Proving Compliance with Fiduciary Duties in a Stock Redemption
Elsewhere on this website and blog post, we have argued that majority shareholders and corporations owe fiduciary duties to minority shareholders in the context of a stock transaction. This is an incredibly important exception to the general rule, after Ritchie v Rupe, that majority shareholders owe no legal duties to minority shareholders. In Allen v. Devon Energy Holdings, L.L.C., 367 S.W.3d 355, the company redeemed a minority shareholder’s interest. The company 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. The Texas Supreme Court in Ritchie v. Rupe cited Allen v. Devon twice with approval as an example of existing causes of action that survived the change in the law pronounced by the Ritchie decision.
How do these fiduciary duties operate in stock redemption? In Johnson v. Peckham, 120 S.W.2d 786, 788 (Tex. 1938), the Texas Supreme Court dealt with the buy-out of one partner by another partner in a Texas general partnership. Texas statutory and common law has always recognized that partners owe fiduciary duties generally. These are the same duties that apply in the context of a stock redemption in a closely-held corporation or LLC. In the context of a buy-out or stock redemption, the majority shareholder/corporation must consummate the transaction (1) in good faith, (2) with full disclosure, and (3) for a fair consideration. See id.; see also 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.).
Most of the cases dealing with these duties, including Allen v. Devon, focus on the full disclosure duty. Most of these cases involve inside information that the majority shareholder had and failed to disclose. In Allen v. Devon, the majority shareholder was aware that technological developments in fracking and other nascent business opportunities would greatly increase the value of the company in the short term. The majority shareholder did not disclose that information to the minority shareholder. The two shareholders entered into a voluntary buy-out in which the corporation purchased the shares of the minority shareholder for a price that was based on an independent, third-party appraisal, but one that the majority shareholder knew was out of date. The court of appeals held that the majority shareholder committed fraud by nondisclosure and breach of fiduciary duties because the majority shareholder had a formal fiduciary duty of full disclosure in the context of a stock redemption.
Full disclosure, however, is not the only duty that the majority shareholder/corporation owes to the minority shareholder. There are also the duties of good faith and fair consideration. These duties apply even when there was full disclosure. They apply even with the buy-out was contractually mandated rather than voluntarily negotiated. For example, if the majority shareholder had negotiated the sale of the company for a very high price, and on the eve of that sale, the majority shareholder exercised a buy-sell provision that permitted him to cause the company to redeem the shares of the minority shareholder for a lesser price and thus cheat the minority shareholder out of the lucrative terms of the buy-out, then the minority shareholder would certainly have a claim that the majority shareholder did not act in good faith and did not pay a fair price.
The same argument might be available even in the absence of a circumstance like a pending sale. Take a common situation of shareholder dissension. A common situation is a buy-sell agreement triggered by the termination of employment. Normally, the buy-sell is an option that the corporation has—the corporation may buy-out the shareholder but is not obligated to do so, and the shareholder has to right to compel or block the sale. Also, normally, the buy-out price is determined by a formula rather than an appraisal—almost always this is book value. Few decisions are more misguided than to peg a buy-sell price to 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. Business appraisers never use book value to determine the value of a going concern business. Book value almost always grossly understates the value of a company. However, book value is the most common valuation used in buy-sell agreements. This is in part because when a company is first starting and has no operations or income, book value is the only value there is—the company at its outset is only worth what has been invested into it. Owners of new businesses are often incredibly short-sighted in setting up their shareholder and company agreements and get atrocious legal advice.
Take a common situation: the majority shareholder and the minority shareholder no longer get along, or the company is rapidly growing in value and the majority shareholder no longer wants to share the rewards of owning the company with the minority shareholder. There is the usual sort of buy-sell agreement described above. The majority shareholder terminates the minority shareholder’s employment and the exercises the corporation’s option to redeem the shares at book value. If the jury were convinced that the decision to terminate was made solely for the purpose of acquiring the stock for a price that was substantially below a fair price (and not done for legitimate corporate reasons), then it would seem that the decision to terminate and the decision to buy were not made in good faith. Furthermore, a fair price was not paid because of these decisions.
Therefore, in a variety of circumstances, a minority shareholder who sells his stock back to the company, either voluntarily or as a result of a buy-sell agreement, may challenge the transaction after the fact and claim that the price paid should have been higher. “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.” Allen v. Devon Energy Holdings, L.L.C., 367 S.W.3d at 383. The most important implication of the fiduciary duties being imposed on the majority shareholder/corporation in the context of a stock redemption is that the burden of proving the validity of the transaction rests on the majority shareholder/corporation. 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 corporation. Int’l Bankers Life Ins. Co. v. Holloway, 368 S.W.2d 567, 577 (Tex. 1963). See also Gum v. Schaefer, 683 S.W.2d 803, 806 (Tex. App.—Corpus Christi 1984, no writ) (“The effect of the presumption of unfairness is to place the burden of proving that the transaction was fair upon the party seeking its enforcement.”).
“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.” Chien v. Chen, 759 S.W.2d 484, 495 (Tex. App.—Austin 1988, no writ). See also Lesikar v. Rappeport, 33 S.W.3d 282, 298 (Tex. App.—Texarkana 2000, pet. denied) (same); Lee v. Hasson, 286 S.W.3d, 1, 13 (Tex. App.—Houston [14th Dist.] 2007, pet. denied) (“[T]he existence of such a relationship not only imposes on Hasson the elevated duty of a fiduciary, but also place the burden on him to prove that the complied with that duty.”). 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.” Collins v. Smith, 53 S.W.3d 832, 840 (Tex. App.—Houston [1st Dist.] 2001, no pet.).