Majority Shareholders May Not Maliciously Time a Transaction
In prior blog posts, we have dealt with the issue of shareholder oppression that ends in a stock redemption. While generally majority shareholders do not owe fiduciary duties to minority shareholders, there is an important exception to that rule. When the corporation purchases the shares of one of its owners, then there are fiduciary duties owed to the minority shareholder by the corporation.
An important subset of stock redemptions involves those buy-outs that are the result of buy-sell clauses in a stockholders’ agreement or company agreement. A carefully-crafted buy-sell agreement can be an important contractual protection against oppressive conduct. The Texas Supreme Court in the Ritchie v. Rupe opinion repeatedly emphasized that foresight and contractual protection at the time of investment are the primary (and in many cases only) protection that minority shareholders have against oppression. However, even fair buy-sell agreements can be manipulated in unfair ways by majority shareholders. Let us take a hypothetical example of a buy-sell agreement that would be fair to all—an extremely rare phenomenon. Such a buy-sell would be mandatory upon a triggering event, not optional. And the triggering event would be something that either the majority or the minority would be able to invoke. An example of a fair buy-sell agreement would be one in which the sale occurred automatically upon the termination of employment, and either the shareholder-employee or the corporation could terminate the employment at will. Furthermore, the price for the buy-out would need to be set by an independent, third party appraiser. If the majority shareholder decided to oppress the minority shareholder, then the minority could invoke the buy-sell and be paid a fair price. If the majority and the minority could no longer get along, then the majority could invoke the buy-sell and cash out the minority. The minority might not like being involuntarily removed from the corporation, but at least he would be paid a fair price—which is the most he could expect from a shareholder oppression lawsuit.
Such a buy-sell agreement would seem to eliminate the motivation for shareholder oppression and to provide an effective remedy for dissension among shareholders. Now, drop that ideal agreement into the real world. Even a buy-sell agreement that is carefully thought out and fairly crafted can still be abused. Majority shareholders have inside knowledge of the corporation and its business and are in a position of absolute control. They may manipulate even the fairest buy-sell agreement to achieve an unfair result. One example would be if the majority shareholder had negotiated a highly lucrative sale of the company or investment into the company. The majority shareholder might trigger the buy-sell before the sale or investment became effective or known and thus cheat the minority shareholder out of the profits on the sale. Similarly, a company might have received (or believe that it will receive) a major contract that will greatly increase the value of the company. An unscrupulous majority shareholder might very well trigger the buy-sell before the new business was known. A majority shareholder might also have inside knowledge that new technology or other developments would in the near future increase the value of the company, and trigger the buy-sell before that increase became apparent. Finally, in highly cyclical industries such as the oil and gas industry, the majority shareholder might time the buy-out at the bottom of the cycle, just as oil prices were beginning to rise, so as to minimize the buy-out price.
The question is whether the fiduciary duties that companies have in a stock redemption provide any protection against such manipulation. In Allen v. Devon Energy Holdings, L.L.C., 367 S.W.3d 355, the company redeemed a minority shareholder’s interest. The redemption price was based on a recent appraisal, but the majority shareholder knew that the appraisal was already out of date because developments in fracking technology were about to greatly increase the value of the company’s oil and gas property holdings. In the event, the company a short time later sold for almost twenty times the value used for the redemption price. Id. at 367. The court held that the majority shareholder owed formal fiduciary duties to the minority shareholder in the redemption. Id. at 392.
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.
Id. at 395-96.
Although Allen was an LLC case, the same principle applies to closely-held corporations. Texas LLC law generally follows Texas corporate law, except where the LLC statute specifically diverges. Moreover, the Allen case relied on corporate law precedents in supporting its holding. It is also important to note that the holding in Allen applies not only to a stock redemption by the company but to an outright purchase by the majority shareholder/member.
Allen was not a case involving the buy-sell agreement. The buy-out in that case was voluntarily negotiated based on fraudulently incomplete information. The cause of action was fraud based on non-disclosure, but the duty of full disclosure was based on a formal fiduciary duty held by the Court to exist in a stock redemption. The same fiduciary duty would apply in a contractual stock redemption that was unfairly manipulated by the majority shareholder. Texas law recognizes three distinct obligations arising from fiduciary duties in the context of a buy-out: (1) in good faith, (2) with full disclosure, and (3) for a fair consideration. See Johnson v. Peckham, 120 S.W.2d 786, 788 (Tex. 1938); Gum v. Schaefer, 683 S.W.2d at 805; Johnson v. Buck, 540 S.W.2d 393, 399 (Tex. Civ. App.—Corpus Christi 1976, writ ref’d n.r.e.). In the context of our examples, not only would the majority shareholder/corporation have the duty to share known or foreseen events that would increase the value with the appraiser, the majority shareholder/corporation would also have a duty to exercise good faith in the timing of triggering the buy-sell and also have a duty to pay a fair price.
Fiduciaries may not time transactions to unfairly disadvantage minority shareholders. Rabkin v. Philip A. Hunt Chem. Corp., 498 A.2d 1099, 1105 (Del. 1985) (“timing, structure, negotiation and disclosure of a cash-out merger all had a bearing on the issue of procedural fairness.”); Weinberger v. UOP, Inc., 457 A.2d at 711 (“The concept of fairness … embraces questions of when the transaction was timed, how it was initiated, structured, negotiated”); Sealy Mattress Co. of New Jersey, Inc. v. Sealy, Inc., 532 A.2d 1324, 1336 (Del. Ch. 1987) (“Here the merger was timed and structured in a way that had the foreseeable effect, if not the intent, of producing an unfair result.”); Jedwab v. MGM Grand Hotels, Inc., 509 A.2d 584, 599 (Del. Ch. 1986) (“The timing of such a transaction … may be such as to constitute a breach of a fiduciary’s duty to deal fairly with minority shareholders.”). “The majority stockholder was obliged not to time or structure the transaction, or to manipulate the corporation’s values, so as to permit or facilitate the forced elimination of the minority stockholders at an unfair price.” Sealy Mattress Co. of New Jersey, Inc. v. Sealy, Inc., 532 A.2d at 1335.
While Texas courts have not addressed the timing aspect of corporate fiduciary duties, Texas courts look to Delaware for guidance. L Series, LLC v. Holt, 571 S.W.3d 864, 871 (Tex. App.—Fort Worth 2019, pet. filed) (“We have no qualms looking to Delaware law….”). Texas courts routinely utilize Delaware corporate law on issues that have not yet been decided in Texas. Id. at 875 (Delaware case law is “persuasive” “in the absence of Texas authority.”); Coates v. Parnassus Syss., Inc., 2002 WL 534595, at *2 (Tex. App.—Austin Apr. 11, 2002, no pet.) (following Delaware law where the court had “not found any Texas cases addressing the critical” issue); Tow v. Bulmahn, 2016 WL 1722246, at *14 (E.D. La. Apr. 29, 2016) (Texas courts consider Delaware decisional law persuasive in resolving unsettled issues of Texas corporate law); In re Life Partners Holdings, Inc., 2015 WL 8523103, at *11 (W.D. Tex. 2015) (Texas Supreme Court would look to Delaware in deciding a director oversight claim).The Delaware Supreme Court is regarded as the “mother court” for corporate law. In re Aguilar, 344 S.W.3d 41, 47 (Tex. App.—El Paso 2011, no pet.) (“Courts throughout the country look to Delaware for guidance on matters of corporate law.”).
Delaware case law clearly prohibits fiduciaries from timing a redemption to harms the minority. See Rabkin v. Philip A. Hunt Chem. Corp., 498 A.2d at 1106; Sealy Mattress Co. of New Jersey, Inc. v. Sealy, Inc., 532 A.2d at 1336; Jedwab v. MGM Grand Hotels, Inc., 509 A.2d at 599. “[I]nequitable conduct will not be protected merely because it is legal.” Rabkin v. Philip A. Hunt Chem. Corp., 498 A.2d at 1107. A corporation or majority shareholder will breach their fiduciary duties in a stock redemption if the transaction “was timed and structured in a way that had the foreseeable effect, if not the intent, of producing an unfair result.” Sealy Mattress Co. of New Jersey, Inc. v. Sealy, Inc., 532 A.2d at 1336. The “prototype instance” of illegal timing is “(1) that the minority was financially injured by the timing (i.e., from their point of view it was an especially poor time to be required to liquidate their investment) and (2) that the controlling shareholder gained from the timing of the transaction what the minority lost.”Jedwab v. MGM Grand Hotels, Inc., 509 A.2d at 599.
In Rabkin v. Philip A. Hunt Chem. Corp., the Delaware Supreme Court held that timing violated fiduciary duties when the acquiring company waited until the expiration of the one-year price guaranty and redeemed the minority shares at a much lower value.498 A.2d at 1106. In Sealy Mattress Co. of New Jersey, Inc. v. Sealy, Inc., the Delaware Court of Chancery held that the corporate defendants breached fiduciary duties by timing a merger “to occur at a time when valuation of Sealy was difficult” which resulted in depressing “the price of Sealy [stock] until the minority stockholders were eliminated by merger or some other form of acquisition.” 532 A.2d at 1336.