Protecting the Rights of Minority Shareholders
Small businesses are often owned by more than one person. If an owner owns less than 50% of a business, he or she is referred to as a minority owner or, in the case of a corporation, a minority shareholder. Most of the time, the business operates smoothly and the owners treat each other fairly. Sometimes, however, one or more majority owners will abuse their power and try to squeeze the minority owner(s) out of the business. When this happens, what can the minority owner do?
Fortunately, California law provides several avenues for minority owners to fight abusive and unfair treatment. These include (1) the right to inspect corporate records; (2) the right to petition for dissolution and liquidation of the corporation; and (3) the buyout of the minority’s interest at a fair value ordered by the court. Each of these remedies is explained in detail below.
1. What is the purpose of inspecting corporate records?
If a minority shareholder is being treated unfairly by the majority shareholder(s), the first step is to request an inspection of the corporation’s records. This is a good idea for a number of reasons. First, it allows for the shareholder to objectively assess and verify any suspicions of financial impropriety. In any business, people may sometimes misuse or misunderstand corporate terminology, e.g. confusing dividends with shareholder distributions and/or employee wages. Inspecting the corporate records is frequently the easiest (and cheapest) way to clarify a misunderstanding.
Second, inspecting corporate records provides a mechanism for conducting some basic discovery and investigation without actually having to file a lawsuit. If a lawsuit becomes necessary, you may not need to compel the Corporation to provide this information through arduous discovery procedures in court.
Third, it provides an effective avenue for contacting the opposing party, and opening up a dialogue before any litigation begins. When faced with the prospect of shareholder rights litigation, both minority and majority shareholders will (almost) always be better off if they can settle the matter before going to court.
2. What kind of corporate records can be inspected?
Shareholders in California corporations have broad rights of inspection, provided the shareholder owns at least five percent in the aggregate or one percent individually of the outstanding shares of the corporation. (Corp. Code, § 1600, subd. (a).) Shareholders who meet these requirements may “inspect and copy the record of shareholders’ names and addresses and shareholdings during usual business hours upon five business days’ prior written demand.” (Ibid.) Furthermore, any shareholder is entitled to inspect and copy the record of shareholders, accounting books and records and minutes of the board, committees thereof and shareholders’ meetings after a written demand on the corporation stating a proper purpose related to the shareholder’s interest as a shareholder. (Corp. Code, §§ 1600, subd. (c); 1601.) Corporations Code section 1501, subdivisions (a) and (c), also provide that any shareholder has the right to inspect a copy of the Corporation’s financial statement for the prior fiscal year within 30 days of a written request. (Corp. Code, § 1501, subd. (a) & (c).)
Shareholders who are (or were) employees of the corporation have independent rights under the California Labor Code to inspect all records the corporation must maintain under, inter alia, Labor Code section 226, subdivisions (a) and (b), and Labor Code section 1174, subdivision (d). Finally, the articles of incorporation may provide additional inspection rights or describe different categories of corporate records to which the statutory inspection rights would apply.
The inspection rights afforded under Corporations Code sections 1501, 1600 and 1601 will usually apply to the following types of records:
Articles of Incorporation of the corporation, or amendments thereto;
Bylaws of the corporation, or amendments thereto;
Records of shareholders’ names, addresses and shareholdings;
Records of shareholders;
Accounting books and records of the corporation which although not specifically defined may include the following: tax returns, corporate filings, corporate check registers, corporate bank statements, records of real property, equipment leases and the like;
Annual reports and accompanying financial statements of the corporation;
Financial statements of the corporation from the last fiscal year to the present;
Minutes of shareholders meetings; and
Resolutions or records of corporate actions.
3. What happens if the Corporation does not let the minority shareholder inspect the records?
If the corporation does not allow the shareholder to inspect these documents, the shareholder may petition the court for an order compelling the inspection, and ask the court to appoint an accountant to audit the books and records, and investigate the property, funds and affairs, of the corporation. The court may award the shareholder his attorney’s fees and costs incurred to enforce these statutory inspection rights. (See e.g. Corp. Code, §§ 1603, 1604.)
4. What is the minority shareholder’s remedy if the dispute cannot be resolved through settlement?
No matter how hard we try, there are some disagreements that are so personal and emotional that they simply cannot be settled. Usually that means one or both sides simply refuse to compromise. In the case of minority shareholder oppression, the next step is usually a lawsuit to dissolve the corporation and distribute the cash value of the business proportionately among the shareholders.
Generally speaking, the minority shareholder may petition the court for involuntary dissolution when the majority shareholder(s) are being oppressive or unfair. The Corporations Code expressly authorizes involuntary dissolution of a corporation when the controlling interest(s) have been “guilty of or have knowingly countenanced persistent and pervasive fraud, mismanagement or abuse of authority or persistent unfairness toward any shareholders or its property is being misapplied or wasted by its directors or officers.” (Corp. Code, § 1800, subd. (b)(4).) Any shareholder owning more than one-third of the outstanding shares, excluding shares of the alleged wrongdoers, may petition the court for dissolution on this ground. (Corp. Code, § 1800, subd. (a)(2).) Shareholders may also petition for dissolution if “liquidation is reasonably necessary for the protection of the rights or interests of the complaining shareholder or shareholders.” (Corp. Code, § 1800, subd. (b)(5).)
5. What can the majority shareholder(s) do in response to a petition for involuntary dissolution?
Generally, majority owners can oppose dissolution on its merits, or invoke the statutory right to buy out the minority shareholders’ interest. Even if the majority owners dispute the minority shareholder’s reasons for seeking to dissolve the corporation, there are often very good reasons for avoiding litigation and severing ties with the complaining shareholder. In that case, the corporation may elect to avoid involuntary dissolution proceedings by purchasing for cash, the fair value of the shares of any shareholder who brought an action to dissolve the corporation. (Corp. Code, § 2000, subd. (a).) If the corporation declines to exercise this right, the holders of the 50% or more of the voting shares of the corporation may do so. Under this procedure, the fair value of the corporation is determined by the liquidation value at the time the action for involuntary dissolution was filed. (Corp. Code, § 2000, subd. (a).)
Once the buyout remedy is elected, the court will stay the pending litigation to determine the fair value of the shares owned by the moving parties. (Corp. Code, § 2000, subd. (b).) After the buyout election is made, if the purchasing parties “cannot pay the purchase price, or decide not to do so, then both sides must walk away, receiving pro rata the proceeds resulting from dissolution of the corporation.” (Go v. Pacific Health Services, Inc. (2009) 179 Cal.App.4th 522, 531.) If litigation is over and dissolution has already started when the buyout option is elected, the purchasing party must post a bond equal to the estimated expenses, including attorney’s fees, the complaining shareholder might incur if the purchasing parties fail to complete the deal. (Corp. Code, § 2000, subd. (b).)
If the parties cannot agree on a valuation, the court will appoint three independent appraisers to submit valuations of the business. When considering the fair value of the corporation, the appraisers’ must evaluate the business as a going concern. (Corp. Code, § 2000, subd. (a).) Moreover, the fair value of the purchase price is computed without any adjustment for minority discount. (See Brown v. Allied Corrugated Box Co. (1979) 91 Cal.App.3d 477, 487 [“A minority shareholder who brings an action for the involuntary dissolution of a corporation should not, by virtue of the controlling shareholder’s invocation of the buy-out remedy, receive less than he would have received had the dissolution been allowed to proceed.”].) Ordinarily, the majority opinion of the appraisers’ will be confirmed and the purchasing party must then complete the buyout for the fair value price of the shares. (Corp. Code, § 2000, subd. (c).) If the purchasing party backs out of the buyout, the corporation continues with dissolution and liquidation.