On June 20, 2014, the Texas Supreme Court reversed more than 25 years of Texas law, and declared that minority shareholders in closely-held corporations cannot force the buy-out of their shares, even when the majority owners engage in oppressive conduct that is unreasonable or unfair. This landmark decision in Ritchie v. Rupe drastically alters the landscape in shareholder disputes.
In the Ritchie v. Rupe case, an 18% shareholder in a family-owned business married his second wife, Ann Rupe, in 1983. From the very beginning, the new wife was greeted coldly by the rest of the family, who told her that she would “never get any money in this family.” Over the next 20 years, the rest of the family continued its plan to exclude Ann from sharing in the success of the family business. When Ann Rupe’s husband died in 2002, however, she became the legal owner of the 18% stake. When she expressed an interest in selling her stock, the rest of the family told her that the only sale they would allow would be to the family, and they refused to allow any other potential purchasers to engage in meaningful due diligence that might have allowed a potential purchaser to value the stock. The family eventually made two paltry purchase offers for the 18% stake, both of which were far below any reasonable estimation of the fair market value. Ann Rupe sued for minority shareholder oppression, a legal claim that has had deep roots in Texas law for almost 60 years, and which had been expressly recognized in hundreds of judicial opinions since 1988. Ann Rupe succeeded on this claim, and a Dallas jury awarded her $7.3 million as the fair value of her stock.
On appeal, the Texas Supreme Court turned Texas law on its head, finding that the legal claim for minority shareholder oppression is no longer available under Texas law. Instead, the court said that the only remedy available to Texas shareholders moving forward is the imposition of a temporary receivership over the corporation to address the abuse of the majority’s authority over the corporation “with the intent to harm the interests of one or more of the shareholders, in a manner that does not comport with the honest exercise of their business judgment, and by doing so create a serious risk of harm to the corporation.”
While this new pronouncement would appear to leave some protections in place, the reality is that virtually no minority shareholder will be able to meet this standard. In its new definition, the Texas Supreme Court has established three major “loopholes” that will make applications for even a temporary receivership impossible. First, the Texas Supreme Court requires “the intent to harm.” Under the law, intent is viewed on a subjective standard — you have to prove the actor’s actual motivation. When the actor denies his true motivation, and fabricates another motive, proving intent is difficult. Second, the court’s inclusion of the business judgment rule (“in a manner that does not comport with the honest exercise of their business judgment”) means that courts will give extreme deference to any plausible business justification for the oppressive conduct, and will never second guess the wisdom of any corporate act. Third, the court added another provision that requires the oppressive conduct to cause harm to the corporation, rather than to the minority shareholder. As was the case in Ritchie v. Rupe, oppressive conduct typically benefits the corporation. If the corporation choses to withhold dividends from the minority shareholder (while simultaneously paying majority shareholders for their share of profits, but disguising the payments as bonuses), that act will benefit the corporation financially by allowing it to maintain a greater cash reserve.
After the Ritchie v. Rupe decision, all Texas shareholders should realize the importance of getting their expectations for the corporation in writing before a dispute arises. The Texas Supreme Court justified its decision in Ritchie v. Rupe with the statement, “Of course, shareholders may also prevent and resolve common disputes by entering into a shareholders’ agreement to govern their respective rights and obligations.” While this statement is theoretically true, it ignores reality in the context of closely-held businesses. When entrepreneurs band together to form a new business, the vast majority of them are struggling to pull together the initial investment capital necessary to succeed. In fact, inadequate capitalization is usually cited as the leading cause of failure in new ventures. Under those circumstances, far too many businesses simply cannot afford to hire lawyers to draft customized by-laws and shareholder agreements that cover the unique expectations of the shareholders. In reality, most businesses opt for downloading standardized corporate documents from Legal Zoom, Rocket Lawyer, or one of the other websites offering free corporate forms. Even worse, many businesses file only a Certificate of Formation with the Secretary of State, and never follow through with the drafting of any corporate by-laws.
If your small business utilized standardized forms, it is never too late to amend your corporate documents or enter into a shareholders’ agreement that provides the type of basic shareholder protections that Texas law provided prior to the Ritchie v. Rupe decision. In fact, a simple shareholders’ agreement could reinstate those protections and negate the harsh impact of Ritchie v. Rupe. The agreement would merely need to say:
The Shareholders hereby agree that any minority shareholder shall be entitled to an equitable remedy of a buy-out at fair market value of his stock if: (a) the majority’s conduct substantially defeats the expectations that objectively viewed were both reasonable under the circumstances and were central to the minority shareholder’s decision to become a shareholder; or (b) the majority engages in burdensome, harsh and wrongful conduct, exhibiting a lack of probity and fair dealing in the affairs of the corporation to the prejudice of some of its shareholders which is a visible departure from the standards of fair dealing and a violation of fair play on which every shareholder who entrusts his money to a corporation is entitled to rely.
This same language could also be incorporated into the company’s by-laws or other governing documents.
If your corporation does not have a shareholders’ agreement, there are still actions that can be taken to rein in a majority interest owner who is bent on destroying the value of the minority’s ownership interest. In the new world emerging after Ritchie v. Rupe, the remedies will be more limited, but share ownership has its rights, and all minority owners should ensure that their rights are not trampled by the majority owners.