Minority Shareholder Oppression in Family Businesses in Pennsylvania
Do frustrated shareholders have a right to relief?
Decades ago, Pennsylvania courts, as well as other state courts, were reluctant to interfere with business judgments of majority shareholders managing a corporation, even where the expectations of a minority shareholder had been wholly frustrated. A minority shareholder denied or removed from employment and denied dividends had nowhere to turn. Today, the legal climate has changed in Pennsylvania and elsewhere. The courts are more inclined to protect the reasonable expectations of minority shareholders and to recognize what has come to be known as minority shareholder oppression. Now, under Pennsylvania law, majority shareholders have a duty to refrain from using their power in such a way as to exclude minority shareholders from their proper share of benefits accruing from the enterprise. Remedies for oppression, even somewhat creative remedies, have become more readily available to minority shareholders.
Ironically, perhaps the most prevalent form of minority shareholder oppression occurs in family owned corporations. This occurs where there is an attempt by the majority shareholders to “freeze-out” the minority shareholders. One of the most frequent scenarios occurs when a successful family business lands in the hands of the children when the founder unexpectedly dies or becomes incapacitated. The decedent’s children eventually cannot agree on the management of the business and the division of corporate benefits. Existing dysfunctional family relationships are now imbedded in the dynamics of the management of the business. Jealousy, greed, rivalries and ambition can, and often do, play roles in creating and fostering the oppressive actions. The dispassionate mindset of business partners in a typical non-family setting is absent. As a consequence of these factors, the majority shareholder(s) often feel an entitlement to control the company and reap the benefits based on reasoning that has no basis in reality or the law.
Most family businesses are closely held corporations, meaning the corporation has a small number of shareholders. In a closely held corporation, the majority shareholders owe a fiduciary duty to minority shareholders not to use their power in such a manner as to frustrate the expectations of the minority or to exclude them from any of the benefits flowing from the corporation.
The types of conduct that courts have found to be oppressive include but are not limited to, the following:
- Ignoring corporate formalities such as failing to hold shareholder meetings and board of directors meetings. Frequently, controlling shareholders fail to hold annual shareholder meetings and also fail to obtain board of director approval where necessary by law. When this occurs, there are no corporate procedural safeguards to protect the minority from oppressive management by the minority.
- Refusing to provide information to the minority about company affairs, including officer salaries, bonuses, perks, etc. One of the hallmarks of oppression is the denial of a minority shareholder’s right to information relating to company affairs. Pennsylvania law requires the delivery of financial statements to all shareholders on an annual basis in connection with the required annual shareholder’s meeting. Shareholders should be permitted to ask questions at shareholders meetings and be able to obtain full disclosure relating to issues such as officers, salaries and perks.
- Adopting a “no-dividend” policy or refusing to make sub-chapter S distributions. Majority shareholders who work in the business oftentimes believe their “sweat equity” entitles them to the profits created by their efforts. Accrued profits can be distributed solely to the majority by way of increased salaries, bonuses, excessive perks and the like. This practice is sometimes referred to as taking “disguised dividends.” In proper corporate practice, profit not needed for working capital is distributed to all the shareholders as a corporate dividend.
- Unjustly terminating a minority shareholder’s employment with the company. When relationships sour in family businesses, the termination of the minority shareholder’s employment is a frequent form of oppression and perhaps the mostserious in terms of defeating the expectations of the shareholder.
- Attempting to buy the minority shares at a depressed price. Since there is no market for his shares, when a minority shareholder receives no benefits for his share ownership, the majority often uses this tactic to take advantage by purchasing the minority interest at a below-market price, thereby increasing their ownership interest.
- Self-dealing by the majority. Self-dealing occurs when a controlling shareholder, officer or director causes the business to enter into a transaction that benefits his own interests to the detriment of the other owners of the company. For example, a majority shareholder might create a trucking concern to ship the company’s products and cause the company to enter into shipping contracts that are not “arms-length” transactions. Another example would be the controlling shareholder setting his own excessive salary and bonuses without board approval.
- Siphoning off of corporate funds through leases or other contracts. Sometimes corporations enter into leases for the company premises and similar arrangements for tax purposes. These arrangements run afoul of minority shareholder rights when they are used to siphon off profits for the benefit of a controlling shareholder, his cronies or family. In one of the author’s cases, involving a chain of restaurants, discovery revealed the company had entered into above market leases for properties held in trusts for the majority shareholder’s children, thereby allowing the majority shareholder to siphon off profit to the detriment of the other shareholders. Without a careful investigation by the minority shareholder, this siphoning off of profit would never have been discovered.
- Excessive compensation. The proper corporate procedure for the setting of officer salaries involves a thoughtful consideration by the corporation’s board of directors of salaries and bonuses. Approval follows a consideration of various categories of data relating to the proper salary or bonus level for corporate positions with similar responsibilities and performances in comparable companies. Controlling shareholders who have undue influence on the board of directors are often capable of gaining approval of excessive salaries to the detriment of shareholders. Obviously, excessive salaries decrease available profits to dividend to shareholders.
- Wasting corporate assets such as the purchase of corporate airplanes, boats, and luxury cars. In a recent case brought by the author for a minority shareholder, the controlling shareholders purchased a company jet allegedly to aid the business. Discovery revealed numerous personal trips such a golf outings with individuals who had no business relationships with the company. Children of the management were flown back and forth from college. An analysis of the business trips revealed that the use of first class tickets on commercial airlines, instead of deploying the corporate jet, would have saved the company hundreds of thousands of dollars.
- Excessive perks for executives. The controlling shareholder(s) sometimes cause the company to purchase multiple club memberships, pay personal insurance premiums, or make low or no interest loans.
- Usurping corporate opportunities. A controlling shareholder may not take a business opportunity for his own benefit, if that opportunity is within the scope of the existing or prospective business of the corporation. An example would be where an individual undertakes to manufacture or distribute a product that could have been manufactured or distributed by the corporation.
- The use of company money to fund the majority’s legal defense to fend off claims made by the minority shareholders. To “add insult to injury,” majority shareholders often use the company coffers to defend themselves from claims of impropriety or oppression made by a minority shareholder.
What can the company do to avoid oppression claims?
From the corporation’s perspective, there are a number of things that it can do to avoid claims from its minority shareholders. The most important safeguard must be accomplished at the outset of the venture (or while the shareholders are still getting along), and that is the implementation of a shareholder agreement among all of the shareholders. The minority shareholder also benefits from the use of shareholder agreements. Shareholder agreements must be signed by all shareholders to be effective.
Consideration should be given to addressing the following issues in the agreement:
- Should shareholders have a right to employment or no right to employment?
- What happens if shareholders or directors are deadlocked, especially in 50/50 shareholder cases?
- Should the sale of shares be restricted and in what ways?
- Should super majority approvals be necessary for some corporation decisions?
- Are non-compete provisions appropriate?
- Is an arbitration provision needed?
- If employment of a shareholder is terminated, a shareholder dies or other triggering event occurs, should company have option to purchase shares of the departed shareholder?
- In the event of a buy-out of shares, how will share value be determined, i.e., fair value, fair market value, or book value?
Probably the second most important safeguard is for the majority to make certain that corporate formalities are followed. This is a matter that is typically ignored in family businesses. In a setting where all the shareholders are on friendly terms, ignoring corporation formalities has little adverse impact on the business. Unfortunately, however, times change and stock changes hand or a falling out occurs among shareholders. Once an adversarial or less than friendly relationship develops, it is too late to change history and solve the problems created by ignoring formalities such as obtaining necessary board approval for the operation of the company including the setting of officer salaries, entering into contracts, permissible self-dealing, etc.
The annual meeting of shareholders should take place at the same time each year and with proper notice to all shareholders. In advance of the meeting, an agenda should be distributed to the shareholders as well as the company’s financial statements. All shareholders should be given the opportunity to ask questions at the annual shareholder meeting. The election of directors should take place at the meeting. The majority should consider whether it should permit an outspoken minority shareholder to have a seat on the board. Officer’s salaries should be considered, set, and approved. The company should avoid excessive use of “Consents in Lieu” of shareholder and directors’ meetings.
The corporation should pay at least modest dividends if profits permit. So often one of the biggest leverage points in minority shareholder oppression cases is the fact that there have been no dividends paid over a course of many years. Since the majority will receive most of these dividends, it is not particularly painful for them to approve dividends.
Consideration should be given to permitting shareholders, who so desire, to have some form of employment with the corporation even if it is a minor role. Again this prevents the shareholder from claiming his expectations of participation in the enterprise have been frustrated by the majority.
In close corporations where there are multiple minority shareholders or a potential for minority shareholder claims because of personalities of the shareholders, careful consideration should be given to the purchase of a directors and officers liability policy. These policies provide a very broad coverage for “wrongful acts” committed by the directors and officers of the insured company. Most acts of oppression obviously will be considered a “wrongful act.” These policies typically are not expensive in relation to other types of insurance. Generally speaking, the limit available will be one million dollars. The purchase of such a policy is a great benefit to the corporation if a minority shareholder oppression suit is filed. Not only will its defense costs be covered but usually any indemnity owed by the majority shareholder as officers and directors for breach of fiduciary duty will be covered, assuming the breaches do not amount to willful illegal acts. Of course, a buy-out will not be covered. Generally speaking, minority shareholders obtain leverage in suits from the expense a corporation must endure in defending such claims. The existence of a D&O policy negates that leverage.
Defending Oppression Claims
Since most minority shareholder suits are resolved by way of a settlement in which the minority shareholder’s interest is bought out, the majority should carefully consider that option at the outset of such litigation. Money spent defending the claim, even if it has little merit, is typically better spent in the “business divorce.” For the majority, winning a minority oppression suit is sometimes a hollow victory. The minority shareholder is still around to criticize their future conduct. The company should be careful to make all disclosures necessary to allow the minority shareholder to value his shares. It makes little sense to hide information from the minority shareholder only to have the corporation and majority shareholders subject to liability for a securities or fraud claim.
In defending the minority shareholder oppression claim, the majority should make use of the business judgment rule. All actions directed toward the minority should be carefully documented and all corporate formalities followed. This is especially important where the minority shareholder’s employment is terminated. Careful documentation of the problems experienced with the employee’s job performance is necessary. An employment attorney should be consulted with respect to all such matters. If a shareholder agreement exists, there should be strict adherence to that agreement.
Resisting Oppressive Conduct
A shareholder who has no specific knowledge of company affairs is at a severe disadvantage in protecting his rights. While the majority oppressor typically keeps the shareholder in the dark, there are steps that the minority can take to force disclosure of information necessary to evaluate the majority’s conduct. If a minority shareholder suspects he or she is being oppressed and that majority shareholders are financially “plundering” the company, the first step in rectifying the situation is to hire counsel knowledgeable concerning minority shareholder rights and capable of bringing litigation, if necessary, to obtain the leverage necessary to achieve a satisfactory remedy for the aggrieved shareholder.
The first step counsel will take is to even the playing field by forcing disclosure of the financial affairs of the company, most importantly detailed information relating to the majority’s overall compensation. This will include salaries, bonuses, perks, (such as auto expense, country clubs, company loans, entertainment, expense and the like). The shareholder has the right by law to make a “shareholder demand” for information and documents. The corporation must promptly comply. In the event it does not comply, a shareholder can petition the court to order the corporation and its management to supply the information and to pay the minority’s counsel fees. Typically counsel will hire a forensic accountant to assist in ferreting out the extent of plunder. Where the total compensation received by the majority officers appears excessive, the aid of experts in executive compensation can be employed to prove the extent of the excess. Oftentimes this excess can be categorized as a disguised dividend for which the minority should be compensated. This can be remedied by way of a direct damage award to the shareholder or as an “add-back” to the value of the minority’s share in the case of a remedy by way of a forced buy-out of the minority’s shares.
A very useful tool for minority shareholders holding more than 20% of the company’s shares is the calling of a special shareholder meeting. Typically, counsel for the minority can attend by way of a proxy to vote one or more of the minority’s shares. Counsel should consider whether the attendance of a court reporter at the shareholder meeting is necessary to adequately record the meeting. This meeting is an opportunity to confront the majority with what has been found by the forensic accountant and obtain answers to the minority’s questions about the company’s affairs.
As part of its investigation, the minority shareholder should obtain all of the basic corporate documents including the articles of incorporation, by-laws and any shareholder agreements. In Pennsylvania, shareholders have a right to vote their shares cumulatively when voting on candidates for the board of directors unless the articles of incorporation have eliminated that right. Cumulative voting is a procedure where a minority shareholder is entitled to one vote for each of his shares multiplied by the number of directors to be elected. This is different from the manner in which directors are typically elected and advantageous to the minority shareholder because he can apply all his (or her) votes towards one person, including voting for himself. Depending on how the share holdings are split and the number of directors to be elected, cumulative voting can often enable a minority shareholder to obtain a seat on the board. Despite the fact that the minority will be outnumbered on the board if elected, he or she will have inspection rights relating to company affairs much greater than that of a shareholder.
Once a minority shareholder has obtained detailed information confirming the oppressive acts, he should consider making a demand on the board of directors to remedy the oppressive behavior. A demand is not necessary, however, where it would clearly be futile as is typically the case with family businesses.
Asserting Minority Shareholder Claims
The victim of oppression will usually need to assert claims in court to obtain the leverage necessary to obtain a remedy. In addition to a claim of minority shareholder oppression, seeking statutory and equitable relief, a typical case will include claims for breach of fiduciary duty and direct damages to the shareholder. Other claims that are frequently joined with oppression claims are wrongful discharge, misrepresentation, conversion, and punitive damage claims.
Statutory remedies for oppression include court-ordered involuntary dissolution, the appointment of receiver and the appointment of a custodian for the business. While these remedies are considered drastic and not usually granted by courts, the mere existence of these remedies and the “interrorem effect” of the possibility of their use by the courts often provides the leverage to motivate the majority to settle the minority’s claims, which usually involves a buy-out of minority’s shares.
When a company is profitable or can be continued by non-conflicted management, the modern trend is for courts to resolve shareholder oppression cases by ordering a buy-out of the oppressed shareholder’s interest at fair value. Such a buy-out is preferable to dissolution and other drastic remedies because it allows the business to continue uninterrupted. Preserving business for the benefit of its employees and the region. Pennsylvania courts have not hesitated to use their inherent power to order buy-outs.
Fair market value typically involves the application of significant discounts, discounts for lack of marketability and control that typically aggregate between 25 and 50 percent, decreasing the shareholder’s pro-rata share of the value of the enterprise. In a minority shareholder oppression setting, the goal is to obtain fair value, a price that represents the shareholder’s percentage share of ownership multiplied by the value of the enterprise as a whole, without any discounting. For example, if the shareholder owns 25% of a company worth $10 million, the fair value of his stock would be $2.5 million.
When determining the value of shares in the context of a minority shareholder oppression suit, it is not proper to place discounts on the value. Courts have recognized that where a shareholder is forced to seek judicial relief because of oppressive conduct, it is improper to apply discounts when valuing the oppressed shareholder’s stock. Otherwise, the oppressor would enjoy a windfall from his oppressive conduct. Almost all courts that have considered the question have rejected the application of a minority discount in minority shareholder oppression cases. Sometimes the court’s reasoning is that if the corporation had been dissolved, the minority shareholder would have received the prorata value of the entire enterprise. Other courts have reasoned that discounts relating to lack of marketability and lack of control simply do not apply to the majority who already has control and can sell the company if they wish. Purchasing the minority shares does not put them at risk in terms of marketability or control.
Partnerships and LLCs
In the case of partnerships or limited partnerships and LLCs, most of the same concepts, principles and procedures applicable to minority shareholder are applicable, most notably inspection rights, protections against oppressive conduct and the availability of similar remedies. For more information, please contact Jeffrey P. Ward at (412) 297-4961 or firstname.lastname@example.org. To receive future bulletins by e-mail, please send an e-mail to email@example.com.