Tom Rutledge (pictured) is an extraordinary combination of practicing lawyer, scholar, bar leader, lecturer, and prolific writer on business organizations. He’s a member of Stoll Keenon Ogden PLLC resident in its Louisville, Kentucky office and, among his many extra-curricular activities, is chair of the ABA Business Law Section’s Committee on LLCs, Partnerships and Unincorporated Entities. When Tom questions engrained notions about shareholder oppression in closely held businesses, people take notice.
I, for one, took notice of Tom’s thought-provoking article in the July-August 2014 issue of the Journal of Passthrough Entities entitled “Minority Shareholder Oppression? — The Problem is Not With the Answer But Rather With the Question.” Targeting legal doctrine that, Tom contends, improperly treats the majority’s termination of a minority shareholder’s at-will employment as an act of oppression, the article takes issue with what Tom calls the “classic prevailing analysis of shareholder oppression” under which courts are expected
to modify the contractual terms of the corporate form to create and enforce rights not afforded by the statute and not, as to the venture at hand, negotiated for and incorporated into the agreements comprising the venture.
In other words, the “classic formula under which the ‘oppression’ of minority shareholders and members is framed,” as Tom puts it, in the case of the terminated minority shareholder places the remedial cart before the rights-and-obligations horse. It does so, first, by failing to acknowledge the “separate and distinct” legal relationships that arise from the “corporate contract” as opposed to the “employment relationship” and, second, by encouraging ex-post judicial modification of the former by deeming oppressive conduct (i.e., termination of an at-will employee) that is fully sanctioned by the latter’s governing principles.
Corporate Contract vs. Employment Relationship
What is the “corporate contract”? Tom describes it as a “mesh of overlapping” contracts encompassing the shareholders’ obligation to contribute capital in exchange for shares having certain defined benefits; the rights and fiduciary obligations undertaken by persons elected to the board of directors to manage the corporation’s affairs; the procedural rules and limitations contained in the by-laws; the subordination of shareholder distributions to the rights of creditors, and so on. “Notably,” Tom writes, “these contracts are not personal,” meaning that when someone transfers or terminates his or her status as shareholder, director, or creditor, the rights and obligations associated with that status also terminate.
Tom contrasts these “multi-lateral” corporate relationships with the “bilateral and unique” nature of the employment relationship between the corporation and its employee who also happens to be a shareholder. As Tom explains,
None of the other shareholders, the directors, the officers or the corporation’s creditors are parties to that employment arrangement. It is unique in that the agreement is that the corporation will employ a particular person; there is no capacity in the employee to substitute the services of another for his or her own. Based upon these distinctions, the employment relationship of a shareholder versus his or her employer corporation needs to be assessed under the contractual principles of employment law rather than as an aspect of the law of corporations; the employee’s status as a shareholder is immaterial.
The Contractarian Argument
Tom’s article uses the example of the at-will shareholder-employee’s termination to promote the broader, contractarian argument that calls for stakeholders in a business entity — be it a partnership, corporation or limited liability company — in Tom’s words, to “accept all of the consequences, both benefits and burdens, of the choice of entity decision that is made” subject only to those additional or different rights and obligations that the stakeholders negotiate and contract for ex-ante. Tom writes:
If an actor chooses, whether consciously or otherwise, to not negotiate particular terms as to the relationship, then “they’ve only themselves to blame” when it comes to pass that the default rules of the relationship do not yield him or her protections that, ex post, the structuring of the relationship, he or she wishes were in place.
Professor Benjamin Means, whose writings Tom’s article cites as counter-point, and whom I interviewed for this blog, nicely summarizes both sides of the contractarian debate in the abstract to his article entitled “A Contractual Approach to Shareholder Oppression Law”:
According to standard law and economics, minority shareholders in closely held corporations must bargain against opportunism by controlling shareholders before investing. Put simply, you made your bed, now you must lie in it. Yet, most courts offer a remedy for shareholder oppression, often premised on the notion that controlling shareholders owe fiduciary duties to the minority or must honor the minority’s reasonable expectations. Thus, law and economics, the dominant mode of corporate law scholarship, appears irreconcilably opposed to minority shareholder protection, a defining feature of the existing law of close corporations.
The New York Experience
In New York as in most other states, the statute providing oppressed minority shareholders with standing to seek judicial dissolution does not define oppressive conduct, which has been left to the courts to define. New York’s highest court, in its 1984 decision in Matter of Kemp & Beatley, Inc., adopted a reasonable-expectations test for oppression, stating:
A shareholder who reasonably expected that ownership in the corporation would entitle him or her to a job, a share of corporate earnings, a place in corporate management, or some other form of security, would be oppressed in a very real sense when others in the corporation seek to defeat those expectations and there exists no effective means of salvaging the investment.
The court quoted with approval a leading commentator on close corporations who observed even more pointedly that, in many instances, those who acquire ownership interests essentially are buying themselves a job and a salary, where
participation in that particular corporation is often his principal or sole source of income. As a matter of fact, providing employment for himself may have been the principal reason why he participated in organizing the corporation. He may or may not anticipate an ultimate profit from the sale of his interest, but he normally draws very little from the corporation as dividends. In his capacity as an officer or employee of the corporation, he looks to his salary for the principal return on his capital investment, because earnings of a close corporation, as is well known, are distributed in major part in salaries, bonuses and retirement benefits.
Five years after Kemp, in a case called Ingle v Glamore Motor Sales, Inc., the same court rejected a minority shareholder’s contention that his status as such exempted him from the at-will employment doctrine and allowed him to seek a remedy for wrongful termination of his employment. (Read here my post on Ingle.) Sounding much like Tom in his article, the Ingle court wrote:
A minority shareholder in a close corporation, by that status alone, who contractually agrees to the repurchase of his shares upon termination of his employment for any reason, acquires no right from the corporation or majority shareholders against at-will discharge. There is nothing in law, in the agreement, or in the relationship of the parties to warrant such a contradictory and judicial alteration of the employment relationship or the express agreement. It is necessary in this case to appreciate and keep distinct the duty a corporation owes to a minority shareholder as a shareholder from any duty it might owe him as an employee.
The Ingle court, however, was careful not to imply that its ruling as to the minority shareholder’s employment rights and remedies negated any rights and remedies he might have as an oppressed minority shareholder under the dissolution statutes, stating that “[w]e have no occasion to address issues involved in cases where the minority shareholders may be discharged solely to avoid assertion of the legal rights afforded to them under [those statutes].”
The Kemp/Ingle diptych highlights an important distinction between a minority shareholder’s rights as shareholder and his or her rights as employee, namely, the different remedial schemes attached to each. Generally speaking, an employee’s remedy for wrongful termination is damages for lost employment income retroactively and sometimes prospectively. The statutory remedy afforded oppressed minority shareholders is judicial dissolution paired, in New York and most other states, with the majority shareholders’ corresponding right to avoid dissolution by purchasing the minority shareholder’s stock for fair value.
Is There a Contradiction?
With the remedial distinction in mind, the question arises, is there a real-world contradiction between enforcement of employment law’s at-will doctrine and recognition of a minority shareholder-employee’s termination of employment as ground for a judicial dissolution petition?
I don’t think so, though I must confess an attraction of the theoretical kind to Tom’s point of view. If I was designing the law of business organizations on a clean slate, with the objective to organize relations between business co-owners so as to minimize judicial oversight, likely I would opt for a contract-based system dependent primarily on the private ordering of rights and obligations including employment rights, though I might also require that all prospective business owners sign some sort of state-sponsored acknowledgement form, akin to the Surgeon General’s warning on tobacco products, advising them that becoming a minority shareholder without consulting counsel and negotiating adequate contractual safeguards is a danger to their financial health. In such a brave new corporate world, if you didn’t bargain up front for rights over and above those provided by the standard form, you couldn’t later seek a judicial remedy for their subsequent, alleged deprivation. You made your bed, now you must lie in it.
But as someone who’s been in the business-divorce trenches for almost 30 years, I’m convinced that, on a case-by-case basis, and applying their wise discretion, judges can and ought to employ their remedial powers, including dissolution and compelled buy-outs, to intervene on the side of oppressed minority shareholders even when the minority shareholder failed to bargain for rights of employment, or a seat on the board, or an officer’s title.
- Too many times, I’ve encountered business owners who, out of trust and/or for lack of resources, never made a shareholders’ agreement or, if they did, signed whatever was put before them without having a clue what rights and obligations it conferred.
- Too many times, I’ve encountered business owners (and some lawyers too!) who were utterly clueless as to the differences among partnerships, corporations and limited liability companies, and who simply went along with whichever form their attorney or accountant put them into.
- Too many times, I’ve encountered sons, daughters, nieces and nephews who were brought into the family business and given ownership interests with no realistic opportunity to negotiate employment and management rights.
- Too many times, I’ve encountered owners who managed their business as an informal partnership, with nary a board or shareholders meeting, much less meeting minutes.
- Too many times, I’ve encountered corporation kits that functioned as dust collectors, containing blank stock certificates, a blank stock ledger, and unsigned, boilerplate by-laws.
- Too many times, I’ve encountered majority shareholders who give themselves salary increases and bonuses after terminating the employment of a minority shareholder.
Judges wield the power of dissolution, and its attendant lesser remedies including buy-out, as courts of equity. I don’t think the contractual concerns underlying the law of employment, and which give rise to remedies distinct from those available to oppressed minority shareholders, should be a deterrent to the judicial power granted by the dissolution statutes.
Update October 22, 2014: Click here to read Tom Rutledge’s follow-up post called “A Bridge Too Far In Shareholder Oppression?” in which he comments on a recent New York dissolution case in which the petitioning minority shareholder alleged oppression based on the controlling shareholder’s termination of the petitioner’s husband’s at-will employment with the company.