Over the past decade, the Limited Liability Company (“LLC”) has become one of the most favored forms of a closely held business organization in New York. As an unincorporated business entity, the LLC is favored because of its pass-through tax treatment coupled with maximum operating flexibility. However, an LLC also demands a well-written and comprehensive operation agreement - especially with regard to withdrawal and dissolution - because it may create the only chance for a member to exit the company.
Under Limited Liability Company Law (“LLCL”) §606, for example, unless the operating agreement specifically provides for the right of withdrawal, a member is not allowed to withdraw prior to dissolution of the LLC. Thus, where there is no such provision, if a member wants to withdraw, he must try to force a dissolution under LLCL §702, which provides:
What can minority shareholders do in under Texas law to protect themselves against unfair treatment, including “squeeze-outs”, “freeze-outs” and the taking of disproportionate benefits by the majority?
Texas recognizes both the shareholder oppression doctrine and “breach of fiduciary duty” theories in close corporations to protect the rights of minority shareholders.
The Dissolution Statute:
The Texas corporate dissolution statute, Article 7.05 of the Texas Business Corporation Act, provides for the appointment of a receiver and the possibility of dissolution when an aggrieved shareholder establishes “illegal, oppressive, or fraudulent” conduct by directors or those in control.
Of significance, Texas Courts have used this statute as a basis to fashion a broad range of remedies less harsh than dissolution, where they find that minority shareholder rights have been abused.
What is Oppressive Conduct?
Though illegal and fraudulent conduct is fairly easy to identify, oppressive conduct is less readily definable. One of the leading cases in Texas, Davis v. Sheerin, adopts the language of New York’s Matter of Kemp for oppression, and defines “oppressive conduct” as follows:
Delaware does not have a cause of action for oppression per se, but it does offer relief for minority shareholder oppression-like claims applying other legal principles. Thus, oppression-like claims must be carefully pleaded in Delaware.
Since court’s in other states are likely to apply Delaware law to oppression-like claims to companies organized in Delaware, vigilance must also be exercised in pleading claims relating to Delaware corporations in non-Delaware courts. Some courts outside of Delaware, such as the Southern District of New York and the Northern District of Illinois, have upheld causes of action for shareholder oppression under Delaware law, while others, such as the District of New Jersey, have dismissed oppression claims for failure to state a claim under Delaware law.
Nixon v. Blackwell, 626 A.2d 1366 (Del. 1993), is a Delaware case that often cited for the proposition that Delaware does have a shareholder oppression remedy, and also for the proposition that it does not. The case states that “[t]he entire fairness test, correctly applied and articulated, is the proper judicial approach” to deciding claims brought by minority shareholders against those in control of the corporation. Thus, some conclude that oppression claims may be pursued under the entire fairness doctrine.
However, Nixon v. Blackwell also, contains language that seems to indicate otherwise:
The New Jersey Shareholder Oppression Statute, N.J.S.A. § 14A:12-7, provides that when those in control of a corporation having 25 or fewer shareholders “have acted fraudulently or illegally, mismanaged the corporation, or abused their authority as officers or directors or have acted oppressively or unfairly toward one or more minority shareholders in their capacities as shareholders, directors, officers, or employees,” the Court can impose a wide variety of equitable remedies, including ordering a buy-out at “fair value.” (emphasis supplied).
The buyout that the Court can order does not necessarily have to be of the minority shareholders’ interest. It can order a buyout of the majority’s interest. The purchaser can be the corporation or the other shareholders.
What is Oppressive Conduct?
Oppressive conduct is defined in New Jersey as conduct that frustrates the “reasonable expectations” of the minority as of when they joined the enterprise.
In Brenner v. Berkovitz (1993), the New Jersey Supreme Court stated that the special circumstances, arrangements and personal relationships that frequently underlie the formation of close corporations generate certain expectations among the shareholders concerning their respective roles in corporate affairs, including management and earnings. A court, then, must determine initially the understanding of the parties in this regard. Generally, the court noted that any increase in benefits to the majority shareholders without corresponding benefit to minority may provide a claim of oppression.
In Stephanie (Younger) Waters v. G&B Feeds, Inc. and Wiliam Younger, No. SD29745, March 4, 2010, the Missouri Court of Appeals upheld the trial court's finding of shareholder oppression, showing that a pattern of oppressive acts is key to the cause of action. The trial court recited a medley of actions taken by Appellant-Defendant which the trial court considered to be acts of shareholder oppression:
[h]e assumed control of the corporation and the operation of its business without lawful authority and in complete disregard for the rights of [Respondent]. He borrowed money and refinanced debts on his own without consultation with [Respondent]. He testified that throughout the term of the business he purchased livestock feed at cost for [his] herd of 500-600 head of livestock, a substantial savings over a period of six years. However, the court has no evidence, other than [Bill’s] testimony, as to any such amounts paid for feed. He declined the opportunity to pay [Respondent] $70,000[.00] for her stock, the amount she had paid for it, and thus be in a position to have complete ownership of the corporation and the lawful right to operate the corporation business as he was doing without lawful right. He refused to cooperate in the sale of the business property to the ultimate financial detriment of both shareholders. He retained all rental receipts from the storage units and gave no accounting therefore. He has totally failed to give a proper accounting of his stewardship of the business affairs.
The Court of Appeals went on to hold that there was "sufficent evidence supporting the trial court's determination that [Appellant-Defendant] breached his fiduciary duty to Respondent in his dealings with her and in his operation of the affairs of [the company]" and upheld the trial court's finding of minority shareholder oppression.
For the entire decision, click here.
New York State’s corporate dissolution statute, NY Business Corporations 1104-a, provides for the involuntary dissolution of a corporation when the “directors or those in control of the corporation have been guilty of illegal, fraudulent or oppressive actions toward the complaining shareholders” in a company that is not publicly traded.
New York courts have held that oppressive conduct is distinct from illegal or fraudulent conduct, and thus also a reason for corporate dissolution.
What is Oppressive Conduct?
In an “oppression” case, the first inquiry of a New York court will be to determine whether the complained of acts are actually “oppressive.” Though the dissolution statute does not define what oppressive acts are, one of the leading cases on the subject, Matter of Kemp & Beatley, Inc., interprets them as actions which “substantially defeat shareholder expectations that, objectively viewed, were both reasonable under the circumstances and were central to the petitioner’s decisions to join the venture.” This standard is widely followed.
Oppressive conduct is most often found when there are a number of actions that, when taken together, have the effect of denying the minority shareholder benefits from the company that he or she had the reasonable expectation of. Often the Court will look at what is motivating the majority’s actions and whether there is an effort to “freeze out” or “squeeze out” the minority.
The “shareholder oppression” doctrine is a set of legal principles that protect minority shareholders from abuse by the majority. As such, these principles stand in direct contradiction to the central rule of corporate decision making that the will of the majority governs. The doctrine also runs contrary to and can prevail over several other well established legal principles, including the business judgment rule, the employment at will doctrine and derivative claims distinction. More on these later.
The principles protecting the rights of minority equity owners are articulated and implemented differently from state to state, and their implementation often involves a balancing of the rights of the majority to control the business entity’s destiny and the rights of the minority to receive the often unarticulated benefits they anticipated when they joined the enterprise. The rules may vary within a state depending on the type of entity, as well.
The general rule in the corporate governance of business entities -- including corporations, limited liability companies and partnerships -- is that absent an agreement or statutory requirement to the contrary, majority rule governs. Indeed, majority equity owners often assume that they can do pretty much anything they want with regard to the business entity.
However, this is an erroneous assumption. Over the years, many legal principles have evolved which limit the freedom of the majority to do as they wish.