self-dealing transaction, even payment of salary. There is nothing inherently wrong with a self-dealing transaction, so long as it is properly authorized after full disclosure and is entirely fair to the company. At one time, interested directors were required to abstain from voting on self-dealing transactions, giving minority shareholders a veto in some instances. That is not the law today. An interested director may vote on a self-dealing transactions, and the vote is valid even if the interested director’s vote was necessary for the majority.
10. Not understanding special voting rules of LLCs.
Limited liability companies are similar to corporations in many ways, but their voting rules are unique. An LLC is required to designate itself as “member managed”or “manager managed.” In a manager-managed LLC, voting works very much like that of a corporation. The members elect managers, and the managers make decisions as a board—one vote each. In a member-managed LLC, the members decide as a board and get one vote each. This is true even if one member owns 99% of the equity and the other owns 1%--the vote is 50-50 unless the operating agreement specifically provides otherwise.
There are a great many other traps for the unwary in dealing with the complex law governing closely-held corporations. The risk to majority shareholders, officers, and directors is not simply that they will do something wrong, but that actions advised or permitted by their attorneys result in unnecessary exposure to substantial liability. Conversely, the risk to minority shareholders is that their rights will be trampled when they law would have provided protection. In either case, owners and investors in Texas closely-held companies must make sure that their attorneys really know this complex and changing area of the law. Knowledge makes the difference!
