Disclosure: The author represents the plaintiff and argued the appeal in the case discussed in this post.

Minority shareholder oppression takes many forms, the most common ones being termination of the minority shareholder’s employment, expulsion from the board of directors and payment of excessive compensation to the controlling shareholders.

Oppression also can take the form of stock dilution, as occurs in the absence of preemptive rights when the controlling shareholders authorize and issue new shares to themselves without providing minority shareholders the opportunity to maintain their percentage interest. The Xtenit case, in which the controlling shareholder authorized and granted himself new shares sufficient to dilute the minority shareholder from 15% to 1%, is one of the more notable examples of a court placing the burden on the controlling shareholder as fiduciary to demonstrate a bona fide business purpose for such unequal shareholder treatment.

This principle was reaffirmed in a recent decision by the Appellate Division, Second Department, in Armentano v. Paraco Gas Corp., 90 AD3d 683, 2011 NY Slip Op 09075 (2d Dept. Dec. 13, 2011), involving a dispute between the second generation shareholders of a family-owned propane distribution business. The decision in Paraco primarily turned on whether the bonusing of treasury shares to the controlling shareholders had a dilutive effect on the minority shareholder’s stock interest. The lower court held that it did not and dismissed the complaint. The appellate court unanimously reversed the lower court’s order, holding that the plaintiff’s complaint sufficiently alleged that the controlling shareholders breached fiduciary duty by granting themselves treasury shares without  legitimate business purpose and for the sole purpose of diluting the minority shareholders.

Paraco Gas, based in Westchester, New York, is among the largest propane distributors in the United States with sales over $100 million. At one time the company’s founder, Pat Armentano, and his four sons all worked in the business. At the time of Pat’s death in early 2010, his sons Joseph and John managed the business and held a majority of the shares. His two other sons, Robert and Michael, who had left Paraco’s employment to pursue other ventures, held minority stakes consisting of non-voting Class B shares.

Paraco’s capital stock included a number of Class A voting and Class B non-voting shares held in treasury. Joseph and John, holding two of the board’s three seats, approved annual stock bonus compensation plans for themselves under which they received (and will continue to receive) shares of Paraco stock from treasury.

Robert filed suit in mid-2010, alleging that the stock bonus plans had no substantial business purpose and were adopted solely to dilute the shares of the minority shareholders. Robert’s complaint alleged self-dealing, breach of fiduciary duty and unjust enrichment, and sought rescission of the bonus shares given to Joseph and John out of treasury.

Joseph and John moved to dismiss the action, arguing that the complaint failed to plead valid causes of action and that all of the claims were precluded by the business judgment rule. They contended that the bonus treasury shares were issued pursuant to proper employment agreements and that in any event the utilization of treasury shares did not dilute the number or value of Robert’s shares.

By Decision and Order dated August 11, 2010, the lower court granted defendants’ motion, finding that the challenged stock bonus plans “did not dilute the number of shares held by plaintiff, which remain the same both in number and percentage of stock ownership.” The lower court also found that, absent a showing of “bad faith” the compensation of corporate officers is “a matter within the purview of the board of directors” immune from judicial scrutiny under the business judgment rule.

Robert’s subsequent appeal focused on the nature of treasury shares which are defined in Section 102(14) of New York’s Business Corporation Law (“BCL”) as:

shares which have been issued, have been subsequently acquired, and are retained uncanceled by the corporation. Treasury shares are issued shares, but not outstanding shares, and are not assets.

Under other express provisions of the BCL, Robert argued, treasury shares carry no entitlement to dividends or voting rights, and do not participate in the surplus of the corporation. Thus, when treasury shares are re-issued to select shareholders and once again carry voting and dividend rights, and the right to participate in the corporate surplus, as a matter of simple math the proportionate interest of the other shareholders becomes diluted. Robert also argued that the business judgment rule does not apply to the self-dealing conduct of the defendant directors in approving stock bonuses for themselves.

In opposition, the defendants argued that the treasury shares did not increase the capitalization or the number of Paraco’s outstanding shares, and that the complaint did not offer factual support for its allegations that the stock bonus agreements diluted plaintiff’s shares, or that the stock bonus plans lacked a substantial business purpose.

The Appellate Division agreed with Robert and reversed the lower court’s order. Its decision notes that the directors of a corporation have a fiduciary duty to treat all shareholders fairly and evenly, including when it comes to issuing stock. The court also referred to the directors as “trustees” for all the shareholders in regard to the issuance of shares, and that as such they are prohibited from increasing their own proportionate interest in breach of their duty, although “‘[d]eparture from precisely uniform treatment . . . may be justified . . . where a bona fide business purpose indicates that the best interests of the corporation would be served by such departure'” (quoting Schwartz v. Marien, 37 NY2d 487, 492 [1975]). The court then ruled:

Here, affording the complaint liberal construction, accepting the facts alleged therein as true, and according the plaintiff the benefit of every possible favorable inference, the complaint sufficiently alleged that the Armentano defendants, as directors of the corporation, breached a fiduciary duty owed to the plaintiff, and the other shareholders similarly situated, by issuing to themselves treasury shares without a legitimate business purpose and for the sole reason of diluting the equity interest held by the plaintiff and the other shareholders. Moreover, the complaint sufficiently stated a cause of action to recover damages for unjust enrichment, as it alleged that the Armentano defendants were unjustly enriched by receipt of the treasury shares, at the expense of the corporation and its shareholders, and that it is against equity and good conscience for them to retain the treasury shares. [Citations omitted.]

The Appellate Division also held improper the lower court’s reliance on the business judgment rule, which “‘does not foreclose inquiry by the courts into the disinterested independence of members of the board of directors of a corporation and cannot shelter individuals from responsibility for breaches of duty of care they owe as directors'” (quoting Ench v Breslin, 241 AD2d 475, 476 [2d Dept. 1997]).

In the realm of corporate finance — especially for public companies — the acquisition and re-issuance of treasury shares can serve a valid purpose. Public companies will often repurchase their own shares on the open market to protect against a takeover threat, or to enhance shareholder value when the stock’s market price is under-valued, or to create a pool of treasury shares available for use as incentive compensation for employees.

These reasons have little or no application to closely held corporations. In any event, the appellate decision in Paraco puts to rest the notion that no dilution occurs when directors of closely held corporations grant themselves treasury shares. It also reinforces that the business judgment rule does not obviate the directors’ heavy burden to demonstrate a legitimate business purpose for departing from their general duty to treat all shareholders equally in relation to the issuance of shares.