Texas Business Dispute Blog

Friday, July 25, 2014

The Legal Landscape after the Texas Supreme Court’s Rupe (Majority) Decision: “It Was Only a Flesh Wound:” Minority Shareholders Disabled But Not Disarmed

By Ladd Hirsch and James Sheppard

From Monty Python and the Holy Grail - The Black Knight

Arthur:                 I command you as King of the Britons to stand aside!

Black Knight:      I move for no man.

Arthur cuts off the Black Knight’s left arm.

. . .

Black Knight:      ‘Tis but a scratch.

Arthur:                 A scratch? Your arm’s off!

Black Knight:       I’ve had worse.

. . .

Arthur cuts off the Black Knight’s right arm.

. . .

Black Knight:     Oh, had enough, eh?

Arthur:                Look, you stupid bastard, you’ve got no arms left.

. . .

Black Knight:     Just a flesh wound.

The New Battleground for Private Company Minority Investors - Post-Rupe Claims

The Texas Supreme Court’s recent opinion in Ritchie v. Rupe was a clear setback for the rights of minority shareholders in close corporations in Texas.  But unlike the Black Knight, who refused to acknowledge that he had legitimately been vanquished, minority shareholders after Rupe continue to have viable claims to assert against majority owners when they overstep their bounds in exploiting their control of the company.      

As discussed in our previous Post, the majority opinion in Rupe imposed new limits and burdens on minority shareholders – well above those in courts of other states – that seek to pursue claims against majority owners.  In brief, the Rupe majority: (1) redefined “oppressive” conduct in the Texas statute to mean an abuse of authority by directors or offices with the intent to harm one or more shareholders in disregard of their honest business judgment, (2) held that the appointment of a rehabilitative receiver is the only remedy available to minority shareholders claiming oppression under the Texas statute, and (3) refused to recognize a common-law cause of action for shareholder oppression under Texas law due to other available remedies.

With regard to the other legal protections for minority shareholders, the majority in Rupe made two key observations when it stated: (1) “we have not abolished or even limited the remedies available under the common law or other statutes for the kinds of conduct that give rise to rehabilitative receivership actions” and (2) “Texas law should ensure that remedies exist to appropriately address such harm [to the minority shareholder] when the underlying actions [of the majority owner] are harmful.” 

The majority opinion then listed nine different common-law claims that already exist to address misconduct by directors/officers and includes: (1) Accounting, (2) Breach of Fiduciary Duty, (3) Breach of Contract, (4) Fraud and Constructive Fraud, (5) Conversion, (6) Fraudulent Transfer, (7) Conspiracy, (8) Unjust Enrichment and (9) Quantum Meruit.

After providing this list, the Rupe opinion highlighted the following claims: (1) derivative actions filed on behalf of the company, (2) breach of formal or informal fiduciary duty; and (3) the appointment of a receiver to rehabilitate the company; and (4) fraudulent inducement claims. 

KEY MINORITY SHAREHOLDER CLAIMS AVAILABLE AFTER RUPE

            1.         Shareholder Derivative Actions

Derivative Actions (Generally): As the Rupe majority opinion noted, minority shareholders retain the right to file derivative lawsuits on the company’s behalf against the majority (or controlling) to redress the majority owners bad acts that harm the company.  Importantly, a shareholder of a statutory “closely-held corporation” (“fewer than 35 shareholders”) can more easily pursue a derivative claim because the statute allows shareholders to forgo pre-suit requirements that typically apply to derivative actions, such as making a “demand” on the corporation or proving that they “fairly and adequately represent the interests of” the company.  See Tex. Bus. Org. Code §§ 21.563(a), (b) (pre-suit requirements in Sections 21.552-21.559 “do not apply to a closely held corporation”).

Derivate Action (“Formal” Fiduciary Duty to Company):  The Rupe majority also recognized the long-standing principle in Texas that:

“[A] fiduciary duty [is] owed by corporate officers and directors to the corporation, which prohibits officer and directors from usurping corporate opportunities for personal gain and requires them to exercise their ‘uncorrupted business judgment for the sole benefit of the corporation.’”

See Rupe at p. 25 n. 27 (citing Int’l Bankers Life Ins. Co. v. Holloway, 368 S.W.2d 567, 577 (Tex. 1963) (discussing corporate officers and directors engaged in self-dealing and taking actions to compete with company).  Generally, Texas courts confront “formal” fiduciary duty claims arising from actions of the officers or directors that cause misappropriation or waste of corporate funds, misappropriation of trade secrets, and/or the usurpation of a business opportunity for personal purposes. 

Breach of “Informal” Fiduciary Duty (Duty Owed to Shareholder): Most fiduciary duty claims arise from duties to the corporation, but some minority shareholders will have facts supporting a claim that an “informal” fiduciary relationship exists with the majority owner.  Rupe described an informal fiduciary relationship as arising from “a moral, social, domestic, or purely personal relationship of trust and confidence.”  Rupe also stated that informal fiduciary duties “are not owed in business transactions unless the special relationship of trust and confidence existed prior to, and apart from, the transaction(s) at issue in the case.”   This seems to limit potential “informal” fiduciary duty claims, but Rupe recognized that this duty may arise “in some circumstances” and the Court remanded the case to the Dallas Court of Appeals to determine if the minority shareholder could recover on her “informal” fiduciary duty claim.

Following Rupe, key issues regarding fiduciary duty claims are:

  • Minority shareholders have valid fiduciary duty claims against majority owners acting as officers/direction: (a) risk harming the company or all shareholders collectively and (b) they fail to act in the honest exercise of their business judgment
  • Minority shareholders must file fiduciary breach claims against majority owners as derivative actions unless they are based on an informal fiduciary duty.
  • Minority shareholders who prove that majority owners breached their fiduciary duties “may” be able to obtain a buyout of their minority interest

            2.         Wrongful Suppression of Dividends

Rupe acknowledged that Texas courts have generally held that a minority shareholder has a legitimate claim against majority owners when there is either: (a) a malicious suppression of dividends; or (b) a scheme to create “disguised dividends” that favor the majority owner.  See Patton v. Nicholas, 279 S.W.2d 848, 854 (Tex. 1955).  The decision in Patton upheld the jury’s findings that the majority owner had withheld dividends for an improper purpose and concluded that “[u]ndoubtedly the malicious suppression of dividends is a wrong akin to a breach of trust, for which the courts will afford a remedy.”  Id.  Although Rupe did not specifically disavow Patton, the two holdings seem to conflict and the status of the claim appears unsettled.

For the suppression of dividends, the Court in Rupe and commentators typically describe such schemes as “freeze out” or “squeeze out” techniques attempting to deprive the minority owner of any return on its investment in the company, or to induce them to relinquish their ownership for less than it is otherwise worth.  See, e.g., Douglas K. Moll, Shareholder Oppression & Dividend Policy in the Close Corporation, 60 Wash. & Lee L. Rev. 841, 852 (2003) (link to Moll Article).   A classic example of a freeze-out involves the majority owner denying the minority owner any returns (or dividends) and then proposes to buy the shares at a very low price.  See id.; see also 2 F. Hodge O’Neal & Robert B. Thompson, Oppression of Minority Shareholders and LLC Members, § 7-11 (Rev. 2d ed. 2012) (“By declaring no dividends at all . . . majority shareholders may force a minority shareholder to sell the minority interest at considerably less than its actual value” and “[e]ven if the minority shareholder is in a sufficiently strong position to hold onto stock during a dividend squeeze, the [squeezed shareholder] is still deprived of any return on the investment during the years that dividends are withheld.”).

The second type of claim for wrongful use of dividends occurs when majority owners pay themselves “disguised dividends” by giving themselves large salary increases at the same time they refuse to issue dividends shared with the minority owners.  See, e.g., Boehringer v. Konkel, 404 S.W.3d 18, (Tex. App.—Houston [1st Dist.] 2013, no pet.) (approving jury’s finding, in context of shareholder oppression claim, that majority owner “wrongfully withheld the payment of the 2008 corporate dividend while increasing his own salary to [the minority owner’s] detriment”); In re White, 429 B.R. 201, 210 (Bankr. S.D. Tex. 2010) (“[I]t is necessary to ‘carefully scrutinize the payments [of bonuses or salary] to ensure that they are not disguised dividends.’”).  When majority owners increase their salary (or bonuses) while refusing to issue dividends shared with the minority owner, this may give rise to the minority owner’s claim for breach of fiduciary duty (likely as a derivative claim) for misappropriation of assets.  Litigation of this claim will present questions about whether the compensation was reasonable in light of the dividend policy – and involve a battle of the parties’ compensation experts.

The take-aways regarding dividend suppression claims are:

  • Minority shareholders who contend that majority owners paid themselves excessive salaries and/or bonuses need to retain executive compensation experts to testify these amounts are unreasonable
  • Claims challenging the compensation and/or bonuses paid to majority owners will likely need to be filed on a derivative basis 

            3.         Appointment of a Receiver (With Uncertain Powers)

Rupe sharply narrowed the definition of shareholder oppression and limited the remedy to the appointment of a rehabilitative receiver, but the Court did not address the scope of the receiver's powers.  For example, if the majority owner engaged in a disguised dividend scheme, can the trial court appoint a receiver and order the receiver to issue dividends or require a buyout of the minority owners’ stock?  The Court in Rupe never explains how the receiver should act to “rehabilitate” the company and cure the oppression.

            4.         Fraudulent Inducement Claims

The Court in Rupe stated that majority and minority owners in private companies should obtain a “corporate pre-nup” when they invest to protect their rights.  If that is not done, the minority owners are more likely to pursue claims for fraudulent inducement, because a minority investor who establishes that his investment decision was based on the majority owners’ false statements can seek rescission or damages equal to the benefit of his bargain.  Fraud claims may be based on statements made to the investor about what physical assets or intellectual property the company owned, how the company would be structured, how it would be operated and how profits would be distributed.  Fraudulent inducement claims are fact-specific making it more likely that the minority investor will be able to secure his day in court on this claim.

The take-aways here regarding fraudulent inducement claims are:

  • Minority shareholders who invested under false pretenses may pursue claims for fraudulent inducement against the parties who misled them.
  • Remedies for fraudulent inducement include both rescission and damages equal to the benefit of the bargain the defrauded party expected to receive.

 Summary

The majority opinion in Rupe narrowed the scope of shareholder oppression claims, but the Court also stressed that minority shareholders continue to have several viable legal claims available against majority owners that include: (1) “formal” breach of fiduciary duty claims that are filed on a derivative basis, (2) “informal” breach of fiduciary duty claims for duties owed to the minority shareholder; (3) claims related to wrongful withholding of dividends and (4) claims for fraudulent inducement.  Rupe’s emphasis that the Court’s decision will not deprive minority shareholders of viable claims against majority owners signals that the battle lines have shifted, but future litigation by minority shareholders is likely to proceed on multiple fronts. 


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