net profits interest

Right to Proportional Share in the Net Profits.

The Texas Supreme Court has held that the “right to the income from use by others” is a fundamental right inherent in property ownership. As the Court stated in Sheffield v. Hogg, “a right to [property] essentially implies a right to profits accruing from it, since, without the latter, the former can be of no value.”

Net Profits Interest

The principal reason for stock ownership is the expectation of economic return, if the venture is successful. Texas cases have held that the right to share “pro tanto” in the corporation’s “profits and, upon dissolution, its assets” are among the “incidents of stock ownership.” Turner v. Cattleman's Trust Co. held that among the “rights, powers, and privileges that accrue to a stockholder in a corporation” is “the right to receive dividends from the profits and gains made by the common fund.” So important are the interests of shareholders to participate in net profits of the corporation, “that courts of equity will, in a proper case, compel a payment of dividends.” Because the shareholder beneficially owns a definite portion of the corporate enterprise, his property right is not only to receive a share in any economic return but to receive the full proportional share of what is his own.

Right to Dividends from Net Profits

As a general rule, courts are particularly deferential to boards of directors on the decision whether to declare dividends or leave net profits in the corporation. However, Texas law nevertheless recognizes that dividends are often the only way that a shareholder has to obtain his net profits interest in any economic return on his investment, and that the decision not to declare dividends can be made in bad faith as a way to oppress minority shareholders. A shareholder can obtain an injunction compelling payment of a reasonable dividend where the corporation is withholding dividends in bad faith for a fraudulent or abusive purpose.

Once a dividend has been declared by the corporation, it is a debt of the corporation, and shareholders may bring suit to compel payment. Dividends declared by the corporation are payable to every record shareholder as of a date specified by the board.

Shareholder Claims Relating to Corporate Dividends

Among the various “squeeze-out” or “freeze-out” tactics that the Texas Supreme Court specifically noted in Ritchie v. Rupe for which “Texas law should ensure that remedies exist to appropriately address such harm when the underlying actions are wrongful” is withholding payment of, or declining to declare, corporate dividends. The Supreme Court recognized that a common complaint by those alleging shareholder oppression relates to the corporation’s declaration of dividends, including the failure to declare dividends or the failure to declare higher dividends.

Right to Corporate Dividends

The right to corporate dividends is clearly a legal right that the individual shareholder has as against the corporation. The Texas Supreme Court pointed out in Ritchie v. Rupe that “that shareholders already have a right to receive payment of a declared dividend in accordance with the terms of the shares and the corporation’s certificate of formation, and they can enforce that right as a debt against the corporation.” The corporation’s fiduciary duties as trustee also encompass the shareholder’s right to dividends. As the Supreme Court held in Yeaman v. Galveston City Co., the corporation, as trustee, has a fiduciary duty to preserve both the shareholder’s stock and “its fruits.” “Though considered a debt, as a shareholder’s dividends are payable by the corporation only on demand, its holding of them until the demand is in the nature of a trustee relation.”

Limitations on the Right to Corporate Dividends

The right to corporate dividends derives from the shareholders fundamental property right to share proportionally in the profits of the corporation. However, the right to dividends (unlike, say the right to vote) is not straightforward. There is no right to receive corporate dividends per se. Receipt of dividends is one way that shareholders can proportionally share in the profits of the company. Corporate dividends, by law, may only be paid out of the company's "surplus," meaning the net profits in excess of the par value of the stock. The directors of the corporation must decide how much of that surplus should be distributed to the shareholders and how much should be retained. There are a host of legitimate reasons to retain earnings within the corporation: funding capital expenditures, maintaining adequate working capital, creating a reserve against cashflow shortfalls, avoiding the necessity of debt, saving for a rainy day, etc. The decision to distribute profits or reinvest them into growing the company or save them for future use is a matter left to the discretion of the board of directors to which the business judgment rule applies. Court decisions involving the declaration of corporate dividends tend to give unusually wide latitude to the judgment of the board of directors.

Furthermore, most closely-held corporations do not pay out dividends, or at least do so very, very rarely. The payment of corporate dividends results in a tax penalty. Corporate profits are taxed when received by the corporation, and are then taxed again when received by the shareholders. Currently, ordinary dividends are taxed at the long-term capital gains rate that maxes out at 20%, but double taxation is still a burden. Therefore, closely-held corporations ordinarily pay out all profit to shareholders in the form of salary, bonuses, and perks, which are deductible expenses to the corporation and are taxed once, as ordinary income to the shareholder-employees. Most small corporations can qualify for the Subchapter-S election, in which all corporate profits are taxed at the shareholder level (whether or not paid out to the shareholders) and the corporation pays no taxes. However, in practice, even most Sub-S corporations choose to pay out profits as compensation, rather than dividends.

Corporate Dividend Claims

The corporation's control over dividend declarations can result in significant unjust treatment of minority shareholders in closely-held corporations. When some shareholders do not work in the company or are fired, then the failure to pay dividends deprives those shareholders of their right to share proportionally in the corporation's profits. Payment of corporate profits outside of the dividend process creates the opportunity for majority shareholders to receive a disproportionate share of the distribution of profits. Efforts by majority shareholder to squeeze out minority shareholders almost always involves corporate dividend decisions: Typically, the squeeze-out is accomplished by firing the minority shareholder or inducing him to quit, refusing to pay dividends, and diverting profits that would have been paid to the minority shareholder to the majority shareholder through increased salary, personal benefits, payments to his family, or outright theft. If the closely-held corporation has elected Sub-S status, then the minority shareholder's loss of income will be coupled with tax liability on corporate profits, which he will not be able to access to pay the taxes. This fact pattern is evidence in the classic shareholder oppression case, Boehringer v. Konkel.

Under the former shareholder oppression doctrine, wrongful manipulation of dividends in order to harm minority shareholders was treated a part of a pattern of oppressive conduct and remedied, usually, with a compulsory buy-out order. The Texas Supreme Court in Ritchie v. Rupe struck down the shareholder oppression doctrine in Texas and held that aggrieved shareholders must rely of other remedies and causes of action to address the wrongful manipulation of corporate dividends. Prior to the advent of the shareholder oppression doctrine, many Texas cases had recognized the shareholder's fundamental interests in receipt of dividends and had held that in an appropriate case, Texas courts had the power to order the payment of corporate dividends. The leading case was the landmark 1955 Texas Supreme Court decision in Patton v. Nicholas, which held that the suppression of dividends for a malicious purpose may be remedied by equitable relief, in that case a mandatory injunction to pay dividends. That case was followed in 1956 by the court of appeals decision in Morrison v. St. Anthony Hotel, applying the same cause of action and holding that a damages remedy was available to former shareholders. The Texas Supreme Court's (mis)reading of the Patton opinion in Ritchie v. Rupe raises some significant uncertainty regarding whether a suppression of dividends claim must sometimes be asserted as a derivative action, rather than a direct claim.

In this section, we explore the shareholder's cause of action for suppression of dividends, including a look at the unique issues involving suppression in Subchapter-S corporations. We also examine Argo Data Res. v. Shagrithaya, one of the last shareholder oppression doctrine cases, which was reversed at the same time as Ritchie v. Rupe in light of Ritchie's treatment of dividend claims. We also explore challenging a corporate policy against payment of dividends and analyze the shareholder's cause of action arising out of the payment of constructive dividends to the majority. The individual shareholder's right to dividends arise from the same rights and duties that underlie the breach of trust cause of action, and many oppression scenarios involving wrongful manipulation of corporate dividends may be remedied through a claim for breach of trust. In certain circumstances, wrongful manipulation of dividends may also give rise to a claim for stock conversion.