Reprinted with permission from the January 5, 2016 edition of the The Legal Intelligencer.

A client came to me complaining that he had been “squeezed out” by the majority shareholders of the closely held corporation he himself had founded. He was outraged and upset.

I assured him that the majority shareholders of a closely held corporation do indeed have a fiduciary duty to protect the interests of minority shareholders, as held in Weisbecker v. Hosiery Patents, 356 Pa. 244 (1947), and Bair v. Purcell, 500 F.Supp.2d 468, 483 (M.D.Pa. 2007). But, he wondered, what does that mean exactly? How can you tell when the duty’s been breached? And what can you do about it anyway?

Under the law of Pennsylvania (and many other states), “oppressive actions refer to conduct that substantially defeats the ‘reasonable expectations’ held by minority shareholders in committing their capital to the particular enterprise,” as in Gee v. Blue Stone Heights Hunting Club, 145 Pa.Cmwlth. 658, 604 A.2d 1141, 1145 (1992), and Ford v. Ford, 878 A.2d 894 (Pa. Super. Ct., 2005). As another Pennsylvania court has explained, “majority shareholders have a duty not to use their power in such a way to exclude minority shareholders from their proper share of benefits accruing from the enterprise,” as in Viener v. Jacobs, 834 A.2d 546, 556 (Pa. Super. Ct., 2003).

There are countless ways such oppression can occur, but here are a few of the more common:

• Failure to pay dividends.
• Payment of excessive compensation to majority shareholders.
• Refusing to provide access to information, or a voice in decision-making.
• Altering the capital structure to favor the majority, such as by diluting the minority’s stock interest or fabricating excessive debt obligations (typically via purported loans, leases or other contracts) owed to the majority.
• Denying compensation to the minority, or terminating employment.
• Appropriating corporate assets or opportunities to benefit the majority alone.

Contrary to most corporate decision-making, majority shareholders will arguably not be entitled to the deferential protection of the business-judgment rule to the extent their decisions focus on the internal rights of shareholders relative to each other, as in Viener. Rather, the burden typically shifts to the majority, then, to establish the “entire fairness” of such decisions—that is, “their utmost good faith and the most scrupulous inherent fairness of the bargain,” as in Weinberger v. UOP, 457 A.2d 701, 710 (Del. 1983), and In re Glosser Bros., 555 A.2d 129, 134 (Pa. Super. 1989). As the Viener court explained, this “does not mean that majority shareholders may never act in their own interest, but when they do act in their own interest, it must also be in the best interest of all shareholders and the corporation.”

Unfortunately, litigation often arises. Typical remedies include providing information to the minority, such as by accountings or access to corporate records, or compensating the minority for the loss of reasonably anticipated benefits, most commonly in the form of damages for lost dividends or salary, or via a forced buyout of minority shares. Punitive damages may also be awarded against majority shareholders for egregious breaches of their fiduciary duties. And a minority shareholder who was forced to leave the company may be relieved of any noncompete obligations.

Because redemption of minority shares is such a common remedy, the focus of the parties’ dispute may quickly shift to the value of those shares. As a result, engaging a credible expert witness to testify regarding valuation is often critically important.

But the lawyers should not sit on the sidelines during the valuation process. They can, instead, play a key role at the valuation stage—because valuation involves policy questions. There is generally little dispute about the first step in the valuation process: The business should be valued as a whole, as a going concern. But disputes often arise over two other questions that any appraiser must confront—whether a minority discount should be applied, and the proper valuation date.

The courts do not appear to have definitively resolved the question of minority discounts. Under Delaware law, which often guides Pennsylvania courts, such discounts are not favored, as in Cavalier Oil v. Harnett, 564 A.2d 1137, 1144-45 (Del. 1989), which states that “to fail to accord to a minority shareholder the full proportionate value of his shares imposes a penalty for lack of control, and unfairly enriches the majority shareholder who may reap a windfall from the appraisal process by cashing out a dissenting shareholder, a clearly undesirable result.”

While New York law takes the same approach relative to minority discounts, it does, however, allow discounts for lack of marketability “because the shares of a closely held corporation cannot be readily sold on a public market,” as in Blake v. Blake Agency, 486 N.Y.S.2d 341, 349 (N.Y.A.D. 2 Dept., 1985). The U.S. Court of Appeals for the Eighth Circuit, by contrast, has expressly rejected both types of discounts as being contrary to the statutory purpose of protecting minority shareholders, as in Swope v. Siegel-Robert, 243 F.3d 486 (8th Cir. 2000).

As to the valuation date, Pennsylvania’s dissenters rights statute, 15 P.S. Section 1572, provides that the “fair value” of the corporation shall be determined “immediately before the effectuation of the corporate action to which the dissenter objects.” That approach usually makes sense in a typical dissent case in which, say, a shareholder did not approve of his company’s plans to merge with another company, voiced his dissent prior to the merger and requested a buyout, and therefore is not equitably entitled to whatever fruits may later grow from the very merger he had opposed. But the rationale may not apply so neatly in an oppression scenario, where the majority may have selected the squeeze-out date precisely to minimize the value of the minority interest. Under those circumstances, courts have recognized the need to consider different dates (and other factors) that may affect valuation, as in Viener, which set valuation at an earlier date on account of post-squeeze-out diminution in value; Mitchell Partners v. Irex, 53 A.3d 39 (Pa. 2012), which allowed for broad post-merger remedies given fraud or fundamental unfairness; and Cinerama v. Technicolor, 663 A.2d 1134, 1144-48 (Del. Ch. 1994), which applied “rescissory damages” in a breach of loyalty case to put the plaintiff in the position it would have occupied absent the invalid transaction.

Shareholder disputes will arise for as long as people form businesses together. The key to resolving them efficiently is knowing the parties’ rights and remedies. After exploring those with my client, we were able to achieve a successful resolution in early mediation by presenting a clear narrative, key documents and a detailed valuation report from a qualified appraiser that was supported by solid legal arguments.

Originally posted on TheLegalIntelligencer.com

Reprinted with permission from the January 5, 2016 edition of the The Legal Intelligencer. Copyright 2016 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For further information, contact 877-257-3382 – [email protected] or visit www.almreprints.com.