Dealing with – or being – a minority shareholder can be problematic, and friction between majority and minority owners is not uncommon. The majority owner may find itself hamstrung in its efforts to conduct business by the unreasonable or obstructionist demands of a minority owner. Or the minority owner may find itself confronted with a majority owner who simply doesn’t want to share potential profits or opportunities.
Whatever the impetus for wanting to be rid of a minority owner, the majority-initiated freeze-out merger is one of the most common tools used to achieve that goal. In its simplest, “classic” form, the majority owner creates a new, separate corporation that offers to buy all the first company’s stock. The majority owner then uses its greater voting power to accept that offer, buys out the minority owner(s), and is left as the sole owner of the resulting company.
Freeze-out mergers have been an accepted part of Arizona business practice for decades, but a footnote in the recent decision of World Egg Bank v. Nesco Investments suggests that the rules governing majority-initiated freeze-out mergers may be dramatically changing.
There’s a long-standing controversy over freeze-out mergers.
Courts and commentators have been divided for decades over the merits of freeze-out mergers. A freeze-out may be the only way to remove an obstructionist minority shareholder that’s blocking company strategy and is unwilling to be bought out voluntarily. On the other hand, freeze-outs can be prone to abuse, depriving minority holders of their stake in a profitable business for the financial benefit of the majority owner.
The states are likewise divided in their treatment of these mergers. Many follow the traditional Delaware approach, known as the “entire fairness” test, which allows freeze-out mergers if they are: (1) carried out for a legitimate corporate purpose; (2) implemented fairly; and (3) the minority holders receive a fair price for their shares. Critics say this approach is ambiguous, because it can lead to litigation over what is “legitimate” and “fair.”
As a counterpoint, the ABA crafted the Model Business Corporations Act, which says that, in the absence of fraud or illegality, a minority owner’s only recourse to a freeze-out is to request a court-supervised appraisal of its shares. Under this approach, “fair price” is the sole criteria for judging the propriety of the merger. The Model Act has been adopted in a slim majority of states, including Arizona, which adopted the “appraisal” approach in 1994.
Regardless of whether a state uses the “entire fairness” or “appraisal” approach, majority owners attempting a freeze-out often run afoul of two other legal doctrines: (1) corporate directors must refrain from self-dealing, and (2) majority shareholders in closely-held corporations have a fiduciary duty to the minority. Courts in “entire fairness” states often find that violation of these duties renders a merger “unfair.” And courts in “appraisal” states often hold that violation of these duties constitutes the kind of fraud that allows minority shareholders to raise challenges to the merger beyond just seeking an appraisal. When that happens, the entire merger can end up invalidated.
The footnote heard ‘round the world…or at least around Arizona.
Arizona has been an “appraisal” state for 25 years. However, the Court of Appeals has hinted that our state may take a third path that simply bypasses both of these two tests.
In World Egg Bank, the 93% owner resolved to sell the company to her wholly-owned affiliate, and the 7% minority owner demanded an appraisal. The issue before the Court of Appeals was whether the shares should be valued as of the date the vote was held to approve the merger, or the date on which the shares were actually transferred, nearly a year later. The court held that the transfer date controls.
More importantly for this article, the Court also dropped a footnote indicating that the entire merger was probably invalid. In footnote 5, the Court observed that “to be sure, the sale was a ‘director’s conflicting interest transaction’” under existing Arizona law, thus the majority owner “was not entitled to vote [her] shares to authorize the sale.” In other words, in this closely-held, two-person corporation, only the minority shareholder was legally entitled to vote on the proposed merger because the majority owner’s interest in the transaction precluded her from voting. Thus, according to the footnote, the entire transaction should never have occurred.
Unfortunately for the minority shareholder, she didn’t make this objection at the shareholders’ meeting when the merger resolution was approved or raise the issue in the trial court, so the Court of Appeals held that she had waived her right to challenge the merger on this basis. But the next minority shareholder in a freeze-out may have a very different experience.
Freeze-outs may not survive the next hot Arizona summer.
For the moment, the World Egg Bank footnote is dicta; that is, a comment on the law that was not essential to the court’s decision and therefore does not constitute binding precedent. So this issue still remains to be decided in some future case. However, if this approach becomes the rule, it would dramatically change the availability of freeze-out mergers.
Under World Egg Bank, the minority shareholder’s approval could become the deciding factor in whether an “internally-initiated” merger can go forward. Ironically, this is exactly the situation that the Model Act was designed to avoid; Arizona’s appraisal statutes say that, absent fraud, the minority’s objection is irrelevant because any unfairness to the minority will be remedied by the appraisal process. Even under the Delaware “entire fairness” test, the lack of minority shareholder approval is just one factor in determining fairness, and its absence doesn’t nullify the merger. World Egg Bank flips these rules on their heads by precluding the majority holder from voting, so now the merger simply can’t happen if the minority objects.
While the footnote is dramatic, it also isn’t entirely a surprise. The concept is consistent with early Arizona case law, as our courts have traditionally been staunch defenders of minority shareholder rights. It’s also consistent with the 2016 revisions to the Model Act, which propose stepping away from appraisal as the exclusive remedy in some cases, including when a merger has not been approved by a majority of the “disinterested” owners. It could thus be argued that the Court was properly acting in accord with existing precedent, or that it was stepping on the Legislature’s toes by preemptively adopting changes to the Model Act.
Key takeaways from the World Egg Bank decision.
We emphasize that Arizona law hasn’t officially changed, but the Court wasn’t shy about saying what it believes the law should be. So, the writing is very much on the wall. There are a few practical takeaways that minority and majority shareholders should keep in mind.
Minority shareholders facing a potential freeze-out need to avoid waiving the issue like the World Egg Bank plaintiff. The shareholder must raise the conflict-of-interest objection in the boardroom, when the merger is proposed and voted upon, and again in any subsequent legal proceedings regarding the merger. Challenges should be made in writing so there’s a formal record to show the Court if necessary. The minority holder shouldn’t skip a vote that appears to be futile and must make sure that its “no” vote is tallied on the record.
For companies seeking to separate themselves from a minority holder, a freeze-out merger may no longer be the way to do it—or at least not in the “classic” form. In larger corporations where other shareholders may also favor the merger, a freeze-out can still be approved over a dissent. But in closely-held corporations with only a handful of shareholders, the minority holder may now effectively hold a veto power, and companies will need to be more cautious and creative in pursuing their goals.
Are you navigating complex corporate legal issues either as a shareholder or company officer? If so, the attorneys at Ryley Carlock & Applewhite can help you make sense of your unique situation and can advise you in a manner consistent with your business goals.