by Peter Shenas

Even in the best of times the relationship between majority and minority shareholders in closely held corporations is difficult to maintain at the high optimistic plane upon which those relationships generally commence.  With the passage of time many such relationships tend to deteriorate into an uneasy truce maintained only for the common economic benefit.

In harsh economic times such as we are now experiencing, the pressures become greater as minority shareholders tend to blame the controlling shareholders for the problems the business may be experiencing.  In some cases, the friction escalates to a point where the corporation and both factions would be better served by a buy-out of one group by the other.

When Negotiations Break Down

Obviously, a negotiated buy-out of the minority faction is the best solution, but the disparity in bargaining power between the majority and the minority factions generally renders those negotiations difficult in the early stages of the dispute. Ultimately, when all else fails, an involuntary dissolution proceeding in the Superior Court must be considered.

The goal of the minority shareholders in filing the action may be either to cause an involuntary dissolution as the only means of recovering their investment, or to coerce the majority shareholders into buying the minority shares.  One-half of the directors or shareholders owning 33 1/3% or more of the stock of a California corporation are entitled to file such an action.  In order to prevail, they must be able to prove the existence of one of six statutory grounds.

The most commonly used of those grounds are, essentially, that (a) there is a deadlock between two or more factions of shareholders, or (b) that the controlling group has been guilty of or countenanced fraud, mismanagement, or abuse of authority.  The broadly stated statutory grounds for dissolution give the courts great latitude in deciding whether dissolution should be ordered.  Since this is a suit "in equity," the parties are not entitled to a jury.  The decision is made by a Superior Court judge.

A corporate dissolution action is unique in that it is not necessary for the parties to await trial for a determination of whether the plaintiff is entitled to dissolution.  This determination can be made early in the case by a hearing in which the court may or may not choose to take oral testimony.  The court can, in its discretion, choose to decide the matter on sworn written declarations.  If the court decides that grounds for dissolution exist, it will enter its "order for winding up and dissolution."

From that point forward, the board of directors conducts the winding up of the affairs of the corporation subject to the supervision of the court.  The winding up process involves, in general, the sale of the assets of the business, either as a going business or separately, the payment of the debts, and the distribution of the balance of the proceeds to the shareholders.

The court has broad and extraordinary powers in this process, including the processing and adjudicating of creditors’ claims, the determination of the rights of shareholders to the assets, and the removal of any director for dishonesty, misconduct, neglect, or abuse of trust in conducting the winding up.  At the end of the winding-up process, the court will make its order declaring the corporation to be duly wound up and dissolved, and a copy of the order will be filed in the office of the Secretary of State.

Frequently the minority shareholders will combine their request for involuntary dissolution with causes of action for the removal of directors, and for damages against the directors and officers for breaches of fiduciary duty or for other wrongdoing. This has the effect of creating greater pressure upon the majority shareholders to come to the bargaining table and bargain in good faith, in that, unlike the involuntary dissolution cause of action, causes of action for damages may, at either side's option, be decided by a jury.

The prospect of an unpredictable jury dealing with the complex issues which are often involved in such claims is sufficient to frighten the most courageous.  The likelihood of such a jury trial makes it imperative that, in spite of the sometimes great temptation to "stonewall" or attempt to intimidate the minority, the controlling shareholders be extremely cautious, fair and temperate in their conduct of the business and their dealings with the minority both before and after the dispute arises.  This may be difficult in times of stressful negotiations, but the majority's course of conduct should be such that they would not be embarrassed to have that conduct closely scrutinized by a jury.

Beware of Compulsory Buy-Out Rights

It is important for the minority shareholders to understand that the ability of minority shareholders to threaten the majority with dissolution of the corporation is a two-edged sword that must be handled with caution by the minority.

The Corporations Code provides that, subject to any contrary provision in the articles of incorporation, in any suit for involuntary dissolution commenced by shareholders representing 50% or less of the voting power, the corporation may avoid the dissolution by electing to purchase the stock of those shareholders for cash at its fair value.  If the corporation declines to purchase, holders of 50% or more of the voting power may exercise the election. Unless the parties can agree to the purchase price, it is determined by a court-appointed panel of three independent appraisers.

The award of a majority of the three appraisers, when confirmed by the court, is final and conclusive.  The fair value is determined on the basis of the liquidation value as of the date of filing of the dissolution complaint and must be paid in cash. Whether the possibility of a buy-out is, in any given case, something that the minority shareholders would look upon with favor or with concern depends on the economic factors involved. In either case it is extremely important that both sides be aware of the existence of the buy-out right from the inception of the dispute.

In conclusion, the best advice that can be given to warring factions of shareholders is to exhaust all settlement possibilities before the filing of involuntary dissolution proceedings.  The expense of such proceedings can be significant, especially if the statutory buy-out proceedings are instituted. When the cost of three independent appraisers is added to the legal expenses, even a poor pre-litigation settlement may not look so bad.

Published in the San Diego Daily Journal on July 9, 1998.

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