Originally published by Ladd Hirsch.
The legal front remains forbidding for private company minority investors who seek to secure a buyout of their ownership stake based on claims for oppression against the company’s majority owners. It has been six years since the Texas Supreme Court eliminated a court-ordered buyout as an available remedy for minority shareholders claiming oppression, and no other legal avenue exists that provides minority owners with a buyout of their interest based on claims for mistreatment by business owners who manage the company. See Ritchie v. Rupe.[1] The best advice for minority investors therefore is simply this—before investing in a private business, minority owners need to insist on securing a buy-sell agreement.
We have written extensively about the terms of buy-sell agreements in previous posts (Read Here). A buy-sell contract provides investors with the right to obtain a buyout of their minority ownership interest in the company at a future time.
No Buy—Out For Breach of Fiduciary Duty
When minority owners have claims for misconduct by majority owners, these claims most commonly include: (1) breach of contract, (2) fraud, and (3) breach of fiduciary duty. None of these claims permit the trial court, however, to award the minority owner with the remedy of a buyout of his/her or its minority interest. Instead, the remedy for these claims is typically the recovery of actual damages. In the case of fraud, if the minority owner can prove that he/she was fraudulently induced to make the investment in the company, the court could rescind the transaction and require the majority owner to return the investor’s purchase price. Instances of outright fraudulent inducement are relatively rare, however, and this will not be a claim or remedy available to most investors. The fiduciary duty claim against the majority owner in control of the company does give rise to a potential shareholder derivative action, however, which is discussed below.
In Ritchie, the Supreme Court left open the possibility that a court-ordered buyout of the minority interest could be a remedy for breach of fiduciary duty claims against the company’s majority owners, because the Court remanded all fiduciary duty issues to the appellate court for resolution. At trial in Ritchie, the jury found that the majority owners had breached the informal fiduciary duties they owed to the plaintiff, but on remand, the Dallas Court of Appeals concluded that no fiduciary duty was owed to the plaintiff as a matter of law. Ritchie v. Rupe, No. 05-08-00615-CV (Jan. 12, 2016) (mem. op.). As a result, the appellate court did not have to decide whether the breach of a fiduciary duty could support a buy-out remedy for a minority owner. In the six years since Ritchie was decided in 2014, no Texas appellate court has held that a breach of fiduciary duty by the majority owners in control of the company authorizes a trial court to order a buyout of the minority owner’s interest in the company. At this point, more this six years after Ritchie, it does not seem likely that a trial court will step forward to seize the opportunity to impose a buy-out remedy for the first time based on a breach of fiduciary duty committed by the controlling officers, managers or directors of a private company.
No Receiverships Granted Since Ritchie Based on Shareholder Oppression
The Supreme Court in Ritchie did provide minority shareholders with one remaining remedy, although it is also not clear this remedy would allow them to monetize their ownership interest based on claims that the company’s control persons engaged in oppressive conduct. This remedy is the appointment of a “rehabilitative receiver,” which the Court concluded was the sole remedy authorized by the Texas legislature upon a finding of shareholder oppression based on the statutory language. See Section 11.402 of the Texas Business Organizations Code. Of note, the Court’s 6-3 decision rejected 25 years of prior decisions by numerous Texas appellate courts that had construed this provision. Before Ritchie, Texas appellate courts had consistently and universally concluded that the statute authorized trial courts to award a buyout and other lesser remedies as remedies for minority shareholder oppression rather than appointing a receiver. In any event, the Supreme Court did not make clear whether any receiver who is appointed by the trial court to “rehabilitate” the company in response to oppressive conduct would have the power to require a majority owner to purchase the minority owner’s interest in the business.
Moreover, since the Court’s decision in Ritchie, receivership as a remedy for oppression has proven to be illusory or non-existent. In the six years since Ritchie, we were not able to find any reported decisions in which a minority shareholder was able to secure the appointment of a rehabilitative receiver based on a finding of shareholder oppression. The only exception may be one case in which a receiver was appointed by the state court, but the case included a host of other claims, including fraud and misappropriation of trade secrets. The court cited to Ritchie in holding that because the Supreme Court had determined that the appointment of a receiver was the exclusive remedy available for oppression, the shareholder was not entitled to recover any compensatory damages based on this claim. In re Mandel, 578 Fed. App’x 376 (5th Cir. 2014).
In sum, the court appointment of a receiver to preside over a profitable company based on a finding of shareholder oppression by the majority owners may be a legal unicorn—something known but never actually seen. What the past six years have shown is that the Supreme Court’s Ritchie decision turned the oppression provision into a toothless legal statute, and the Court thus allowed a wrong by majority owners—minority shareholder oppression—to take place without a clear legal remedy to address the harm that has been suffered by minority shareholders.
Primary Claim for Minority Shareholder Abuse is Derivative Action
Without question, Ritchie decision represents a significant legal setback for minority shareholders who are being oppressed by the company’s control group. The Court in Ritchie, however, correctly pointed to the Texas derivative statute as one avenue available for relief by minority investors, and the derivative action has become the chief weapon wielded by minority owners in the post-Ritchie world. This statute provides minority shareholders with some notable advantages by removing a host of procedural requirements that exist in other states and which largely prevent these actions from being filed.
In Texas, the Business Organizations Code (TBOC) provides a straightforward path for minority investors in closely held corporations and limited liability companies to file claims on a derivative basis against the company’s officers, directors and managers who have abused their authority. See TEX. BUS. ORG. CODE §§ 21.563, 101.463. The term closely held is defined by the statute as a company with fewer than 35 shareholders or members and one that is not listed on a public exchange or quoted in an over-the-counter market. Id. Some of these important procedural advantages for minority shareholders in derivative lawsuits filed under Section 21.563, of the TBOC, are summarized below:
- The minority shareholder is not required to make a written demand on the company before filing suit. Most derivative statutes, including the one in Texas for non-closely companies, require a written demand to be issued to the company as a condition to filing suit and the company then has the right to respond after it has been provided as specified amount of time to conduct an investigation of the shareholder’s claim;
- The shareholder who is making the demand is required to establish that he/she will fairly represent the interests of the company. This “proper plaintiff” requirement does not exist or apply in the TBOC for closely held companies;
- Any recovery obtained in a typical derivative case is paid to the company, but under the TBOC, the trial court is authorized to award the amount of any recovery obtained in the suit directly to the minority shareholder (plaintiff) “where justice so requires,” and
- Finally, minority shareholders can recover their legal fees in bringing the claim under TBOC 21.561(b) in the derivative proceeding if the court finds that the case “has resulted in a substantial benefit to the corporation.”
As noted, following Ritchie, a derivative action is the most effective legal weapon available to minority shareholders in closely-held companies when they can show that the majority owners breached their fiduciary duties in managing the company. The key distinction is that the claim for shareholder oppression permitted shareholders to bring a direct (non-derivative) claim against the majority owners based on the harm their oppressive conduct had caused the shareholders to suffer individually. When shareholders bring a claim for breach of fiduciary duty, however, they must present evidence of harm not to themselves, but of harm sustained by the company. This “harm to the company” rule exists in derivative actions because the company’s officers, directors and managers owe their fiduciary duties to the company, and they do not owe fiduciary duties directly to the company’s shareholders or members.
This distinction is, perhaps, most important in considering dividends or distributions that are being withheld by the company. Under the oppression doctrine, a shareholder could contend that the withholding of dividends/distributions constituted oppressive conduct by the control group and that this practice is oppressive and has unfairly deprived the shareholder of profits that the shareholder was entitled to receive. By contrast, a shareholder will find it difficult to show that the company’s decision to retain earnings caused any harm to the business, when the business touts the value of retaining these profits for re-investment in and growth of the business. As a result, the company’s retention of earnings at the direction of its control group will not be seen as a breach of their fiduciary duties. Thus, while the fiduciary duty claim is powerful, it applies to a more narrow scope of improper conduct by those in control of the company.
Conclusion
The Supreme Court in Ritchie never acknowledged the existence of the real world in which family members, spouses and good friends frequently form, invest in and grow private companies together, but without formally documenting their rights as co-owners. The Court’s elimination of a court-ordered buyout as a remedy left these minority owners who do not have any type of buy-sell agreement with no legal exit right when they are subject to oppressive conduct by the company’s controlling owners. The resulting legal landscape after Ritchie should signal loudly to minority owners that they need to exercise significant caution before making private company investments. Specifically, before investing in a private company, minority owners need to secure a buy-sell agreement or other contract exit right, or they will be left without any right to demand a buyout of their ownership interest at any point in the future.
[1] Ritchie v. Rupe, 443 S.W.3d 856 (Tex. 2014).
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