What Is Shareholder Oppression in Texas?
“[P]eople enter closely-held businesses in the same manner as they enter marriage: optimistically and ill-prepared.” Sooner or later, there is trouble in paradise. Resentments, jealousies, and disagreements always surface. In a corporation, someone always has control. Someone always winds up with the short end of the stick. What is minority shareholder oppression in Texas closely-held corporations? How do we fight it?
Minority Shareholder Oppression
Typical scenario: Two friends dream of working for themselves. Joe and Sally create a new business. They want the new company to seem legitimate. They want to limit their liability. They want to grow the business and either sell it or leave it to their children. So they incorporate. ABC, Inc. is born. Now the Joe and Sally receive stock, seats on the board of directors, fancy titles. What is it worth? Nothing. Not yet. Now comes the hard part. Joe and Sally work. They sacrifice. They spend their life savings. They go without pay. And the business starts to make money and grow. Now the shareholders each have a secure job, a decent income, and the pride of owning their own business. At last, Joe and Sally work for themselves. Or so they think.
In the beginning, Joe and Sally make decisions together and share the profits. But someone had to be the "president," right? The company was Joe's idea; he had more experience in the industry; he had the contacts. So, Joe gets 51% and the title of president. Joe manages the checkbook and makes most of the decisions. Sally works hard. Joe works hard.
Eventually, Joe begins to think that Sally is getting more than she is worth. Sally never thought of Joe as her boss but as her equal partner. Joe disagrees. Sally wants to know how Joe is spending the money. Sally doesn't want Joe to make more money than she does. Sally want to question the decisions Joe is making. Joe thinks Sally has gotten too big for her britches. Who is Sally to criticize Joe? ABC, Inc. was his idea. ABC, Inc. is the result of his hard work. Where is the gratitude? Joe doesn't need Sally any more.
Joe fires Sally, so Sally has no income. ABC, Inc. doesn't pay dividends, so Sally receives no money from the company. Sally owns 49% of ABC, Inc., which should be worth a lot of money. Sally can't sell it. Sally can't borrow against it. Sally can't do anything with it except sell it to Joe -- who might be willing to pay ten cents on the dollar.
We call this story "shareholder oppression." Or sometimes "squeeze-out" or "freeze-out." This same story plays out in thousands of private corporations all across the country every day.
Legal Structure of the Corporation
The corporate structure separates the ownership and control of business. This separation allows some owners to be investors and not managers. A corporation is different from a partnership. Partners in a partnership are responsible for all company debts. When a partner quits, the business ends, and the partners split up everything. A corporation is a separate legal person, distinct from the owners. The corporation shields its owners from debts of the business. The corporation is permanent and not subject to the whims of the participants.
Shareholders do not control the corporation. Rather, shareholders elect directors to manage the business. TEX. BUS. ORGS. CODE § 21.401(a)(2) (“The board of directors of a corporation shall . . . direct the management of the business and affairs of the corporation.”). The corporation's stock breaks ownership into chunks evidenced by a document. The corporate structure allows persons with talent to manage and individuals with money to invest.
Majority Rule: The majority of the shares of the corporation elects the directors. So, whoever controls the majority of the shares, controls who runs the company. Joe may only own 51% of the shares, but Joe can place himself (or his friends and family) in 100% control of 100% of the company.
Ownership in a Closely-Held Corporation
The legal structure of the organization is the same for both public and private companies. Public companies are large businesses like Exxon. Public company shareholders own stock with no involvement in the management. Exxon shareholders make money through dividends and increased market value of their shares. Public corporations have lots of shareholders. These companies don't abuse their power against individual minority shareholders. State and federal regulations requiring disclosure and financial controls protect public shareholders. But, most corporations in this country are not public. The vast majority are so-called “closely-held corporations.” These small companies are mostly unregulated. And the dynamics of management–owner interaction are very different.
Practical Differences Between Public and Closely-Held Corporations
First, closely-held corporations are small. They cannot afford independent, professional management. The shareholders themselves work in and run the company. Most small businesses pay out the profits as wages rather than dividends. The company can't take shares away from its shareholders. But if the shareholders are also employees, the company can take away their jobs. The company must pay dividends according to share ownership. Not so with wages.
Second, closely-held corporations have a small number of shareholders. Public corporations have lots of shareholders, most with tiny percentages. These companies almost never have a majority shareholder. Closely-held corporations always have a majority shareholder or controlling group. The majority shareholder in a closely-held corporation sets the salaries. The majority shareholder decides who gets fired. The majority shareholder makes the spending decisions. In short, the shareholders controlling the money have the ability to get more of it for themselves.
Third, there is no market for the closely-held stock. This point is important. Public corporation shareholders buy and sell their shares on a stock exchange. Public shareholders can cash out at any time. If public shareholders don't like the management, they can dump their stock. There is no stock exchange for private companies. No one wants to buy minority shares in a private corporation. No matter how valuable an ownership interest in a closely-held corporation might be in the abstract, a minority shareholder is not able to sell his closely-held stock, generally at all, and not at anything approaching its full value. Thus, no one invests in a closely-held corporation for capital appreciation. A sale of the entire company can happen, but that scenario is a long time off and not a viable exit strategy. People invest their time, talent, and treasure in private companies for a job and a share of the profits.
Minority Shareholder Oppression in Closely-Held Corporations
As the Texas Supreme Court noted in Ritchie v. Rupe: "Occasionally, things don’t work out as planned: shareholders die, businesses struggle, relationships change, and disputes arise. When, as in this case, there is no shareholders’ agreement, minority shareholders who lack both contractual rights and voting power may have no control over how those disputes are resolved.”
The Temptation of Shareholder Oppression
Power corrupts, and absolute power corrupts absolutely. This principle is a matter of human nature. It doesn't matter if it a dictator ruling over a nation. Or a majority shareholder controlling a corporation with power over one other person. The minority shareholder is at the mercy of the majority shareholder. The temptation to abuse power may come from greed or for personal reasons. The result of giving into that temptation is devastating to the minority shareholder.
Sally can do little if Joe succumbs to the temptation to abuse his power. Joe may cut off Sally from any income from the corporation. Joe may take her share of the profits. Joe may deny her voice in management. Joe may ignore her requests for information. Joe has the power to effectively (or sometimes actually) render Sally a non-owner.
Sally wants to make Joe pay out her 49% of the profits that ABC, Inc. earned. She can't. Sally intends to withdraw the thousands of dollars she has invested in the company. She can't. The company balance sheet shows hundreds of thousands of dollars as Sally's "capital." She can't touch it. Sally wants to sell or liquidate the business and take her share. She can't make that happen. Sally wants to sell her shares to someone else. No buyers. Why can't Sally find a buyer? Not only because there is no stock exchange for trading ABC, Inc. stock, but because nobody wants the stock. Who in his right mind would want to be under Joe's control? Sally is stuck. Trapped. The only person in the world who would want to buy her shares is Joe, and he is not going to pay a fair price. Why should he? Joe will wait Sally out. He controls the money. She gets none of it. He pays himself whatever he wants.
What About Shareholder Agreements?
Minority shareholders may protect themselves from minority shareholder oppression through a shareholders' agreement. But the shareholders must have the foresight to enter into a sort of prenuptial agreement in the beginning. According to the Texas Supreme Court in Ritchie v. Rupe: “Shareholders of closely-held corporations may address and resolve such difficulties by entering into shareholder agreements that contain buy-sell, first refusal, or redemption provisions that reflect their mutual expectations and agreements.” Shareholder agreements may set management and voting, sharing of profits, payment of dividends, and rights to sell shares. Shareholder agreements are rare. And contracts that solve unanticipated problems are more unusual still. The dissenting opinion in Ritchie aptly noted: “From a relational standpoint, people enter closely-held businesses in the same manner as they enter marriage: optimistically and ill-prepared.” Because the shareholders are friends or family, they trust each other. They believe that such protection is unnecessary. Until it is too late.
Minority Shareholder Oppression Tactics
Controlling shareholders are in a position to abuse their power in many ways. The abuse destroys or diminishes the value of a minority shareholder’s ownership interest. The majority may violate shareholder rights or defeat the shareholder's expectations relating to the ownership of their shares. This conduct takes many forms and appears in many different factual situations. When times are good, and the corporation is growing, the majority may take a greater part of the economic benefits for themselves. When times are bad, the majority may grab a bigger piece of the shrinking pie. At any time, the majority may wish to get rid of minority owners. Majority shareholder may be motivated by greed or by a perception (valid or not) that the minority owner is not contributing. Often, the motivation is interpersonal conflict.
The majority shareholder might attempt to “squeeze out” a stockholder. The "squeeze play" forces a minority shareholder to sell his shares for a low price. The majority shareholder might attempt to “freeze out” the minority shareholder. The majority shareholder just pretends the minority shareholder doesn't exist. No meetings. No information. No job. No distributions. Almost always the majority shareholder manipulates the finances of the business to grab the profits. No dividends. Big salaries to the majority and his family. Little or none to the minority.
The Texas Supreme Court has acknowledged that minority shareholders in closely-held corporations have no statutory right to receive a return of capital and no ability to sell their shares: “Unhappy with the situation and unable to change it, [minority shareholders] are often unable to extract themselves from the business relationship, at least without financial loss.”
Legal Protection Against Minority Shareholder Oppression
Without legal protection, minority share ownership in a closely-held corporation can become a joke—in other words: “There are 51 shares . . . . that are worth $250,000. There are 49 shares that are not worth a ----.” The Texas Supreme Court acknowledged: “Closely-held corporations have unique attributes that may justify different protections under the law.”
The majority opinion in Ritchie v. Rupe stated:
Our review of the case law and other authorities also convinces us that it is both foreseeable and likely that some directors and majority shareholders of closely-held corporations will engage in such actions with a meaningful degree of frequency and that minority shareholders typically will suffer some injury as a result. Although the injury is usually merely economic in nature, it can be quite substantial from the minority shareholder’s perspective, as it often completely undermines their sole or primary motivation for engaging in the business. We thus conclude that the foreseeability, likelihood, and magnitude of harm sustained by minority shareholders due to the abuse of power by those in control of a closely-held corporation is significant, and Texas law should ensure that remedies exist to appropriately address such harm when the underlying actions are wrongful.
Before 2014, Texas courts had taken “an especially broad view of the application of oppressive conduct to a closely-held corporation, where oppression may more easily be found.” Texas appellate courts adopted a common-law cause of action for shareholder oppression. The courts forced majority shareholders to buy out minority shareholders at a fair price. But, in 2014, the Texas Supreme Court's Ritchie decision did away with the shareholder oppression claim. The Court admitted that it left a "gap" in the law. Still, the Court held that the existing common law did protect minority shareholder rights. And the Court predicted that existing common-law remedies would develop to fill in the gaps left by the Ritchie decision.
HCWD, PLLC Fights Shareholder Oppression
HCWD, PLLC has been fighting for minority shareholder rights for more than 20 years. That struggle has become even more important after Ritchie v. Rupe. In light of the change in the law, we are innovating and fighting hard every day for our clients. We are empowering shareholders with information on the Shareholder Oppression website. We have completely rewritten and relaunched www.shareholderoppression.com for its tenth anniversary. We share our analysis and innovations in dividend claims, stock fraud, breach of trust, stock conversion, and other claims. We are reaching out through this blog and social media. HCWD, PLLC has written a two-part law review article on the future of shareholder oppression law in Texas. The Texas Journal of Business Law will publish both parts this year. An advance copy of Part One is available for download now.
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