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Dealing with Disruptive Minority Shareholders

Your company has dealt effectively with ups and downs in sales and market fluctuations, challenges in managing human resources, increases in the cost of doing business, and the normal wide variety of bumps in the road which a company of any size experiences. But now there is a new problem, a big one: a disgruntled minority shareholder. On several occasions this minority shareholder has disrupted company operations, and he has made it clear that this conduct will continue into the future or get even worse. The minority owner has threatened a derivative lawsuit. He claims that he is owed fiduciary duties that have been breached. And he has alleged oppression of a minority owner. Something must be done. But what? There is an answer, and, in the appropriate case, that answer might be a forced buy-out. This article discusses the recipe for forcing a minority shareholder to give up his ownership in the company.

Minority shareholders have certain legal protections specific to their status because, absent a definitive shareholder agreement, they are effectively “locked in,” meaning there is no formal exit strategy, and they may have little or no voice in corporate decision-making or operations. There are many reasons that a minority shareholder can become disenchanted with the company and its officers and directors, but usually it comes down to money. The majority owners are taking more than their fair share of corporate profits, or conversely the minority shareholder is not receiving his fair share of the money.

In certain limited circumstances when the minority owner is angry with corporate operations he might assert claims owned by the company “derivatively.” This is a special form of class action brought ostensibly for the benefit of all similarly situated shareholders against third parties, including the directors and officers. He must establish four things to in order have standing to assert derivative claims: (1) the plaintiff must be a shareholder at the time of the complained of transaction and during the pendency of the lawsuit; (2) the action must not simply be collusive in order to confer jurisdiction on the court; (3) the complaint must allege what attempts the shareholder made to have the directors or corporation bring the suit; and (4) the shareholder bringing suit must fairly and adequately represent the interests of the other shareholders. If, however, the shareholder combines his personal claims against third parties, such as oppression of a minority shareholder, conversion or breach of fiduciary duty with a derivative claim, courts have dismissed the derivative claim under the fourth criterion because the plaintiff does not “fairly” represent the interests of all shareholders.

This article focuses on the first criterion: being a shareholder at the time of the complained of transaction. If the plaintiff is not a shareholder at all relevant times, including after commencement of the derivative suit, he loses standing. Two standing cases, Johnson v. United States, 317 F.3d 1331 (Fed. Cir. 2003) and Schilling v. Belcher, 582 F.2d 995 (5th Cir. 1978), hold that a shareholder loses standing to pursue derivative claims when he is divested of his stock. In the Washington Supreme Court case of Sound Infiniti, Inc. v. Snyder, 169 Wn.2d 199 (2010), a disgruntled minority shareholder sued his co-shareholders for conversion, breach of fiduciary duty and asserted a derivative claim to boot. After the trial court declined to dismiss the claims, the defendant divested the plaintiff of his stock ownership and the entire plaintiff’s case was dismissed. The Supreme Court affirmed.

By following a set of prescribed steps starting with a reverse stock split which leads to the divestiture of the minority shareholder’s stock interest, he is left with an exclusive remedy: appraisement and sale of his stock. Once the election to purchase his stock is made, his recourse is statutorily limited to challenging the “fair value” offered for his shares, and all other causes of action emanating from stock ownership (fiduciary duty, minority oppression, conversion, fraud) are eliminated. How is this achieved?

Step One. The board of directors convenes a meeting and resolves two things: (1) to effectuate a reverse stock split which results in reduction of the minority shareholder’s interest to a “fractional” share; and (2) to purchase the resulting minority shareholder’s fractional equity interest for a “fair value.” The Corporations Act authorizes the company to either issue a fractional certificate or to redeem the shares at fair value, at its sole discretion. Once the repurchase election is authorized by the board and the shareholder is paid fair value for the stock, the shareholder no longer owns his shares.

By way of example, assume three shareholders, one with 50 shares of the company, one with 40 shares and our minority shareholder with 10 shares. A 15:1 reverse stock split reduces the share ownership to 2.66 shares, 3.33 shares and 0.66 shares. The minority shareholder still holds 10% of the company, but his share ownership is now fractional and subject to purchase.

Step Two. Fair value is established, preferably professionally, by appraising the company as of the moment the board elects to redeem the fractional share ownership of the minority shareholder. Interest at the rate normally paid by the company is added to the fair value up to the date of tender. Fair value is not the same as ‘fair market value.’ Fair value eliminates the minority discount and the marketability discount, both of which are factors in determining fair market value. In order to assure transparency, the law requires that certain financial and other records of the company utilized in determining fair value, accompany the election to purchase the minority shareholder’s fractional interest.

Step Three. Within a prescribed time limit, the company must tender the “fair value” (plus interest) to the minority shareholder for his shares. The shareholder must respond to the tender within a prescribed time limit by asserting his limited “dissenter’s rights.”

Step Four. The shareholder’s “dissenter’s rights” are limited to challenging the fair value appraisal. He may object that the procedure followed was “fraudulent” (which under Washington law is a broader concept than common law fraud). But the Legislature by enacting the dissenter’s rights tacitly acknowledged that there is nothing inherently fraudulent about the process in and of itself, even given its draconian character. Fiduciary breach may also be asserted but only to the extent that such a breach adversely impacted the fair value of the stock.

Step Five. If a challenge to the appraised fair value is mounted by the minority shareholder, the company must commence suit within a specified time to obtain a declaration regarding the appropriateness of the value. If the court determines that the valuation was inaccurate, then the court may assess the company with the dissenter’s attorney’s fees and costs.

Obviously, close familiarity with the procedures and with accounting methods underlying the appraisal are essential. Faltering on any one of these steps exposes the company and its board to an array of minority shareholder claims otherwise completely avoidable. Working with a competent and experienced business appraiser who understands the commonly used metrics to establish a credible fair value is also a must.