There Are Fiduciary Duties to Minority Stockholders in a Stock Redemption

Fiduciary Duties to Minority Stockholders in a Stock Redemption

After Ritchie v. Rupe, it is clear in Texas that there is no fiduciary duty generally that majority stockholders owe to minority stockholders. This means that in many instances, majority stockholders are free to use their control over the corporation to treat minority shareholders unfairly. This conduct is generally referred to as “oppression” or a “freeze-out” or “squeeze-out.” The typical pattern of conduct is that the minority shareholder is cut off from information, excluded from management, and then terminated from employment. In most small corporations, dividends are not paid at all. If they are, then they will not be paid in a squeeze-out scenario. The intent and effect of these oppression actions is to make the minority shareholder feel helpless and to cut off any economic benefit of share ownership—in fact, in a Subchapter S corporation or an LLC, where the owners pay the taxes directly, then ownership becomes a financial liability because the minority shareholder must still pay taxes on corporate earnings but receive no money from the corporation. In this situation, the majority shareholder still owes fiduciary duties to the corporation, but so long as the oppressive conduct does not harm the corporation, the majority shareholder is under no legal duty to the minority shareholder.

The majority shareholder’s motivation is almost always to obtain the minority shareholder’s ownership interest in the corporation by forcing the minority shareholder to sell. The minority shareholder, faced with no information, no ability to influence management, no economic benefit from ownership, and perhaps the financial detriment of having to pay taxes, will often feel forced to sell. In these situations, the majority shareholder can usually name the price of the sale, and it will always be a low price.

The transaction will almost always be structured as stock redemption—that is, a sale of the minority shares back to the corporation, using the corporation’s money. This structure avoids having the majority shareholder having to dip into his personal funds even though the personal benefit to the majority shareholder is the same whether he buys the stock himself or has the corporation do it. If the buy-out is paid over time, as is usually the case, then the redemption structure also transfers the economic risk to the minority shareholder. If the corporation runs into economic trouble, then the minority shareholder won’t get paid. The majority shareholder will have received 100% of the benefit of the transaction, but the minority may not receive full payment. However, in this situation, Texas law still recognizes a very significant exception to the general rule that no fiduciary duties are owed to minority shareholders.

When a company purchases its own stock from one of its owners, unique fiduciary duties do arise. Allen v. Devon Energy Holdings, L.L.C., 367 S.W.3d at 393 (“a formal fiduciary relationship [arises in] the specific type of transaction in question: a purchase of a minority owner’s interest ….”). The reason is that, while co-shareholders do not owe fiduciary duties to each other, the corporation may owe limited fiduciary duties to its shareholders. Generally, the relationship between corporation and shareholder is “akin to one of trust.” Disco Mach. of Liberal Co. v. Payton, 900 S.W.2d 124, 126 (Tex. App.—Amarillo 1995, writ denied). The Texas Supreme Court has held that a corporation “is a trustee … and is under the obligation to observe its trust for [the shareholders’] benefit.” Yeaman v. Galveston City Co., 167 S.W. 710, 723 (Tex. 1914). See alsoHinds v. Sw. Sav. Ass’n of Houston, 562 S.W.2d 4, 5 (Tex. Civ. App.—Beaumont 1977, writ ref’d n.r.e.) (“[T]rusteeship of a corporation for its stockholders is that of an acknowledged and continuing trust . . . .”); Graham v. Turner, 472 S.W.2d 831, 836 (Tex. Civ. App.—Waco 1971, no writ) (“the relation of a corporation to its stockholders is that of a trustee of a direct trust.”); Rex Ref. Co. v. Morris, 72 S.W.2d 687, 691 (Tex. Civ. App.—Dallas 1934, no writ) (“A corporation stands in the relation of a trustee to its stockholders”). The Texas Supreme Court has held:

[T]he trusteeship of a corporation for its stockholders is that of an acknowledged and continuing trust. It cannot be regarded of a different character. It arises out of the contractual relation whereby the corporation acquires and holds the stockholder’s investment under express recognition of his right and for a specific purpose. It has all the nature of a direct trust.

Yeaman v. Galveston City Co., 167 S.W. at 723.

This legal relationship takes on special significance in a stock redemption. In In re Fawcett, the corporation repurchased the stock of the widow of a shareholder. Estate of Fawcett, 55 S.W.3d 214, 216 (Tex. App.—Eastland 2001, pet. denied).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.”Id. Subsequent cases have cited In re Fawcett as holding that fiduciary duties arise contractually in a stock redemption. See In reRosenbaum, No. 08-43029, 2010 WL 1856344, at *7 (Bankr. E.D. Tex. May 7, 2010); Redmon v. Griffith, 202 S.W.3d 225, 237 (Tex. App.—Tyler 2006, pet. denied); Willis v. Donnelly, 118 S.W.3d 10, 31, 33 (Tex. App.—Houston [14th Dist.] 2003) rev’d in part on other grounds, 199 S.W.3d 262 (Tex. 2006).

In Miller v. Miller, 700 S.W.2d 941 (Tex. App.—Dallas 1985, writ ref’d n.r.e.), 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. Id. at 944. 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. Id. at 945 (“Recognition of a fiduciary duty in this case is based not only on the personal relationship between Howard and Judy but also on Howard’s position as a founder, officer, and director of InteCom.”). 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 same duty applies to corporations. Allen relied on Miller. Id. at 393-94.

The Texas Supreme Court affirmed this line of authority in Ritchie v. Rupe, citing Allen for the ability of individual shareholders to sue directors and majority shareholders for “fraudulently [] manipulat[ing] the shares’ value.” Ritchie v. Rupe, 443 S.W.3d at 888 n.56. The duties to shareholders described by Fawcett, Miller, and Allen, apply equally to the corporation, officers, directors, and majority shareholders. See also Thywissen v. Cron, 781 S.W.2d 682, 685 (Tex. App.—Houston [1st Dist.] 1989, writ denied) (“[T]he majority shareholder and chief executive officer [] had the fiduciary obligation to deal fairly with [the minority shareholder] in connection with the right of first refusal”).

What does this mean to the minority shareholder? When the corporation buys the shares of a minority shareholder, then the corporation owes fiduciary duties to that shareholder in that transaction—which means that the transaction must be entirely fair to the minority shareholder. The redemption purchase must have been done in good faith, with full disclosure, and for a fair price.