Corporate and M&A Articles by David R. Pierce

Corporate deadlock is often cited as a reason why the court should invoke its powers and order the sale of one shareholder’s stock in minority shareholder litigation. While deadlock is a legitimate reason to bring a lawsuit seeking the court’s intervention, it is not a magic bullet that will automatically lead to the court ordering a buyout of one or more shareholders.

Deadlock is defined under the New Jersey Business Corporations Act and can be found under one of two circumstances. Deadlock can be found to exist when “the shareholders are so divided that they have not been able, for two consecutive meetings, to elect successors to directors whose terms have expired or would have expired if successors had been elected and qualified.” N.J.S.A. 14(a):12-7(1). The second manner in which deadlock may exist is if “the directors or other persons having management authority are unable to effect action on one or more substantial matters respecting the management of the company’s business.” N.J.S.A. 14(A):12-7(1).

The first deadlock provision may seem like an easy one to satisfy in closely held companies since many small companies do not hold formal shareholder meetings as required under the statute. The owners of small closely held companies are so focused on running the business that they forget about the formal requirements. Instead, since the shareholders in such companies generally work together closely and see each other practically every day, they make management decisions informally as necessary to operate the business and without formal meetings or corporate resolutions.

Because of the fiduciary duties owed by business owners to each other, whether they are shareholders in a closely held corporation, members in a limited company, or partners in a general or limited partnership, a business owner generally is prohibited from competing with the company. This general prohibition can be modified by an agreement among the owners, but in the absence of such an agreement the prohibition stands.

Failure to do so is referred to as the diversion of corporate opportunities. An owner of a closely held business has a duty to bring to the company any business opportunity that the company would normally expect to seek to pursue. The opportunity must be presented to the company and cannot be pursued individually unless the company decides not to pursue that opportunity.

As with the prohibition on competition, the requirement to present all opportunities to the company can be altered by contract. Pursuant to N.J.S.A. 14A:3-1, a corporation can renounce its interest in, or expectancy of the opportunity to pursue, specific opportunities. One manner in which corporate opportunities can be relinquished is to insert the pertinent language in the Certificate of Incorporation. When starting a new business, if there is any thought that one or more owners might want the right to pursue competing opportunities, you want to include language in the Certificate of Incorporation, or a separate shareholder agreement, that specifies what competing businesses the shareholder may appropriate.

Have you ever heard a story among your friends about a company where two partners got along great, but then one suffered an untimely death and then his widow or children caused the company to breakup? That is a common scenario, although one might not be able to place the blame on the surviving spouse or the children. This is one of the ultimate worst case scenarios that proper planning can help avoid.

As shareholders in a small company each shareholder may have a reasonable expectation of continuing employment and participation in management of the company. When one shareholder dies, unless an agreement among the shareholders is in place providing a right for the company or remaining shareholder to purchase the deceased shareholder’s stock, that stock will be transferred to that deceased shareholder’s heirs, whether by will or by intestacy. As a result, most often the deceased shareholder’s stock ends up in the hands of a surviving spouse or children. In some cases the heir of the deceased shareholder will be able to step into his or her shoes and be able to participate meaningfully in the operation of the business. There may be personality conflicts and other difficulties in operating the business with a new partner, but hopefully, those can be worked out.

More often, however, the deceased shareholder’s stock is inherited by someone who does not have any clue about the business and cannot be expected to participate in or contribute to the operation of the business in any realistic sense. Sometimes this leads the remaining original shareholder to think that he will not pay them a salary since they are not working in the business and he can retain the earnings to reinvest in the business since he is not required to pay dividends. This is a recipe for disaster and some really unfortunate consequences.

Statutory remedies are made available to shareholders in a small, closely held corporation should harmful actions be undertaken by other shareholder or directors of the corporation. Importantly, these statutory remedies are available only to owners of a corporation with 25 or fewer shareholders.

Pursuant to N.J.S.A. 14A:12-7(1)(c), a shareholder in a closely held corporation may seek judicial remedies if the directors or other persons in control of a corporation have:

• Acted fraudulently;

Does your business partner owe you anything? We’re not talking about money, although that may be an ultimate outcome, we’re talking about how they treat you. Do they owe you any duty to be fair or to bring business opportunities to your company? Whether you are a shareholder in a small, closely held corporation or a member in a limited liability company, the answer to this question is yes, with some exceptions.

Every small business owner, again, whether be it a corporation or limited liability company, has a fiduciary relationship with the other business owners. What is a fiduciary relationship? A person who is a fiduciary is someone charged with a legal and/or ethical relationship of trust with one or more other persons. A fiduciary duty, in turn, is the highest standard of care that can be imposed on someone. A fiduciary is required to be loyal to the beneficiaries of that duty and there must be no conflict of interest between the fiduciary and beneficiaries. The fiduciary cannot profit personally from his position as a fiduciary.

Since each shareholder or limited liability company member owes each other a fiduciary duty the responsibility is reciprocal. Therefore, as a small business owner, you owe a fiduciary duty to your other partners whether you own 60% of the company or 5% of the company and they also owe you a reciprocal fiduciary duty.

What is a shareholder dispute or, in other words, shareholder oppression? The terms “shareholder dispute” and “shareholder oppression” are short hand references to business disputes between two or more owners of closely held businesses. Although the phrases both refer to “shareholders” they are used interchangeably by most people to refer to disputes between owners of not only corporations, but between owners of partnerships and limited liability companies. There are important distinctions between the various business entities that can be used, but those are beyond the scope of this introduction.

In a closely held business there are often several shareholders/partners who decided to go into business together. They can be relatives, close friends or even just business acquaintances who realized that they could combine their efforts and make a go of a new business. In many cases there is an inside partner and an outside partner. The inside partner typically is responsible for the production and fulfillment operations of the business while the outside partner is responsible for promoting the business and securing orders for the businesses goods and/or services. Sometimes a business is started by one person with a vision, but they want to share their success with others who have helped them out, when the business founder decides that he or she wants to give those individuals a chance to share in the growth and prosperity of the company, they do so by giving them stock in the company. Other times the founder opens up the ownership of the business to others in an effort to raise capital to help take the business to the next level. Whichever scenario, or even any other scenario that hasn’t been mentioned, there is the very real potential for disputes to develop over, among other things, the management of the business, the direction of the business, the level of effort being expended by owners, the compensation being paid or lack of profits to distribute.

Any of these disputes can blossom into full-fledged, to the death litigation contests, pitting partners, and their respective wills, against each other. Often times the dispute erupts over perceived slights or resentment that has festered beneath the surface for months or even years. These disputes can, and do, usually lead to the breakup of the business relationship. One owner may be compelled to sell his or her interest to the other owner at a price determined through a valuation process. In rare cases the sale of the business to a third party may be forced.

New Jersey’s General Corporations law establishes an important statutory remedy for oppressed minority shareholders in a closely held corporation.  It is critical to understanding your rights as a shareholder, however, to understand who is considered under the statute to be a minority shareholder.  You may well think, I own 50% of the stock in my company so, I can’t possibly be a minority shareholder. Well, if that is what you think, then you are potentially shortchanging yourself.

An owner of 50% of closely held corporation’s stock can be considered a “minority shareholder” within the meaning of N.J.S.A. 14A:12-7(1)(c).  Bonavita v. Corbo, 300 N.J.Super. 179, 188 (N.J.Super.Ch. 1996).  Thus, even where a corporation is owned equally by two shareholders, a court may order an equitable remedy to a shareholder dispute upon proof that the “minority” shareholder has been oppressed, or the majority shareholder has acted fraudulently or illegally, mismanaged the corporation, or abused their authority. Depending upon the particular circumstances of the case, one court has even indicated that in appropriate circumstances the owner of 98% of stock in closely-held corporation could be considered a “minority” shareholder.  The existence of voting agreements and other control restrictions may tilt the playing field in your favor.

New Jersey’s General Corporations law provides a statutory remedy for oppressed shareholders in a closely held corporation.  N.J.S.A.  14A:12-7 that so long as a corporation has 25 or fewer shareholders, then any shareholder can bring an action in New Jersey Superior Court seeking dissolution of the corporation when “the directors or those in control have acted fraudulently or illegally, mismanaged the corporation or abused their authority as officers or directors or have acted oppressively or unfairly toward one or more shareholders in their capacities as shareholders, directors, officer or employees.”

Shareholder oppression is not the only circumstance under which such a lawsuit can be commenced, but the other bases for such a lawsuit are relatively straight forward.  Thus, the definition of “shareholder oppression” requires some explanation as that term is interpreted by the courts.

As defined by New Jersey’s courts, shareholder oppression means conduct which “frustrates a minority shareholder’s reasonable expectations.” Brenner v. Berkowitz, 134 N.J. at 506.   In determining whether a particular course of conduct has oppressed a minority shareholder, courts will examine the understanding of the parties concerning their roles in corporate affairs. Muellenberg v. Bikon Corporation, 143 N.J. 168, 178-9 (1996).   When reviewing an oppression claim, the courts will consider even non-monetary expectations of the shareholder when determining whether a shareholder’s expectations are reasonable and whether the corporation or controlling shareholders or directors unreasonably thwarted them.  One of the most common expectations of a shareholder in a closely held corporation is continuing employment by the corporation and the termination of a shareholder’s position as an employee frequently leads to shareholder oppression litigation.

The New Jersey Appellate Division recently issued a ruling in a minority shareholder oppression case which reinforces the concept that the best way to resolve a minority shareholder oppression case is through settlement. The decision, Wisniewski v. Walsh, et al. (A-2650-13T3), is an unreported case but reaffirms that the finder of fact, whether it be jury or judge, is not bound by, or required to accept, the testimony of any expert and may, in fact, make its own determination of value, as long as it is based upon facts in the record.

Wisniewski v. Walsh is a case that has been in the courts for 20 years on a variety of legal issues. The issues in this particular ruling concerned whether a marketability or illiquidity discount had been imbedded in the valuation experts’ determination of the value of the company and, if not, what discount should be applied. On a prior appeal the Appellate Division had ruled that Norbert Walsh, the oppressing shareholder, was to be bought out and that a marketability discount should be applied to the value of his shares to reduce the purchase price and ensure that he, as the oppressing shareholder, did not receive a windfall by having the purchasing shareholders bear the full burden of the company’s illiquidity.

In this case the dueling experts had used different methods of valuation, one had used a discounted cash flow method of valuation while the other had used a market approach, and the trial court during the valuation aspect of the case had found the discounted cash flow approach more reliable and sound and adopted the first expert’s approach for valuation. The discounted cash flow approach involves estimating the company’s revenues over a period of time, normalizing its expenses and then discounting the resulting income stream to a present value at an appropriate rate. When determining the valuation, the trial judge accepted the first expert’s estimation of future revenues, but rejected his analysis of the company’s expenses, adopting instead the second expert’s approach to normalizing adjustments. The valuation trial judge then accepted the first expert’s discount rate of 12% for purposes of determining the present value of the resulting income stream.