April 2015: Business Law

Maintain clear shareholder pacts

Columnist Larry Covell

Columnist Larry Covell

In February’s column, I discussed options of an owner who wants to withdraw from a Limited Liability Company when there is a falling out between any of its members. If the LLC operating agreement has contract language on member withdrawal, the matter is easy since the method has been established. However, when an operating agreement fails to address it, the member who wishes to withdraw faces an uphill legal battle.

Here, I will examine some legal options if a shareholder wishes to withdraw from a closed corporation. A closed corporation is one in which there is a restriction on the sale of stock to anyone outside its ranks. Closed corporations are generally small family-owned businesses that employ family members who have significant roles in the corporation. More than likely, the closed corporation is also a sub-chapter S corporation, which means shareholders or owners do not derive any income from dividends, but are taxed on the amount of income that they receive from the corporation in the form of salaries. This business model represents many of the north country’s small businesses.

There are two statutory methods by which a shareholder can ask a court to order dissolution. The first is pursuant to Business Corporation Law section 1104. Under terms of the statute, the aggrieved shareholder must own 50 percent or more of the stock in the corporation and it must be established that either the board of directors are so divided that the corporation cannot be managed; the shareholders are so divided that a board of directors cannot be elected; or there are two or more factions of shareholders that create so much dissension that the dissolution of the corporation would be beneficial. The major problem with the statute is that it requires holders of 50 percent or more of the stock in order to file the petition for dissolution. In most cases, it’s minority owners who are frozen out of management of the corporation.

In the second method, a shareholder with as little as 20 percent or more ownership in the corporation can file for dissolution. Pursuant to BCL section 1104a, a shareholder must establish that either the directors are guilty of illegal, fraudulent or oppressive actions; or assets of the corporation are being looted, wasted or diverted for non-corporate purposes.

The benefits of this action are twofold. First, holders with 20 percent or more shares can get justice if the majority shareholders use their superior status to deny them a return on their investment. Secondly, the statute provides a remedy for a broader range of a grievance than under the first option.

Once the action is filed, other shareholders or the corporation may elect to purchase the shares from the complaining shareholder. The election must be made within 90 days after the filing of the petition, and the complaining shareholder will receive “fair value” for their shares. If the parties cannot agree on “fair value” for the shares, the majority shareholders are obligated to pay the amount as established by a court.

If the majority shareholders decide to defend against the action under BCL 1104a and do not offer to buy shares of the complaining shareholders, they face the possibility of a court-ordered dissolution. This outcome exists if the complaining shareholders prove that majority shareholders use “oppressive actions” to defeat the “reasonable expectations” held by the minority shareholders when they invested in the business.

This legal theory was created in the famous case of “In the Matter of the Judicial Dissolutions of Kemp & Beatley, Inc.” In this case, two complaining shareholders, who were also long-time employees of the corporation, were pressured to resign. The majority shareholders used their status to deny the complaining shareholders income from profits and decision-making authority in the corporation. This is a classic illustration of shareholders who are frozen out of corporate ownership.

Actions to dissolve a corporation pursuant to either BCL section 1104 or 1104a are expensive and time-consuming matters. There is no practical way to keep shareholders from becoming fractionized and freezing other shareholders out of the corporation. Drafting appropriate shareholder agreements is perhaps the best method to prevent one fraction from freezing out another.

Larry Covell is a professor of business at Jefferson Community College and an attorney. Contact him at lcovell@sunyjefferson.edu. His column appears bimonthly in NNY Business.