Limitations on the Rights of Minority Owners in Closely-Held Businesses
February 10, 2022
In an earlier post, I offered a broader-than-usual overview of certain key rights that a minority owner holds in a closely-held business: the right to vote on company action, the right to inspect books and records, the right to prosecute derivative actions, and the right to seek judicial dissolution, to name a few.
While those rights often provide minority owners with a valuable means to understand the condition of the company, influence company action, and protect their investment, they are subject to some substantial limitations. Despite all the statutory and common law protection, minority owners remain, in many ways, subject to the whim of the majority. Those considering investment in a closely-held business, negotiating an owners’ agreement, or contemplating litigation are wise to consider the impact of these notable limitations:
Limited Rights in Derivative Actions
Among the most significant rights a minority owner has is the right to bring derivative suits in the name of the corporation or LLC. But the derivative action is subject to some substantial limitations. The minority owner must first demand that the corporation take action to remedy the wrong complained of (or demonstrate that such a demand would be futile), and plead that demand with particularity. The derivative plaintiff must also maintain her ownership throughout the entire litigation: even after a derivative suit is commenced, a company with buyout rights can head off the derivative claims by exercising their buyout rights (see this post on Tabs Motors v. Louros). Additionally, any recovery in a derivative suit goes to the company, not directly to the minority owner. This means that many times, the economics of a derivative suit weigh sharply against minority owners. Derivative claims are also subject to superior claims against the company held by others, and a derivative plaintiff has no right to a jury trial on her claims.
In post-1997 corporations, New York’s business corporation law does not provide the minority shareholder with any statutory protection against the dilution of her interest. Nor does the BCL protect against dilutive share issuances that do not “adversely affect” the voting or dividend rights of the minority shareholder. Thus, absent protection in the shareholders agreement, a post-1997 corporation can issue new shares without offering the minority owners the right to purchase those shares to maintain their ownership percentage. In those cases, the majority need only demonstrate that the dilutive share issuance serves a bona fide business purpose (see Dingle v. Xtenit, Inc., 20 Misc 3d 1123[A] [Sup Ct NY Co 2008]).
New York’s LLC Law does not contain an analogue for BCL 622, so minority LLC owners do not have preemptive rights unless their operating agreement provides for them.
Likewise, many LLC operating agreements give the majority the right to make capital calls and provide for potentially severe consequences if the minority members fail to meet those capital calls. Section 502 of the LLC Law provides that those consequences “may include, but are not limited to, reduction or elimination of the defaulting member’s interest, subordination of the defaulting member’s interest to that of nondefaulting members, a forced sale of the defaulting member’s interest, [or] forfeiture of the defaulting member’s interest.” In LLCs without an operating agreement or with an operating agreement that is silent on the issue of capital calls, the minority member is better-protected (see this post on Georgi v. Polanski).
Minority LLC members should be mindful that in some cases, they can be expelled from the LLC. Some LLCs have provisions in their operating agreement that allow for expulsion of members in certain circumstances such as, for example, upon a majority or supermajority vote of other members.
What if your LLC does not have an operating agreement? New York has no statutory provision for member expulsion, so without an operating agreement providing expulsion, it may seem unlikely. New York courts, however, have held that a majority of LLC members can adopt an operating agreement without the consent of all members (see this post on Shapiro v Ettenson). As a result, a majority of members can first adopt an operating agreement containing an expulsion provision, then expel a minority member pursuant to that operating agreement.
Notably, in many states, including those states adopting the Revised Uniform LLC Act, an LLC can request that a court expel a member based on a finding of wrongful conduct, willful and persistent breach of the operating agreement, or that it is not reasonably practicable to continue the LLC with that member.
A freeze-out merger is a combination of transactions in which the majority owners cause the entity, through a written agreement or plan of merger, to merge with and into a new entity, with a minority owner of the original entity receiving no ownership interest in the new entity, and her ownership interest being extinguished and exchanged for cash.
In corporations, a minority shareholder can seek to challenge the merger for alleged fraud or illegality in the procurement of the merger, including if the proposed merger is a breach of fiduciary duty to the minority shareholder (see this post on Van Horne v Ben Dov). LLC minority members, however, have no basis to challenge a freeze out merger (see this post on Farro v Schochet).
In either case, the majority shareholders must offer the frozen-out minority fair value for her shares. If the minority disagrees with the amount offered, the majority can trigger an appraisal proceeding under BCL 623 or LLCL 1002, in which the sole issue to be determined by the court is the fair value of the minority shareholder’s interest.
In summary, while minority owners can (i) vote on certain actions, participate in the management of the company to the extent set forth in the governing documents; (ii) inspect books and records; (iii) commence a derivative action in the name of the company; and (iv) petition for dissolution, their rights often are subject to dilution, expulsion, and freeze-outs. For the minority owner, these limitations should underscore the critical importance of a carefully crafted owners’ agreement that includes bargained-for protections. Absent additional protections in an owner’s agreement, minority owners may find that their investment is not as secure as they thought.