Shareholder Oppression Blog

Corporations are so ubiquitous that it is surprising that they are a relatively recent legal development. Here is a history of the development of the Texas corporation.

“Domestic corporations are the creatures of the state, under its dominion and control.” Zerr v. Lawlor, 300 S.W. 112, 113 (Tex. Civ. App.—San Antonio 1927, no writ). “A corporation—whether for-profit or not-for-profit—is a distinct legal entity which comes into existence by charter from the state.” Waddill v. Phi Gamma Delta Fraternity Lambda Tau Chapter Texas Tech Univ., 114 S.W.3d 136, 141 (Tex. App.—Austin 2003, no pet.).

Historical Development

The concept of a corporation—a private business organization composed of a group of individual participants but having its own separate legal identity—traces its roots back to Roman law. See 1 Fletcher Cyc. Of the Law of Corp. § 1 (September 2016 Update) (“According to 1 W. Blackstone, Commentaries on the Laws of England 468, “The honor of originally inventing” the corporate concept falls to the Romans. The first corporations (corpora, corporata) were bodies politic consisting of ‘separate societies of every manual trade and profession. They were afterwards much considered by the civil law.’”); see also Leach v. F.D.I.C., 860 F.2d 1266, 1270 & n.7 (5th Cir. 1988) (noting “the antecedents of the modern corporation reach back to Ancient Rome,” citing 1 W. Blackstone, Commentaries 468, 469). The English Crown granted corporate charters to many public, municipal, and charitable corporations, which seem to have “been the models upon which the organization of a business corporation was devised, furnishing the concept of a separate collective business or private entity operating through representative personal agents or officers.” 1 Fletcher Cyc. Corp. § 1. With the growth of the English Empire, corporate charters were granted to many colonial institutions, which served public, but also distinctly for-profit purposes—familiar examples include the East India Company, chartered by Elizabeth I, and the Hudson Bay Company. Id. See also Leach v. F.D.I.C., 860 F.2d at 1270 & n.8 (“the large commercial corporations of the modern era began to make their appearance in the form of the great trading houses of England during the middle of the Seventeenth Century” with some of the “more familiar trading corporations were the East India Company and Hudson Bay Company.”). Many of the American colonies, including Virginia, chartered in 1606, and Massachusetts, chartered in 1629, were essentially for-profit corporations serving public purposes. 1 Fletcher Cyc. Corp. § 2.

What is a corporation? How is it different from a partnership? What are the legal obligations?

Attributes of the corporate entity

The corporate structure allows the owners of a business to shield themselves from liability for debts incurred by the business, to securitize their ownership, to separate the ownership and control of a business so as to allow the existence of owners who are purely investors and are not required to manage the affairs of the business, and to make the business structure permanent and not subject to the whims of each of the participants.

As a general rule, buy-sell agreements are important protections against shareholder oppression. The reason that oppressive tactics are so effective is that the minority shareholder is trapped. There is no market for minority shares in closely-held corporations—the minority shareholder cannot sell his ownership interest to a third party no matter how badly he needs or wants to do so. Very frequently, the minority shareholder’s stock is subject to contractual stock restrictions that prohibit any transfer to a third party. Therefore, when the majority shareholder decides to get rid of the minority shareholder by applying pressure through oppressive conduct, then the minority shareholder will have no other alternative than to sell to the majority shareholder (or to the corporation, which is functionally the same thing). A carefully crafted buy-sell can protect the minority shareholder against oppression by providing the minority shareholder with an exit from the corporation at a fair price—usually a price set by an independent, third-party appraiser. The Texas Supreme Court in Ritchie v. Rupe held that a carefully crafted contract is essentially the only legal protection that a minority shareholder has against oppressive conduct. The problem is that most buy-sell agreements are not carefully crafted to avoid oppression.

No Ability to Exit

The most basic fact about shareholder oppression is that the minority shareholder is subject to oppression because he is trapped in the corporation with no ability to sell his stock. It is for that reason that we speak of shareholder oppression as a phenomenon peculiar to closely-held corporations. In a public corporation, the shareholder has a ready market and can always exit. If the shareholder doesn’t get along with other shareholders or disagrees with the management of the company or is otherwise dissatisfied with his share ownership, he simply sells his stock. In a closely-held corporation, there is no market for minority shares. Therefore, the minority shareholder is can only sell to the majority shareholder. Because of the majority shareholder’s control over the corporation, including control over payment of dividends and over termination of the minority shareholder’s job, the majority shareholder has the power to force the minority shareholder to sell and to set the price. In order to provide a remedy against oppression, the minority shareholder must be provided with an exit mechanism. Most buy-sells do not provide the minority shareholder an ability to exit at will. Most buy-sells are triggered by events beyond the minority’s control: death, disability, divorce, loss of employment. The shareholder must be able to trigger the buy-sell at will in order for the agreement to provide any protection against oppression. If the majority shareholder has total control over when and whether the buy-sell is triggered, then the buy-sell does not protect against oppression, instead it becomes a tool that can be used to oppress.

Optional vs. Mandatory

Even if the minority shareholder has the ability to trigger the application of the buy-sell, there is no meaningful protection if the buy-out is optional. Most buy-sells are triggered by termination of employment. That triggering mechanism allows the shareholder the ability to trigger the buy-sell by terminating his own employment. But almost all buy-sells provide that, after the triggering event, the corporation has the option to purchase; in other words, the corporation may enter into a buy-out of the minority shareholder’s stock but is under no obligation to do so. Therefore, the majority shareholder has ultimate control over whether the buy-sell provides any protection against oppression. That is like choosing the fox to guard the henhouse. No matter how fair and reasonable the buy-sell, it does no good if it is not mandatory. Otherwise, the majority shareholder simply declines to exercise the option, continues the oppressive behavior, and forces the minority shareholder to sell out at a price even below what he would get under the buy-sell.

Using a Formula for Valuation

Once the buy-sell is triggered and the option to purchase is exercised, then the next issue is at what price the stock is to be sold. Most buy-sell agreements provide a formula for determining the price. There are a wide variety of formulas. A common practice is to provide for the shareholders to vote to set the price at the annual meeting each year and to bind all the shareholders to that price. The problem, of course, is that this method gives the majority shareholder complete control over the price to be paid. He can set the price as low as he wants since he controls the vote. As a practical matter, most companies that utilize this method forget to reset the price on a regular basis, usually after the first or second year of the company’s existence, which then leave an extremely outdated and almost certainly unfairly low price in place when the buy-sell is used against a minority shareholder.

The other formula most commonly used is book value. Book value is the net worth of a company, measured by the value of its assets minus its liabilities. Book value completely ignores the earnings capability of the company and the stream of income it generates for its owners through salary and dividends. Book value ignores the market value of the company. Book value almost always grossly understates the value of a company. Therefore, using book value can turn a buy-sell agreement into an instrument of oppression instead of a remedy for oppression—forcing the minority shareholder to accept a buy-out for grossly inadequate consideration.

You and your business partner are fighting. He hires a lawyer and has the company sue you. What's wrong with this picture? Why is our company suing me instead of him? How did he hire a company lawyer without my agreement? How can he use my company (and my money) against me? This happens every day. And, yes, its not right. Your partner didn't have authority to hire the lawyer. The lawyer didn't have authority to sue to. But you can send the lawyer packing and get the suit dismissed using this little known rule.

Using the Motion to Show Authority in Texas

In my practice, I encounter this scenario often. When there are two partners, two directors, two managers, and they disagree, you have a deadlock. You can also have a deadlock when the bylaws or company agreement gives one partner a veto. But one partner is still in control, right? Whoever has the title "president" still runs the business, still signs the checks. That partner will get sick of the fight and use his power. He will have the company hire (and pay) a lawyer to sue the other partner. This power play can be devastating. But what the partner (and even the lawyer) doesn't know is that Texas law provides a remedy. The Rule 12 Motion to Show Authority is rarely used and not well known, but it is effective.

This blog post is drawn from HCWD, PLLC White Paper: Deadlocked Companies Can't Hire Lawyers.

Download the free White Paper to get the complete legal analysis and citations to all the legal authority.

Who Has Authority to Hire the Corporate Lawyer?

Only the "governing authority" of a business entity may hire a lawyer. That means the board of directors at a noticed meeting for a corporation. The managers at a noticed meeting for an LLC; or the members in a member-managed company. Retaining counsel and instituting litigation are board-level decisions. A majority must make the decision.

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. Rupe made 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.