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Majority Shareholder Fraud by Deception

Majority shareholders and corporate insiders commit fraud by deception when they purchase minority shares in violation of duties of full disclosure and fairness.

fraud by deception

Majority Shareholder's Fraud by Deception

The one unique instance in which the corporation’s fiduciary duties to its shareholder seem to be extended to controlling shareholders and directors by implication is when majority shareholder and other corporate insiders use their position of control over the corporation and insider information to take unfair advantage in purchasing minority shareholder interests.

Fiduciary Duties to the Minority Shareholder

In Miller v. Miller,  the court addressed duties of controlling shareholders in purchasing shares from minority shareholders. Certain aspects of the case are unusual, and the case probably could have been resolved without reference to the corporate law issues. The case arose out of a divorce between a husband and wife. The husband had started a corporation with three other engineers, each of whom were issued 25% of the shares.  The husband was an officer and director. None of the shares were in the wife’s name; her interests were purely the result of community property. At the time that the corporation was organized, the husband and wife were already separated. The purpose of the corporation was to develop and market some extremely promising telephone switching technology. A subsidiary of Exxon had agreed to provide venture capital and to take a significant equity stake.

Exxon required, as a condition of its investment, that the shareholders enter into a shareholders’ agreement restricting the sale of their shares. One of the provisions required any divorcing spouse of the shareholders to sell any shares owned by them back to the shareholder spouse, to the corporation or to the other shareholders at a price determined by a formula that was guaranteed to result in a fairly low price.  All of the spouses were required to sign. The husband presented the agreement to the wife, and explained that it was an agreement between Exxon and the founders and was necessary to get the company started. He did not explain the agreement and did not disclose the facts he knew about the prospects of the company, the size of Exxon’s investment or the price per share paid by Exxon, or the potential value of the enterprise. The wife read the agreement and signed it and later testified that she had believed that she was already bound by it.

The husband’s 700,000 shares apparently were not dealt with in the divorce, but were treated as his separate property, and he never demanded that she sell the shares or offered her the consideration under the agreement, which he contended was only $2500. Two years later, the wife learned that the corporation was worth far more than she had believed. She sued to rescind the agreement and partition the shares.  The case was tried to a jury, which rejected the fraud by deception theory. The jury found the affirmative representations made by the husband were false and material and that the husband had failed to disclose that Exxon had purchased 1.5 million shares at $1 per share, that the wife would be required to sell in the event of a divorce, that the stock had a fair market cash value, and that the corporation was developing technology that would be in great demand. However, the jury also found that the husband did not act with the intent to deceive. With regard to breach of fiduciary duties, the jury found that the husband had acted in good faith, that the agreement had a reasonable business purpose, but that the agreement was unfair to the wife.  On the basis of these findings, the trial court denied rescission of the shareholder’s agreement and ordered that the wife be paid the amount due under the shareholders’ agreement.

The wife appealed only the breach of fiduciary duties. The jury had found a confidential relationship, and certain fiduciary duties would have existed as a matter of law by virtue of the marriage relationship. However, the court of appeals’ analysis places primary emphasis on the husband’s power over the wife’s stock rights as a result of his controlling position in the corporation:

The record shows that as a founder, officer, and director of InteCom, Howard had an insider’s knowledge of the affairs and prospects of the corporation. . . . Recognition of a fiduciary duty in this case is based not only on the personal relationship between Howard and Judy but also on Howard’s position as a founder, officer, and director of InteCom.”

The court noted that no Texas case had addressed the issue of whether an officer and director of a corporation has a duty to disclose to a stockholder his knowledge of information affecting the value of the stock before purchasing it from the stockholder.  The court noted that majority rule was that a director or officer does not stand in a fiduciary relation to a stockholder in respect to his stock and, therefore, has the same right as any other stockholder to trade freely in the corporation’s stock. However, some jurisdictions had held that officers and directors have a fiduciary duty to individual stockholders, as well as to the corporation itself and, thus, cannot properly purchase stock from a stockholder without giving him the benefit of any official knowledge they have of information that may increase the value of the stock.  Still other courts had followed the majority rule, but recognized an exception when “special facts” impose on the officer or director a limited fiduciary duty to disclose any knowledge of special matters relating to the corporate business—e.g., merger, assured sale, etc.—that may affect the value of the stock.  The court declined to rule whether Texas would follow the “majority” or “minority” rule, but held that even under the majority rule the “special facts” of this case were sufficient to bring it within the exception.  The “special facts” critical to the court’s decision were that the husband knew that “Exxon was purchasing 1,500,000 shares at one dollar per share and that if IBX was developed, it would be in great demand” and that the husband therefore had a fiduciary duty to disclose those facts prior to contracting with the wife regarding the ownership of her shares.

Directors' and Officers' Fraud by Deception

In Westwood v. Continental Can Co., the Fifth Circuit decided a case involving a shareholder and managing director of a Texas corporation who negotiated a deal sell the stock of his corporation, and then negotiated option agreements with all the stockholders that would permit him to buy their stock and resell it at a premium. Ultimately, the buyer refused to consummate the transaction, and the shareholder sued for breach of contract. The buyer successfully defended the action on the grounds that the contract was unenforceable because it constituted a breach of the shareholder’s fiduciary duties to the corporation and its shareholders.

The Fifth Circuit held that the contract was unenforceable because “when directors or other officers step aside from the duty of managing the corporate business under the charter for the benefit of stockholders, and enter upon schemes among themselves or with others to dispose of the corporate business and to reap a personal profit at the expense of the stockholders by buying up their shares without full disclosure and at an inadequate price, there is a breach of duty.”  “If a favorable opportunity arises to sell out, the stockholders and not the managing officers are entitled to have the benefit of it. If an agreement cannot be reached by the stockholders, no doubt one faction may buy out the other.”  Any shareholder, even though an officer and director, could legally buy up the stock of the other shareholders with the purpose of reselling at a profit, but only on full disclosure.  The shareholder had disclosed to the other shareholders in a letter “the state of the business, the want of harmony among the stockholders, and the wisdom of acting promptly to save the investment.” 

In making his offer for the stock, he stated that he proposed to resell it as an entirety, and if unable to do so, to dissolve the corporation and dispose of the assets, hoping to make a profit as the reward of his risk and efforts.”  He had even disclosed that he was in the process of carrying on negotiations for a possible sale.  However, in the lawsuit, the shareholder contended that he in fact had a contract with the buyer; and the court held that, if so, “the plan as a whole was thus one for the managing officer to deceive the stockholders and acquire the corporate assets for his own and another's profit.” 

Both Miller and Westwood involved shareholders who were also officers and directors, and both opinions emphasize their duties as officer and directors. Neither case was a derivative action—in Miller, the plaintiff was suing individually, and in Westwood the corporation was not involved in the transaction. The duties of disclosure in these cases are best understood as flowing from the corporation’s duties to its shareholders, with the courts imposing those same duties on the defendants because of their control of the corporation. If a corporation could not enter into a transaction or purchase shares from a shareholder because the corporation was in possession of undisclosed, material information, then a shareholder, officer or director who is in the same position of advantage over the shareholder as a result of his control over a corporation is subjected to the same duties of disclosure.

Majority Shareholder Fraud by Deception

Allen v. Devon Energy Holdings, L.L.C. concerned the redemption of Allen’s minority interest in an LLC involved in natural gas exploration and development.  The LLC redeemed Allen’s interest in 2004 based on a 2003 $138.5 million appraisal of the LLC.  In 2004, however, the LLC sold for $2.6 billion—almost twenty times the value used to calculate the redemption price.  Allen sued, claiming that the majority shareholder and the LLC made misrepresentations, failed to disclose facts regarding the LLC’s future prospects, and that Allen would not have sold his interest in 2004 if he had known these material facts.  For instance, the majority shareholder withheld information concerning the LLC’s technological advances in horizontal drilling and significant lease acquisitions in an existing natural gas field, both of which occurred after the redemption offer but before the redemption. 

Although the transaction was a redemption in which the company was the purchaser, the court of appeals treated the transaction as though it were a purchase by the majority shareholder. “We note that the duty we recognize is owed by Rees-Jones, a majority owner and manager with virtually unmitigated control over an LLC, not [the LLC] itself—whether [the company] owed Allen any fiduciary duties is not before this Court.”  The appellate court determined that a majority shareholder owed a fiduciary duty to a minority shareholder in the context of a redemption agreement. The court based its decision on majority shareholder’s operating control over the affairs of the company and intimate knowledge of the company’s daily affairs and future plans.  Further, the purchase of a minority owner’s interest benefitted the majority owner. 

Ritchie v. Rupe’s treatment of this line of authority is significant.  The majority opinion cited Allen as authority for the ability of individual shareholders to sue directors and majority shareholders for “fraudulently [] manipulat[ing] the shares’ value” under existing causes of action. In re Fawcett, Miller, and Allen all clearly recognize that corporations—and by extension officers, directors, and controlling shareholders—owe fiduciary duties to minority shareholders at least in the context of a transaction to purchase the minority’s shares when there is knowledge of material facts within the corporation not disclosed to the shareholder. These duties are completely consistent
with the legal relationship and duties described in Yeaman v. Galveston City Co.; they are completely
inconsistent with notion that no common-law duties are owed directly to minority shareholders. However, Ritchie’s citation of Allen as “addressing fraud claims relating to closely held company’s purchase of minority shareholder interests” —a fraud by deception claim that existed only because of the fiduciary duty to make full disclosure—is at least an implicit acknowledgment of the existence of some duties owed to minority shareholders.

Houston Business Lawyer Eric Fryar About the author: Houston Business Lawyer Eric Fryar is a published author and recognized expert in the field of shareholder oppression and the rights of small business owners. Eric has devoted his practice almost exclusively to the protection of shareholder rights over the last 25 years. Learn more

 

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This post represents our opinion regarding the relevant shareholder oppression and minority ownership rights law. However, not everyone agrees with us, and the law is changing quickly in this area. This page may not be up to date. Be sure to consult with qualified counsel before relying on any information of this page. See Terms and Conditions.

 

 

 

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