The Rights of Minority Owners in Closely-Held Businesses

Farrell Fritz, P.C.
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The pages of this blog are filled with cases pitting a minority owner of a closely-held business—most often a corporation or an LLC—against the majority. Books and records proceedings, derivative actions brought on behalf of the company, bids for dissolution, and cases seeking to enforce the terms of the owners’ agreement, are all different litigation strategies in the minority owner’s playbook.

As these and other posts make clear, the law in the area of minority owners’ rights is incrementally evolving with each new case and decision. Every so often, however, we must take a step back and consider the body of minority owners’ rights more generally. Otherwise, we risk losing sight of the forest among all those trees.

This post and a webinar in which I recently spoke (available here) seek to provide a broader-than-usual overview of the rights of minority owners in New York corporations and LLCs. A potential investor, a nascent company choosing its structure, or a minority owner crafting her litigation strategy would be wise to peruse this refresher.

Depending on the nature of the closely-held company—most often, a corporation or an LLC—and subject to the terms and rights set forth in the owners’ agreement, the rights of a minority owner are established both by New York’s statutory regime (for corporations, the Business Corporation Law; for LLCs, the LLC Law) and the common law. Significant minority rights include:

The Right to Vote on Company Action / Participate in Management

Minority shareholders’ rights to participate in the management of a corporation are limited. They can vote to elect the Board of Directors (BCL 614), vote on a merger or consolidation of the corporation (BCL 903), vote on an amendment to the Certificate of Incorporation (BCL 803), and vote on items requiring shareholder approval in the shareholders’ agreement. Beyond those voting rights, however, minority shareholders do not have a right to be involved in the day-to-day operations of the business.

A minority member in an LLC may have more substantial management rights, depending on the nature of the LLC. In a member-managed LLC (the default under New York law [LLC Law 401]), the members are vested with the right and ability to run the company. Thus, a minority member in a member-managed LLC may have the independent authority to hire and fire employees, manage accounts, make payments and enter into contracts on behalf of the company. A manager-managed LLC is more like a corporation; the members simply elect the managers, and the managers have day-to-day authority over the company.

The Right to Inspect Books and Records

Minority shareholders are entitled to inspect the books and records of corporation under both BCL 624 and the common law right of inspection. BCL 624 allows a minority shareholder to inspect (i) annual balance sheets and income statements and, (ii) upon a proper showing, a record of shareholders and minutes of shareholder meetings. The common law right of inspection is generally broader than the inspection rights under BCL 624—including things like company tax returns, account books, and records of subsidiaries—but it also requires a greater showing: shareholders seeking to access records under their common law rights must demonstrate that they seek them for a “proper purpose” (see this recent post discussing the proper purpose requirement).

LLC members may access an LLC’s books and records under LLC Law 1102—which allows for the inspection of member information, articles of organization, tax returns—and their common law right of inspection, which is analogous to the common law governing shareholders’ inspection rights.

The Right to Purchase Shares to Avoid Dilution

What rights does a minority owner have when a potential new investment in the company threatens to dilute the minority owner’s interest? In pre-1997 companies, BCL 622 provides that a minority shareholder shall have the right to purchase additional shares to avoid dilution of his interest when the corporation intends to issue new shares that would adversely affect either the dividend rights or the voting rights of that shareholder. In post-1997 companies, the BCL expressly states that a shareholder does not have preemptive rights unless they are provided for in the corporation’s certificate of incorporation.

New York’s LLC Law does not contain an analogue for BCL 622, so minority LLC owners do not have preemptive rights unless their operating agreement provides for them.

The Right to Prosecute Derivative Actions

A hallmark right of the minority owner is the right to prosecute legal actions on behalf of the company when those in control of the corporation refuse to do so. For corporations, BCL 626 authorizes minority shareholders to commence an action on behalf of the corporation for injury to the corporation. While the LLC law does not have an analogue to BCL 626, the New York Court of Appeals in 2008 held that an LLC member has a common-law right to sue derivative for injury to the LLC in Tzolis v. Wolff, 884 N.E.2d 1005 (2008).

A minority owner suing the majority must clearly state whether she is bringing her claims directly in her capacity as an owner or derivatively on behalf of the company; a suit that mixes or confuses direct and derivative claims is likely to be dismissed. Whether a claim should be pled derivatively or directly depends on (1) who suffered the alleged harm (the corporation or the stockholders); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders individually. Derivative claims include claims against management for waste, misuse of company funds, claims against management for self-dealing, breach of fiduciary duty, and claims that the company wrongly advanced legal fees.

While an indispensable tool for minority owners, the derivative action is subject to some notable limitations. Those include the requirement of a particularized pre-suit demand, ownership of an interest throughout the litigation, and certain standing requirements. Additionally, any recovery in a derivative suit goes to the company, not directly to the minority shareholder. This means that many times, the economics of a derivative suit weigh sharply against minority owners. Derivative claims are also subject to superior claims against others held by the company, and a derivative plaintiff has no right to a jury trial on her claims.

The Right to Petition for Involuntary Dissolution

A minority shareholder seeking to have the corporation dissolved has a few potential options under the BCL. First, BCL 1104 allows a 50% owner or owners to petition for dissolution on the grounds of director deadlock precluding board action, shareholder deadlock precluding an election of directors, or because “there is internal dissension and two or more factions of shareholders are so divided that dissolution would be beneficial to the shareholders.” Second, BCL 1104-a allows the holders of shares representing at least 20% of all voting shares to petition for dissolution when, inter alia: (i) the directors or those in control of the corporation have been guilty of illegal, fraudulent or oppressive actions toward the complaining shareholders; or (ii) the property or assets of the corporation are being looted, wasted, or diverted for non-corporate purposes by its directors, officers or those in control of the corporation. A minority shareholder holding less than 20% of the shares entitled to vote seeking to petition for dissolution must rely on the common law. Common law dissolution requires showing that the corporation exists solely to enrich the majority at the expense of the minority, as discussed here.

If a minority shareholder seeks dissolution under BCL 1104-a, the majority has the right, pursuant to BCL 1118 to purchase all of the petitioning shareholder’s shares for fair value.

New York’s LLC law, by contrast, does not provide for dissolution in the event of deadlock or minority owner oppression. Rather, a minority member seeking to have an LLC dissolved must show that “it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” (LLC Law 702; Matter of 1545 Ocean Avenue, LLC, 72 AD3d 121 [2d Dept Jan. 26, 2010] [its influence on dissolution of LLCs discussed here]). So as long as the company is (i) operating–i.e., generating revenue–and (ii) acting in accordance with its stated purpose, dissolution of an LLC is difficult to obtain. Notably, many LLCs state in their governing documents that the LLC “is formed for any valid business purpose.” In those cases, as discussed here, a revenue-generating LLC is exceedingly difficult to involuntarily dissolve.

Additional Limitations of Minority Owners’ Rights

A minority owner’s interest is subject to several other critical limitations, including the majority’s power to dilute ownership interests, make capital calls, expel minority owners in certain circumstances, and cash out the minority’s interest in a freeze-out merger. We’ll unpack those and other limitations on a minority owner’s interest in a subsequent post. For those that can’t wait, we cover all these limitations and their import in this webinar.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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