Texas Business Dispute Blog

Tuesday, May 20, 2014

Majority Rules - But Not Always With Total Impunity

By Ladd Hirsch

Private companies are governed as mini-democracies - the majority rules.  In Texas, however, majority owners in private businesses do not have total discretion to act as they wish.  In fact, when majority owners engage in conduct that unduly benefits themselves, they are likely to find themselves subject to claims in litigation where their conduct may not survive judicial scrutiny.  When they overreach, majority owners remain subject to claims for breach of fiduciary duties and to claims for minority shareholder oppression.  There are three key danger areas that often trip up majority owners.  One of these may not be sufficient to create liability, but majority owners who engage in more than one of these are likely to find themselves in legal hot water.

1. Handling of Profits/Dividend Policies

Texas law does not require majority owners to declare dividends when the company is profitable.  In particular, directors appointed by majority owners are protected by the business judgment rule when they reinvest the company's profits in a growth strategy.  Yet, there are several cautions for majority owners in this area.  First, when majority owners do issue dividends, the minority owner is entitled to receive its pro rata share of the dividend pool.  Second, majority owners who retain capital may be challenged if they are retaining earnings as part of a squeeze out plan designed to remove the minority owner, i.e., when there is no business plan for use of the retained funds.  See Argo Data Res. Corp. v. Shagrithaya, 380 S.W.3d 249, 271 & 275 (Tex. App.—Dallas 2012, pet. filed) (No. 12-1012) (reversing $85 million dividend awarded by trial court based upon minority shareholder’s claim for shareholder oppression of suppression of dividends).  Finally, majority owners may also be challenged when they generate profits and tax liability in pass-through entities (LLC's, S Corps and LP's), but refuse to issue any distributions to cover the amount of taxes owed by the business owners.

2. Self-Dealing and Misuse of Corporate Funds Without Board Approval

As noted, majority owners owe fiduciary duties to the companies they control.  When they engage in self-dealing, they act in violation of their duty of loyalty to the company.  Some examples of majority self-dealing include: sweetheart deals with other companies that favor other companies owned/controlled by the majority owner; putting family members or friends of the majority owner on the company payroll who do not provide any valuable services to the company and using company funds to pay for the majority owner's personal expenses.  See Redmon v. Griffith, 202 S.W.3d 225, 235 (Tex. App.—Tyler 2006, pet. denied) (discussing majority owners that “made improper personal loans to themselves” and paid personal expenses from corporate funds without approval from board of directors); Cardiac Perfusion Servs, Inc. v. Hughes, 380 S.W.3d 198, 201-02 (Tex. App.—Dallas 2012, pet. filed) (No. 13-0014) (affirming shareholder oppression claim where majority owner “improperly paid family members” and paid personal expenses with company funds) Argo Data, 380 S.W.3d at 272 (discussing jury finding that majority owner misused corporate assets).   

3. Excessive Compensation and Disguised Dividends

The final area of conduct by the majority owner that may be problematic concerns the compensation – salary and bonus – paid to the majority owner.  When the majority owner pays himself grossly excessive compensation in comparison to industry standards, courts and juries may find that the compensation amounts to a “disguised dividend,” i.e., a way to funnel profits to the majority owner that are not shared with the minority owner.  See Four Seasons Equip., Inc. v. White (In re White), 429 B.R. 201, (affirming equitable relief on shareholder oppression theory when majority owners paid “bonuses” to themselves that were, in substance “disguised dividends” and excluded the 8% minority owner); Cardiac Perfusion, 380 S.W.3d at 201 (affirming shareholder oppression claim based upon jury’s finding that majority owner “paid himself excessive compensation” from corporate funds). 

In sum, the majority owners of private businesses are accorded the legal right to control the company's governance and operations.  Yet, majority owners of Texas companies who engage in conduct that significantly favors themselves to the substantial detriment of the minority investors may find themselves subject to legal claims that find traction in Texas courts.  


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