Because of the lack of a ready market for their shares, minority shareholders in a private corporation are especially vulnerable to tactics by majority shareholders designed to “squeeze” or “freeze” them out of the corporation. These tactics include withholding dividends, excluding minority shareholders from company employees, and paying excessive compensation to the majority shareholders.
In order to protect minority shareholders, many states have passed statutes permitting judicial dissolution of a corporation in which the majority shareholders are attempting to freeze out the minority shareholders. For example, Iowa Code § 490.1430(2)(b) allows the district court to dissolve a corporation in a proceeding by a shareholder if it is established that “the directors or those in control of the corporation have acted, are acting or will act in a manner that is illegal, oppressive or fraudulent.” This provision is based on § 14.30(2)(ii) of the Model Business Corporation Act. It is designed to protect minority shareholders in a private corporation from being “squeezed out” or “freezed out” of the corporation by the majority shareholders.
1. Majority Shareholder Responsibilities
In general, oppression of minority shareholders occurs when the majority shareholders do not adequately perform one of their required functions. Stated differently, majority shareholders have the right to control the affairs of the corporation, if done so lawfully and equitably, and not to the detriment of minority shareholders. Cookies Food Products, Inc. v. Lakes Warehouse Distributing, Inc., 430 N.W.2d 447(Iowa 1988); Berger v. Amana Soc., 95 N.W.2d 909 (Iowa 1959) (a radical and fundamental change in objects, purposes, or business of a corporation interfering with contract rights of each stockholder cannot be made without the consent of all stockholders, except by virtue of some act of legislation which may be read into a contract of incorporation).
Specifically, stockholders have the right to examine corporate books showing the financial status of the corporation. Ontjes v. Harrer, 227 N.W. 101 (Iowa 1929). Iowa Code § 490.705 requires a corporation to notify shareholders entitled to vote of the date, time, and place of each annual and special shareholders’ meeting no fewer than ten nor more than sixty days before the meeting date. In addition, a notice of a special meeting must include a description of the purpose or purposes for which the meeting is called. Iowa Code § 490.1202 requires shareholder approval of dispositions if the disposition would leave the corporation without a significant continuing business activity. If a corporation retains a business activity that represented at least twenty-five percent of total assets at the end of the most recently completed fiscal year, and twenty-five percent of either income from continuing operations before taxes or revenues from continuing operations for that fiscal year, the corporation will conclusively be deemed to have retained a significant continuing business activity.
2. What Amounts to Oppressive Conduct?
In the recent Iowa case of Baur v. Baur Farms, Inc., the Iowa Supreme Court adopted a reasonableness standard for the adjudication of minority shareholder claims of oppression in Iowa under the Iowa Business Corporations Act. 832 N.W.2d 663 (Iowa 2013). In Baur, the plaintiff minority shareholder brought an action against his family farm corporation; the plaintiff requested that the Court order the dissolution of the corporation or that his shares of stock be purchased from him for fair market value. Id. The Court emphasized that “[m]anagement-controlling directors and majority shareholders of [closely-held] corporations have long owed a fiduciary duty to the company and its shareholders” and “every shareholder may reasonably expect to share proportionally in a corporation’s gains.” Id. at 673-74. The Supreme Court specifically stated:
“The determination of whether the conduct of controlling directors and majority shareholders is oppressive under section 490.1430(2)(b ) and supports a minority shareholder’s action for dissolution of a corporation must focus on whether the reasonable expectations of the minority shareholder have been frustrated under the circumstances. We need not catalog here all the categories of conduct and circumstances that will constitute oppression frustrating the reasonable expectations of minority shareholders’ interests. We hold that majority shareholders act oppressively when, having the corporate financial resources to do so, they fail to satisfy the reasonable expectations of a minority shareholder by paying no return on shareholder equity while declining the minority shareholder’s repeated offers to sell shares for fair value.” Id.
In Maschmeier v. Southside Press, Ltd., the Iowa Court referred to the North Dakota Supreme Court definition of oppression finding, “[t]he alleged oppressive conduct by those in control of a close corporation must be analyzed in terms of ‘fiduciary duties’ owed by majority shareholders to the minority shareholders and ‘reasonable expectations’ held by minority shareholders in committing capital and labor to the particular enterprise, in light of the predicament in which minority shareholders in a close corporation can be placed by a ‘freeze-out’ situation.” 435 N.W.2d 377, 380 (Iowa Ct. App. 1988) (citing Balvik v. Sylvester, 411 N.W.2d 383, 386-87 (N.D. 1987)). The Iowa courts have also looked to the Oregon definition of oppressive conduct: “burdensome, harsh and wrongful conduct; a lack of probity and fair dealing with the affairs of a company to the prejudice of some of its members, or a visual departure from the standards of fair dealing, and a violation of fair play on which every shareholder who entrusts his money to a company is entitled to rely.” Id.(quoting Baker v. Comm. Body Builders, 507 P.2d 387, 393 (Or. 1973)). This definition includes consideration of the reasonable expectations of minority shareholders. Jorgensen v. Water Works, Inc., 582 N.W.2d 98, 107 (Wis. Ct. App. 1998)); See In re Kemp & Beatley, Inc., 473 N.E.2d 1173, 1179 (N.Y.S. 1984) (“Oppression should be deemed to arise only when the majority conduct substantially defeats expectations that, objectively viewed, were both reasonable under the circumstances and were central to the [plaintiff’s] decision to join the venture.”). The definition of oppressive conduct is intended to be broad and flexible. In the context of a close corporation, the oppressive conduct of those in control is closely related to breach of the fiduciary duty owed to minority shareholders. Id.
Courts have developed three principal approaches to defining oppression. First, some courts define oppression as “burdensome, harsh and wrongful conduct . . . a visible departure from the standards of fair dealing and a violation of fair play on which every shareholder who entrusts his money to a [corporation] is entitled to rely.” See Fix v. Fix Material Co., 538 S.W.2d 351, 358 (Mo. Ct. App. 1976)). Second, some courts link oppression to the breach of a fiduciary duty owed directly from one close corporation shareholder to another. Third, a number of courts tie oppression to the “frustration of the reasonable expectations of the shareholders.” See In re Kemp & Beatley, Inc., 473 N.E.2d 1173, 1179 (N.Y. 1984) (equating oppression with conduct that “defeats the ‘reasonable expectations’ held by minority shareholders in committing their capital to the particular enterprise”). Of these three approaches, the “reasonable expectations” standard garners the most approval, and courts have increasingly used it to determine whether oppressive conduct has occurred. The highest courts in several states have adopted the reasonable expectations standard. See, e.g., Maschmeier v. Southside Press, Ltd., 435 N.W.2d 377, 380 (Iowa Ct. App. 1988) (adopting the reasonable expectations approach).
As a distinct statutory ground for dissolution, oppression may be shown to exist even in the absence of mismanagement or misapplication of assets. Thus, a minority shareholder has the right to seek dissolution upon a showing of oppressive conduct which has the effect of excluding him from taking part in the affairs of the corporation. Courts may determine, according to the facts of a particular case, whether the acts complained of serve to frustrate the legitimate expectations of minority shareholders, or whether the acts are of such severity as to warrant the requested relief.
3. Analysis Techniques to Determine Oppression
There are two common analysis techniques to determine the oppression of minority shareholders. The more traditional “fiduciary duty” analysis focuses on the business justification offered by the majority for the conduct, to determine whether the majority breached its duty. A newer, alternate approach is the “reasonable expectations” analysis, adopting the perspective of the minority shareholders. Under this approach, corporate decisions may be found oppressive because they violate the expectations that the minority reasonably maintained toward employment, remuneration, or control. Importantly, this approach can allow for a finding of oppression whether or not the majority acted wrongfully. See Maschmeier v. Southside Press, Ltd., 435 N.W.2d 377, 380 (Iowa Ct. App. 1988) (citing Balvik v. Sylvester, 411 N.W.2d 383 (N.D. 1987) (The alleged oppressive conduct by those in control of a close corporation must be analyzed in terms of “fiduciary duties” owed by majority shareholders to the minority shareholders and “reasonable expectations” held by minority shareholders in committing capital and labor to the particular enterprise, in light of the predicament in which minority shareholders in a close corporation can be placed in a “freeze-out” situation).
The fiduciary duty applied to close corporation shareholders is sometimes said to be more demanding than the duty applied to directors and shareholders in public corporations. A leading case on close corporations, Donahue v. Rodd Electrotype Co. of New England, Inc., applied the “more rigorous duty of partners” to shareholders. 328 N.E.2d 505 (Mass. 1975). Chiles v. Robertson stated unequivocally that “[t]he majority shareholder of a close corporation owes the minority fiduciary duties of loyalty, good faith, fair dealing and full disclosure.” 767 P.2d 903, 911-12 (Or. Ct. App. 1989).
According to Jones v. H.F. Ahmanson & Co., majority shareholders may not use their power to control corporate activities to benefit themselves alone or in a manner detrimental to the minority. Any use to which they put the corporation, or their power to control the corporation, must benefit all shareholders proportionately and must not conflict with the proper conduct of the corporation’s business. 460 P.2d 464 (Cal. 1969). The decision stated that “majority shareholders, either singly or acting in concert … have a fiduciary responsibility to the minority and to the corporation to use their ability to control the corporation in a fair, just, and equitable manner. Majority shareholders may not use their power to control corporate activities to benefit themselves alone or in a manner detrimental to the minority.” Id. at 471. A subsequent California decision reaffirmed this principle. DeBaun v. First Western Bank & Trust Co., 46 P.3d 686 (Cal. Ct. App. 1975).
Fiduciary duties exist in constant and unavoidable tension with the prerogative of the majority shareholders to determine corporate policy, which requires balancing. Accordingly, courts recognize that decisions by those in control may be justified, despite adverse effects on minority shareholders, if supported by a legitimate business purpose. See, e.g., Gabhart v. Gabhart, 370 N.E.2d 345, 353-54 (Ind. 1977) (stating “[o]n the one hand is the necessity to provide adequate protection for the interests and expectations of minority shareholders, and the other is the necessity of allowing sufficient corporate flexibility, as is required by modern commerce”).
4. Remedies for Minority Shareholder Oppression
In practice, courts rarely grant judicial dissolution for oppression. Courts are not absolutely required to order dissolution upon a showing of oppression but may exercise their discretion in fashioning a remedy appropriate under the circumstances. Corporations -Dissolution – Denial of Right to Participate in Management of Close Corporation Entitles Shareholder to Liquidation, 74 Harv L Rev 1461 (1961). Courts repeatedly describe dissolution as a drastic remedy, to be avoided in ordinary cases. The strong preference is to keep the business together and operating for the benefit of all shareholders.
Typically, a court orders a corporation or its controlling shareholders to purchase the shares of the minority due when minority shareholder oppression exists. In this situation, the court must determine a “fair value” of the minority’s shares.
5. What Does Fair Value Mean?
There are two conflicting approaches to the meaning of fair value. The first approach equates fair value with fair market value. Under this position, a court values an oppressed minority’s shares by considering what a hypothetical purchaser would pay for them. Because minority shares, by definition, lack control, a hypothetical purchaser is likely to pay less for minority shares than for shares that possess control (the minority discount). Moreover, because close corporation shares lack a ready market and are, as a consequence, difficult to liquidate, a hypothetical purchaser is likely to pay less for close corporation shares than for readily traded public corporation shares (the marketability discount). Under the fair market value interpretation of fair value, therefore, minority and marketability discounts are appropriate.
The second approach to the meaning of fair value defines fair value simply as a pro-rata share of a company’s overall value. The enterprise value approach sees an oppressed shareholder in a buyout setting as an investor forced to relinquish his ownership position, rather than as an investor looking to sell his shares. Such an approach assumes that, absent from the oppressive conduct, the investor would have retained his ownership position in the corporation and would have continued to receive the benefits of owning a stake in the overall enterprise. Under this position, the value of close corporation shares is determined not by referencing what the particular shares would fetch in a hypothetical market sale, but instead by valuing the company as a whole and by ascribing to each share its pro-rata portion of that overall enterprise value. Under this enterprise value approach, discounting for the shares’ lack of control and lack of liquidity is inappropriate. Neither marketability nor a minority discount should be applied in oppression cases. Columbia Management Co. v. Wyss, 765 P.2d 207, 213; See Chiles v. Robertson, 767 P.2d 903, 926 (Or. Ct. App. 1989) (“Fair value” is “fair market value” but without any discount for minority or lack of marketability); Hayes v. Olmsted & Assocs., Inc., 21 P.3d 178, 188 (Or. Ct. App. 2001) ([v]aluation is based on the minority’s pro-rata share of the corporation’s value as a going concern).
Instead of a voluntary sale conception, it is more accurate to characterize an oppression buyout as a compelled redemption of the minority’s ownership position. The oppressive conduct has forced the minority to relinquish his investment, and a court order (or threat of dissolution) has forced the majority to “cash-out” that investment. The buyout, in other words, should be viewed as a proceeding in which the majority compensates the minority for the investment that the minority has unwillingly surrendered. It is the value of that investment that the buyout proceeding should award. Because a buyout of the typical oppressed shareholder resembles a forced redemption far more than it resembles a voluntary sale, the fair market value standard should be rejected. By providing an oppressed investor with his pro-rata share of the company’s overall worth, the enterprise value standard properly focuses on what the investor has relinquished. The buyout remedy should provide an oppressed minority investor with his pro-rata share of the company’s overall value, with no reductions (or “discounts”) for the lack of control or liquidity associated with the minority’s shares.
Accordingly, Iowa case law has stated that “discounts only applicable to minority shares … cannot be considered.” Security State Bank v. Ziegeldorf, 554 N.W.2d 884, 890 (Iowa 1996). In addition, Ziegeldorf stated “[t]o allow a marketability discount … would undermine the legislature’s intent to protect minority shareholders from being forced out at a price below the fair value of their pro-rata share of the corporation.” Id.; Rath v. Rath Packing Co., 136 N.W.2d 410 (Iowa 1965) (A shareholder who dissents to a merger may obtain the value of his stock if right thereto is provided by statute and if procedure established therefore is followed by him).
6. Conclusions & Recommendations
As discussed above, minority shareholders in a private corporation must be aware of tactics by majority shareholders designed to “squeeze” or “freeze” them out of the corporation. If these tactics occur, minority shareholders have remedies to ease the wrongs of the majority shareholders. Including, but not limited to, the recovery of the fair value of corporate shares. If you sense, as a minority shareholder, that you are being “squeezed” or “frozen” out of the corporation, an attorney at LaMarca Law Group, P.C. would be available to discuss your concerns and possible remedies.