The Legal Thaw Continues for Frozen-Out Shareholders
Courts are showing stronger support for the minority shareholders' rights to equal treatment.
Minority shareholders in close corporations frequently complain that they are locked into illiquid securities, receive low returns, and cannot sell out at anywhere near the true value of their shares. The majority in control of management can restrict dividend income and deny jobs to non-participating family shareholders, while at the same time they pay themselves large salaries and even get the company to buy their shares at favorable prices.
The relative powerlessness and lack of voice claimed by many minority shareholders may be ending. Courts in several jurisdictions have recently imposed a heightened fiduciary duty on directors and officers in favor of the minority. These decisions make it essential for both majority and minority holders to review their legal positions.
The trend in these cases is to require privately held corporations to extend "equal protection" to minority shareholders in some circumstances. The equal-protection rule was first developed in a 1975 Massachusetts case, Donahue v. Rodd Electrotype Co. of New England Inc. In this case, a shareholder who controlled the board of directors had gotten the company to buy back some of his stock but denied the same opportunity to the minority. In a lawsuit brought by the minority, the state court ruled that the plaintiff had been denied equal protection. In sweeping language, the court wrote that "in any case in which the controlling shareholders have exercised their power over the corporation to deny the minority [an] equal opportunity [to have access to corporate benefits] the minority shall be entitled to appropriate relief."
After the Donahue decision a number of states applied the equal-protection rule to defining the responsibilities of the majority. The rule has received added impetus, however, from two recent Delaware Court of Chancery decisions.
Delaware's stance is, important not only because many large public and private companies are incorporated in the state, but also because its corporate law decisions are widely respected and relied upon by many other state courts.
Courts in Delaware have long had rules to prevent oppressive freeze-outs of minority stockholders. But they had never expressly acknowledged that minority shareholders have a right to equal access to income from the company or equal opportunities to sell stock. In the 1991 case of Blackwell v. Nixon, however, the Delaware Court of Chancery moved the state decisively toward, if not squarely into, the equal-protection camp.
The suit was brought by locked-in minority shareholders of E.C. Barton & Co., a lumber company operating in the Mississippi Delta. The majority shareholders held salaried executive positions, while the minority did not. The group in control had adopted a policy of paying low dividends and plowing much of the firm's cash back into the company for growth. At the same time, they had provided themselves with an outlet for selling their shares. The shares they held in an ESOP could be sold to the company periodically; in addition, because the company had purchased key-man life insurance for its executives, the company could afford to buy back their shares at their death. The minority, by contrast, had common grievances: lack of returns, lack of jobs, lack of market.
After a trial, the court in Blackwell saw this situation as unfair to the minority. The decision noted that all Barton stockholders faced the same liquidity problem. If the majority's focus was on appreciating the value of the stock rather than paying dividends, the judges wrote, "it would be logical to assume that [the majority] had or were developing a plan that would enable the company's stockholders to realize the increased value of their shares." While the court found that there was such a plan for the majority—through the ESOP and key man life insurance—there was no such plan for the minority shareholders. If the minority wanted to sell, the decision observed, they were "entirely at [the majority's] mercy."
The Chancery Court distinguished Blackwell from other rulings that have compelled payment of dividends, stating that, "if this was merely a dividend case, [the minority shareholders] would have to establish that the directors set dividends so low as to be oppressive, a gross abuse of discretion, or the product of bad faith." Few if any cases, the court noted, "have involved a set of facts egregious enough to meet that standard."
The court also cautioned that it was not suggesting there is "some generalized duty to purchase illiquid stock at any particular price." What the court was saying was that "the needs of all stockholders must be considered and addressed when decisions are made to provide some form of liquidity."
Blackwell was confirmed and expanded in a more recent Chancery Court decision, Litle v. Waters. The case involve co-founders of two businesses in Nashua, New Hampshire, a catalog sales and credit card processing company that merged into DMGT Corp. The minority shareholder, Litle, managed the company, while the majority shareholder, Waters, had provided the capital and substantial loans. Both Litle and Waters had agreed to have the corporation elect Subchapter S tax status, so that they could pay the corporation's tax bills directly, regardless of dividends.
In his complaint, Litle alleges that after several years of losses, Waters fired him from his job as manager of DMGT. Thereafter, the corporation began to make profits and personal tax liabilities accrued. DMGT paid no dividends, but the corporation began to pay back Waters' loans, enabling him to pay his share of the tax.
Litle's lawsuit alleged that he was a victim of "a classic squeeze-out situation." He argued that he had an annual tax bill to pay, but his lack of a corporate voice, income from the company, or easy exit from ownership meant that he could get no money from the investment in order to pay that liability.
The case did not come to trial. Since this decision was on a motion to dismiss (unlike Blackwell, which was decided after a trial), the Litle opinion did not deal with the merits of the case but only the applicable law.
Last February, the court found that Litle's allegations, if true, would justify relief. Waters had argued that the board had met the requirements of fairness because it "treated all shareholders the same in their status as shareholders" — neither the majority nor the minority received a dividend. The court, however, looked at the financial realities of the situation. By not paying dividends, it noted, Waters "was able to ensure that he would receive a greater share of the cash available for corporate distributions via loan repayments." Further, the decision enabled Waters to put pressure on the minority shareholder to sell his shares to him at a discount, since the shares were only a liability to Litle. Such behavior, if proven, could constitute a breach of duty if the majority shareholder failed to prove at trial that his actions were "intrinsically fair."
Although both Litle and Blackwell spoke in terms of "fairness" not "equal protection," these decisions appear to have been driven, at least in part, by the equal-protection concept embraced by other jurisdictions. While the Delaware Supreme Court has yet to agree to that position, the Court of Chancery decisions are now more in line with equal-protection decisions made elsewhere in the country.
These cases make it doubly important for majority stockholders to carefully review corporate procedures for fairness. The courts do not find fault with executives who pay themselves fair salaries, whether or not they are stockholders. Likewise, owner-managers are not barred from employing ESOPs, key-man insurance, and low-dividend policies.
But when such policies deprive the minority of their rightful economic share of the corporation's benefits, the courts will increasingly step in. In the future, we can expect to see more minority shareholders asserting their rights and taking their cases to the courts.
Rodman Ward Jr. is a partner in the Delaware office of Skadden Arps Slate Meagher & Flom. Scott E. Schroeder is an associate in the firm.