The concept of “majority rules” is a concept with which we are all no doubt familiar. But what happens when the majority owners of a closely held business exploit their power over minority owners in an abusive or oppressive manner? Is there no standard of fairness or other limitation on the power of the majority when it comes to corporate governance? Over the last two decades, some Texas courts have answered those questions in the affirmative by acknowledging the existence of a cause of action for what has been called “minority shareholder oppression”. Courts have even gone so far as to require majority owners to purchase the ownership interests of affected minority owners in some of those cases. However, the existence of this amorphous and often-debated area of corporate law may be over.
The Texas Supreme Court has recently ruled in Ritchie v. Rupe, No. 11-0447 (Tex. June 20, 2014) that it will not recognize a general cause of action for minority shareholder oppression. In the case, an 18 percent owner desired to sell her shares in a corporation. Other shareholders owning 79 percent of the corporation refused to meet with prospective purchasers of the minority shareholder’s interest to discuss long-term financial strategies, which refusal negatively impacted the minority owner’s ability to sell her shares.
With the Ritchie v. Rupe decision it is more important than ever to contractually establish rules applicable to closely held businesses and avoid relying upon the judiciary, the legislature, or others to solve disputes between co-owners. That is not to say that the judiciary, for example, will not and cannot play a role in addressing disputes between co-owners. Rather, our focus should be on taking the initiative to define, in a comprehensive and clear manner, a contingency plan to which all owners have agreed for dealing with the most prevalent sources of internal conflict. If performed properly, it is only when that plan is not honored that we have to look to the courts, but even then, we are only looking to the courts to enforce our rights, not to define them.
Whether it takes the form of a shareholders’ agreement, company agreement, operating agreement, partnership agreement, voting trust, buy/sell agreement, or some other name, the title of the document is all but completely irrelevant. The primary purpose of these types of agreements is to govern the relationship between co-owners and to create and manage expectations. Generally, these types of agreements can be as simple or as complex as the parties desire or are willing to tolerate but some of the most common things that these agreements cover include:
1. Will there be restrictions upon voluntary transfers of ownership interests? State and federal securities transfer regulations aside, owners need to decide if the ability of an owner to voluntarily transfer his or her ownership in the business should be limited and if so, what those limitations should be. Foreclosing all voluntary transfers outside of unanimous consent from the non-transferring owners may not be feasible or always appropriate. On the other hand, permitting voluntary transfers to go on unabated can alter a business entity’s tax status, impede access to additional capital, create conflict through the entry of incompatible personalities, and otherwise negatively impact a business. A proper balance of the restrictions on voluntary transfers is often found by requiring an owner that wishes to sell his or her interest to a prospective purchaser to first offer his or her interest to the other owners. In this manner, the freedom of an owner to liquidate his or her interest in maintained and the remaining owners have the ability to block the transfer to the proposed purchaser by instead purchasing the interest themselves.
2. Should there be restrictions upon involuntary transfers of ownership interests? The answer to this question is most always “yes”. When dealing with involuntary transfers, we are referencing transfers that take place by virtue of death, divorce, bankruptcy, or other situations in which the owner’s disposition of his or her ownership in the business is taking place without his or her consent. In situations where the owners of the business are also its employees, it may make sense to specify that termination of an owners employment with the business will constitute an event that requires the departing owner/employee to sell his or her interest back to the company or the other owners. In those situations, we must again be vigilant to guard against the potential tyranny of the majority by perhaps meticulously describing the circumstances that must exist for an employee/owner’s employment to be terminated.
3. What is the proper dichotomy between ownership and management of the business enterprise? For publicly traded corporations, the divide between management and ownership of the corporation can be immense. On the other hand, for closely held businesses where there are only a handful of owners, there may be no line at all between ownership and management and even when there are lines, the boundaries between the two may not always be perceptible. Whether ownership and management of a business are separate, owners need to have a firm grasp on what powers can be exercised and by whom. Perhaps it should take more than the decision of a simple majority to steer the company or at least to make major decisions. It is not uncommon to require the approval of a supermajority (e.g. two-thirds or three-fourths) for major issues.
4. Should we have drag along and/or tag along rights? It is not uncommon for one owner to desire to sell the business to a third party but the prospective purchaser is only willing purchase the entire business and not simply a partial ownership interest in it. In such situations, if the owner desiring to sell out had drag along rights, he or she could force the other owners to sell their interests to the third party at the same price and on the same terms. Conversely, if one owner desires to sell his or her interest to a third party but the other owners were not invited to sell their interests as well, if the other owners have tag along rights they can elect to participate in the sale to the third party.
5. Apart from litigation, what dispute resolutions procedures are we going to employ? While the merits of mediation and arbitration are constantly being argued among legal practitioners and their clients, these are not the exclusive means for resolving disputes. For example, in what has been called a “Texas Shootout” provision, each owner is vested with the right to present the other owners with a price at which he or she is willing to acquire the interests of the other owners. The other owners then have the ability to either sell their interests to the offering owner at that price or to turn the offer around and purchase the interest of the offering owner at that price.
The lesson to be learned from Ritchie v. Rupe is that owners need to take a more proactive role in protecting themselves and managing their expectations. While it is not possible to guard against every potential conflict or abuse, many of the sources of such maladies can be eliminated through thoughtful and reasoned contractual protections to which all parties can agree. We welcome the opportunity to discuss these strategies with you.