What protection does the law provide against shareholder dilution?
A major concern of many minority shareholders is wrongful dilution of their share ownership position. Most shareholders in closely-held corporations do not think in terms of the number of shares owned but rather in terms of their ownership percentage. A transaction in which a shareholder’s stake in the company is diluted from 20% to 10% causes extreme consternation, sometimes justified, sometimes not. In and of itself, shareholder dilution is not necessarily harmful, and Texas law does not recognize any vested interest in a certain percentage of ownership. If a corporation has 100 shares, each worth $10, and a minority shareholder owns 20% of the company, then the minority shareholder owns 20 shares worth $200. If a new investor buys 100 newly issued shares for $10 each, then the minority shareholder is diluted from 20% ownership to 10%. The shareholder’s voting power has been cut in half, but he still owns 20 shares worth $200. The number of shares in the corporation has doubled, but so has the corporation’s capital; therefore, the shareholder suffering dilution is in the same place economically.
Shareholder Dilution as a Squeeze-Out Tactic
The problem with this scenario, of course, is that if the consideration paid for the new shares is less than $10, then the shareholder dilution does harm the minority shareholder. The ability of majority shareholders to cause corporations to issue themselves new shares presents a serious opportunity for oppressive conduct. If the majority shareholder in our hypothetical corporation issued himself ten million new shares, then the minority shareholder’s position would be diluted effectively to zero. Even the threat of such a maneuver can cause a minority shareholder to cave in to squeeze-out pressure. Section 21.159 of the Texas Business Organizations Code requires that shares be issued for consideration, but provides that the forms of permissible consideration include almost anything: “a tangible or intangible benefit to the corporation,” debt, services already performed or promised to be performed, or “any other property of any kind or nature.” Furthermore, “in the absence of fraud,” the judgment of the board of directors is “conclusive in determining the value and sufficiency of the consideration received for the shares.” BOC § 21.162.
The only legal mechanism to protect shareholders from dilution are pre-emptive rights, which usually are not present and are subject to several exceptions that limit their utility. Preemptive rights only permit the shareholder to avoid shareholder dilution by purchasing additional shares in any new issuance to maintain his percentage. If the shareholder is without sufficient financial means to take advantage of pre-emptive rights when they do exist, those rights are of little benefit in preventing dilution.
Shareholder Dilution Under the Former Shareholder Oppression Doctrine
Several courts in other jurisdictions have protected minority shareholders from oppressive shareholder dilution under the shareholder oppression doctrine. No doubt such protection would have been available under that doctrine in Texas, particularly if the shareholder could have established a reasonable expectation in a certain share percentage. However, the Texas Supreme Court’s Ritchie v. Rupe decision overruled the former shareholder oppression doctrine in Texas and eliminated any duties that majority shareholders, officers, and directors owe to individual minority shareholders. After the Ritchie decision, however, there may still be some legal remedies for harm caused by shareholder dilution.
Ultra Vires Action
If the issuance of new shares was done in violation of pre-emptive rights provided or some other restriction in the certificate or the Code, of if the shares issued exceeded number of authorized shares in the certificate, or if the shares were issued for no consideration whatsoever, then the shareholder could enjoin the share issuance under the ultra vires doctrine. The same thing would be true if the officers or directors exceeded their authority in issuing the shares.
Breach of Fiduciary Duty Based on Inadequate Consideration to the Corporation
If the shareholder dilution was accomplished by issuing a great numbers of shares for grossly inadequate consideration, then the shareholder could bring derivative claim on behalf of the corporation based on the majority shareholder’s breach of fiduciary duties to the corporation (based on his control or position on the board of directors). Issuance of shares for inadequate consideration is self-dealing, and the defendant would bear the burden of proving the fairness of the transaction, including the fairness of the consideration paid. The problem is that § 21.162 makes the board’s determination of adequacy of consideration conclusive, but that provision only applies “in the absence of fraud.” Breach of fiduciary duty in Texas is a form of constructive fraud, and Texas courts would likely hold that unfair self-dealing by the majority for the purpose of shareholder dilution would constitute fraud. Shares issued in violation of the consideration provisions of the BOC are void, and the shareholder would be entitled to an injunction cancelling the share issuance.
Alternatively, the shareholder might pursue a damages remedy through a derivative action. Section 21.162 deals only with the validity of the shares issued, it does not trump the fiduciary duties of directors in entering into an unfair transaction with the corporation. If the circumstances of the share issuance did not amount to “fraud” for the purpose of rendering the shares void, the majority shareholder (through his control of the board or his position on it) would still have the fiduciary duty of fairness and loyalty to the corporation, which the Ritchie Court held would require that his actions were “solely” for the benefit of the corporation. If the majority shareholder acted for the purpose of causing shareholder dilution to benefit himself, then he would certainly have violated his fiduciary duties to the corporation. The remedy would be a damages award against the majority shareholder requiring him to pay to the corporation the fair value of the shares issued to him, the difference between what he should have paid and what he did pay. Under the special rules governing derivative suits in closely-held corporations, the minority shareholder would be able to receive his proportionate share of the damages award directly.
Finally, the shareholder could bring a derivative claim for the loss in value of the corporation’s shares. Dicta in the Ritchie opinion stated that Texas law would recognize a cause of action by the corporation directly for the lost value of its shares, a notion previously completely foreign to Texas law. Shareholder dilution without adequate consideration certainly diminishes the value of the shares. Mathematically, this remedy may not be any different from an award of damages based on what the majority shareholder’s self-dealing benefit—what he should have paid for the shares. However, the price that thee corporation should have placed on the shares at may involve more complex and subjective factors, particularly given that “intangible benefits” and promises of future service are permissible consideration. Determining the diminution in the value of the shares as of the date of issue may be a much more straight forward as a remedy.
Courts have almost universally held that actions based on shareholder dilution are derivative actions and must be brought on behalf of the corporation, and not by the shareholder individually. The one notable exception was laid down in the Delaware Supreme Court case of Gentile v. Rossette. The Delaware Court held that a minority shareholder has an individual cause of action for shareholder dilution where: “(1) a stockholder having majority or effective control causes the corporation to issue “excessive” shares of its stock in exchange for assets of the controlling stockholder that have a lesser value; and (2) the exchange causes an increase in the percentage of the outstanding shares owned by the controlling stockholder, and a corresponding decrease in the share percentage owned by the public (minority) shareholders.” In the Gentile case, the corporation had been denuded of its assets and dissolved, so that there was no derivative claim remedy, because there was no corporation. In a subsequent unpublished opinion by the Chancery Court, the plaintiff was awarded the approximate difference in value between the shares pre-dilution and post-dilution, a measure that the court held was not “perfect,” particularly on the thin evidentiary record before the court, but the court held that the award did equity and that the defendant could not be heard to complain about incomplete financial records for which he was responsible. It is unlikely that Texas would follow the Gentile exception under a fiduciary duty theory. Delaware courts are much more willing to extend the directors’ fiduciary duties directly to the shareholders where appropriate, than the Ritchie Court indicated would be permissible under Texas law.
Causes of Action
Individual Causes of Action
Massive shareholder dilution for inadequate consideration would certainly constitute a breach of trust. If the minority shareholder could sustain his burden that he had no adequate remedy at law, then he could seek equitable relief for conduct that clearly violated the corporation’s duty of impartiality. Fact situations like Gentile or like Morrison v. St. Anthony Hotel, in which the derivative remedy was unavailable because the corporation no longer existed or because the plaintiff was no longer a shareholder, would likely permit the shareholder to redress the shareholder dilution through a breach of trust claim. if the shareholder dilution were part of a larger squeeze-out scheme, then the shareholder might also successfully argue that the derivative remedy would not make the minority shareholder whole and allow his pursuit of a buy-out or other equitable remedies available for breach of trust.
The minority shareholder might also have a claim for stock conversion, particularly if the shareholder dilution altered the condition of his stock by violating pre-emptive rights. Even in the absence of pre-emptive rights, dilution that effectively wipes out a minority shareholder would certainly fit the Fifth Circuit's definition of the “dominion or control” element under Texas law, of corporate action that diminishes the value of the plaintiff’s stock. Such an application of the tort of stock conversion to shareholder dilution would be a significant extension of the law, and the affirmative defense of good faith would almost certainly apply.
Finally, the shareholder might be able to prove that there was an express or implied shareholder agreement that both shareholders would maintain the same percentage of ownership, thus prohibiting shareholder dilution by contract. The Massachusetts Supreme Court followed that reasoning in imposing liability for shareholder dilution in Bodio v. Ellis.