Minority Shareholder's Bill of Rights
Today’s minority shareholders come to the corporation with varied attitudes and agendas. Although their shareholder status results from a variety of circumstances, it is important in each case to make their relationship with the corporation and the other shareholders as productive as possible. This is best done by understanding their rights and striking the appropriate balance among all shareholders. Taking this action early will help avoid problems which at the very least can be distractive and, in many cases, leads to a substantial waste of time and money, a result few businesses can afford and even fewer wish to endure. This article will describe in general terms what I believe to be the primary rights of a minority shareholder in a nonpublic, North Carolina corporation. The term "minority shareholder" will refer to any shareholder owning less than 50% of the stock in the corporation.
The most fundamental right of every shareholder is the right to vote their shares. However, under the current Business Corporation Act (the "BCA") this right is very limited. A shareholder may only vote in the election of directors and to approve certain extraordinary matters affecting the corporation. After the issuance of shares these actions include most charter amendments (other than mere housekeeping amendments) including those that give rise to dissenter’s rights (described below), most mergers or share exchanges, the sale of all or substantially all of the corporation’s assets other than in the ordinary course of business, voluntary dissolution and the issuance of shares for promissory notes or future services. The practical effect of this limitation is that once shareholders have put directors in office, unless they themselves become officers or directors, they have no real participation in the operation or management of the business.
Shareholders generally have the right to one vote per share and, except under limited circumstances, a majority of the shares can govern. As noted above, one of the shareholder’s basic rights is to participate in the election of directors. This right, however, is very limited in practice since the number of shares owned by a minority shareholder is generally not sufficient to carry the vote for even one director. This can be modified somewhat under the BCA which, under certain circumstances, permits "cumulative voting." That approach permits a shareholder to vote the number of shares he/she owns, times the number of directors to be elected. Under certain circumstances, that can be mathematically calculated, shareholders owning less than a majority of shares can elect one or more directors. With cumulative voting, the more directors elected, the fewer number of shares a minority shareholder needs to elect a director. The number of directors to be elected each year would thus become important and the use of a "staggered board" would limit these rights, since under that approach only a portion of the directors (smaller number) would be elected each year. Unfortunately, under the BCA shareholders will only have the right to cumulative voting if it is granted in the corporation’s articles of incorporation.
A more dramatic right in connection with shareholder voting is a shareholder’s right to "dissent" from certain extraordinary transactions. These actions include most mergers or share exchanges, conversion of the corporation, the sale or exchange of all or substantially all the assets of the corporation other than in the ordinary course of business and certain charter amendments that materially and adversely affect their shares. Dissenters’ rights can also be conferred on shareholders by special provisions contained in the corporation’s charter, bylaws or a resolution of the board of directors. Upon dissent, a shareholder following the requirements of the statute may demand that his shares be redeemed for their fair value. Thus, a shareholder may force his way out of a corporation that is taking certain significant action with which the shareholder does not agree.
The effort has been made under the BCA to strike a balance between the right of all shareholders to take certain action and the ability of a minority shareholder to "cash out" if he/she disagrees with the action. The BCA tries to support this approach by providing that a dissenting shareholder may not otherwise challenge the corporate action unless the action is unlawful or fraudulent with respect to the shareholder or the corporation. This exception, although strengthening the position of shareholders seeking to take the questioned action, provides a "statutory toehold" for shareholders that do not agree with the action and do not want to leave the corporation. Case law will have to further develop this area and the extent to which our courts will find actions unlawful or fraudulent.
Shareholders have the right to expect their officers and directors to act in good faith, with due diligence and in the best interests of the corporation. This right becomes even more important to minority shareholders who, as a result of their limited ownership in the corporation, have little if any practical control over corporate affairs. Shareholders can expect and demand, through derivative suits and otherwise, that officers and directors of corporations operate in the best interests of the corporation. These duties prevent officers and directors from competing against the corporation or developing opportunities for themselves without first providing that opportunity to the corporation.
Shareholders also have the right to prevent directors from becoming personally involved in transactions with the corporation in which they have a conflict of interest or from lending money to themselves or guaranteeing their own debts. Although their are statutory means by which directors and shareholders may approve these transactions, these rules provide some structure and protection for minority shareholders.
As noted above, shareholders may question the decisions of officers or directors and this can be done in the name of the corporation through derivative actions. These are civil lawsuits brought to recover damages under a right that belongs to the corporation. To be entitled to bring such an action, a shareholder must have been a shareholder, or holder of a beneficial interest in such shares, at the time of the questioned transaction, or that the shares or beneficial interest devolved to the questioning shareholder by operation of law from someone who held that status. Before filing the suit, the questioning shareholder must also have exhausted all intracorporate remedies by demanding that the directors act.
Under certain circumstances a shareholder may also sue in his/her own name to protect an individual right as a shareholder. These include actions to enforce any of the rights set forth in this article (e.g., right to inspect records or declare dividends). They can also be brought as a class action, if the right being protected applies to a number of shareholders.
Majority shareholders also have certain obligations to minority shareholders in their capacity of controlling the corporation. These obligations and the corresponding rights of minority shareholders have developed through case law in North Carolina. Basically, majority shareholders have the obligation to act in the best interests of the corporation and all its shareholders. In certain cases this minority shareholder right can be exercised directly against a shareholder, without having to go against a corporation or through the derivative action process.
A corporation is required to maintain certain permanent records, including information on meetings and actions of the directors. Corporations must also keep appropriate accounting records and records of its shareholders. Once a shareholder has owned stock in the corporation for six months or owns at least five percent of the stock in the corporation (a "qualified shareholder"), he may inspect and copy any of the records a corporation is required to keep at its principal office after giving the corporation five days written notice of his request. This would include records such as the corporation’s bylaws and minutes of shareholder meetings and records of all action taken by shareholders without a meeting, for the past three years. In addition, qualified shareholders may inspect and copy additional records, including minutes and actions of directors and shareholders, accounting records and the record of shareholders. This inspection is available if the shareholder meets other requirements and gives five days advance written notice of his/her request. To have access to these records, a qualified shareholder must make his demand in good faith and for a proper purpose, describe with reasonable particularity his purpose and the requested records, and he may only inspect the records that are directly connected with his purpose. Although the right to inspect these additional records is protected by certain safeguards, under the appropriate circumstances a shareholder should be able to inspect those records that will be important to protecting his/her rights and seeing that the corporation is operated in the best interests of all shareholders.
Shareholders may also inspect and copy the corporation’s voting lists (e.g. name, address and number or shares). These records may be reviewed by any shareholder for a period beginning two days after notice of a shareholder meeting and continuing through the meeting. These rights are in addition to the rights of qualified shareholders noted above. This may be important if a shareholder is trying to enlist the support of other shareholders in connection with matters to be addressed at a shareholders’ meeting, or otherwise determine the shareholders and their interests in the corporation.
Shareholders are also entitled to receive reports from the corporation. Within one-hundred twenty days after the close of each fiscal year, a corporation must mail each shareholder the corporation’s annual financial statements or a written notice of their availability. Each corporation must also file an annual report with the North Carolina Secretary of Revenue that includes such information as the name and business address of the officers and directors of the corporation. At the option of the filer, this report may also be filed in electronic form directly with the Secretary of State. Naturally, a shareholder can obtain and review those reports as public records. The BCA tries to strike a balance between the right of shareholders to have access to basic business information, such as financial reports, and the need for protection of certain corporate records from general dissemination.
Realizing the benefit of business operations is another aspect of minority shareholder life which finds some protection under North Carolina law. Receipt of dividend distributions is the typical means by which shareholders benefit from corporate operations. The BCA protects minority shareholders by providing that in corporations with less than twenty-five shareholders, subject to certain exceptions, a shareholder holding at least twenty percent of the shares of the corporation may demand payment of dividends up to one-third of corporation’s net profits. In the alternative, the corporation may redeem a demanding shareholder’s stock for its fair value. If the corporation elects to redeem the shares, the demanding shareholder has the right to withdraw the request and keep his/her shares or complete the redemption.
Certain rights of a minority shareholder are based upon the percentage of shares he owns in the corporation. Thus, it is important for a shareholder to be able to continue to retain that percentage and protect his proportionate voting and financial interests. The BCA provides that under certain circumstances a shareholder will have preemptive rights-- rights to maintain his/her respective percentage interest in the corporation if additional shares are sold. These rights are effectuated by permitting the shareholder to purchase the number of shares necessary to retain that percentage interest. As in the case of cumulative voting, the BCA only recognizes preemptive rights for corporations organized after July 1, 1990 if they are granted in the corporation’s articles of incorporation.
The common law in North Carolina also provides protection from dilution of a shareholder’s interest. Case law precludes directors under certain circumstances from issuing or redeeming shares in a fashion that does not treat all shareholders equally. This right has evolved from the directors’ statutory standards of conduct. However, since these cases generally turn on the reason for the director’s actions, certainty would dictate that this right be established in a shareholders’ agreement or under other legally binding means.
A shareholder may force the dissolution of a corporation if he/she can establish, among other things, that certain deadlocks exist in the corporate management, that liquidation is reasonably necessary to protect the rights or interests of shareholders or that corporate assets are being misapplied or wasted. If a shareholder can establish that one of the required conditions exists, a superior court has the authority to dissolve the corporation and to issue injunctions, appoint a receiver and take other actions it deems appropriate to preserve corporate assets and carry on the business of the corporation.
Case law in North Carolina also provides minority shareholders with some rights that evolve from their "reasonable expectations." These cases have established that the protectable rights or interests of minority shareholders can include expectations that may have developed from the actions and relationship of the shareholders. In appropriate circumstances, these could include the expectations to participate in the management of the business, as well as continued employment. These cases make it even more important to establish and to periodically review and document the expectations of the parties (e.g. shareholder agreement provision). The exercise of analyzing and documenting these expectations will also help avoid misunderstandings which often lead to shareholder controversies.
Under the BCA, a corporation may avoid judicial dissolution by deciding to redeem a complaining shareholder’s stock at its fair value. Thus, as in the case of trying to force a dividend, a shareholder must be prepared to have his/her stock ownership terminated by the corporation.
The other fundamental shareholder right is to participate in distributions from the corporation upon its dissolution. A shareholder is entitled to receive his/her share of liquidating distributions from the corporation. Generally, all shares participate equally in the distribution. The actual distribution, however, will be subject to the statutory priorities and to preferences, if any, set forth in the corporation’s articles of incorporation.
No review of the rights of a minority shareholder would be complete without considering the use of shareholder agreements. Without a doubt, the best means of dealing with the rights of minority shareholders, from both majority and minority shareholder perspective, is through the use of an effective and well drafted shareholders’ agreement. The BCA permits the shareholders of a corporation in North Carolina to establish their relationship, including voting rights and management of the corporation, in the same way that would be appropriate for partnerships. That provides shareholders with a great deal of flexibility in developing their relationship in a fashion which strikes a balance between the rights described above. A shareholders’ agreement can also address restrictions on the transfer of shares which can help protect all shareholders from having "outsiders" become shareholders in the corporation. This is important to both the minority and the majority shareholders.
The designation of the directors of the corporation may also be a matter minority shareholders would want to address in a shareholders’ agreement. The shareholders of a corporation can name specific individuals or grant certain shareholders the right to designate individuals to serve on the board of directors. This would assure minority representation on the board. High vote and high quorum requirements can also provide some minority protection, as would the use of a veto power over selected corporate activities. By using this approach, a minority shareholder can remain involved with corporate activities. Having this protection may prevent certain corporate activities which could change the fundamental nature of the corporation or the basic approach that was the basis of the shareholder’s initial investment. This is also a method by which majority shareholders can keep the minority shareholders informed and involved, which may help prevent misunderstandings and feelings of exclusion, which can be the basis of shareholder controversies.
A shareholders’ agreement can also cover the expectations of the parties, sale of the business, Subchapter S elections, mandatory distributions, additional capitalization, the death of a shareholder or the termination of employment of a shareholder-employee. There are many benefits to be derived from having established in advance the effect of these events to help place some order into what may otherwise be very disruptive to the corporation.
Shareholders have certain statutory and equitable rights which may be expanded or restricted by agreement, by the articles of incorporation, bylaws, and by the course of dealing among shareholders. Some of these rights are fundamental in nature and meant to protect the interest of all shareholders, while others seek to protect minority shareholders. The exercise of rights by minority shareholders can at a minimum be an irritant and could cause a great deal of wasted time and effort if exercised with an adversarial agenda. The BCA now places added emphasis on understanding the rights of minority shareholders. In some cases affirmative action is now required in order to effectuate certain protection for minority shareholders. Understanding these rights is important to keeping the relationship among shareholders well structured and meeting the expectations of all involved. Unfortunately, this aspect of a business is not often very high on the priority list of those organizing the corporation. It is, however, one of those areas where the allocation of resources early in the life of a corporation can help avoid the expenditure of a great deal more time and money after the business has matured and the relationship of the parties has changed.
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