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February 05, 2014 Articles

Shareholder Oppression: Texas Supreme Court to Weigh In on National Debate

Resulting decisions could have impact far beyond the state

by Kelli Hinson and Lyndon Bittle

The Texas Supreme Court is currently considering three cases that could drastically alter the legal landscape for owners of close corporations in that state. Each case was brought by a minority shareholder alleging that the majority shareholders had wielded their majority power so as to unfairly prejudice or "oppress" the minority. The minority shareholders all prevailed in front of Dallas juries on the theory of "shareholder oppression," but then had mixed results in the Dallas Court of Appeals. The Texas Supreme Court is now considering all three cases. The resulting decisions could have impact far beyond Texas, however, as other states similarly struggle with whether to recognize, and how to define, this increasingly popular cause of action.

"Two guys go in on a bar." This could either be the start of a bad joke or a petition for shareholder oppression. But imagine that two guys do go in on buying a bar. Jack puts in $55,000; Daniel puts in $45,000; and they become 55 percent/45 percent shareholders. They initially contemplate that Daniel will tend bar and Jack will keep the books and that they will take their money out in modest salaries. But the two have a falling out, and Jack uses his majority vote to fire Daniel, depriving Daniel of the ability to earn his salary. And because Jack now has to tend bar too, he doubles his own salary such that there is no extra money to pay to Daniel in "dividends." The bar is never going to make enough money to pay Daniel back his $45,000 investment. Does Daniel have a remedy for this alleged "oppression"?

The Struggle to Define Shareholder Oppression
Although Texas courts had previously confronted shareholder disputes in a variety of contexts, "shareholder oppression" as a specific cause of action was first recognized in Texas in 1988. The first Texas court to define an action for "oppressive conduct" was the Houston Court of Appeals in Davis v. Sheerin, 754 S.W.2d 375, 378 (Tex. App.—Houston [1st Dist.] 1988) (writ denied). Because no Texas court had yet recognized such a cause of action and a statute providing a remedy for certain "oppressive" conduct did not define it, the court of appeals looked to how other jurisdictions defined oppressive conduct and recited the varying definitions. Id. at 381 (citing In re Wiedy's Furniture Clearance Ctr. Co., 487 N.Y.S.2d 901 (N.Y. App. Div. 1985), and Baker v. Commercial Body Builders, Inc., 507 P.2d 387 (Or. 1973)). This hodgepodge of definitions has since become the two-category "definition" of shareholder oppression used by Texas trial and appellate courts:

1. majority shareholders' conduct that substantially defeats the minority's expectations that, objectively viewed, were both reasonable under the circumstances and central to the minority shareholder's decision to join the venture; or

2. burdensome, harsh, or wrongful conduct; a lack of probity and fair dealing in the company's affairs to the prejudice of some members; or a visible departure from the standards of fair dealing and a violation of fair play on which each shareholder is entitled to rely.

Texas courts have discussed the two definitions as if they were complementary alternatives, but they actually derive from conflicting lines of authority and differences in various jurisdictions' presumptions about corporate governance, the duties owed to minority shareholders, statutory provisions, and judicial philosophies. Although some states have not yet recognized shareholder oppression as a cause of action at all (including Arizona, California, Florida, Kentucky, and Nevada), most jurisdictions have entertained shareholder oppression cases, at least in the lower courts. The jurisdictions that have recognized the claim largely utilize one or both of the definitions quoted above, with the majority of states (including Alaska, Illinois, Massachusetts, Minnesota, New Jersey, New York, North Carolina, and Pennsylvania) adopting the first definition, requiring a defeat of the minority's reasonable expectations.

A minority of jurisdictions (including Colorado, Michigan, Missouri, Oregon, South Carolina, Virginia, and West Virginia) still appear willing to find oppression when the majority's conduct is deemed "burdensome, harsh, or wrongful," a definition that is closely tied to the fiduciary duty that some jurisdictions—notably not Texas—impose on majority shareholders in closely held companies.  Under either definition, problems arise when the meaning of "oppressive conduct" is so broad and amorphous that it provides no clear boundaries to guide corporate shareholders in their actions or to guide courts in reviewing those actions. Indeed, some courts have trumpeted the lack of standards, using shareholder oppression as a "cure all" for conduct that seems unfair but violates no laws or agreements.

That's Not Fair!
A majority shareholder's obligations are particularly unpredictable in the states that have adopted the "burdensome/fair dealing" definition of shareholder oppression. Absent an explicit shareholders agreement or legal rule, a minority shareholder generally has limited rights, which do not include the ability to dictate dividend policy or his or her own salary, or to force management to cash out his or her stock or sell the company on demand. Accordingly, many facts of life for a minority shareholder—such as lack of control and a limited market for shares—may seem "burdensome and harsh" or lacking in "fair play" to a jury or court reviewing the minority's claims. For example, there is no general requirement that a corporation pay dividends, even when it has the money to do so. But if the lack of dividends is "burdensome" to some shareholders, should that create a cause of action? Likewise, the firing of a shareholder-employee may under some circumstances seem "harsh." But should that alter the shareholder's status as an at-will employee? There appears to be a growing consensus that basing liability on such a vague and subjective standard is simply unworkable.

Great Expectations: Moving Toward an Expectations-Based Analysis
The other definition of oppressive conduct, which defines shareholder oppression as the defeat of the minority's reasonable expectations, can provide business owners and courts with much better guidance and predictability than the burdensome/fair dealing approach, as long as it emphasizes shared expectations that are objectively reasonable. In recent years, courts in Texas and elsewhere have begun to focus more on the shareholders' reasonable expectations and less on subjective "fairness."

Ritchie v. Rupe. The Dallas Court of Appeals took the first hard look at what a minority shareholder should and should not reasonably expect when investing in a corporation in Ritchie v. Rupe, 339 S.W.3d 275 (Tex. App.—Dallas 2011) (petition granted), now on appeal to the Texas Supreme Court. It also cautioned that courts must "balanc[e] the minority shareholder's reasonable expectations against the corporation's need to exercise its business judgment and run its business efficiently."

The court recognized there are certain "general reasonable expectations" held by all shareholders simply by virtue of stock ownership (unless limited by agreement) and that such expectations are presumptively reasonable and central to the shareholder's decision to invest in the corporation.

These include

• the right to proportionate participation in earnings,
• the right to any stock appreciation,
• the right (with proper purpose) to inspect corporate records,
• the right to vote if the stock has voting rights, and
• the right to sell stock to another person at a mutually acceptable price.

Although not an issue in Rupe, an established principle of corporate governance that should also be considered part of the general reasonable expectations of all shareholders is majority rule, except to the extent limited by statute, shareholder agreement, or bylaws.

In contrast to these general expectations, "specific reasonable expectations" require proof that the particular shareholders involved reached a mutual understanding about a certain entitlement the minority was to receive in return for his or her investment in the business.

After defining general and specific reasonable expectations, the court in Rupe found that the majority's actions—failing to meet with potential purchasers of the minority's stock—had frustrated the minority's general expectation of being able to sell her stock to a third party. In order to meet that expectation, the court ordered the corporation to purchase the plaintiff's stock for "fair market value," i.e., what she could have expected to receive from a third party.

Rupe has been fully briefed and argued at the Texas Supreme Court and is awaiting a decision on the merits.

ARGO Data Resource Corp. v. Shagrithaya. The Dallas Court of Appeals later reviewed the case of ARGO Data Resource Corp. v. Shagrithaya, 380 S.W.3d 249 (Tex. App.—Dallas 2012) (petition filed),under this same expectations-based analysis. The jury in that case found that the majority shareholder engaged in 11 acts of wrongful conduct against the minority shareholder, including reducing the minority's salary, retaining the company's earnings for the purpose of buying out the minority's shares, offering to have the company purchase the minority's shares for fair market value (which the minority called a "low-ball" offer), and appointing a nonowner as the president of the company without formal board approval. Based on the jury's findings, the trial court ordered the majority shareholder to cause the company to issue an $85 million dividend and awarded the minority shareholder other damages, including back pay and attorney fees.

On appeal, the Dallas Court of Appeals reversed and rendered a take-nothing judgment. The court held that most of the jury's factual findings were supported by sufficient evidence. But, reiterating and applying the standards adopted in Rupe, it held as a matter of law that the enumerated acts were not "oppressive" because they did not defeat the minority's general or specific reasonable expectations. Because the minority had received millions of dollars of return on his investment in the form of salary, dividends, and increased share value, the court found that his general expectations were not defeated. And, because the evidence was undisputed that the two shareholders never discussed salary or dividends before ARGO was formed, the minority had no specific expectations subject to being defeated. The court reiterated that, absent some agreement, a minority shareholder has no reasonable expectation of a particular salary or payment of dividends.

Defining and Protecting Your Rights as an Owner of a Closely Held Business
The Texas Supreme Court has heard oral arguments in the Rupe case and has received full briefing on the merits in ARGO and one other shareholder oppression case, Cardiac Perfusion Services v. Hughes, 380 S.W.3d 198 (Tex. App.—Dallas 2012) (petition filed), which set aside a shareholders agreement concerning buy-out of shares upon termination of employment. So it is apparent that the court is interested in this issue, and many hope the court will answer some of the outstanding questions in this area of the law, at least as to Texas.

But until the high court in each state provides business owners with these answers—and probably even after—investors in closely held corporations would be well served to define their rights and obligations themselves through a comprehensive shareholders agreement. Even in states that apply the "burdensome/fair dealing" definition of oppressive conduct, an agreement between shareholders or comprehensive bylaws can help determine the "standards . . . on which each shareholder is entitled to rely." Through such an agreement, the investors can define at the outset their expectations of one another in terms of contributing to the business enterprise, how the investors will receive a return on their investment (whether through salary or dividends, etc.), what rights they will have to sell their shares, how a purchase price will be determined in the event the company redeems an investor's shares, and how conflicts will be resolved. Deciding these issues at the outset of the relationship may save headaches—and possibly litigation—in the future.

Keywords: litigation, commercial, business, shareholder oppression, shareholder rights, Ritchie v. Rupe

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