The information and advice that I am about to give is derived from fighting (in litigation, of course) to protect the interests of minority shareholders and non-controlling shareholders who, after years of hard work and financial investment, find themselves locked-out and on the “outside” of their own business. Much more often than not, these individuals are left either unprotected by a poorly drafted shareholders agreement or, worse, with no agreement at all.
So, if you could go back in time or, better yet, assuming that you have not made your investment yet – if you are going to be a minority shareholder (i.e., you control less than 50 percent of the voting shares) – what provisions should you consider and put in place to protect yourself?
- Mandatory Employment as an Officer. Assuming that it is your intention and the intention of your partners that you will each be officers of the corporation, then you must include a specific provision stating that, as long as you remain a shareholder, you are also to serve in a guaranteed role as an officer (president, vice-president, etc…) and that you will serve in that role until your death or resignation.
- Acknowledgments to the Court. If a dispute arises, chances are that your partners will attempt to lock you out and claim some pretext that you engaged in acts of wrong doing. You and your lawyer will, most likely, file an order to show cause (basically an emergency motion) asking the court to issue an injunction ordering your partners to let you back in. The problem is that New York courts are reluctant to issue such injunctions, especially where your partners claim that everything is going well for the business and they will give you access to books and records. However, this is your business and you want back in. So, how can you address this? By explicitly stating in the shareholders agreement your intentions and how everyone expects a court to act in the future. For example, consider provisions that state things like:
“The Parties expressly acknowledge and agree that it is our intention that as long as each party remains a shareholder that each party shall also serve as an officer and director who participates in the day-to-day management and absent a showing of fraud or harm caused to the corporation that courts are advised that a shareholder that is locked out will suffer irreparable harm (as will the corporation as its management structure will have been violated) and that an injunction, temporary restraining order and preliminary injunction should be granted to the locked-out shareholder”.
- Super-majority Voting Rights. Basically, important decisions, like setting officer compensation, selling assets of the company, and determining when distributions are made, should be based on a super-majority provision whereby any action requires a vote that includes your shares. Otherwise the status quo as contained in your shareholders agreement should govern.
- Tax Status and “S” Elections. Most small businesses and family owned businesses are corporations that file an “S” tax election. This means that income of the corporation is not taxed at the corporate level but rather the income of the corporation passes on to the individual shareholders who then report and pay taxes on their portion of the income attributed to their percentage of ownership interest. One problem that a minority shareholder may face is where the majority locks the minority shareholder out and refuses to pay distributions while the corporation continues to earn profits. What ends up happening is that while the minority shareholder receives no income he or she will nevertheless incur a tax liability. So, at a minimum, there should be a provision to state that distributions will be issued every year to cover the tax liability incurred by each shareholder.
There are other points, but these four are big for minority shareholders who are faced with a lock-out or oppression from the majority. Addressing these four points will take you a long way toward better securing your rights.
Learn more: Order a complimentary copy of Charles N. Internicola’s book “The New York and New Jersey Partnership Dispute Guide”.