Abusive Use of Buy-Sell Agreements

Abusive Use of Buy-Sell Agreements

While shareholder agreements—in particular, Buy-Sell provisions—may provide some protection for minority shareholders against shareholder oppression, ordinarily they are not. More often, the Buy-Sell provision becomes the means of oppression. Normally, the buy-sell provides the option to purchase a shareholder’s shares upon termination of at-will employment at  at book value or some other low price. In such a situation, the majority may file a minority shareholder for no reason other than to use the Buy-Sell to obtain the minority’s shares at an unfairly low price. The minority shareholder would be stuck with the (in retrospect) very unfair bargain set forth in the buy-sell. In this situation would the minority shareholder have any remedy? Perhaps.

Ritchie v. Rupe speculates: “There may be situations in which, despite the absence of an employment agreement, termination of a key employee is improper, for no legitimate business purpose, intended to benefit the directors or individual shareholders at the expense of the minority shareholder, and harmful to the corporation. Though the ultimate determination will depend on the facts of a given case, such a decision could violate the directors’ fiduciary duties to exercise their ‘uncorrupted business judgment for the sole benefit of the corporation’ and to refrain from ‘usurp[ing] corporate opportunities for personal gain.’

This claim would require a showing that the terminated shareholder was a “key employee” whose loss was detrimental to the corporation and the lack of a legitimate business purpose—as the Supreme Court notes, a very “extreme” situation and very hard to prove. Arguably, the burden of proving a legitimate business purpose would be on the majority shareholders/directors/officers that made the termination decision because they owe fiduciary duties to the corporation. It is not at all clear what the remedy would be. If the termination decision breached fiduciary duties to the corporation, then reinstatement (and backpay) to unwind the illegal transaction would obviously be available, but this remedy would leave the minority shareholder vulnerable to further oppressive conduct. The Texas Business Organizations Code would allow a minority shareholder in a closely-held corporation to request that the court treat the derivative suit as “a direct action brought by the shareholder for the shareholder’s own benefit.” This relief would be available if the court finds that “justice requires” the treatment. If so, then the action might be treated as a wrongful termination claim in which lost wages and earning capacity might be recoverable. Also, the court’s equitable authority might permit a court-ordered buy-out at a judicially-determined fair price. The Supreme Court has strongly hinted that such relief would be available under Section 21.563.

There might also be a remedy based bad faith if the exercise of the Buy-Sell for the sole purpose of obtaining the minority’s stock for grossly inadequate consideration. There is a strong argument that, in a stock redemption transaction in which the minority is divested of his property rights in his stock, the majority owes fiduciary duties directly to the minority. At least one court has held that, when a company purchases its own stock from one of its owners, unique formal fiduciary duties arise. 

In In re Fawcett, the corporation repurchased the stock of the widow of a shareholder. She later sued the corporation for breach of fiduciary duties. The court of appeals held: “An officer or director of a closely held corporation, as well as the corporation itself, may become fiduciaries to a shareholder when the corporation, officer, or director repurchases the shareholder’s stock.”

In Miller v. Miller, the husband founded a corporation and had his wife sign a shareholder’s agreement providing for the redemption of her shares upon divorce. Two years after the divorce, the wife learned that the corporation was worth far more than she had believed. She sued to rescind the agreement and partition the shares. The jury found that the agreement had a reasonable business purpose but was unfair to the wife. The trial court denied rescission. The Dallas Court of Appeals’ reversed, holding that controlling shareholder owed fiduciary duties in the redemption.

In Allen v. Devon Energy Holdings, L.L.C., a Limited Liability Company redeemed a minority member’s ownership interest. The company later sold for almost twenty times the value used for the redemption price. The court held that the majority shareholder owed formal fiduciary duties to the minority shareholder in the redemption.

We conclude that there is a formal fiduciary duty when (1) the alleged fiduciary has a legal right of control and exercises that control by virtue of his status as the majority owner and sole member-manager of a closely-held LLC and (2) either purchases a minority shareholder’s interest or causes the LLC to do so through a redemption when the result of the redemption is an increased ownership interest for the majority owner and sole manager.

All transactions between the fiduciary and his principal are presumptively fraudulent and void, which is merely to say that the burden lies on the fiduciary to establish the validity of any particular transaction in which he is involved.” “A transaction between a fiduciary and the party to whom the fiduciary duty is owed is not conducted at arm’s length; rather, a heightened standard applies to the fiduciary’s part of the transaction.” The fiduciary must prove “good faith and that the transaction was fair, honest, and equitable. A transaction is unfair if the fiduciary significantly benefits from it at the expense of the beneficiary, as viewed in the light of circumstances existing at the time of the transaction.” According to the Texas Supreme Court, “well-established rules governing the duties of one occupying a fiducial relationship to the corporation and its stockholders unquestionably cast” the burden of proving fairness on the fiduciary. The majority may rebut the presumption by proving that the transaction was (1) in good faith, (2) with full disclosure, and (3) for a fair consideration.

It is true that the minority shareholder is contractually bound by the Buy-Sell, but a recent unreported Dallas case notes that the existence of the contract is not necessarily dispositive: “Be that as it may, contracts do not exist in a vacuum. Rather, contractual rights, such as those claimed by [appellant], do not operate to the exclusion of fiduciary duties. Instead, where the two overlap, contractual rights must be exercised in a manner consistent with fiduciary duties.” 

A transaction in which a Buy-Sell provision was invoked solely to deprive the minority of his shares for an unfairly low price would seem to be one that was not taken “in good faith” and thus a breach of fiduciary duties owed in a stock redemption transaction. The obvious remedy would seem to be that the minority shareholder would be entitled to recover the difference between the price paid for his stock in bad faith and a fair consideration as determined by the finder of fact.

This article is taken from a recent CLE paper presented by HCWD, PLLC at Essentials of Business Law: Meeting 2020 Challenges. Get the full analysis and case citations.

Shareholder Agreements CLE Paper