Squeeze-out of minority shareholders in close corporations can take many different forms. One common technique is stock dilution. The careful minority shareholder will insist, before investing capital or sweat equity, on a shareholders’ agreement that preserves his or her percentage by a combination of preemptive rights, super-majority approval requirements for changes in authorized and issued shares, and other protective devices. Absent such bargained-for protection, however, is a minority shareholder’s stake at the mercy of the controlling faction?
The answer is a qualified "no", according to a recent decision by New York County Commercial Division Justice Herman Cahn in Dingle v. Xtenit, Inc., 20 Misc 3d 1123(A) (Sup Ct NY Co 2008), where the court elevated the controlling shareholder’s fiduciary duty over his reliance on statute and the business judgment rule in refusing to dismiss the minority shareholder’s wrongful dilution claim.
Xtenit is a closely-held New York corporation engaged in the business of developing, marketing and supporting computer software. Brian McFadden is Xtenit’s Chairman, CEO and majority shareholder. In 2001 Mark Dingle joined Xtenit as its COO. Under his employment agreement, because Xtenit was a start-up, Dingle agreed to accept 1.5 million Xtenit shares representing a 15% equity interest in lieu of salary until such time as the company had sufficient funds to pay its executives. Dingle’s shares were fully vested and issued by the time he resigned from Xtenit in September 2002. Apparently Dingle’s employment agreement did not require him to redeem his shares upon resignation.
According to Dingle’s complaint, when he contacted McFadden three and a half years later, in March 2006, to ask how Xtenit was doing financially, and to assess the value of his shares, McFadden told him that new shares had been issued and that he no longer had a 15% interest. It turned out that in October 2004, McFadden convened a special meeting of Xtenit’s board to approve an increase in Xtenit’s authorized shares from 10 million to 500 million. The meeting minutes stated that the shares "will be awarded to current officers of [Xtenit] and future employees" and that "[no] additional provisions will be made for existing shareholders of [Xtenit’s] common stock."
Dingle’s complaint alleged that McFadden was the only officer and director of Xtenit, and that McFadden received all the additional shares without paying for them, thereby diluting Dingle’s stock interest to less than 1%.
Dingle asserted derivative claims for rescission, unjust enrichment and breach of fiduciary duty, and individual claims seeking recovery in quantum meruit and unjust enrichment.
McFadden moved pre-discovery for summary dismissal of the complaint on the ground that his actions were authorized under provisions of the Business Corporation Law including Section 501(a), regarding the corporation’s power to issue shares authorized in its certificate of incorporation, and Section 801(b)(7) governing amendment of the certificate of incorporation to authorize additional shares. He also argued that his actions were shielded by the business judgment rule.
Justice Cahn denied the motion, holding that Dingle presented "a prima facie case of unequal shareholder treatment" in violation of McFadden’s fiduciary duty owed to minority shareholders as director and majority shareholder. Justice Cahn’s decision includes the following quotation from a 1975 decision by New York’s highest court in Schwartz v. Marien (37 NY2d 487, 492):
Departure from precisely uniform treatment of stockholders may be justified, of course, where a bona fide business purpose indicates that the best interests of the corporation would be served by such departure. The burden of coming forward with proof of such justification shifts to the directors where, as here, a prima facie case of unequal stockholder treatment is made out. Particularly is this so when it appears that members of the board of directors favored themselves individually over the complaining shareholder.
The burden of justification as articulated in Schwartz is to establish a bona fide independent business objective which "could not have been accomplished substantially as effectively by other means which would not have disturbed proportionate stock ownership."
Applying this standard, Justice Cahn ruled that:
Plaintiff has presented a prima facie case of unequal shareholder treatment by proof that new shares were authorized and issued, that they were not offered to plaintiff, and that McFadden obtained the new shares, with the result that plaintiff’s percentage interest in Xtenit went from 15% to less than 1%. McFadden has failed to present even a scintilla of evidence regarding a bona fide purpose for the dramatic increase in the number of authorized and issued shares in Xtenit. The statement in the minutes of the special meeting of the Board at which this action was approved, that the "extra shares will be awarded to current officers of the Corporation and future employees" fails to provide any such justification (Notice of Mot., Exh. B). In fact, no business justification at all is offered to sustain the authorization and issuance. Even if McFadden had offered a corporate purpose for this increase, which appears to have benefited only himself, there would be factual issues as to his motives and credibility. Moreover, without any discovery, plaintiff has not even had the opportunity to determine the facts and motives surrounding the authorization and issuance. (Citations omitted.)
Justice Cahn also rejected McFadden’s reliance on the business judgment rule, noting that the rule does not apply to self-interested decisions by directors and officers.
Absent from the court’s discussion is any mention of BCL Section 505(d) which authorizes close corporations, upon majority shareholder vote, to issue rights and options for shares to directors, officers and employees as an incentive to service or continued service with the corporation. Since it appears uncontested that Dingle was not given notice of the October 2004 increase in authorized shares, it also seems likely that McFadden did not hold a shareholders’ meeting in connection with the October 2004 board meeting, hence Section 505 doesn’t apply. Even assuming McFadden had followed proper shareholder authorization procedure, and further assuming the absence of independent directors recommending the increased stock authorization, a different outcome is unlikely assuming Dingle were to prove at trial his allegation that the company actually issued to McFadden the additional shares for no consideration.
There clearly are circumstances where a close corporation has a legitimate interest in authorizing and issuing additional shares to executives as incentive compensation or in lieu of salary. McFadden’s failure to articulate any business purpose for a fifty-fold increase in Xtenit’s authorized and issued shares naturally invites a high degree of suspicion. Perhaps McFadden was motivated by plans to sell the company. Whatever it was, it seems likely that after Dingle departed and was out of touch for two years, McFadden must have believed that Dingle had lost interest entirely. I’m also guessing that Xtenit is a subchapter C corporation, so Dingle was not getting K-1s that would have alerted him earlier to the dilution. The March 2006 phone call from Dingle must have been an unpleasant surprise for McFadden. In any event, as Justice Cahn’s Xtenit decision highlights, a controlling shareholder in a close corporation must be attuned to his or her fiduciary obligations before authorizing and issuing additional shares in a manner that dilutes minority shareholders.