The Threat:
Being a defendant in a shareholder oppression case can pose a significant threat to a closed corporation and its majority shareholders. Not only can the majority or the corporation be forced to buy out the shares of the minority at what the court determines to be “fair value,” the litigation itself can be a significant distraction and drain on company finances and managerial resources.
“Fair value” often involves an appraisal process, expert reports and expert testimony at a trial – and great uncertainty as to what the court will ultimately decide. “Fair value” is a technical legal terms that is a legislative and judicial creation; it is not the same as “fair market value” and it can often be substantially different from what the minority’s shares can fetch in the open market or the amount of financing a company can obtain to buy these shares.
The court may also impose such equitable remedies, as it sees fit, can on rare occasion order a buyout by the minority of the majority and can award counsel fees to the minority if it determines that there was oppression.
Needless to say, the mere threat of a shareholder oppression lawsuit is enough to give minority shareholders considerable leverage to negotiate an exit at favorable terms.
What is Oppression?
Looking at New Jersey as an example, the state has an “Oppressed Shareholder Statute” which provides that the court may order relief including a buyout of shares where:
“In the case of a corporation having 25 or less shareholders, the directors or those in control have acted fraudulently or illegally, mismanaged the corporation, or abused their authority as officers and directors or have acted oppressively or unfairly toward one or more minority shareholders in their capacities as shareholders directors, officers, or employees.”
Oppression is not the same as fraud or illegality; it is defined as frustrating the reasonable expectations of the minority, taking into consideration the role the minority shareholder is to play in the corporation.
Notably, a 50% shareholder can be considered a minority shareholder, if he is not in control of the business.
What are Reasonable Expectations?
To determine whether there has been oppression, a court must first determine the parties understanding of the role the minority was and then decide whether the controlling shareholders have acted in a fashion that is contrary to this understanding.
The role in a corporation can include –
- employment rights
- rights to participate in management
- rights to receive information
- rights to receive dividends
- rights to maintain equity interest, including protection against a “squeeze out” from the corporation or reduction in percentage ownership.
How to Avoid an Oppression Claim?
This is not easy and never foolproof, but here are a few guidelines.
1. Avoid having non-contributing minority partners - This is a general rule, which can have applicability in a variety of circumstances. It is important to be very careful as to whom you award equity to, and it is a very good idea to have a right to buy back shares of those who leave the company’s employment.
2. Have everyone’s role and rights in the corporation well defined - and redefined as and when they change. These can be spelled out in a shareholders agreement or documented independently.
3. Create a strong documentary trail on potentially sensitive issues - One of the first things that a lawyer retained to help a minority shareholder create a favorable exit for himself, will do is go through documents, including emails, looking for evidence of oppression. Any documentary ambiguities will likely be exploited. Thus, it is critical that there is no room to dispute how many shares each shareholder is entitled to and has, and what precise rights they have.
4. Do not “squeeze out” a minority shareholder – i.e., take steps to force them to sell their shares, in a way that is legally unacceptable. There are circumstances where a minority shareholder can legitimately be required to sell his or her shares, but these require the payment of “fair value.”
5. Take steps to establish and document the company’s fair market value - This is important to counter the situation where the minority shareholder hires a valuation expert, who determines the value to be many times what the company is realistically worth.
6. Be proactive - The way to turn a small problem into a large one is to do nothing. If you anticipate a possible problem with minority shareholders down the road, it is better to take appropriate steps to address the issue, rather than letting it fester.