Majority Shareholder Abuses Could Harm The Minority Shareholders In More Ways Than One
May 25th, 2010 | 
Author: I have written previously about majority shareholder abuses that may constitute oppression, entitling a minority shareholder to be paid fair value for his or her shares. Now I would like to focus on how such abuses by a majority shareholder may wind up harming the (oppressed) minority shareholder in more ways than simply cheating him out of money.
Majority shareholders using the company as a “personal piggy bank” is often how a minority shareholder proves that he is being treated unfairly. Personal vacations are paid for by the company; family members are placed on the payroll for “no show” jobs; health insurance is paid for adult family members who don’t even work for the business; home improvement contractors are paid from corporate funds. The list is endless. Such abuses occur quite often. In many cases all a minority shareholder has to do is open his eyes to see what is going on right under his nose.
But abuses like this might mean more – much more – than potential liability to pay a minority shareholder for his shares. If the corporate form is abused, meaning that the distinction between the corporation and its owners are ignored in a widespread and pervasive manner, in New Jersey the individuals may lose the protection of the corporate form and subject themselves to personal liability. (This principal may be applied to both LLCs and partnerships in New Jersey, as well.)
At first blush to an abused minority shareholder, this may seem like a good thing. After all, if the shareholders in the majority, and not you (the minority owner), were the ones sucking all the money out of the company for personal expenses, you may feel that they deserve to be held personally liable for corporate debts. But to an outsider looking in, there is often no way to distinguish at the outset who is involved in the abuse; someone filing a suit will likely not know who is really in control of this company and who is not.
When the corporate debtor sues the individuals, he will likely sue them all, including you. You may be given representation by the very business partners whom you no longer trust, or you may have to hire your own lawyer. You probably can’t use the same lawyer who is representing the company and the majority shareholders, because you are going to have different interests, and a different viewpoint, than they do. Either way, you are in a lawsuit arguing that you did not know what was transpiring, with all of the wasted time, money and opportunity costs associated with litigation. The next posting will discuss how to protect yourself from just such a situation.
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Memorialize Important Facts Prior to Shareholder Dispute Litigation
Shareholder dispute litigation can arise at any time. When you consider that these types of cases almost always arise among business partners who once trusted one another – whether they are family members, or simply people who worked together to build a company – it highlights the fact that no one is immune from such a suit. And whether the litigation arises over a shareholder being terminated, a situation involving something as sinister as embezzlement, or simply results from an uncontrollable “power trip” by the majority shareholder, there is a common theme to all these cases: everyone attempts to re-create the past.
Sometimes the “re-creations” are founded in a genuinely-held view of how things transpired, albeit from one’s own biased point of view. For example, when the majority shareholder says he terminated the minority shareholder’s employment because the minority was lazy and useless, the majority shareholder’s own financial self-interest may actually cause him to believe this. Other times, of course, people just plain lie. Regardless of motivation, if you see a potential litigation coming down the road, it is never too early to start protecting yourself from revisionist history. Of course, it is obvious that things are easier to prove when in writing, so it goes without saying that you should, at the very least, start making a paper trail once you sense a showdown on the horizon. But many people don’t realize that it may not be too late to make a paper trail for things even in the distant past.
May a Shareholder Compete After He is Fired as an Employee?
In a previous posting (9/2/08) I discussed the fact that termination of a shareholder from his or her status as an employee could constitute “oppression”? under New Jersey law and entitle the shareholder to certain remedies, including a court-ordered buy-out at fair value. Since then, I have encountered several clients wondering what their rights are while they wait for their case to play out in court. In other words, when the company fires you and then tells you that you can’t even work in the industry, or for a competitor, is this legally binding?
The answer may depend on what documents you have signed and the circumstances of the termination. Often shareholder-employees sign a restrictive covenant containing a non-compete agreement, either as a separate document or as part of a larger shareholder agreement. While such a document is sometimes enforceable, in New Jersey there are often very fact-specific reasons why the agreement cannot be enforced (for example, the non-compete must protect a legitimate interest, like keeping proprietary information secret, and cannot be designed simply to prevent competition). In addition to such reasons relating to the nature of the particular industry, the mere fact of termination could in some cases prevent the majority shareholders or the company from enforcing the provision against you. After all, it is difficult to argue on the one hand that your work performance was so bad you needed to be terminated, while arguing on the other hand that it would damage the company if a competitor hired you.
Suing a Family Member Is Never Easy
Handling oppression actions means being involved in family fights; it’s simply the nature of the business. While not all closely held businesses are family-owned, many are. And family-owned businesses tend to have more problems than other types of businesses, since interpersonal issues frequently mix with the business end, often to toxic result.
If you are reading this, and you have your own issue regarding a family-owned business, then this is nothing new or unexpected. Whether the majority shareholders are cheating you out of money that should be coming to you, lying about income, over-compensating themselves, or whether you have been oppressed because the majority shareholders have terminated your employment (which may be actionable oppression under certain circumstances),[1] the thought of suing your own family members may be unnerving.
Excess Compensation as Oppression
What are the rights of a minority shareholder in a closely-held business who is not directly involved in running the company and receives no benefit whatsoever for his shares – no salary, no dividend, no benefit of any kind? Of course, the answer depends on the specific facts of any particular case. However, if the company could afford to pay dividends but for the “excess compensation” paid to the majority shareholders, New Jersey law may afford protection to the minority shareholder.
Shareholders find themselves “on the outside looking in” for a variety of reasons. The case of a shareholder-employee who was terminated was addressed in an article dated September 2, 2008. In addition to termination, the shareholder may have simply decided to change fields, or may never have been involved in management, or as an employee, in the first place. Such a situation is more prevalent in a family-run business, in which family members may inherit shares but assume no management role.
The Special Situation of “Passive” Shareholders
As the economy keeps getting worse, many family-run businesses are finding that conflicts between shareholders that had been brewing beneath the surface for years are finally coming to a head. The humming economy helped to mask those problems, since there was less of a reason to act on them while everyone was making money.
Passive shareholders are those who own an interest in the company, but who are not involved in management or as an employee. Often the existence of passive shareholders in a family owned business means that the “next generation” has inherited from the one before it, and that some family members have chosen, for whatever reason, not to work the family business. Those that do the work often feel that they “deserve” more money than their salary alone provides them, and that those that provide no “sweat equity” are entitled to nothing. This is a litigation just waiting to be filed.
Are Your Majority Shareholders Acting As Greedy as AIG Executives?
The headlines about the millions in bonuses paid to AIG executives with our tax dollars have struck a chord with many people. But for minority shareholders of many small, closely held businesses, this issue has struck a raw nerve because it is reflective of what is going on in their own business.How could the situation at a huge conglomerate like AIG that has taken billions in bailout money bear any resemblance to the inner workings of a construction company, or small manufacturer, owned by just a handful of people?
One would expect that certain sacrifices would have to be made by those in charge of such businesses in today’s dismal economy. If revenues are down twenty percent, forty percent, or even more, one would think that salaries, bonuses and certain perqs would have to be reduced. However, those in charge of running and operating small, closely held businesses often simply refuse to decrease their own salaries when such a cut clearly warranted; worse, they keep taking huge bonuses that the company can no longer afford. In fact, the sight of one majority shareholder (who sets his own salary, of course) recently driving away from a car dealership in a brand new Mercedes was considered by one of his minority shareholders to be the “last straw;” litigation is about to be filed.
Trust Your Instincts – They are Probably Right
In my last posting, I discussed how the current recession could be used by an unscrupulous majority shareholder to hide his embezzlement. Unfortunately for several clients I have met with in the past couple of months, these words proved prescient.
One shareholder in particular thought she saw herself in that posting and started questioning what was happening with the company. Of course, she was told that all dividends had stopped because the company was losing money as a result of “the economy.” However, something in the back of her mind told her that things were just not right. Although she figured that the company would probably lose at least some money as a result of the economic downturn, she did not think her dividend checks should stop altogether. After all, she left her employment with the company years ago on the premise that she would retain her shares, along with her right to receive proportionate distributions.
How Your Business Partner Can Use a Recession to Hide His Fraud
Tough economic times can sometimes be used by one’s unscrupulous business partner to mask his fraudulent activities. In times like these, minority owners who suspect improper activity by the majority should be more vigilant than ever.
Often minority shareholders, especially those not intimately involved in the business, simply get used to receiving little financial information about the company. The attitude often is, there’s no cause for alarm as long as the dividend checks keep coming. If you are being paid a dividend, or receiving some other form of payment or benefit from the company, it’s all too easy to fall into the trap of not paying close attention to the company’s finances.
Employment Termination As Oppression
Shareholder oppression can take many forms, but one of the most common is terminating a shareholder/employee from his or her employment. New Jersey case law discusses “oppression” under the applicable statute as a frustration of a shareholder’s “reasonable expectations.” Terminating one’s employment may satisfy this test.
Not every shareholder/employee who is terminated may succeed in making this argument. However, if a shareholder was one of the founders of the company, or at least became a shareholder with the express (or implied) understanding that he was doing so to become an employee, as well, this argument may have considerable merit.
The logic of this argument is compelling. Becoming a shareholder may have considerable appeal if one also works in the business, able to directly contribute to its success, as well as see first-hand how it is performing. However, when one is no longer employed, you may view yourself as being “stuck” in the company with no way out.