Could Your Client Be an “Oppressed Shareholder?”
One of the many frustrations of practicing family law is that there is rarely, if ever, a decisive victory. Divorce is about doing “equity” and that rarely means a result where the Court finds that one side “wins” and the other “loses.”
Most family lawyers stay far away from the world of corporate shareholder litigation. After all, we do divorces, right? But many clients have organized their financial affairs such that husband and wife own shares in a family business. In fact, sometimes the wife will hold 51% so that the business can qualify as minority controlled. But, let’s change up the facts a bit and assume Husband owns 50% of the family business. He set it up that Wife owned 50% but after a few years he and wife agreed that 10% of the shares would go to a key employee; the man or woman who husband considers indispensable to the business. So, when the separation occurs Husband owns 50%; wife 40% and key employee 10%.
The typical owners of small family businesses pay no attention to issues like corporate governance, shareholder agreements or minority shareholder rights. Yet, in almost every state the corporation laws are replete with statutes and caselaw addressing minority shareholder rights. The laws can be different from state to state and realize that many businesses are incorporated in Delaware even though the owners of the corporation would be hard pressed to find Delaware on a map. The principles behind these laws are that you can’t cheat minority shareholders or deny them access to information about their investment. Again, many, if not most small businesses have never given a thought to these issues and that opens an interesting door.
In 2005, the Superior Court of Pennsylvania decided Adler v. Tauberg, 881 A.2d 1267. Adler is a shareholder who filed an action asking for a receiver be appointed to manage a corporation in a setting where Adler had been President of a corporation but a majority of shareholders demanded he step down and a substitute be appointed in his place. Adler was a physician in a medical practice and when he didn’t comply with the requests of his fellow shareholders he saw his own professional schedule cut and his earnings reduced. His fellow professionals who were also shareholders attempted to bring in a new physician who would acquire Adler’s patients and portions of his income. When Adler resisted his two fellow physician owners voted to increase the number of shares and award them to the person they wanted to replace Adler. They also voted to reduce Adler’s income and increase theirs. They voted to reduce Adler’s corporate authority and employ/pay a new attorney to represent the practice.
In Pennsylvania, where a shareholder or group act illegally, oppressively or fraudulently toward fellow shareholders who own more than 5% there is an event legally described as a “freeze out.” This typically involves action to reduce the powers or compensation of an existing shareholder. 15 Pa.C.S. 1767. In Pennsylvania, New York and New Jersey the Courts look to the reasonable expectation of the existing shareholders. The remedy available to the oppressed shareholder is appointment of a custodian or receiver to assure that all shareholders are treated fairly. The Adler case is unusual because the plaintiff actually controlled half (50%) of the shares. But clearly his fellow shareholders had seized control by admitting new shareholders and cutting his patient load and compensation without his consent.
Adler sued for someone to take control of what he asserted was a runaway corporation. His burden was to show that he had fallen prey to “burdensome, wrongful conduct visibly departing from principles of fair dealing and violating fair play.” Pennsylvania , New Jersey and New York employ a test predicated upon the reasonable expectation of the shareholders.
How does Adler have a place in family law? Because when shareholders are also spouses it is not uncommon for games to be played, especially when things are not happy at home. In our fact pattern, the 50% owner is married to a 40% owner. Mr. 50% united with the 10% owner he brought to the business to fire or change the responsibilities and compensation of the 40% owner. The changes and their effect promoted no valid business purpose. It merely punished the 40% owner to the immediate benefit of the oppressive majority.
The case is a complicated one but the takeaway is that where one shareholder employs tactics that visibly harm the economic or management rights of another shareholder or the interests of the corporation, a court can act to protect the oppressed shareholder. What’s important about Adler is its acknowledgment that even 50% owners can be oppressed. This is also true in “deadlock” situations where there are two 50% shareholders or three 33.33% investors.
How does this apply in a family setting? Doctors A&B are spouses and each 50% shareholders of a dermatology practice. They admit Dr. C with her 10% coming out of the Dr. B’s shares. Drs. A & C now act to erode the practice responsibilities and compensation of Dr. B to her detriment. A court finds no bona fide business reason for these decisions, so it appoints a receiver to manage the practice. The Superior Court affirmed that receivership. A court also has the power to order the liquidation of the practice or its sale.
Shareholder oppression is fairly common where two spouses own a business and the marriage disintegrates. The once friendly and efficient shareholders A&B now declare war on each other and Dr. C allies with Dr. A. They play games with Dr. B’s practice and compensation to her visible detriment. Adler stands for the proposition that Dr. B has a remedy in the courts, even if it means removing control and handing it to a neutral who will be paid to intervene in management.
If you have ever had any experience with a third party managing a business you know that it often causes the worst result for all owners. The third party won’t be a physician let alone a productive dermatologist. so there is no contribution to revenue, only the cost. The neutral often is clueless about the practice or its economics. We have even seen situations where the neutral running the business neglects to pay things like payroll taxes, insurance or retirement contributions, inflicting unnecessary pain and cost on all parties for no good reason. Yet the third party is entitled to compensation for services and he or she is often “friendly” with the judge who selected them. After a receiver is appointed, the warring parties often find common ground on one subject; the third party receiver is an expensive nightmare for all. A receiver who fails to pay employee payroll taxes or insurance can often trigger a default of loan covenants and that can trigger a bank to close the otherwise unhappy but productive business.
How does this play into a divorce case? Appointment of a third party receiver pushes a corporation into a kind of legal “hyperspace.” If your client is Dr. B. she feels her professional life is out of control because Drs. A & C have seized control of her practice. When she files for a receiver, the practical threat is that all of the professionals and employees in the practice will be “ruled” by any receiver who is appointed. This threatens the welfare of all and causes everyone to think about how bad a receivership can be. We have worked with receivers, some honorable and well intentioned who did incalculable damage to the otherwise fruitful business because they didn’t understand the business and how it operated.
So, if you have the oppressed shareholder and ordinary resort to special relief applications in divorce does not look promising, think about filing under the Business Corporation Law for a receivership. It is what the U.S. Senate and nuclear deterrence specialists call the “nuclear option.” You file for relief, then contact the oppressing shareholder and any fellow conspirators and say: “If we don’t all get reasonable about management matters, the golden goose may be dissolved and we will all be seeking other employment.” Dr. A may be so angry about these events that he will profess not to care. But Dr. C is going to ask: “Am I risking my practice, income, and livelihood because my two knucklehead partners have decided they want a divorce war? Hell no!” The threat may cause everyone to put down the cudgels and take a reasonable approach. The leading Pennsylvania case is:
Adler v. Tauberg, 881 A.2d 1267 (Pa. Super. 2005)
https://caselaw.findlaw.com/pa-superior-court/1250965.html
There are two related articles in the Pennsylvania Bar Quarterly that address minority oppression and derivative actions. They can be found at:
http://galfandberger.com/files/2013/09/Minority-Shareholder-Freeze.pdf
https://www.utbf.com/downloads/PABAR-Dwyer-April-2013.PDF
The cases cited in these articles and more recent cases referencing them are not a light read and family lawyers are counseled to tread in this ground carefully. But few things are more frustrating to a client than the feeling of powerlessness associated with being an investor in a business entity and observing other shareholders either seizing control without valid purpose or diminishing value by not protecting corporate interests. Those who exercise control have a duty to protect and promote the interests of the business enterprise. Emotion and self interest sometimes blind those actors and keep them from doing the “right thing.” Derivative and oppressed shareholder actions send a clear signal that they do so at their peril. They key here is that by filing under the corporation laws, you are sending a clear message that unless everyone plays nicely in the corporate pool, there may be a third party appointed lifeguard or that the pool might have to be drained.
For a discussion of minority shareholder rights, see this blog published on 8/5/16 under “Shareholder Rights”
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