Legal Rights of Minority Shareholders in S Corp – California

Author: LegalEase Solutions 

Introduction

Client, a 45% shareholder in an “S” corporation, was recently fired by the company. The remaining 55% is owned by a married couple. The bylaws of the corporation define a “quorum” as 56% of the outstanding shares.

Questions Presented

  1. What are the legal rights, if any, of a minority shareholder, and can he force a liquidation of the corporation?
  2. Can the corporation conduct business without a quorum?

Short Answers

  1. The minority shareholder can apply for involuntary dissolution under Cal Corp Code § 1800(b)(3) and Cal Corp Code § 1800(b)(5).
  2. The corporation cannot conduct business without a quorum, but may bypass this restriction by taking action without a shareholder meeting or by having the Board amend the bylaws.

DISCUSSION

  1. The Minority Shareholder May Apply for Involuntary Dissolution Under Cal Corp Code § 1800(b)(3) and Cal Corp Code § 1800(b)(5).

A minority shareholder can sue for liquidation of the corporation. Cal Corp Code § 1800 details the grounds under which a shareholder can apply for involuntary dissolution of a corporation. The application may be made by one or more shareholders with at least one third of the outstanding shares or equity of the corporation. In a closely-held corporation, any shareholder may bring a forced dissolution action. Cal Corp Code § 1800(a)(2). Thus, as owner of 45% of the shares in the closely-held corporation, client has standing to bring an action for forced dissolution of the corporation.

There are several grounds for involuntary dissolution. Grounds based on misconduct of the majority shareholders include fraud, mismanagement, abuse of authority, persistent unfairness toward any shareholders, or misapplication or waste of property by the directors or officers. Cal Corp Code § 1800(b)(4). If internal dissension within the company creates two or more factions of shareholders that are so deadlocked that corporate business can no longer be conducted with advantage to its shareholders, then an application can be made for involuntary dissolution under Cal Corp Code § 1800(b)(3). Alternatively, an application for dissolution may be made when, in any corporation with 35 or fewer shareholders, liquidation is reasonably necessary for the protection of the rights or interests of the complaining shareholders. Cal Corp Code § 1800(b)(5).

In order to force dissolution under Cal Corp Code § 1800(b)(3), a complaining shareholder must show both internal dissension and deadlock. If the applicant cannot prove both these facts, the court will not grant dissolution. Belio v. Panorama Optics, 33 Cal. App. 4th 1096 (Cal. Ct. App. 1995). In Belio, a shareholder filed an action for forced dissolution of the Panorama corporation.  There were only 2 shareholders in the corporation: Belio, who owned 46 percent of the stock, and his brother Larry, who owned 54 percent of the stock.  Belio alleged that there was internal dissension between the two shareholders and they were deadlocked for the purposes of Cal Corp Code § 1800(b)(3). The Court held that Belio was not entitled to involuntary dissolution of the corporation under Cal Corp Code § 1800(b)(3), which authorizes involuntary dissolution when there is “internal dissension and two or more factions of shareholders in the corporation are so deadlocked that its business can no longer be conducted with advantage to its shareholders.” The requirements are in the conjunctive and therefore both internal dissension and deadlock must exist to establish a basis for dissolution. Id. at 1103.

Belio was able to prove internal dissention based on the facts that the two shareholders had completely different views of how the business should be operated, Larry had told employees to ignore Belio’s instructions, and the two shareholders had been involved in a physical altercation. Id. at 1105. However, Belio failed to show a deadlock because Larry owned 54% of the stock, and only a simple majority was necessary for the company to conduct its business. Id. at 1104-05. The court illustrated several situations in which a deadlock could occur, such as where two shareholders each own 50% each the corporation’s shares, where no faction holds sufficient shares to overcome a supermajority or unanimous voting requirement, or where three or more minority factions exist and none can come together to form a majority coalition. Id. at 1104. Although the court did not mention the situation in the instant case, where neither of two factions can overcome a heightened quorum requirement, the same logic is applicable. Without the participation of the other faction, neither side can hold a shareholder’s meeting and pass resolutions, and the corporation now stands in deadlock. Because both internal dissention and deadlock can be proven, the client will be able to force dissolution under Cal Corp Code § 1800(b)(3).

Moreover, a shareholder may force dissolution when, in any corporation with 35 or fewer shareholders, liquidation is reasonably necessary for the protection of the rights or interests of the complaining shareholder(s). Cal Corp Code § 1800(b)(5).  This provision is broad and takes into its ambit several factors that the court must consider before granting dissolution. Ultimately, it is within the discretion of the trial court to force dissolution. Stumpf v. C. E. Stumpf & Sons, Inc., 47 Cal. App. 3d 230 (Cal. Ct. App. 1975).  Stumpf was decided under former section 4651, the predecessor to section 1800. Former section 4651, subdivision (f) allowed involuntary dissolution where “the liquidation is reasonably necessary for the protection of the rights or interests of any substantial number of the shareholders, or of the complaining shareholders.” Id. at 233.  In Stumpf, the corporation was owned by a father and two sons.  One of the sons left employment after a managerial dispute and was removed as an officer of the corporation. He was subsequently granted an involuntary dissolution. On appeal, the corporation argued that dissolution was inappropriate as there was no finding of deadlock, mismanagement or unfairness. The appellate court concluded that section 4651(f) was not limited to situations of the kind specified in the other subdivisions of the section. Id. at 234.  The court reasoned that the other provisions, providing for dissolution in cases of deadlock, mismanagement, and unfairness, were in place before 4651(f) and therefore the legislature would have had no reason to pass 4651(f) it were intended to be limited to those situations. Instead, the legislature intended “to empower the courts to order dissolution when required to assure fairness to minority shareholders and at the same time to lessen the danger of minority abuse.” Id.  But the Court also recognized the potential danger of minority abuse and set out a balance:

The minority must persuade the court that fairness requires drastic relief under section 4651, subdivision (f); involuntary dissolution is not an automatic remedy but, rather, a matter for the court’s discretion. A minority stockholder suing under a statute, just as if he were suing in the absence of statute, must still convince the court that his application is meritorious.

Id. at 235

The court held that dissolution was proper because there was evidence of extreme hostility between the two brothers. The ousted brother had no say in the operation of the business and he received no salary, dividends or other revenue from the corporation. Because the dissolution was supported by substantial evidence, it was a proper exercise of the trial court’s discretion. Id. Just as in Stumpf, in the instant case the minority shareholder was fired from his employment by the corporation and removed from his managerial posts. It is thus likely that a court would grant dissolution under Cal Corp Code § 1800(b)(5).

Where there is evidence of bad faith on part of the shareholder applying for dissolution, the court will not grant dissolution. Bauer v. Bauer, 46 Cal. App. 4th 1106 (Cal. Ct. App. 1996). In Bauer, the minority shareholders of a closely held corporation were removed from employment after they went into business in direct competition with the corporation and solicited the corporation’s customers. The minority shareholders argued that dissolution was appropriate both under section 1800(b)(4) (persistent fraud, mismanagement, abuse of authority or persistent unfairness toward shareholders) and 1800(b)(5) (dissolution necessary to protect rights or interests of complaining shareholders). The court concluded that in light of the bad faith conduct of the minority shareholders in setting up a competing business and soliciting the corporations customers, the trial court did not abuse its discretion in concluding that the “drastic relief of involuntary liquidation was not reasonably necessary to protect the minority shareholders’ interests. Bauer, 46 Cal. App. 4th at 1117. The court rejected the minority shareholder’s argument that the corporation was withholding dividends, noting that there were no profits from which dividends could be paid. Id.  Since they had already left the corporation, they did not have a reasonable expectation of receiving salaries from the corporation, and involuntary dissolution was not reasonably necessary to protect the minority shareholders’ rights and interests. Id. at 1118.   The Court held that granting involuntary dissolution would be tantamount to sanctioning the ability of minority shareholders, acting in bad faith, to abuse subdivision (b)(5) as a coercive tool to force an involuntary dissolution. Id. at 1117.

Dissolution is also inappropriate where there is no evidence of bad faith by the majority and the applicant continued to receive benefits from the corporation in the form of dividends. Stuparich v. Harbor Furniture Manufacturing, Inc., 83 Cal. App. 4th 1268 (Cal. Ct. App. 2000). In Stuparich, two sisters, as minority shareholders of a small, closely held family corporation, brought an action against the corporation, seeking its involuntary dissolution under Cal. Corp Code § 1800(b)(5). The corporation was running two businesses: a mobilehome park and furniture business. The Plaintiffs alleged that although the corporation had an economic interest in reducing or ending the significant losses suffered from running the furniture business, defendant refused to end the business because he and his family drew benefits from the furniture operation in the form of salaries and bonuses. Plaintiffs wanted to end the business, as they were not getting any salary and were not obtaining any benefit from it. They also alleged that they were not allowed any meaningful participation in the corporation, and that the dispute with the defendant gave rise to a violent confrontation. The court found no evidence of bad faith conduct, on the part of the defendant, that rose to the level demonstrated in Bauer. Id. at 1278. While the court found that the situation was unfortunate, as plaintiffs were minority shareholders in a hostile environment, the court also noted that the situation was hardly unique to this corporation. Id. Though the furniture business was losing money, the mobilehome park was making a profit and the plaintiffs were receiving dividends. Furthermore, the furniture business was beginning to improve. The court held that the plaintiffs could not substitute their business judgment for defendants’ with respect to viability of the furniture operations. Id. at 1279. Although the relationship became hostile, because there was no evidence of bad faith on the part of the defendants, and because plaintiffs continued to receive benefits from the corporation in the form of dividends, dissolution was unjustified.

Thus, in the instant case, if there was no bad faith on the part of the husband and wife and the minority shareholder continues to receive dividends, he may be precluded from forcing dissolution under Cal Corp Code § 1800(b)(5). He may also be precluded based on a showing of his own bad faith. Whether dissolution is granted will be up to the discretion of the trial court.

  1. Although the Majority Shareholders Cannot Conduct Business at a Shareholder’s Meeting Without a Quorum, the Restriction Can Be Easily Evaded by Acting Without a Meeting, and/or By Amending the Bylaws to Reduce the Quorum Requirement

As a general rule, the corporation cannot conduct meetings without a quorum. But the Corporations Code provides certain exceptions whereby business can be conducted without a meeting, with the written consent of a majority of shareholders necessary to authorize such an action. As long as there is no super majority requirement for passing resolutions, the majority shareholders can take action without a shareholder meeting, under Cal Corp Code § 603.

In the absence of a quorum, no business can be transacted at a shareholder’s meeting. Cal Corp Code § 602(c).  Where there is no quorum, the only possible legal action is to adjourn the meeting. Kauffman v. Meyberg, 59 Cal. App. 2d 730 (Cal. Ct. App. 1943).

But actions can also be taken without a meeting, under Cal Corp Code § 603. Any action that may be taken at any annual or special meeting of the shareholders can be taken without a meeting and without any prior notice. This is possible if consent, in writing, is provided by the shareholders who hold the minimum number of votes that would be necessary to authorize such action at a meeting at which all shares entitled to vote are present and voted. Cal Corp Code § 603(a). Thus, the husband and wife can act without a meeting if their 55% combined share would be sufficient to pass a resolution—if the corporation as no supermajority requirement. Such a supermajority requirement may be included in the Articles of Incorporation, under Cal Corp Code § 204, or in a shareholders’ agreement. However, if there is no supermajority requirement, the husband and wife may pass resolutions without a shareholder’s meeting, and would need only solicit the 45% shareholder’s written consent to the resolution, Cal Corp Code § 603(a), or provide notice specified in Cal Corp Code § 603(b). The only limitation is that directors may not be appointed without a meeting unless there is unanimous written consent of all shareholders entitled to vote for the election of directors. Cal Corp Code § 603(d).

In addition to acting without a meeting, the husband and wife can also defeat the quorum requirement by amending the bylaws. Unless the bylaws or articles say otherwise, the Board may amend the bylaws itself, without shareholder approval.  Cal Corp Code § 211.  The quorum may be reduced to as little as one-third of the outstanding shares. Cal Corp Code § 602.

Either action to evade the quorum requirement would obviously lend credence to an argument of the minority shareholder that a forced dissolution is necessary to protect his rights.

CONCLUSION

Although the corporation cannot legally conduct business at a shareholder’s meeting without a quorum, the majority shareholders can easily evade this restriction by acting without a meeting or by having the Board of Directors amend the bylaws, if such an amendment is not otherwise prohibited by the Articles of Incorporation or bylaws.

The minority shareholder may be able to force a dissolution of the company. Because there is internal dissension, and the corporation is currently at a deadlock, the minority shareholder has grounds for dissolution under Cal Corp Code § 1800(b)(3). In the absence of bad faith on his part, the minority shareholder may also be able to show that dissolution is necessary to protect his rights under Cal Corp Code § 1800(b)(5).