EACH OTHER

Majority and Minority Shareholders Relationships: Duties to the Business and Each Other

By Michael J. Zdeb

The relationship of shareholders in private, closely held companies to each other as well as the business involve important implications not only in the establishment of the business but as well in its operations.

The general rule in most states is that the holder of the majority of the voting shares controls the corporation. The majority being the holder of more than 50 percent of the voting power. This is equally true with the limited liability companies. The members holding a majority of interests can effectively control the business (Majority Rule).

The majority therefor can, absent cumulative voting, elect the board of directors or board of managers and control the affairs of the business. The holders who are in the minority effectively can be left without a voice in the affairs of the business. The exceptions to this general position include corporations with cumulative voting; in some states certain fundamental decisions (sale, merger, dissolution; known as Fundamental Decisions) require two-thirds votes and, businesses where the holders have entered into agreements then control voting.

It is worth noting that cumulative voting may enable a minority of shares to elect a minority of the board of directors, with the number of directors being the result of a formula on the voting. For example, if a shareholder holds one-third of the voting shares, in an election of three or more directors, the shareholder would be able to elect one director. Shareholder agreements can address the election of the board and not infrequently, minority investors negotiate the ability to nominate and elect a director as a representative.

Fundamental Decisions include those that amend the formation documents filed with the state; the sale of all or substantially all of the assets of the business; the merger of the business or, the dissolution of the corporation. Fundamental Decisions requiring a special vote also provide a minority with the ability to dissent and force a buyout of the shares. It effectively gives the minority an ability to exit the business and have the interest valued in an appraisal proceeding with the court. It is important to note that the standard of value employed by a court in an appraisal proceeding is not the commonly known standard of "fair market value." Instead the standard of value applied is "fair value." Generally, "fair value" as a standard will produce a valuation significantly greater than "fair market value."

With closely held, private companies, there is rarely a market for the shares or interests of the minority position holders. The minority then may be in a position of having no effective voting rights and no market in which to sell the shares. Unlike shareholders in a publicly traded company who can disagree and sell their shares, the minorities' capital remains locked in the closely held business. As a result, the minority can be in a vulnerable position if the majority chooses a course of action that is adverse to the interests or opinion of the minority.

This vulnerability has led many state courts to treat the relationships in closely held, private companies differently than how the duties and relationships in publicly traded companies are viewed. Some jurisdictions, however, will treat the relationships among the shareholders similar to the approach with publicly traded corporations. In particular, this is the approach in Delaware and states that follow its corporate law and decisions. Consequently, the law of the jurisdiction in which the business is incorporated or formed is an important consideration, as that is the law that will govern the relationships of the shareholders to the business as well as each other.

When the majority or those in control take actions that are adverse to the interests of the minority holders, there can be situations in which the minority may have recourse in the courts.

In all states, the courts impose "fiduciary duties" on the majority to act in the interests of the business. The majority has duties of loyalty (related to self-dealing), due care (informed and not reckless decisions) and to exercise the authorityof the board in good faith. These duties are owed to the corporation.

However, a number of states impose these duties in a way that the duties run directly to the minority as well as to the business as a whole (Direct Duties). When the duties run directly to the minority, actions by the board that violate one or more of the duties mentioned above, can allow the minority to bring an action (lawsuit) directly against the majority for breach of fiduciary duty.

In addition, a majority of the states have provisions that allow for the minority to sue to dissolve the corporation or force the majority to buyout the minority, if the majority has "oppressed" the interests of the minority (Oppression). Oppression occurs when the majority exercises the authority of the board to take actions that are "unfairly prejudicial" to the minority or which defeat their reasonable expectations.

The two theories of Direct Duties and Oppression are seen as limitations on the otherwise exclusive authority of the majority to control the business.

It also is the case that in some states, the minority may have a duty to the corporation. This has arisen in situations where the minority has used its position to injure the business, such as refusing to a restructure of the business for financing in order to force a buyout at a higher price. This also has occurred where a 50 percent shareholder left the business and immediately created a competing business. The legal theory is that the ability to control a decision may be held under the circumstances by the minority, and therefore the exercise of that ability has to consider the prospect of a duty to the other shareholders.

It is important both in negotiating investments in and the setup of a business to consider the effect of the various relationships, duties and the potential areas of dispute that could arise. Planning the manner of voting and the remedies for disagreements can go a long way to avoid these types of issues, which when they arise can be expensive to resolve in court. A number of topics should be considered.

The list of topics can include the following subjects:

The election of the directors or managers and whether the minority will have a right to nominate and elect one or more. Approval of Fundamental Decisions with a voting percentage that may vary from the rules of the particular state. The ability of the minority to dissent on a Fundamental Decision and require an appraisal proceeding. This can be addressed by provisions that require the minority to vote along with the majority on a sale of merger. What types of disputes that may arise and require a buyout of the minority. Dispute resolution mechanisms can be created to resolve differences. In addition if there is to be a buyout, what will be the means of determining the value. Such provisions should address not only the terms of payment but in many respects more importantly the "standard of value." For example, should the standard used be "fair market value" or "fair value." If a similar standard is not used, would some other formula relevant to the business or industry be used.

In many respects, a shareholder agreement that addresses many of these types of issues upfront can avoid disputes later or at least provide a way to address the disputes that do arise.