Minority Shareholders

Succession planning often includes a transition plan for a business. Businesses commonly use one of three forms of incorporation, ‘C’ Corp, ‘S’ Corp, or LLC, though there are other legal forms of incorporation. Regardless of the form of incorporation, there are those who hold the power to make decisions for the business and those who do not. This article identifies how the concerns that those with limited or no power, generically referred to as minority owners have can conflict with the succession plans of the majority owners. When they do, minority shareholders become future plaintiffs.

Business succession planning is about giving up control of a business to a new group of owners. An outright sale of the business to an independent third party typically allows the minority shareholders to sell their shares to the new buyer along with the majority owner. State, and to a lesser extent federal, minority shareholder rights laws address a minority shareholders rights in the event of an independent 3rd party sale. The murkier legal situation occurs when a majority owner seeks to transfer a business to family members or even a key group of loyal employees. Minority shareholders may have no say and no way to sell their shares as ownership transfers from the known, presumably successful, owner to an untested owner.

Even if a firm had no minority shareholders prior to the business succession process, many forms of business succession create minority shareholders. Business owners are often hesitant to give up control of a business to a new management team. They prefer to take the transition in steps. This can include a partial transfer of ownership spread out over a number of years. It may include selling non-voting shares to an intentionally defective grantor trust (IDGT – see the ‘estate planning’ section of this website for details) or another trust. It may involve establishing an Employee Stock Option Plan (ESOP). (Interested readers are advised to see the ESOP article(s) in this Business Succession section for more information on this topic).All involve creating minority shareholders.

While minority shareholders have limited rights, those they have are typically defined by state law. Enforcement of those rights almost always takes the form of a threatened or actual lawsuit. Laws vary from state to state. Enforcement actions almost always involve attorneys. Whether you are a majority or minority shareholder, an attorney is a must when dealing with these issues.

This article offers information only. It is not legal advice. The material presented in this article is sourced from Business Succession Planning, written by Steve Goodman, CPA in 2014.Mr. Goodman is a Long Island, NY based estate planner. The author’s familiarity with minority shareholders business law is concentrated in New York and New Jersey. Many of the references offered in the balance of this article employ New York and New Jersey examples that may not be applicable in other jurisdictions.

Business Succession Planning

Business owners often have the misconception that as long as they retain ownership of at least 51 percent of the voting interests in a business, they are free to continue operating the business as they see fit for their own purposes, without consideration of the other shareholders. They are often shocked to find out just how much control they have actually given up by bringing on minority owners.

Who is a minority owner?

First, it is important to define exactly who is a minority owner, since the laws are written to specifically protect these individuals. That may seem like a no-brainer. Anyone who owns 49 percent or less of an interest in business would have to be considered a minority owner, right? Unfortunately, state laws that protect the rights of minority owners aren’t that simple. For example, New Jersey’s law on the subject (the Oppressed Minority Shareholder Statute (NJSA 14A:12–7)), allows all shareholders to seek relief, regardless of the percentage of ownership they have, if they can prove that they lack control over the operation of the business and are being oppressed by those who do have control. New Jersey courts have actually held that a shareholder cannot be disqualified from seeking relief under the OMS due to the size of his interest. In one case, the New Jersey Superior Court actually allowed a shareholder who owned a 98 percent interest in a corporation to seek relief under the statute (Berger v. Berger, 249 N . Super. 305 (1991)) because he lacked control over voting rights.

The New York laws that protect minority owners are based on statutes (the NY Business Corporation Law) and common law. The BCL allows any shareholders who own at least 20 percent of the equity in business to petition the court for the dissolution of the company under certain circumstances. Another section of the New York law provides that the holders of shares representing one-half of the votes of all outstanding shares may present a petition for dissolution when there is a “deadlock” among directors or shareholders (further defined by that statute).

So there really is no bright-line test to determine who has protection under the law as a minority shareholder. The key here is to realize that if you are controlling the company, and there are others who have an ownership interest, you must consider how your actions will affect the other owners before making business decisions.

What specific rights do minority owners have/what constitutes “oppression”?

In New Jersey, the law requires majority shareholders to act in the best interest of the corporation at all times (referred to as a fiduciary duty of loyalty). By acting in the best interest of the corporation and not solely in their own best interest, they are necessarily conducting business for the benefit of minority shareholders as well. New Jersey statutes specifically state that the superior court may appoint a custodian, appoint a provisional director, order a sale of the corporation’s stock, or enter a judgment dissolving the corporation when, “in the case of a corporation having twenty-five or fewer shareholders, the directors or those in control 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” (1 (NJSA 14A:12–7).

In New York, the law refers to actions by majority owners that are “illegal, fraudulent, or oppressive actions” and also provide relief in cases where majority owners are using business assets in such a way

that the assets are “looted, wasted, or diverted for non-corporate purposes.” New York uses a “reasonable expectation” test to determine whether an action by majority owners rises to the level of oppression. This test was defined by one New York court opinion that stated, “Oppression should be deemed to arise only when the majority conduct substantially defeats expectations that, objectively viewed, were both reasonable under the circumstances and were central to the petitioner’s decision to join the venture.”

The reasonable expectation test was further defined in the case of In re Kemp & Beatley, Inc. as “conduct that substantially defeats the ‘reasonable expectations’ held by minority shareholders in committing their capital to the particular enterprise … A shareholder who reasonably expected that ownership in the corporation would entitle him or her to a job, a share of corporate earnings, a place in corporate management, or some other form of security, would be oppressed in a very real sense when others in the corporation seek to defeat those expectations.” (In re Kemp & Beatley, Inc., 473 N.E. 2d 1173 (New York 1984)).

With all of this talk of state laws on the oppression of minority owners, it is important to note that it isn’t always clear which states’ law should apply. There have been several recent cases in which a business was incorporated in one state, yet the courts applied the laws of a different state. For example, in Krzastel v. Global Resource Industrial and Power, Inc., the business was incorporated in Massachusetts, yet the court applied the laws of New Jersey to the case. (The plaintiff lived in New Jersey.)

While there is any number of different actions that may qualify as oppressive to a minority shareholder, the following are a few of the more common ones that have caused litigation problems for majority owners in the past:

• terminating the employment of a minority owner
• denying access to financial records of the business
• denying the right to vote on major business decisions, such as mergers
• overcompensating majority owners leaving little to no profits for minority owners
• withholding profits from minority owners
• excluding minority owners from shareholder meetings
• withholding information on future business activity
• diverting corporate assets for nonbusiness purposes (i.e., using assets for personal use of majority owners)
• terminating a minority owner’s position as director
• substantially reducing the compensation or benefits paid to minority owners

What if my business is set up as an LLC instead of a corporation?

Much of the discussion above focused on shareholder oppression and the rights of minority shareholders. If you think you are off the hook because your business is established as a partnership or LLC, think again. The good news for partnerships and LLCs is that many of the issues on the rights of partners or members may be addressed in the partnership agreement or operating agreement. A well-drafted agreement will consider what actions are to take place when there is disagreement, what each owner is to receive with regards to distributions, any management responsibilities an owner may have, etc. The bad

the news is that it is difficult to consider every situation and almost impossible to deal with all the potential issues relating to human behavior in a legal document.

In cases where an issue is not addressed in the operating agreement, we again need to rely on state laws. Here is where majority owners may feel they have caught a break as LLC statutes typically do not provide the same protections to minority owners as state laws on corporate shareholder rights do. But the introduction of the Uniform Limited Liability Company Act of 1996 and the Revised Uniform Limited Liability Company Act of 2006 has changed all that. Specifically, section 701 of the RULLCA reads as follows:

SECTION 701. EVENTS CAUSING DISSOLUTION.

1. A limited liability company is dissolved, and its activities must be wound up, upon the occurrence of any of the following:
   1. on application by a member, the entry by [appropriate court] of an order dissolving the company on the grounds that:
      1. the conduct of all or substantially all of the company’s activities is unlawful; or
      2. it is not reasonably practicable to carry on the company’s activities in conformity with the certificate of organization and the operating agreement; or
   2. on application by a member, the entry by [appropriate court] of an order dissolving the company on the grounds that the managers or those members in control of the company:
      1. have acted, are acting, or will act in a manner that is illegal or fraudulent; or
      2. have acted or are acting in a manner that is oppressive and was, is, or will be directly harmful to the applicant.
2. In a proceeding brought under subsection (a)(5), the court may order a remedy other than dissolution.

In the comments to section 701, the drafters noted, “Even in non-RULLCA states, courts have begun to apply close corporation “oppression” doctrine to LLCs.”

RULLCA has been adopted in eight jurisdictions: Nebraska, Idaho, Utah, Iowa, Wyoming, the District of Columbia, New Jersey (effective March 18, 2013, for all new LLCs formed after that date, and March 1, 2014, for all existing New Jersey LLCs), and most recently, Florida (effective for newly formed LLCs after January 1, 2014 and for all LLCs in existence on or after January 1, 2015).

New Jersey’s new LLC Act provides that the superior court may consider an application for dissolution on the grounds that “the managers or those members in control of the company: (a) have acted, are acting, or will act in a manner that is illegal or fraudulent; or (b) have acted or are acting in a manner that is oppressive and was, is, or will be directly harmful to the applicant (§48(a)(5)).”

Interestingly, the new LLC Act also states that the grounds for dissolution cannot be varied by the operating agreement. In other words, the majority owners of the business may not avoid the issue of a disgruntled minority owner by removing their rights in the operating agreement.

While New York has not adopted the RULLCA and its LLC statutes do not provide similar protections for minority owners, its courts have, on several occasions, found in favor of minority LLC members who filed lawsuits against majority members. One court stated, “Courts have repeatedly recognized derivative suits in the absence of express statutory authorization … In light of this, it could hardly be argued that the mere absence of authorizing language in the Limited Liability Company Law bars the courts from entertaining derivative suits by LLC members.”

Conclusion

Minority rights and the potential for lawsuits are always concerns when one is engaged in business succession planning. Readers having businesses they wish to pass along to family and/or employees need to work with experienced attorneys. Minority ownership concerns will always be present. Those who are aware of the potential problems and prepared to defend their actions position themselves to counter a possible challenge. State laws vary depending upon the type of incorporation and actions taken. The research can be extensive and expensive, but it is often cheaper than losing a lawsuit.

As a general rule, if you consider the effects of your proposed actions on minority shareholders, you can reduce the chances that minority rights become a problem. Whether you are considering a gift or sale of stock to a family member, a compensation package for an employee that involves a transfer of stock, or bringing on an equity partner to your business, these individuals will have substantial rights as owners. As majority owner, you have a legal obligation concerning all shareholders.