A. Introduction
For a variety of reasons, disputes often arise in connection with businesses operated as closely held corporations, with few shareholders. Financial difficulties, greed, ego, or personality conflicts are among the causes which may result in actions by a shareholder or group of shareholders to disadvantage another shareholder or group of shareholders. This article will identify some common problems experienced in close corporations and suggest methods of resolution.
Typically, a close corporation(1) is both owned and operated by a small group of individuals. These individuals pool their collective capital and talents in furtherance of the common goal, to earn profits in their chosen business enterprise. For one or more reasons, they have selected a corporate form of business entity, as opposed to a partnership.
B. Shareholder Disputes
More likely than not, the individuals that form the corporation have never owned or operated a business entity previously. One or more individuals may own a controlling interest in the shares, i.e., more than 50% of the shares of the corporation. A controlling interest would provide those shareholders with the ability to control the board of directors of the corporation, which, by law, is responsible for the operation of the corporation. Some shareholders may have a more active role in the operation of the business than others. One shareholder may have contributed an excess amount of capital to the corporation, which may be in the form of debt, or a loan to the corporation, as opposed to the issuance of additional shares. The shareholders, owners of the business entity, are usually compensated employees of the corporation, with varying levels of compensation. Sometimes, the corporation transacts business with one of the shareholders or another entity controlled by a shareholder. A shareholder's perception of the above factors may lead to a breakdown in communications between the shareholders, which may result in a dispute.
A dispute between shareholders in a close corporation sometimes results in a seizure of control of the corporation by one faction of shareholders. Control is exercised by various methods, which include, but are not limited to, the following: 1. shareholders are "squeezed out," or removed from the decision making process; 2. shareholders are "locked out," terminated as an employee and denied access to the business premises; 3. the corporation transacts business with and to favor one shareholder or an entity controlled by that shareholder; 4. one or more shareholders divert additional funds to themselves, either in the form of employee bonuses or by more indirect means; 5. because of design or inattention, corporate assets are squandered; or 6. business decisions are made which may increase the exposure of individual shareholders to personal liability by, for example, requesting additional funding on a loan from a bank which has been personally guaranteed by the shareholders.
C. Shareholder Rights and Remedies
What can be done to protect the interests of an aggrieved shareholder? While every factual scenario is distinct and presents different alternatives in maximizing a particular shareholder or shareholder group's rights, the following legal tools should be considered.
1. Voting Rights
Sometimes, a shareholder with 50% or less of the voting shares takes control of the corporation. If taken by a shareholder with less than 50% of the shares, the aggrieved shareholder(s) may be able to align themselves so as to create a majority interest in the shares. In that case, those shareholders could call a special meeting of the board of directors, elect a new board, demote or terminate the abusing shareholder, and regain control.
If the shareholders have equal voting rights in the shares, a 50/50 split, and the corporate by-laws provide for an even number of directors, an aggrieved shareholder may be required to file a legal action to enjoin the unlawful seizure of control by the other shareholder. To prevent a stalemate and deadlock among the evenly divided group of directors, a shareholder(s) may petition the court to appoint a provisional director, who will act to break the deadlock and enable the corporation to continue to operate.(2)
2. Inspection Rights
Frequently, when one shareholder or group has seized control, an effective remedy for the shareholders who have been removed from control is the right to inspect and copy corporate documents. Under the California statutes, a director has more extensive rights than a shareholder to require the corporation to produce and permit the director to copy corporate documents.(3) Often, an aggrieved shareholder is also a director and able to avail himself of those rights. By this tool, a minority shareholder may be able to keep abreast of the corporation's activities, which may lead to the enforcement of other rights, as set forth below.
3. Derivative Action for Damages
If corporate funds or assets have been misappropriated by a controlling shareholder to the detriment of the corporation, that shareholder may be liable to the corporation for damages for breach of fiduciary duty. Every officer, director or majority shareholder owes a fiduciary duty, or duty of trust, to the corporation. If an individual abuses his position and misappropriates corporate assets or diverts a corporate opportunity to his own advantage, he will be liable to the corporation for damages. The facts showing said conduct may be revealed by an inspection of corporate books and records. A shareholder who pursues this remedy would file a derivative action, on behalf of the corporation. Any damages that may be awarded would enure to the benefit of the corporation.
4. Involuntary Dissolution of the Corporation
A major weapon against abusive conduct by majority shareholders is the right to force the involuntary dissolution of the corporation. Under California law, a suit for involuntary dissolution of a corporation may be filed by one-half of the directors or by the holder of one-third of the shares of the corporation.(4) In determining the holder of one-third of the shares, the California involuntary dissolution statute specifically excludes the shares of persons who have personally participated in any transactions described in a part of the statute as "Those in control of the corporation (who) have been guilty of or have knowingly countenanced persistent or pervasive fraud, mismanagement, or abuse of authority or persistent unfairness toward any shareholders or its (the corporation's) property is being misapplied or wasted by its directors or officers." Accordingly, even if a shareholder or group has less than one-third of the total shares of the corporation, if the amount of shares held by the abusing shareholders is not counted, for any of the reasons set forth above, an action for involuntary dissolution may still be brought.
A corporate dissolution, which may consist of a court approved liquidation or sale of corporate assets, could have devastating effects, both financially and from a tax standpoint, to the shareholders who control of the corporation. Those shareholders may lose a significant source of revenue or be faced with the prospect of having to report a huge capital gain. To avoid this, the corporation or 50% of the shareholders may elect to avoid this by a procedure which could benefit all of the shareholders.
5. Corporations Code § 2000 Buyout
Under California law, the involuntary dissolution of a corporation may be avoided by the corporation or by at least 50% of the shareholders by their election to purchase, for cash, the shares owned by the shareholders initiating the dissolution proceeding.(5) If this election is made, the legal action for involuntary dissolution is stayed. If the parties cannot agree upon a price for the shares, as many as three appraisers are appointed by the court to determine a value for the shares. After a price for the shares, set by the appraisers, is confirmed by the court, the purchasing parties exchange cash to the party who initiated the involuntary dissolution proceeding in return for the shares.
D. Conclusion
In sum, a shareholder with a less than a controlling interest in the shares of a close corporation may, faced with adverse consequences when other shareholders seize control of the corporation, still retains significant rights. These rights may assist said shareholder in taking steps to protect the value of his investment in the corporation.
Footnotes
1. A close corporation is defined, under California Corporations Code § 158, as one in which there is less than 35 shareholders.
2. See California Corporations Code §308
3. See California Corporations Code §§ 1600,1601 and 1602
4. See California Corporations Code § 1800
5. See California Corporations Code § 2000
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