“I formed a business with two partners a couple of years ago. We set up a corporation, and divided the stock three ways. My brother and I each had 40 percent of the company, and a good friend of ours had the remaining 20 percent.
“Things went well for a while, but then our friend with the 20 percent developed other interests and began withdrawing from the business. We tried to reason with him, and offered to buy him out under our Stockholders’ Agreement, but he stonewalled us, accusing us of not running the business properly, and it came to the point where he stopped returning our phone calls. We called a meeting, to which he didn’t show up, and voted to remove him from the board of directors and terminate his employment with the company.
“We didn’t like the fact that he still owned 20 percent of the company, but my brother and I figured he would come to his senses eventually and agree to be bought out, so the two of us paid ourselves a ‘bonus’ at the end of each year so there would be no profits left over to split three ways. Recently, my brother and I were slapped with a legal notice saying our former friend had sued to dissolve our company and was claiming 20 percent of everything the corporation owns. Can he legally do that?”
Depending on the rights he is granted under your state’s corporation law, the answer may well be “yes.”
It used to be that the minority owners of a corporation had no meaningful rights at all — they were at the mercy of the majority owners, who could treat them any way they wished and “freeze” them out of management. Back in the 1920s, somebody wrote a treatise for corporate lawyers on “The Oppression of Minority Shareholders” describing the many techniques for doing so — that book is still in print after 90 years and runs to several thousand pages.
In an effort to give minority shareholders some rights, a growing number of states, particularly in the northeastern United States, have passed laws allowing the holders of a significant minority of shares (usually 10 percent to 20 percent of the total outstanding) to petition a court to dissolve the corporation if the majority owners engage in “harmful and oppressive conduct” toward the minority holders. If harmful and oppressive conduct is found, the court can dissolve the corporation and put its own valuation on the corporation’s assets to determine how much the 20 percent owner (and all of the other owners) will receive when the company is liquidated. Not a good thing.
In New York, the state that first adopted this law, majority conduct is harmful and oppressive when it “substantially defeats the reasonable expectations of minority shareholders,” including the expectation to be actively involved in the company’s management and operation. By terminating your friend’s employment and kicking him off the board, you may have given him the right to ask a court to dissolve your corporation. You may have a defense, since it sounds as if you made every attempt to work things out with him and buy him out for a fair price, but you will have to talk to a local lawyer to see how strong that defense will be.
You should also look at your Shareholders’ Agreement. If that agreement calls for a mandatory buyout at a below-market price of any shareholder who files a petition of judicial dissolution, you may be able to get the court to enforce that provision, allowing you to buy your friend out for the price stated in the Agreement rather than the price independently determined by the court.
If the Shareholders’ Agreement does not allow you to force a buyout, you may be able to agree on a settlement where your 20 percent owner would withdraw his dissolution petition in exchange for 20 percent of your corporation’s fair market value, determined via a “Three Stooges” appraisal: The corporation would appoint one appraiser, your friend would appoint another, and the two appraisers would independently value the corporation. If the two appraisers’ values differ by 10 percent or less, you split the difference, and that’s the agreed value. If the two values differ by more than 10 percent, the two appraisers appoint a third appraiser, who acts as arbitrator and makes the final determination. A “Three Stooges” appraisal is very time-consuming and costly, and, as the name implies, there’s no guarantee the three appraisers will behave in a rational manner.
If your former friend has an unreasonable expectation about what the business is worth, then your only recourse may be to allow your corporation to be dissolved, pay your former friend 20 percent of the value determined by the court, and then form a new corporation with the remaining assets that will be owned by just you and your brother. And make sure to draft a better Shareholders’ Agreement this time.