In the many years I have been working as outside counsel to closely held businesses, one of the frequent pitfalls leading to costly litigation and operational conflicts is the failure of shareholders to adequately document and formalize their expectations, especially as it relates to minority shareholders. The first question I ask when contacted by a business owner who is dealing with shareholder conflicts is “What does your shareholders’ agreement say?” Unfortunately, too often, the answer is “What shareholders’ agreement?”
Many small businesses are formed by a group of people who share a collective belief at the time of formation. There are often unwritten understandings as to the division of roles within the business. Almost universally, the expectation is that all of these founding shareholders will devote ongoing resources to the business. Conflicts arise when those expectations diverge, when one shareholder fails to perform within the business, or even when a shareholder exits the company.
When conflict does arise, mechanisms for resolution can be limited, complex and expensive. Certainly a transfer of a non-performing shareholder’s stock seems like a simple straightforward course of action. However, in the absence of an agreement providing for transfer upon specified events, the business has no absolute right to remove a shareholder or force a transfer of the share ownership interest. Even a shareholder who has ceased to be actively involved in the business continues to enjoy all of the rights attendant to the ownership of the shares: the shareholder need not come to work, need not contribute capital, need not pursue business opportunity in the name of the company. Employment may end, but the right to enjoy distribution of profits does not, as long as share ownership persists. As most small businesses are organized as subchapter “s” corporations, profits must be distributed in accordance with share percentage.
Ownership of stock gives rise to all of the rights provided by statute. Minority shareholders enjoy the right to obtain information about the performance of the company, attend and vote at shareholders’ meetings, and receive distributions of profits derived from corporate operations. Minority shareholders can be an impediment to stock transfers, anchors against change and obstacles to capital expenditures. Such situations are a constant bone of contention among owners of small businesses.
Of course, the best solution is an agreement that accurately reflects the understandings of the shareholders at the time the shares are assigned, or the company is formed. Such agreements can provide clearly defined roles within the business, mandatory transfer upon termination of employment, death or disability, valuation mechanisms and provisions restricting transfer. Adopting an agreement, at minimum, provides a foundation for the business relationship, and may provide a roadmap in the event of disagreement.
In the absence of an agreement, a dispute with a minority shareholder requires careful management. The majority must take care to avoid vesting a minority shareholder with breach of fiduciary duty claims or shareholder oppression. Compliance with corporate formalities is imperative. While there is no guaranty of continuing employment for a minority shareholder (with exceptions), distributions or profits in accordance with ownership percentages is required if the company has elected “s” corporation treatment. Certainly, majority and employed shareholders may receive compensation for services rendered, but an artificial manipulation of corporate profits would certainly be relevant to a minority shareholder oppression claim.
Pennsylvania Business Corporations Law provides little relief to a majority shareholder who continues to run a profitable business without the assistance of his or her minority shareholders. The statute provides no right to extract a non-performing shareholder against his/her will at any price, and provides no absolute right of liquidation. Even the nuclear option of judicial corporate liquidation requires that the complaining shareholder allege irreparable harm to the company; an allegation which may be impossible if the business is successful as a result of the majority’s efforts.
Formation of an appropriate and workable shareholders’ agreement requires legal representation; as does management of divergent goals between shareholders. Owners of s corporations with minority shareholders would be wise to review their governing documents and take proactive steps to safeguard the future value of their shares, and avoid crippling and costly litigation. Antheil Maslow and MacMinn business attorneys are highly experienced in such matters and leverage a team of professionals in differing disciplines to navigate these complex waters.