Small businesses, which often consist of a limited number of shareholders, sometimes consisting solely of family members, often have certain advantages which can come from relatively easy communication between individual shareholders. There are also risks inherent in a small business, often structured as a closely held corporation, when majority shareholders attempt to freeze out, or squeeze out, minority shareholders. If you are in such a situation, or are a minority shareholder in a small business, you should be aware of your rights under Massachusetts law, which provides protection for minority shareholders. This article attempts to explain how a freeze-out is characterized in a small business entity and steps that can be taken by minority shareholders in such a situation.
What is a shareholder freeze-out?
A shareholder freeze-out is an attempt by the majority shareholders (those individuals who control more than 50% of the company’s assets) to exert pressure on the minority shareholders which is designed to prevent these shareholders from the economic benefits or rights of governance they enjoy.
Freeze-outs tend to be more common in small closely held corporations because minority shareholders cannot dispose of their shares so easily on the public market. The majority shareholders may then control decision making, depriving the minority shareholders from defending their rights.
Examples of strategies which Massachusetts law may identify as a freeze-out include the following:
- termination of employment when a minority shareholder is also an employee;
- preventing access to information about financial decision making;
- preventing minority shareholders from management roles or corporate office holding;
- not declaring dividends at the same time that majority shareholders enjoy bonuses or higher salaries;
- using intimidation to sell shares to majority shareholders at an unfair price.
These strategies may be considered illegal under state corporate law as they prevent minority shareholders having a reasonable expectation of their investment in the company.
What makes closely held corporations vulnerable to freeze-outs
A closely held corporation tends to be more likely to experience freeze-outs, but what exactly is a closely held corporation? Such a company tends to be characterized as having:
- no access to the open market that shareholders can use to sell shares;
- shareholder management in the affairs of the company;
- small numbers of shareholders.
Minority shareholders may be exposed to actions taken by majority shareholders which prevent their access to dividends or active participation in the management of the company, but because they are unable to sell their shares they may feel trapped in a situation in which they do not benefit financially from their shares at all.
Massachusetts courts recognize that minority shareholders are potentially vulnerable and treat such closely held corporations in a similar way as it does to partnerships in that it imposes a fiduciary duty on all shareholders to each other.
MA law and the concept of fiduciary duty
As a result of a landmark case (see further below) in 1975, state law ensures that both majority and minority shareholders must act in “utmost good faith and loyalty” to each other. This concept of fiduciary duty means that majority shareholders must act fairly to minority shareholders and avoid any actions, such as a freeze-out, which disproportionately advantage themselves at the expense of minority owners.
Freeze-out case law history
The landmark case that established the concept of fiduciary duty amongst shareholders in a closely held corporation was that of Donahue v. Rodd Electrotype Co. in 1975. The decision taken by the state’s Supreme Judicial Court in this case established that all shareholders in such a small business must treat each other with the same amount of loyalty similar to that expected in a business partnership.
An exception to fiduciary duty was established by the case of Wilkes v. Springside Nursing Home in 1976 which allowed a disadvantageous buyout in the event that a legitimate business purpose could be demonstrated (see further below).
One example of a court decision taken after a claim from a minority owner, in the case of Brodie v. Jordan in 2006, was the order for the majority shareholders to buy out the minority owner’s shares at fair value. The plaintiff had complained that the majority shareholders had refused to provide information about the company’s activity and had excluded him from management decisions.
A “legitimate business purpose” may validate a freeze out
Exceptions to the legal concept of fiduciary duty may occur if it can be proven that there was a legitimate business purpose in a decision by the majority shareholders which disadvantaged minority shareholders. The courts in Massachusetts assess whether such a decision balances the right of minority shareholders to fair treatment with the right of the majority shareholders to manage the company effectively.
This exception may hold if the majority shareholders can demonstrate clearly that they have a legitimate business purpose in their actions, but even in this situation, minority shareholders may still prevent any negative consequences if they can show that the objective of the majority could have been attained by some other method which was not so disadvantageous to the minority shareholders.
Legal remedies available for minority shareholders in MA
Minority shareholders may seek remedies for any negative action taken by majority shareholders through Massachusetts courts. After a review of the claim filed by the minority shareholders, the court may order any of the following actions to remedy the situation:
- fair value given to shares sold by the minority shareholders to the majority;
- compensation awarded to minority shareholders for negative actions taken;
- dividends or distributions ordered by the court;
- reversal of any removal of corporate management positions or termination of employment;
- amendments made to the governance system used by the corporation.
How minority shareholders can avoid a freeze-out
There are various ways that minority shareholders can pro-actively use to avoid a freeze-out. These include the following:
- Ensure that a clear and effective shareholder agreement is negotiated at the outset;
- Maintain oversight of corporate finances and governance procedures to prevent possible future abuses by any majority owners;
- Maintain comprehensive records of corporate decisions;
- Seek early legal advice from a business law attorney if there is any dispute or conflict.