Buy-Out Mechanisms and Their Limitations
The most useful mechanism in a shareholder agreement for dealing with shareholder oppression is a well-written Buy-Sell provision. Because shareholders in closely-held corporations have no market to sell their shares, they are subject to being squeezed-out or frozen-out. It is the ability to sell and exit the enterprise that is necessary to protect a shareholder from oppressive conduct. A Buy-Sell agreement potentially provides such an exit. A Buy-Sell agreement provides (generally) for the corporation to purchase the shareholder’s shares upon the happening of certain events. Commonly, Buy-Sell agreements provide for the purchase in the event of the shareholder’s death, disability, retirement, or termination of employment. They can also be written as an option that can be triggered by either party at will or upon a certain vote of the shareholders or directors. Such agreements can provide an effective resolution to situations of shareholder dissension and disagreement. However, the extent to which such an agreement functions to protect against shareholder oppression depends on how the agreement is written. In practice, Buy-Sell agreements more often enable oppression than provide a solution to it.
Buy-Sell provisions are restrictions on the transferability of shares and are specifically provided for in the Texas Business Organizations Code. Buy-Sell provisions may be included in the certificate of formation, the bylaws, a shareholder agreement, or other agreement between shareholders or the shareholder and the corporation. Buy-Sell provisions are required to be reasonable. Stock transfer restrictions are valid only if “such restraints are reasonable and not contrary to public policy.” “The reasonableness of such a restriction is ordinarily to be determined by applying the test of whether the provision is sufficiently necessary to the particular corporate enterprise to justify overruling the usual policy of the law in opposition to restraints on the alienability of personal property.” “However, stock restrictions are not looked upon with favor and are strictly construed.
Buy-Sell provisions are valid with respect to a security issued before the restriction was adopted only if the holder was a party to the agreement or voted for the restriction.
Section 3.202 of the Code provides that certificates representing shares subject to a transfer restriction must contain a conspicuous full or summary statement of the restriction on the front or back of the stock certificate. The restriction is specifically enforceable if it is conspicuously noted on the certificate but is invalid against a transferee for value without actual knowledge.
There are two events involved in a Buy-Sell: the triggering event and the purchase of the shares. Either or both may be automatic or optional. The triggering event is typically termination of employment. In that case, either the shareholder or the corporation would have the option of triggering the Buy-Sell by deciding to terminate employment. The corporation’s ability to terminate might be circumscribed by an employment agreement. The triggering event could also be the exercise of an option by either side without reference to employment.
Once the Buy-Sell is triggered, then the question is whether the purchase is optional or mandatory. Most Buy-Sell agreements are written to make it mandatory that the shareholder sell but optional for the corporation to buy. This structure provides no protection from oppression because the corporation (read majority shareholder) can simply refuse to exercise the option and leave the minority shareholder without employment or any economic return and stuck with no ability to sell. The majority shareholder would then be in the position of squeezing out the minority by offering terms for a buy-out less attractive than provided in the Buy-Sell or simply freezing out the minority shareholder and allowing him to keep his shares with no employment, no dividends, and no participation.
If the Buy-Sell is triggered, at what price do the shares sell? One court has held that a Buy-Sell agreement is enforceable even if it does not specify a price because it is assumed that the parties intended a reasonable price. Most Buy-Sell agreements, however, do specify a price.
Most commonly, Buy-Sell agreements provide for a purchase of shares based on book value. Book value is the difference in value between the assets and liabilities of the corporation multiplied by the shareholder’s percent of ownership. Using book value is almost always a problem. In virtually all businesses, book value is greatly less than the fair value of the shares, because book value does not include the good will or going concern value of the corporation. Almost no one would sell their business for only for its book value. In valuing close corporations for other purposes, Texas courts have commented that “[b]ook value is entitled to little, if any, weight in determining the value of corporate stock, and many other factors must be taken into consideration.” Nevertheless, courts routinely enforce Buy-Sell provisions as written, even when there is a gross disparity between the price provided and a fair value. In the words of the Fifth Circuit: “[S]pecific performance of an agreement to convey will not be refused merely because the price is inadequate or excessive. The difference must be so great as to lead to a reasonable conclusion of fraud, mistake, or concealment in the nature of fraud, and to render it plainly inequitable and against conscience that the contract should be enforced.”
In order for a Buy-Sell agreement to provide some protection from shareholder oppression, the price must be set either by a third-party appraisal or by some formula that reasonably approximates a fair value—e.g. a percent of prior year’s sales or a multiple of EBITDA.
One pricing mechanism that is sometimes employed is a “push-pull” provision in which one shareholder makes an offer to purchase the other shareholder’s stock at certain price, and then the other shareholder must either sell at that price or purchase the first shareholder’s shares at that same price. This is a financial game of chicken which in theory should yield a fair price since the shareholder desiring to buy-out his partner must also be willing to sell at the same price. In practice, this mechanism is far from perfect. The mechanism only works fairly if both parties have equivalent wealth and liquid assets and roughly equivalent share ownership. If one party is wealthy and the other party is poor, then the rich shareholder can make a low-ball offer, knowing that the other shareholder does not have the resources to buy. Similarly, if one shareholder owns 10% and the other shareholder owns 90%, the 90% shareholder can safely offer a low number to the 10% shareholder, knowing that the burden on the other shareholder of buying 90% of the shares at that price will be insuperable.
Abusive Use of Buy-Sell Agreements
While shareholder agreements—in particular, Buy-Sell provisions—may be effective protection for minority shareholders against shareholder oppression, ordinarily they are not. In fact, the far more common situation is that the Buy-Sell provision becomes the mechanism for oppression. Take a situation that would be the norm: A shareholder agreement provides the corporation with the option to purchase a shareholder’s stock in the event of termination of employment at a price that is set at book value or some other price that may be less than the fair value of the stock. The shareholders have no other agreement guaranteeing employment. In such a situation, the majority would have the power to terminate the minority’s employment at will for no reason other than to squeeze out the minority shareholder and to use the Buy-Sell to obtain the minority’s shares at an unfairly low price. The minority shareholder would be stuck with the (in retrospect) very unfair bargain set forth in the shareholder agreement. In this situation would the minority shareholder have any remedy? Perhaps.
Considering this factual scenario for the loss of employment perspective, Ritchie v. Rupe contemplates a situation in which the minority shareholder might be able to bring a derivative action based on the majority’s absence of a legitimate business justification for the termination: “There may be situations in which, despite the absence of an employment agreement, termination of a key employee is improper, for no legitimate business purpose, intended to benefit the directors or individual shareholders at the expense of the minority shareholder, and harmful to the corporation. Though the ultimate determination will depend on the facts of a given case, such a decision could violate the directors’ fiduciary duties to exercise their ‘uncorrupted business judgment for the sole benefit of the corporation’ and to refrain from ‘usurp[ing] corporate opportunities for personal gain.’
This cause of action would depend upon a showing that the terminated minority shareholder was a “key employee” whose loss was detrimental to the corporation and the complete absence of any legitimate business purpose—as the Supreme Court notes, a very “extreme” situation and very hard to prove. Arguably, the burden of proving a legitimate business purpose would be on the majority shareholders/directors/officers that made the termination decision because they owe fiduciary duties to the corporation. It is not at all clear what the remedy would be. If the termination decision breached fiduciary duties to the corporation, then reinstatement (and backpay) to unwind the illegal transaction would obviously be available, but this remedy would leave the minority shareholder vulnerable to further oppressive conduct. The Texas Business Organizations Code would allow a minority shareholder in a closely-held corporation to request that the court treat the derivative suit as “a direct action brought by the shareholder for the shareholder’s own benefit.” This relief would be available if the court finds that “justice requires” the treatment. If so, then the action might be treated as a wrongful termination claim in which lost wages and earning capacity might be recoverable. Also, the court’s equitable authority might permit a court-ordered buy-out at a judicially-determined fair price. The Supreme Court has strongly hinted that such relief would be available under Section 21.563.
There might also be a remedy based bad faith if the exercise of the Buy-Sell for the sole purpose of obtaining the minority’s stock for grossly inadequate consideration. There is a strong argument that, in a stock redemption transaction in which the minority is divested of his property rights in his stock, the majority owes fiduciary duties directly to the minority. At least one court has held that, when a company purchases its own stock from one of its owners, unique formal fiduciary duties arise. Generally, the relationship between corporation and shareholder is “akin to one of trust.” 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.”
[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.
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. 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.”
In Miller v. Miller, 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. 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.
In Allen v. Devon Energy Holdings, L.L.C., a Limited Liability Company redeemed a minority member’s ownership interest. The company later sold for almost twenty times the value used for the redemption price. The court held that the majority shareholder owed formal fiduciary duties to the minority shareholder in the redemption.
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.
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.” The duties to shareholders described by Fawcett, Miller, and Allen, apply equally to the corporation, officers, directors, and majority shareholders.
“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.” “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.” 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.” 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 fiduciary. The majority may rebut the presumption by proving that the transaction was (1) in good faith, (2) with full disclosure, and (3) for a fair consideration.
It is true that the minority shareholder is contractually bound by the Buy-Sell, but a recent unreported Dallas case notes that the existence of the contract is not necessarily dispositive: “Be that as it may, contracts do not exist in a vacuum. Rather, contractual rights, such as those claimed by [appellant], do not operate to the exclusion of fiduciary duties. Instead, where the two overlap, contractual rights must be exercised in a manner consistent with fiduciary duties.” In that case, the LLC was in default on its lease, and it required an amendment to the company agreement to bring the business into compliance—or face a total loss of the business. The jury found that the defendant breached its fiduciary duties to the company by refusing to amend the company agreement (which required a unanimous vote). On appeal, the defendant argued that it could not breach fiduciary duties merely by exercising its contractual right not to approve an amendment. The court of appeals rejected that argument and affirmed the judgment.
A transaction in which a Buy-Sell provision was invoked solely to deprive the minority of his shares for an unfairly low price would seem to be one that was not taken “in good faith” and thus a breach of fiduciary duties owed in a stock redemption transaction. The obvious remedy would seem to be that the minority shareholder would be entitled to recover the difference between the price paid for his stock in bad faith and a fair consideration as determined by the finder of fact.
There is some authority in other jurisdictions that the discharge of the shareholder-employee to take advantage of a buy-sell agreement results in a breach of fiduciary duty. One court found a sufficient fiduciary relationship between the shareholders to justify a reevaluation of the purchase price. One court has held that the purchase price must be reasonable at the time of purchase.
This article is taken from a recent CLE paper presented by Hopkins Centrich at Essentials of Business Law: Meeting 2020 Challenges. Get the full analysis and case citations.