Minority shareholders are frequently the victims of both negligent and intentional misconduct by officers and directors. This misconduct can greatly impair the value of the shareholder’s investment. It is imperative that shareholder have a basic understanding of their rights and an appreciation of what can reasonably be expected of officers and directors. First, recognize that might does not make right. Just because those who made the decisions own the majority of the stock does not mean that the minority shareholder has no recourse.
The starting point for a disgruntled shareholder is to ask whether the decision makers met the duty of good faith. In re Walt DisneyCompany Derivative Litigation, 906 A.2d 27 (Del. 2006) the Delaware Supreme Court, held that the good faith required of corporate directors encompasses “not simply the duties of care and loyalty…, but all actions required by a true faithfulness and devotion to the interests of the corporation and its shareholders.” The most common factor that gives rise to shareholder litigation is the failure of the decision makers to keep in mind that the corporation is a separate legal entity. Frequently, when corporate officers or directors waste corporate assets, engage in self-dealing or usurp corporate opportunities, it is because they view the corporation as their personal piggy bank. That is wrong and when it damages the corporation the minority shareholder has recourse. Conduct can breach the duty of good faith even if harm was not intended. Officers and directors must act as reasonable and prudent people in making decisions in their corporate capacity. If not they breach the duty of due care which does not require intentional misconduct. For instance, a corporate officer who executes an important document may have breached the duty of due care even if he personally lost money as a result of executing document. Directors must exercise independent judgment and cannot allow themselves to become rubber stamps. The duty of reasonable care is similar to the duty of a person driving a car. If the driver fails to pay attention and hurts someone the driver is responsible even though he did not stand to gain and by his negligence. Waste can occur either by accident or on purpose. When the decision makers are simply not paying attention and the corporation is paying too much for a product of service they are wasting corporate assets. On the other hand, when the corporation is paying for assets that benefit themselves, their families or friends instead of the corporation they are guilty of - among other things – wasting corporate assets. This frequently happens when the corporation allows an insider to operate another business and use corporate space, phone system, equipment or services without fair compensation to the corporation. Normally, shareholder suits do not arise when the decision makers simply made a mistake or were not paying adequate attention. Shareholders sue most frequently – not when the officers or directors were asleep at the switch but – when the decision makers have breached their duty of loyalty. When the decision makers engage in self dealing, usurpation or have tried to squeeze out a minority shareholder consultation with an attorney is always appropriate. Self-dealing often overlaps with wasting and occurs when the decision makers select themselves to provide goods or services for the corporation for a fee. The duty of loyalty requires that these relationships be fair to the corporation. If, for instance, the corporation chooses to hire an insider when it could have gotten the same or better product from a third party a self-dealing is charge must be evaluated.
Usurpation of corporate opportunity happens when officers or directors essentially steal a business opportunity from the corporation. Instead of the corporation hiring the insider the deal never reaches the corporation. For instance, if a corporate client needs a product or service that the corporation could provide for a profit that is a corporate opportunity. If an officer or director decides to do the deal himself the charge of usurpation must be evaluated. That happens a lot more often than we would like to think.
The wrongs we have been discussing so far are generally claims that must be made on behalf of the corporation. When a claim must be brought in the name of the corporation it is called a derivative claim. A derivative claim is one that damages the corporation, as opposed to an individual shareholder. Recovering for this type of misconduct inures to the benefit of the corporation and indirectly to the benefit of all of the innocent shareholders. In a derivative suit the shareholder must make demand upon the board of directors and/or corporate officers before initiating a suit in behalf of a corporation. Frequently, however, corporate management is the ones who engage in the suspect activity in the first place. In such a case the demand would be futile and a demand to cure the situation is generally not necessary. Frequently the shareholder is interested in filing suit in her own name. Personal claims are those which affect the individual shareholder as opposed to the corporation as a whole. For instance, a squeeze-out occurs when the majority shareholders use their control to benefit themselves disproportionally at the expense of the minority shareholder. Suppose Bob, John and Mary are equal share holders in a corporation that sells used cars. Two of them can combine and siphon off funds in a wide variety of means. Frequently they vote themselves large salaries, bonuses, or other “sweetheart” deals. If Bob and John team up and take all, or substantially all, of the profit out of the business so Mary gets no return on her investment a squeeze out claim should be investigated.
Typically, if Mary feels she is getting squeezed out or that John and Bob are engaged in self-dealing, usurpation or waste Mary wants out of the deal. She may be disappointed to learn that her 1/3 of the corporation does not automatically equal 1/3 of the net asset value. Valuation of shares is a major problem in small closely held corporations. For instance, let’s assume the corporation’s inventory consists of one-hundred (100) cars, each of which is worth about $10,000. For simplicity sake, we’ll assume there are no accounts receivable or payable and that the cars are the only assets of the corporation. Having become disgruntled, Mary asks Bob and John to buy her out for her 1/3 of the $1,000,000 net asset value of the corporation. Mary will likely be disappointed. She will likely find that rather than $333,000 her interest in the business would be valued as low as $150,000. The reason is that the value of shares in a closely-held corporations is substantially discounted based upon liquidity and lack of control. A business valuation expert will testify that the market value of the opportunity to become a 1/3 shareholder with Bob and John is worth substantially less than $330,000. First, the expert would apply a liquidity discount which reduces the value of the shares based upon the realization that shares in this corporation will be hard to sell. Shares are not sold on the exchanges and a lot of people do not want to go into business with Bob and John. In addition, the expert will also apply a discounted based upon the lack of control. A prospective purchaser would have to take into consideration that Bob and John can out vote him and he will not be able to control decisions of the corporation. In other words, what would someone else pay to own 1/3 of the corporation with the other two shareholders? If the net value of the cars was $1,000,000, few people would pay $330,000 to own 1/3 of that corporation. The good news: If the minority shareholder is able to prove that management has engaged in culpable misconduct such as waste, self-dealing or usurpation, she is entitled to force a sale of her shares to the corporation for their net asset value. This is a substantial benefit to the minority shareholder and should always be thoroughly investigated. The reason for this rule is fundamental fairness. Why should Bob and John be allowed to bilk the corporation and then when Mary complains buy her interest for .50 cents on the dollar?
Minority shareholders have the right to be treated fairly and they can enforce that right if they are diligent and willing to protect themselves. The starting point is an understanding of what is allowed and what is not. |
