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Oppression Prevention through the Shareholders Agreement

How a shareholders agreement in a closely-held corporation may head-off or deal with future oppressive conduct.

shareholders agreement to prevent shareholder oppression

Shareholders Agreement to Prevent Oppression

A large variety of shareholders agreement provisions are available to limit the future temptation toward oppressive conduct or to provide a fair resolution of shareholder disputes. After Ritchie v. Rupe, the importance of advance planning becomes more more urgent.

Shareholders Agreement Mechanisms

These include agreements to break a deadlock, agreements requiring payment of dividends or limiting board discretion over dividend, providing that some shareholders will be or will have the option to select certain officers and directors, granting minority shareholders a veto power on some or all board decisions, or dictating how shareholders will vote on certain matters. Generally, a shareholders agreement that limits the discretion of the board of directors is void as against public policy. However, the statutory shareholders agreement that complies with section 21.101 and provisions expressly stated in the certificate of formation may limit board discretion.

Locking in Voting Control

Shareholders may also lock in voting control over certain decisions by issuing more than one class of shares, each of which has different voting powers. For example, two shareholders might agree that they are 90/10 in terms of equity and dividends, but want to remain 50/50 in decision making. That can easily be accomplished by issuing one shareholder “Class A” stock which gets 90% of the equity but only 50 percent of the vote, and the other “Class B” stock which gets 10% of the equity and 50% of the vote. Shareholders can also, by agreement or through the bylaws, require certain decisions be made unanimously or with a sufficiently large supermajority to give the minority shareholder a veto. The Business Organizations Code imposes special restrictions on voting agreements.

Cumulative Voting

Cumulative voting and preemptive rights may also be of some use in preventing oppression. Cumulative voting allows minority shareholders to cumulate their votes on to achieve greater power in the selection of directors. If five directors were to be elected, the minority shareholder could cast all five votes for one director and not vote on the other four. Depending on the distribution of shares, cumulative voting can give a minority shareholder with a fairly substantial interest to ensure a place on the board. Likewise, preemptive rights provide some protection against the minority shareholder losing voting power through dilution. Preemptive rights allow a minority shareholder the right to purchase his proportional share of any new shares issued. Texas corporations were presumed to have both cumulative voting and preemptive rights prior to September 1, 2003, unless those rights were eliminated in the articles of incorporation. After that date, all Texas corporations are presumed to have straight voting and no preemptive rights, unless affirmatively established in the certificate of formation. Even when such rights are agreed, the protection is limited. The Code provides several types of share issuance, such as to an employee in exchange for services, to which preemptive rights do not apply.

Advance Dispute Resolution in a Shareholders Agreement

The most useful type of shareholders agreement are designed, if not to prevent shareholder oppression, at least to avoid the worst consequences of a typical squeeze outs and to avoid litigation. The most common mechanism is the buy-sell agreement. This agreement is the same as what might be provided in the event of death or termination of employment, but provides a way out for the parties once they become locked in dispute. Very often, particularly when the corporation is brand new and has no value other than the initial investment, parties setting up a buy sell agreement will specify book value as the sales price. This decision is almost always a mistake. Universally in service businesses, which have few hard assets, and most of the time in other types of companies, book value vastly understates the true value of the company. The true value of any corporate enterprise is the stream of cash flow that it produces for its owners. Book value only measures the assets, net of liabilities, that are in the company at any given time. A minority shareholder in a successful corporation who is trapped with a buy-sell that entitles him only to book value (which may be a tiny fraction of the true value) has no protection against shareholder oppression—worse, the contractual ability to force out the minority for a tiny fraction of the true value creates an incentive for the majority shareholder to find ways to invoke the unfair contract.

Parties wishing to avoid creating a contractual mechanism that encourages squeeze out should take care to build in safe-guards. One common mechanism is to specify a valuation formula that is more likely to reflect the actual value, such as 2 x revenue or 4 x EBITDA. Any fixed formula creates an incentive to manipulate the finances of the company to gain an advantage, but that approach is less expensive and less uncertain than the most common alternative of having the company appraised by a third party. When the appraisal mechanism is selected, then the parties need to agree in advance regarding the appraisal methodology and, in particular, how minority discounts will be handled. Another approach is to allow one party to make an offer and then to grant the other party the option of purchasing or selling at that price. This mechanism works well when the percentages of ownership are close and the financial abilities of the parties are similar. In the situation where a millionaire owns 90% of the company and a person of meager means owns 10%, that mechanism allows for abuse, since the 10% shareholder will almost never be able to purchase the other 90% even at an absurdly low valuation.

We have designed a set of bylaws that contain several of these protective mechanisms.

Finally, the parties can agree in advance to the winding up and liquidation of the entity under a situation of deadlock or dissension. Such a solution may be set up in a shareholders’ agreement or in a stand-by voting trust, where the trustees are required to vote for winding up and dissolution. The parties should also strongly consider alternatives aimed at resolving the dispute—mandatory mediation, arbitration, appointment of an independent board—that would allow the parties to maintain the value of a going concern and solve the specific dispute at issue.

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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