It is not at all uncommon for minority members to claim unfair treatment from actions taken by the managing majority of a closely-held organization. Very often decisions on such matters as the timing or price of an asset sale can adversely affect minority members, as can tax strategy as to whether entity shares are to be converted into 1031-exchangeable real property interests or fully taxable cash. Faced with a business choice that has a disparate impact, minority members often frequently feel abused and want to know what grounds of attack may be available to them.
Management decisions are not vulnerable merely because of a disproportionate adverse impact. Other things being equal, a decision as to what the majority’s managers feel is in the best interests of the organization will survive scrutiny so long as the decision is exercised in good faith and with a reasonable business judgment even if the decision is wrong. But there are exceptions and, as discussed below, a careful eye can often catch and exploit them despite the best efforts of the majority to couch their efforts in terms of the supposed greater good.
The consequences of unsuccessfully asserting claims against a majority are significant because in most operating agreements and corporate by laws a managing member or director is entitled to indemnity from the company for defending actions taken in good faith in the course and scope of management duties. See Cal. Corp. Code Section 17155(a). This means an organization (and hence on a pro rata basis the minority members themselves) must pay for attorney’s fees incurred by the majority in a successful defense of such claims, while their own attorney’s fees may not be recoverable if the minority prevails. Though such high stakes are often used by a majority to discourage legal action, the minority can find leverage in the contention that fees the majority spends to defend themselves must be paid back to the company if self dealing or bad faith is shown.
The challenge for minorities is to demonstrate a breach of the fiduciary duty which the majority owes to the minority. This is legal duty to deal in the utmost good faith, to refrain from placing one’s interests ahead of those to whom the duty is owed, and not to take even the slightest advantage. Cal. Corp. Code Section 16404; Assilzadeh v. California Bank (2000) 82 Cal. App. 4th 399,415. Some courts have even ruled that the burden is on the majority to demonstrate that the fiduciary duty has not been breached — i.e. the actions are prima facie improper and must be justified before they are allowed to stand. Brudner v. Vasquez (1954) 43 Cal.2d 147, 151.
Extensive experience prosecuting minority claims in a multitude of varied fact situations teaches that at least some sort of self-dealing lies at the heart of virtually all successful attacks. In one trial we handled, a general partner was held liable for allowing a lender to foreclose on a partnership asset whose loan was in default and then buying the opportunity from the lender at a discounted value. In another trial, the majority was held liable for failing to disclose to the minority that a key principal in the buyer of a partnership asset was affiliated in an unrelated business transaction with one of the majority members. In yet another case, the managing member exercised certain partnership buyout rights through documents drafted by his lawyer but paid for by partnership funds (the court set aside the transaction and ordered the disgorgement of the fees paid). And a managing partner who had discretion to award bonuses was not permitted to exercise that discretion in distributing a disproportionate bonus to himself.
Related questions frequently arise with regard to minority rights in various entity dissolution contexts. In most states, events triggering dissolution (and hence the consequent need for a windup and termination of the entity) are largely limited to those enumerated in the governing partnership or operating agreement, often excluding the death or withdrawal of a partner. In many states, no vote short of a full majority will result in a dissolution. Accordingly, the minority becomes forced to demonstrate circumstances that make it functionally impossible to continue the business due to internal discord, and with the majority firmly in command this may be difficult to show. Further, in California if the majority refuses to dissolve, then the minority is generally forced to file a lawsuit seeking a court-ordered dissolution, and even then dissolution can be avoided if the defending majority offers to buy out the minority for fair market value. Cal. Corp.Code Section 17351 (b)(1). Here, the problem for minority members is whether, and if so the extent to which, the fair market value of the minority member’s interests should be discounted by reason of their limited influence in partnership affairs. Many appraisers have applied sharp discounts and so the benefits of dissolution can turn out to be problematic. To get around these hurdles, some minority members have turned to the tactic of approaching one or more members of the majority with a private offer above par value in order to assemble enough interests to become the majority.
Perhaps one of the most promising ways to show self interestedness is to expose conflicts of interest. A hidden business relationship with a broker, or an undisclosed finder’s fee, earned or not, are good examples. Certainly there is a need to scrutinize all relationships between majority members (and even perhaps their business partners in other enterprises) and third parties providing services to the entity, from attorneys to accountants or even non-member professional managers. Boilerplate provisions in partnership agreements that a manger is permitted to engage in other competing businesses have been found not to afford a defense to self-dealing claims. And if the entity’s distribution cascade contains priorities favoring positions held by majority members, which positions will be satisfied while positions lower in the cascade will not, then we have seen a decision to sell or even to dissolve successfully challenged in a trial we handled.
Experience shows that acting quickly to investigate and challenge a transaction is critical. Otherwise, the majority have time to paper over technical deficiencies, make after the fact disclosures, or attempt retroactive accounting adjustments. Dissatisfied members should therefore seek qualified legal counsel very early, not to only know what limits there may be on their rights to complain but also to exploit opportunities presented by the mistakes of a majority not fully understanding or following its obligations.