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Have the Controlling Shareholders Breached Their Fiduciary Duties to the Minority in Transferring Co

Control shareholders have a fiduciary duty to the minority shareholders to act with “good faith and inherent fairness.” As such, majority owners have a fiduciary responsibility not to use their influence to engage in self-dealing, including actions that are unfairly prejudicial to the minority shareholders. Majority owners thus should not divert business opportunities, funds or compensation to their benefit, excluding minority owners from that same benefit. This is particularly the case when majority shareholders exercise their power to transfer control of the corporation or its shares.

Examples of Bad Faith Conduct

Here are several examples of the types of change-in-control conduct that, if engaged in by majority owners, would demonstrate bad faith and unfairness to the minority:

  • Sale to “Looter”: Under some circumstances, the duty to minority shareholders may require that majority shareholders as well as the board of directors should undertake reasonable investigation of persons seeking to purchase the controlling majority of shares. For example, if there are grounds to suspect the purchaser may “loot” the corporation (with looting in this sense sometimes termed accounting control fraud over the company’s financial assets), and the control shareholders proceed with the sale without investigating the purchaser or protecting the corporation, they may be liable for resulting losses. Here are some danger signs that may arouse suspicion that the purchaser intends to “loot” the corporation’s assets:

  • Willingness to pay an excessive price for the control shares (from which the majority shareholders disproportionately benefit);

  • Undue interest in the “liquidity” of corporate assets;

  • Relative lack of interest in operating and financial aspects of the corporation's business, such as funding for capital equipment, research and development, marketing or technology.

  • Sale to Purchaser Planning Detrimental Changes: Similar principles apply where the control shareholder has reason to know that the purchaser intends changes in the corporation's operations that will be detrimental to the minority shareholders. This can be done in a variety of ways. The sellers may relinquish their control shares at a premium, knowing that purchasers intended to discontinue dividends and thereby deflate value of minority’s shares. Controlling shareholders also breach their fiduciary duty to the minority where they know that the purchasing entity intends to issue additional shares for inadequate consideration, in order to dilute the minority’s interest.

  • Not Allowing Minority Shares to Participate in “Going Public:” Control shareholders breach their fiduciary duty to the minority if they transfer the control shares to a new corporation for the purpose of “going public,” without allowing the minority to participate. This is particularly true if the articles of incorporation provide for preemptive rights that enable minority shareholders to maintain their fractional ownership of a company by buying a proportional number of shares of any future stock issuance. Thus, where no public market exists for the corporation’s stock, it would be “inherently unfair” to allow control shareholders to obtain the liquidity and advantages of publicly-held shares, while the minority shareholders were locked into a corporation whose shares were relatively illiquid.

  • Denial of Equal Stock Repurchase Rights. Similarly, controlling shareholders of a closely held corporation may breach their fiduciary duty to the minority if they initiate repurchasing the shares of a member of the controlling group, but do not offer minority shareholders equal repurchase rights This would be a flagrant example of self-dealing, in which the controlling group uses its control of the corporation to establish an exclusive market in previously unmarketable shares from which the minority stockholders are excluded.

  • Sale of Shares Accompanied by Resignation of Directors: Typically, sale of control shares will lead a majority of the board members who authorized the change of control to tender their resignations to facilitate appointment of the purchaser’s board designees. The net effect is to give the purchaser immediate control of the company’s management. This is proper as long as the number of shares sold would entitle the purchaser to exercise this level of control over the board, by virtue of having sufficient shares to elect that number of directors under cumulative voting.

However, if the shares sold would not be sufficient to elect a controlling majority of directors at a shareholders’ meeting, the arranged resignations may be invalid as constituting the “sale of corporate office (or directorships).”

Good Faith in Context

It should be noted that no California case has yet held that the premium obtained by a controlling shareholder for his or her shares must be shared with the minority shareholders in every case. In cases where a breach of duty was found, and the control shareholder was required to disgorge the premium, there was some additional element that demonstrated bad faith conduct and breach of the duty of fairness, from among the examples given previously: corporate looting, sale of corporate office, harm to the corporate business, misrepresentations to minority shareholder, or similar misconduct.

Nevertheless, it has been argued that “control” of the corporation is a corporate asset, so that all shareholders should be entitle to share proportionally in any premium obtained by the control shareholders for their shares. Nevertheless, the risk of litigation is high where the control shareholders get a “better deal” for their shares than is available to the other shareholders of the corporation. Controlling shareholders breach their fiduciary duty to the minority where they cause the minority to receive inadequate consideration more disadvantageous than that justified by their minority standing.

The remedy for the minority against the controlling shareholder is an action for damages – either by the corporation (in the form of a derivative suit brought by the minority shareholders) or by the minority shareholders directly (as individuals or as a class of injured shareholders). In any such litigation, minority shareholders can both enforce their rights and recoup their losses if they can demonstrate controlling shareholder misconduct.

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This Alert is made available for educational purposes and to provide general information on current legal topics, not to provide specific legal advice. The publication of this Alert does not create any attorney client relationship, and this Alert should not be used as a substitute for competent legal advice from a licensed professional attorney.

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