Closely Held Corporations
Minority Shareholder Oppression in Closely Held Corporations
The problem of minority shareholder oppression in closely-held corporations. Why oppessive conduct won't go away without legal protection.
Why Are Minority Shareholders Oppressed?
The corporate abuse of power by any group controlling a corporation may be used to destroy a stockholder’s vital interests and expectations in his ownership of closely-held stock. As the stock of closely-held corporations generally is not readily salable, a minority shareholder at odds with management is trapped: without a voice in protecting his interests or any ability to withdraw his investment.
Minority Shareholders Answer to a Majority Owner.
Because the corporation is ultimately subject to the control of the owner(s) of a majority of its shares, any person or family or group of individuals who owns or controls the majority of the shares exercises total power over the corporation because the majority shareholder will almost always vote nimself of his friends and family to all or most of the positions on the board of directors. In closely-held corporations, where number of shares and shareholders is small, the existence of a single person or a small, strongly aligned group of persons, owning or controlling a majority of the shares is the norm. Minority shareholders in these corporations cannot elect officers or directors to protect their interests and cannot win any vote submitted to the shareholders. Minority shareholders have only that amount of influence over the corporation which the majority permits.
Minority Shareholders Cannot Escape Oppression.
Small groups of shareholders in closely-held corporations usually work closely together and have ties of family or friendship. Therefore, the opportunities are greatly increased for interpersonal conflict to arise among the shareholders or between management and particular shareholders. 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.” Because of the absence of a market in which to sell the shares, once minority shareholder oppression begins, these shareholders have nowhere to go with their hard-earned investment of time, talent, and treasure, but are “locked-in” and are vulnerable to attempts to “squeeze” them out (that is, to force them to sell at an unfairly low price) or to “freeze” them out (that is, to render their share ownership meaningless).
Prevent Oppression of Minorities
Lack of Shareholder Agreements to Prevent Oppression of Minorities.
Minority shareholders may protect themselves contractually from minority shareholder oppression. 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.” Such shareholder agreements may define respective management and voting powers, the apportionment of losses and profits, the payment of dividends, and shareholders’ rights to buy or sell shares from or to each other, the corporation, or an outside party. However, shareholder agreements are relatively rare, and truly fair and comprehensive ones that solve future problems not anticipated at the founding of the company are rarer still. The dissenting opinion in Ritchie aptly noted: “[f]rom a relational standpoint, people enter closely-held businesses in the same manner as they enter marriage: optimistically and ill-prepared.” Because closely-held corporation owners are frequently linked by family or personal relationships, they trust each other, and foolishly believe that contractual protection is unnecessary or can be dealt with later.
"people enter closely-held businesses in the same manner as they enter marriage: optimistically and ill-prepared.”
Minority Shareholder Oppression Tactics
Controlling shareholders are in a position to abuse their power over minorities through oppressive conduct that destroys or substantially diminishes the value of a minority shareholder’s ownership interest in the corporation by reducing or eliminating any economic benefits of ownership to the minority, systematically violating the rights associated with share ownership, and otherwise defeating the normal expectations that shareholders have 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 act to appropriate a greater portion of the economic benefits to themselves at the minority’s expense. When times are bad, the majority may act to preserve for themselves a greater piece of the shrinking pie at the expense of the minority. At any time, the majority may wish to get rid of minority ownership positions. Minority shareholder oppression may be motivated by greed or by a perception (valid or not) that the minority owner is not contributing. Often, the motivation for minority shareholder oppression is simply interpersonal conflict among the majority and minority shareholders.
Minority Shareholder Oppression
Often Irresitable Temptation of Minority Shareholder Oppression
Such oppressive conduct against minority shareholders may act to “squeeze out” a stockholder, forcing that him to leave the corporation and sell his shares usually at an unfairly low price, or to “freeze out” the minority shareholder by structuring corporate governance and distribution of economic benefits so as to render the minority shareholder’s ownership essentially irrelevant. In either a freeze-out scenario or a squeeze-out attempt, the oppressing majority typically cuts off the minority shareholders from information about the corporation and from any participation in management. The majority will almost always manipulate the finances of the corporation so that profits are not distributed as dividends but are diverted to the majority through excessive salaries, bonuses, or other personal benefits. When all of the shareholders work in the corporation and all corporate profits are paid out as salary and personal benefits, the majority will often terminate the minority shareholder’s employment (and thus cut off all economic benefit from stock ownership). The Supreme Court acknowledged that minority shareholders in closely-held corporations have no statutory right to exit the venture and receive a return of capital like partners in a partnership do, and usually have no ability to sell their shares like shareholders in a publicly-held corporation do; thus, if they fail to contract for shareholder rights in advance of difficulties, they will be uniquely subject to potential abuse by a controlling shareholder or group. “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.”
Minority Shareholders Is Vital
Legal Protection Against Oppression of Minority Shareholders Is Vital.
“There are 51 shares . . . . that are worth $250,000. There are 49 shares that are not worth a ----.”
Without legal protection, minority share ownership in a closely-held corporation can become essentially 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.” Prior to Ritchie, Texas courts had come to recognize that they must “take an especially broad view of the application of oppressive conduct to a closely-held corporation, where oppression may more easily be found,” and that the minority shareholders who find themselves on the receiving end of a “squeeze out” do not have a ready market for the corporation’s shares, but are at the mercy of the majority.
The majority opinion in Ritchie clearly acknowledged:
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 with 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.
Yet the Supreme Court's Ritchie decision took away the shareholder oppression claim, which was the primary legal protection for minority shareholders against minority shareholder oppression, leaving, as the Court admits, a "gap" in the law. Nevertheless, the Court's ultimate conclusion is that the existing common law, which protects minority shareholder rights and imposes duties upon corporations, will develop to fill in the gaps left by the Ritchie decision.