Common Issues Arising when the Corporation and its Majority and Minority Shareholders Part Ways
By Alice M. Morical and Jeffrey D. Roberts, Hoover Hull, LLP
When starting or growing a business, owners devote great attention to developing a business plan for marketing, operations, sources of capital, and financing. However, the same level of attention is seldom paid to understanding and anticipating issues which may arise between shareholders, particularly where the controlling interest seeks to exclude the minority shareholder from the business.[1]
In a closely-held corporation, the decision to separate from a minority shareholder often involves three relationships: the minority shareholder’s employment (usually in the capacity of a corporate officer), the minority shareholder’s position on the board of directors, and the minority shareholder’s ownership interest in the corporation. Minority shareholders often feel a great sense of personal pride in their involvement with the business. It is therefore easy to anticipate how and where the difficulties can arise particularly in the context of closely-held corporations.[2] A minority shareholder often feels entitled to continuing employment with the company and depends on the stream of salary and cash distributions. A minority shareholder may resent the loss of decision-making authority he or she enjoyed by virtue of a position on the corporation’s board of directors. A minority shareholder may be unwilling to sell his or her interest in the corporation to the majority shareholder out of disdain for the majority shareholder’s attempt at a takeover, or perhaps merely because the minority shareholder believes the purchase price to be too low and the offer unfair. The separation process should be managed carefully.
The fiduciary duties involved in closely-held corporations are the foundation for break-up cases. The duty owed to a minority shareholder in a close corporation is the same whether it arises from the majority shareholder’s capacity as a director, officer or shareholder.[3] “The fiduciary must deal fairly, honestly, and openly with his corporation and fellow stockholders” and “must not be distracted from the performance of his official duties by personal interests.”[4] A minority shareholder who is being removed from his or her company may bring claims styled as “freeze-out” or “squeeze-out,” which the Indiana Supreme Court has defined as “the use of corporate control vested in the statutory majority of shareholders or the board of directors to eliminate minority shareholders from the enterprise or reduce their voting power or claims on corporate assets to relative insignificance.”[5] Indiana is unlike many states in that we do not have minority oppression statutes and therefore freeze-out packaged lawsuits may be viewed as straight claims for breach of fiduciary duty at common law.
It is important to point out that fiduciary duty claims may be brought by a minority shareholder either directly or derivatively.[6] Indiana courts ultimately distinguish direct versus derivative actions based on whether the primary right giving rise to the action belongs to the shareholder, or the corporation. For instance, direct actions are typically brought by shareholders to enforce their right to vote on a formal corporate action, to compel dividends, to prevent oppression or fraud against minority shareholders, to inspect corporate books, and to compel shareholders’ meetings.[7] Shareholders derive those rights from the articles of incorporation and bylaws, state corporate law or agreements with other shareholders. Derivative actions, on the other hand, are brought to redress an injury sustained by, or enforce a duty owed to, the corporation.[8] Examples of derivative actions include recovery for loss of a corporate opportunity, recovery of corporate waste, or recovery of damages to a corporation resulting from an officer or director’s self-dealing.[9] Without specific rights upon which a shareholder can base a claim, the action should be brought derivatively on behalf of the corporation. Importantly, however, Indiana shareholders in close corporations may bypass a derivative action and proceed directly against fellow shareholders if certain conditions are met.[10]
Termination of Employment and Removal from Board of Directors
The fiduciary duties owed between majority and minority shareholders are the same duties owned by partners in a partnership.[11] Can a majority shareholder in a closely-held corporation fire a business “partner?” The short answer is: yes. Indiana follows the doctrine of employment at will,[12] and unlike in some states,[13]courts here have not recognized that a minority shareholder has a reasonable expectation of continuing employment by virtue of his or her ownership of, and role in, the company. At least one Indiana court, however, has acknowledged that minority shareholders typically depend on their salaries as the principal return on investment since the earnings of a close corporation are distributed as salaries, bonuses and retirement benefits.[14] So, minority shareholders challenging their terminators may argue that the fiduciary duties owed to them under Indiana law modify the at-will employment doctrine.
There are two Indiana cases where a fiduciary duty breach by the controlling shareholder involved termination of a fellow shareholder’s employment; however, in both cases, the termination was only part of the story. In G&N Aircraft, Inc. v. Boehm, a shareholder acquired majority control of a closely-held aircraft engine repair company, but wished to become the sole owner to take advantage of personal tax shelter opportunities.[15] When the minority shareholder refused to sell his interest, his employment was terminated by the majority shareholder. “If this was done for legitimate business reasons, it is protected by the business judgment rule.”[16] The Court determined that the termination was motivated by the personal objectives of the majority shareholder – i.e., his desire to combine his several other aircraft businesses and file consolidated tax returns. Therefore, the decision to terminate the minority shareholder was not protected by the business judgment rule.
In W&W Equipment Co., Inc. v. Mink, two partners contemplating retirement from an equipment business hired a new engineer, Mink.[17] Together they formed a closely-held corporation. Eventually Winter (one of the original partners) and Mink became 50% owners. When Winter was preparing to retire, Mink refused to buy Winter’s shares for the price he demanded. Using his remaining allegiances on the board of directors (which continued to consist of Winter’s original partner and the company’s long-time counsel), Winter had Mink removed as an officer and signatory of the corporation. Mink quickly filed a lawsuit, but was then terminated by Winter, who increased his own salary and began winding-up the corporation.[18]
Consistent with the at-will employment doctrine in Indiana, Mink’s cause of action for wrongful termination was disallowed.[19] However, both Winter and the corporation’s board of directors were found to have breached their fiduciary duties to Mink. The court found that Winter terminated Mink simply “to get him out of the way.”[20] The board of directors participated in the termination of Mink as part of an overall scheme to ensure Winter received a certain amount of money upon his retirement. The directors’ scheme included: (i) being generally dishonest with Mink; (ii) never discussing with Mink their ultimate plan to remove him; (iii) sending notice of the meeting regarding Mink’s removal to arrive at his home despite knowing that Mink was vacationing out of state; and (iv) failing to inform Mink that the $250,000 buyout demanded by Winter was the upper limit estimate given by the accountant.[21] In addition, the company’s counsel (who, again, was on the board of directors) gave unhelpful advice to Mink regarding the stock sale.[22] Finally, Winter breached his fiduciary duty by threatening to “use the courts against Mink to bleed the company of its assets.”[23]
In summary, minority shareholders who have been terminated may rely upon Boehm and Mink to argue that their termination by the majority shareholder gives rise to a breach of fiduciary duty. However, Boehm and Mink both make clear that terminating a minority shareholder’s employment, particularly where for business purposes, alone is not enough to support a legal claim against the majority shareholder or directors.
Majority shareholders contemplating use of his or her position as owner, director or officer, to effectuate a split from a minority interest holder would be well-advised to carefully document the legitimate business reasons for doing so and to take all reasonable steps to avoid an inference that the act was done to further the majority shareholder’s personal interests over those of the company itself. Majority shareholders and their counsel must also remain mindful of any corporate bylaws, company policies, and the other employment law considerations, all of which should be heeded during any employee termination. That is particularly true where a shareholder is terminated given the likelihood that he or she may also be a corporate officer and on the board of directors. Attention to the articles and bylaws is critical when removing a minority shareholder from the board of directors, which is a decision that oftentimes accompanies the employment termination and predates finalization of the purchase of the minority shareholder’s interest.[24] Haste in removing the minority shareholder from the board of directors without following the bylaws may be used by the minority shareholder to demonstrate an overall scheme of fiduciary duty breach by the majority interest holder.
Minority shareholders should consider requesting an employment contract spelling out the terms and duration of their employment relationship with the company. Without a contract, minority shareholders are exposed – many unexpectedly – to the at-will employment doctrine and therefore the power of the majority interest holder. In fact, employment contracts for all shareholders may be beneficial where they define the parameters of employment, quell false impressions of guaranteed employment, and demonstrate fairness and a lack of favoritism amongst the owners.
Purchase of Minority Shareholder’s Interest
To effectuate a complete break between shareholders, the majority will generally offer to “buyout” the minority shareholder’s interest. The buyout offer may itself become a point of contention by the minority shareholder. In Boehm, the majority shareholder offered to purchase the minority shareholder’s interest for $100,000 less than the shares’ appraised value and $50,000 less than the minority shareholder paid for them.[25] The court held that the amount of the offer did not itself constitute a breach of duty. “Absent nondisclosure, fraud or oppression, a majority shareholder has no duty to pay a ‘fair’ price for shares.”[26]
On the other hand, recall that the shareholder in Mink demanded that his fellow 50% owner buy him out for a price that was at the “ceiling” of the stock value range estimated by the company’s accountant.[27] The court found a lack of honesty and fair dealing because the shareholder’s demand was made without explaining to his fellow shareholder how the accountant arrived at the “range of figures,” and because the price he demanded was at the “high end of that range.”[28] Despite evidence that the retiring shareholder believed his demand truly accounted for his share of the company’s value, the Mink court found him to be in breach of his fiduciary duty.[29]
Separately, the issues between majority and minority shareholders sometimes originate not from the offer itself, but from the minority shareholder’s unwillingness to sell. That was true in Boehm, where the court weighed whether the majority shareholder’s coercion was “an improper use of his position” or “simply a hardball, but lawful, use of economic power derived from a source other than an office or directorship with [the company].”[30] In that case, when the minority shareholder remained unwilling to sell his interest, the majority shareholder applied economic pressure on the corporation. For instance, the majority shareholder owned the hangar where the corporation operated, and threatened eviction to force a costly relocation.[31] He also threatened to merge the corporation with the other businesses he owned, which would require capital outlays that would preclude future dividend payments to the corporation’s shareholders.[32] When the minority shareholder continued his refusal to sell, cash distributions were cut-off, his employment was terminated, and he was locked out of his office by the majority shareholder.[33] The Boehm court concluded that the majority shareholder used his other business interests (which, by itself, he was legally allowed to do), combined with his officer position at the company (which is where the conduct became a breach) to threaten harm to the company, squeeze out the minority shareholder, and personally benefit.[34]
In summary, while majority shareholders may not be required to offer any certain price to purchase the minority shareholder’s interest, an offer should not be so unreasonably low that it could be construed as part of a scheme to squeeze-out the minority shareholder. Interest holders must not take any action that could be construed as coercing a purchase or sale, by threatening or inflicting damage upon the corporation or the other shareholders. The law requires all shareholders in a buyout transaction to deal honestly and fairly with each other. Shareholders would benefit from securing a company valuation before making a buyout offer or demand. In that regard, minority shareholders may want to request relevant financial records from the company to assist in valuing the interest, and the majority shareholder should cooperate with such a request, following the guidance of the corporation’s bylaws and articles, and Indiana law. Ideally, the parties would enter into a buy-sell agreement. Both majority and minority shareholders would benefit from having a valid and enforceable buy-sell agreement for all shareholders, which thoroughly articulates the triggering events (e.g., termination of employment), valuation methodology, and stock purchase price.
Remedies and Damages in Shareholder Disputes
Compensatory damages are ordinarily the proper remedy for a shareholder aggrieved by breach of duty.[35] In Mink, the court ordered the remedy of dissolution based on the deadlock of the directors and shareholders (each of whom had equal shares in the company) which gave rise to the lawsuit.[36] However, the Mink court also upheld the trial court’s award of compensatory damages against the shareholder who was found to be in breach of his fiduciary duties.[37] The Mink court found that the damages award “could have been based upon evidence of” the aggrieved shareholder’s interest in the corporation‘s total worth before the breaches, the disparity in distributions paid to the breaching shareholders vis-à-vis the aggrieved shareholder, or the amount that would reasonably be required by the aggrieved shareholder to start over and grow a new business to the level of success reached by the dissolved business when the breaches occurred.[38] Damages in shareholder breach actions do not require any specific degree of certainty, provided the amount is supported by the evidence, and is not based upon conjuncture or speculation.[39] Punitive damages are also available.[40]
Further, because actions by shareholders are a creature of equity, “traditional powers of equity courts are available to fashion a remedy.”[41] In addition to the risk of court-ordered dissolution in the event of shareholder or director deadlock,[42] business owners should take note of the remedy used in Boehm, where significant wrongs exacted by the majority shareholder were found to warrant a judicially-ordered purchase of the minority shareholder’s interest by the majority shareholder for “fair value.”[43] The concept of “fair value” is an important one for business owners to understand. Majority shareholders may assume that the minority shareholder’s interest should be valued at a discount because of the minority status. However, Indiana courts have routinely distinguished “fair value” from “fair market value,” and accordingly refuse to apply discounts for minority interest and marketability when calculating the “fair value” of the minority shareholder’s interest.[44]
Conclusion
Parting ways with a fellow shareholder has the potential to spawn what can be a protracted and sometimes expensive dispute to sort out the rights and obligations of the shareholders and the corporation. As discussed herein, those issues often include employment, governance and ownership matters. By planning ahead and by considering all options when a decision to part ways is made, some of these risks may be avoided.
This article was first published in the Spring 2011 issue of the Indiana State Bar Association Business Law Newsletter.
[1] Careful practitioners should start with a diligent review of corporate records to determine whether the action giving rise to the minority shareholder’s exclusion may invoke rights to dissent under Indiana law.
[2] The rules are similar, and often identical, for members of limited liability companies and in partnership settings.
[3] G& N Aircraft v. Boehm, 743 N.E.2d 227, 240 (Ind. 2001).
[4] Id.
[5] W&W Equip. Co., Inc. v. Mink, 568 N.E.2d 564, 574 (Ind. Ct. App. 1991) (citing Gabhart v. Gabhart, 370 N.E.2d 345 (Ind. 1977)).
[6] See Boehm, 743 N.E.2d at 234-35.
[7] Id. at 234.
[8] Id. (citing 2 Principles of Corporate Governance § 7.01, at 17 (A.L.I. 1994)).
[9] Id. at 235.
[10] See Barth v. Barth, 659 N.E.2d 559, 561 (Ind. 1995). The conditions, the procedural requirements (both practical and legal) of derivative actions, and the implications of pursuing a claim directly versus derivatively are beyond the scope of this article.
[11] Boehm, 743 N.E.2d at 240.
[12] Wior v. Anchor Indus., Inc., 669 N.E.2d 172, 175 (1996).
[13] See In re Kemp & Beatley, Inc., 473 N.E.2d 1173, 1179 (N.Y. 1984).
[14] Mink, 568 N.E.2d at 574 (citing Wilkes v. Springside Nursing Home, Inc., 535 N.E.2d 657, 662 (Mass. 1976)).
[15] 743 N.E.2d at 240.
[16] Id. at 242.
[17] 568 N.E.2d at 568.
[18] Id. at 568-69.
[19] Id. at 574.
[20] Id. at 573.
[21] Id.
[22] Id.
[23] Id.
[24] See, e.g., Wenzel v. Hopper & Galliher, P.C., 779 N.E.2d 30, 39 (Ind. Ct. App. 2002) and Boehm, 743 N.E.2d at 241.
[25] 743 N.E.2d at 241.
[26] Id.
[27] Mink, 568 N.E.2d at 574.
[28] Id.
[29] Id.
[30] 743 N.E.2d at 242.
[31] Id. at 233.
[32] Id.
[33] Id.
[34] Id. at 242.
[35] Id. at 243.
[36] 568 N.E.2d at 576-78.
[37] Id. at 577.
[38] Id.
[39] Id.
[40] Id. at 577-78; Boehm, 743 N.E.2d at 245.
[41] Boehm, 743 N.E.2d at 244.
[42] See Ind. Code § 23-1-47-1.
[43] Id. at 243-44.
[44] Id. at 244; see also, Wenzel, 779 N.E.2d at 39-40 (holding as a matter of law that the trial court erred in applying minority and marketability discounts in valuing a departing shareholder’s stock).