In three cases this summer, the Supreme Court of Texas reset the law with regard to disputes between shareholders of closely held companies.
Two of those cases – Shagrithaya v. ARGO Data Resources Corp. and Cardiac Perfusion Services, Inc. v. Hughes – were handled by the lawyers at Carrington Coleman.
Below, we discuss our roles, the implications of the court decisions, and what investors and managers need to know to do business in this new legal environment.
In the ARGO case, we represented a 53% shareholder who was the chief executive officer and chairman of the board of ARGO Data Resource Corp. ARGO was originally a two person operation that had grown into a multi-million dollar corporation.
As the company grew, so did the responsibilities of our client. When the 47% shareholder refused to assume the responsibilities of a true chief technology officer, and insisted instead on continuing simply to develop the software platform for the company’s products, his compensation was reduced. He became dissatisfied and asked that our client facilitate the sale of his shares, and the parties agreed upon an appraisal firm.
When the minority shareholder was unhappy with the appraised value of his shares, he initiated a lawsuit asserting, among other claims, that he had been treated unfairly, or “oppressed.” At the time the case was tried, the tort of “shareholder oppression” was ill-defined and subject to an overly broad interpretation, which placed majority shareholders at risk of being found liable for conduct that was fully within their majority rights. The tort had been developed by lower courts, but it had never been adopted by the Texas Supreme Court.
In the trial court, the jury (with two dissenters) found our client was liable for treating the minority shareholder unfairly and frustrating his reasonable expectations. The trial court entered a judgment compelling an $85 million dividend, $40 million of which would be paid to the plaintiff.
When the Dallas Court of Appeals analyzed the record that had been developed during the trial, it easily concluded that our client had properly acted as a majority shareholder and officer of the company and accordingly reversed the judgment and ordered that the plaintiff receive nothing. The court reached this conclusion even under the overly broad legal standard that existed at the time. The Texas Supreme Court later issued its opinion in Ritchie v. Rupe, which eliminated the common law claim for shareholder oppression and limited the claim to the more narrow statutory requirements. And a week later, the Supreme Court denied Shagrithaya’s petition for review, thus preserving our client’s victory.
“The Court of Appeals completely vindicated our client and I accordingly feel a little of that vindication myself.” – Tim Gavin
About the time the ARGO appeal was getting underway, Carrington Coleman was engaged to represent Cardiac Perfusion Services, Inc., and the owner of 90% of its shares after judgment on a jury verdict was entered against them in a state district court, an appeal had been initiated, and collection efforts had begun. After assisting the clients in suspending execution of the judgment, we assumed responsibility for appeal of the judgment.
The case focused on a “shareholder oppression” claim brought by the minority shareholder (a former employee). Although the two shareholders had previously signed a buy-sell agreement that mandated repurchase of the employee’s shares at their “book value” upon termination of his employment, the trial court ordered a buyout of the minority’s shares at a much higher so-called “fair value” found by the jury. Our primary argument on appeal was that the buy-sell agreement between the two shareholders governed the amount payable to the minority shareholder, and could not legally be set aside under the equitable doctrine of “shareholder oppression,” which was poorly defined and inconsistent with fundamental principles of Texas law. When that argument was not accepted by the court of appeals, we sought review by the Texas Supreme Court.
At the time, the Supreme Court was reviewing three separate judgments involving shareholder oppression claims, with Carrington Coleman representing the majority shareholders in two of them. Ultimately, after requesting and considering briefs in all three cases, the Court in Rupe held there was no common-law cause of action for shareholder oppression in Texas. Its opinion in that case twice criticized the judgment in Cardiac Perfusion and emphasized the importance of enforcing shareholder agreements in closely held companies. One week later – the same day the Court denied Shagrithaya’s petition for review – the Court granted our petition and reversed the judgment in Cardiac Perfusion, vindicating the position we had asserted from the beginning of our representation.
“These cases played a significant role in altering the course of Texas law governing the rights and responsibilities of shareholders and managers of closely held corporations.” – Lyndon Bittle
In refusing to recognize the tort of “shareholder oppression,” the Texas Supreme Court in Ritchie v. Rupe acknowledged that shareholders can, in appropriate circumstances, bring traditional breach of fiduciary duty claims. But those claims are much better defined than the vague parameters of “shareholder oppression.”
ARGO and Cardiac Perfusion demonstrated the mischief that can come from a doctrine that is not rooted in statutes or the common law and purports to override established corporate law principles.
Nevertheless, we expect plaintiffs’ counsel will try to repackage “shareholder oppression” claims as breach of fiduciary duty claims. If so, they will face substantial hurdles overcoming the protections afforded to corporate shareholders and managers who act in accordance with corporate law and applicable shareholder agreements.
“Throughout the history of our firm and its predecessors, our lawyers have been instrumental in the development of Texas corporate law. These decisions continue that trend, and are a testament to the terrific quality of the trial and appellate teams who handled them. Because we have deep experience and expertise defending breach of fiduciary duty claims against majority shareholders, directors, and officers, we will continue to be involved in the litigation of these claims and the development of the law post-Rupe.” – Bruce Collins, Managing Partner
These cases restore some clarity to this area of law. They also serve as a reminder that parties going into business together should make certain their lawyers are setting up the company in a way that serves their needs and expectations.
The Texas Supreme Court suggested as much. Texas law authorizes shareholder agreements that restrict the powers of the board of directors, authorize arbitration to avoid deadlock, and even govern distributions. Shareholder agreements can offer minority shareholders many of the protections they seek by mandating periodic dividends or including buyout provisions. These and other contractual provisions may be effective even when they conflict with Texas law. However, Texas law prevents minority shareholders from using shareholder agreements to sidestep the corporate form and stick the majority with personal liability. And shareholder agreements are not effective if the shares of the corporation are listed on a national securities exchange or are regularly traded in certain markets.
Another option for shareholders is to organize as a “close corporation,” which requires insertion of specific language in a company’s governing documents, either during formation or by amendment. Shareholders in close corporations, but not most other corporations, can sue to enforce a corporate provision, appoint a provisional director, or appoint a custodian. These actions could remedy many types of conduct typically complained of by minority shareholders, including withholding dividends, misapplication of funds, and manipulation of stock values. Their protection can be strengthened by a shareholder agreement or company bylaws requiring a “supermajority” for certain specified actions, such as amending the certificate of formation or bylaws to remove the close-corporation designation.
“The key to all of this is engaging, up front, an attorney who not only understands corporate governance, but also your business, the risks that matter most, and any other issues at hand.”
– Bret Madole