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Rights of Limited Partners in the Face of a General Partner’s Self-Dealing

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Limited partnerships have in large measure been replaced by limited liability companies as the passive investment vehicles of choice.  But, they are still relevant because they are still sometimes used and there are many legacy limited partnerships that are still in existence.

On the surface, it appears limited partners have very few rights and protections.  They are not allowed to participate in management or to second guess the general partner’s actions.  However, while the law requires that they stay passive insofar as management is concerned, it does afford them a number of protections to assure that their financial interests are not abused.

"A limited partner is not in the hopeless position where he must only suffer in silence when an alleged wrong occurs. He has a right of full and free access to information contained in the partnership books, and of all things affecting the partnership, as well as a right to formal accounting." Millard v Newmark & Co., 24 AD2d 333, 336 (lst Dep' t, 1966).

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Selling Minority Equity Interests for What They’re Really Worth - The Lessons of Pappas v. Tzolis

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At first glance it might appear as if the New York Court of Appeals struck a major blow to LLC minority member rights in their November 2012 ruling Pappas v. Tzolis. After all, the New York high court held that a majority member owed no duty to disclose to his fellow members that upon buying out their equity interests, he planned to immediately flip for $17.5 million the interests he had acquired from them for $1.5 million. 

However, implicit in the opinion is the recognition that if business partners have a relationship based on mutual trust, a partner may not be free to cheat his partner out of financial gains by failing to disclose material facts.

            Pappas v. Tzolis involved a Limited Liability Corporation (“LLC”) formed by three parties in January 2006 to acquire a long-term leasehold interest in a Lower Manhattan building. Steve Pappas and Steve Tzolis each contributed $50,000 to this project with Constantine Ifantopoulos contributing another $25,000. Trouble plagued this LLC from the start. Tzolis sought to sublease the property to another company he owned, and according to Pappas and Ifantopoulos, they had to go along with this because Tzolis had blocked efforts to sublease to other entities. Further, Tzolis would not cooperate in the development of the property and his company neglected to pay the $20,000 monthly rent on the sublease.

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For Sellers of Minority Interests, the Rule is "Caveat Vendor" – Let the Seller Beware

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  • New York Court of Appeals rules that seller of minority interest has no remedy when purchasing majority owner immediately flips the interest for twenty times what he paid

Owners of minority interests in companies often have very little say on the most important issues that determine the value of their interests. These issues include:

  •          whether equity owners will receive distributions and if so, in what amounts; and
  •          whether the business will be sold and when.

Because of these reasons and others, the only buyers of their interests are typically the majority equity owners and often, because of this, the majority owners can dictate the price.

What happens when the minority owner, who has been waiting for years to realize on the value of his interest finally gets an offer from the majority owner to buy his interest?  As several recent New York Court of Appeals decisions illustrate, the offer is often precipitated by the fact  that the majority owner has received – or is about to receive - an offer for the entire company that he is ready to accept. He realizes that he can increase his own profit on the sale by buying  out the minority owner at less than the pro-rata share of the value for the company that he is entitled to. So, he makes an offer, but neglects to tell the minority owner about the potential transaction or the value that this indicates for the company as a whole.  The minority owner accepts the buyout offer, contracts are drawn and the minority interest is sold to the majority owner. 

A few weeks later, the minority owner learns that the majority owner has sold the entire company at a value that reflects that the minority position was worth twenty times what he just sold it for.  Rightfully indignant, the minority owner sues to collect the amount he believes he was cheated out of. He claims a breach of the majority owner’s fiduciary duties by failing to disclose the offer at the much higher price.

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Fiduciary Duties of Majority Shareholders in New York -- What the Courts Say

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Duty of Good Faith

Fender v. Prescott, 101 A.D.2d 418,422 (1st Dept. 1984):

[T]he relationship between shareholders in a close corporation, vis-à-vis each other, is akin to that between partners and imposes a high degree of fidelity and good faith.

As was observed by Chief Judge Cardozo in Meinhard v. Salmon, 249 N.Y. 458, 164 N.E. 545, 546 (1928) : "A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior."

The strict standard of good faith imposed upon a fiduciary may not be so easily circumvented.

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Economic Duress and Minority Shareholder Oppression

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If a majority shareholder terminates a minority shareholder’s employment or forces him to sell his shares in the company at a below-market price, the majority shareholder could be vulnerable to a claim of oppression.  But, what happens if the majority shareholder is able to obtain a signed agreement from the minority shareholder in which the minority surrenders its rights in return for some – but far less than fair market – consideration?  Typically, an agreement giving the minority shareholder some severance rights or compensation for his shares will contain a general release provision, which would provide that the minority shareholder releases all claims he may have against the majority shareholder.

Often the minority shareholder – having lost his job and means of support or being compelled to sell his interest in his business – will be under significant pressure to accept an offer that provides him some continuing income or compensation – even if it is much less than what he might legally be entitled to or could negotiate for is he were not under duress.

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Avoiding Shareholder Oppression Claims

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The Threat:

Being a defendant in a shareholder oppression case can pose a significant threat to a closed corporation and its majority shareholders. Not only can the majority or the corporation be forced to buy out the shares of the minority at what the court determines to be “fair value,” the litigation itself can be a significant distraction and drain on company finances and managerial resources.

“Fair value” often involves an appraisal process, expert reports and expert testimony at a trial – and great uncertainty as to what the court will ultimately decide.  “Fair value” is a technical legal terms that is a legislative and judicial creation; it is not the same as “fair market value” and it can often be substantially different from what the minority’s shares can fetch in the open market or the amount of financing a company can obtain to buy these shares. 

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Fraud Claims in the Context of Contract Representations: The Question of Reasonable Reliance

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A recent New York Court of Appeals decision provides some guidance of relevance to all transactional lawyers and clients relating to potential causes of action for contractual representations and warrantees, which prove to be untrue.

In DDJ Management, LLC, et al., v. Rhone Group L.L.C., et al., 15 N.Y.3d 147___N.Y.S.2d___ (June 24, 2010), the New York Court of Appeals addressed the following questions in its decision to allow Plaintiff DDJ Management’s $40 million fraud claim to proceed to a jury:

  • When can a recipient of written representations from a company, which prove to be untrue, sue third parties, such as shareholders and officers of the company making the representations?
  • In what circumstances does neglecting to conduct a due diligence investigation impede the  recipient of contract representations from bringing a fraud claim?

The basic facts, in a nutshell, are as follows:

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Protection of Minority Shareholder Rights and Shareholder Oppression Doctrine in Texas

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What can minority shareholders do in under Texas law to protect themselves against unfair treatment, including “squeeze-outs”, “freeze-outs” and the taking of disproportionate benefits by the majority? 

Texas recognizes both the shareholder oppression doctrine and “breach of fiduciary duty” theories in close corporations to protect the rights of minority shareholders.

The Dissolution Statute:

The Texas corporate dissolution statute, Article 7.05 of the Texas Business Corporation Act, provides for the appointment of a receiver and the possibility of dissolution when an aggrieved shareholder establishes “illegal, oppressive, or fraudulent” conduct by directors or those in control. 

Of significance, Texas Courts have used this statute as a basis to fashion a broad range of remedies less harsh than dissolution, where they find that minority shareholder rights have been abused.

What is Oppressive Conduct?

Though illegal and fraudulent conduct is fairly easy to identify, oppressive conduct is less readily definable.  One of the leading cases in Texas, Davis v. Sheerin, adopts the language of New York’s Matter of Kemp for oppression, and defines “oppressive conduct” as follows:

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Shareholder Oppression in Delaware

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Delaware does not have a cause of action for oppression per se, but it does offer relief for minority shareholder oppression-like claims applying other legal principles.  Thus, oppression-like claims must be carefully pleaded in Delaware.  

Since court’s in other states are likely to apply Delaware law to oppression-like claims to companies organized in Delaware, vigilance must also be exercised in pleading claims relating to Delaware corporations in non-Delaware courts.  Some courts outside of Delaware, such as the Southern District of New York and the Northern District of Illinois, have upheld causes of action for shareholder oppression under Delaware law, while others, such as the District of New Jersey, have dismissed oppression claims for failure to state a claim under Delaware law.

Nixon v. Blackwell, 626 A.2d 1366 (Del. 1993), is a Delaware case that often cited for the proposition that Delaware does have a shareholder oppression remedy, and also for the proposition that it does not.  The case states that “[t]he entire fairness test, correctly applied and articulated, is the proper judicial approach” to deciding claims brought by minority shareholders against those in control of the corporation.  Thus, some conclude that oppression claims may be pursued under the entire fairness doctrine.   

However, Nixon v. Blackwell also, contains language that seems to indicate otherwise:  

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Shareholder Oppression in New Jersey

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Applicable Statue:

The New Jersey Shareholder Oppression Statute, N.J.S.A. § 14A:12-7, provides that when those in control of a corporation having 25 or fewer shareholders “have acted fraudulently or illegally, mismanaged the corporation, or abused their authority as officers or directors or have acted oppressively or unfairly toward one or more minority shareholders in their capacities as shareholders, directors, officers, or employees,” the Court can impose a wide variety of equitable remedies, including ordering a buy-out at “fair value.” (emphasis supplied).

The buyout that the Court can order does not necessarily have to be of the minority shareholders’ interest.  It can order a buyout of the majority’s interest.  The purchaser can be the corporation or the other shareholders.

What is Oppressive Conduct?

Oppressive conduct is defined in New Jersey as conduct that frustrates the “reasonable expectations” of the minority as of when they joined the enterprise.

In Brenner v. Berkovitz (1993), the New Jersey Supreme Court stated that the special circumstances, arrangements and personal relationships that frequently underlie the formation of close corporations generate certain expectations among the shareholders concerning their respective roles in corporate affairs, including management and earnings.  A court, then, must determine initially the understanding of the parties in this regard.  Generally, the court noted that any increase in benefits to the majority shareholders without corresponding benefit to minority may provide a claim of oppression.

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Case Law Update: What are Acts of Shareholder Oppression?

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In Stephanie (Younger) Waters v. G&B Feeds, Inc. and Wiliam Younger, No. SD29745, March 4, 2010, the Missouri Court of Appeals upheld the trial court's finding of shareholder oppression, showing that a pattern of oppressive acts is key to the cause of action.  The trial court recited a medley of actions taken by Appellant-Defendant which the trial court considered to be acts of shareholder oppression:


[h]e assumed control of the corporation and the operation of its business without lawful authority and in complete disregard for the rights of [Respondent]. He borrowed money and refinanced debts on his own without consultation with [Respondent]. He testified that throughout the term of the business he purchased livestock feed at cost for [his] herd of 500-600 head of livestock, a substantial savings over a period of six years. However, the court has no evidence, other than [Bill’s] testimony, as to any such amounts paid for feed. He declined the opportunity to pay [Respondent] $70,000[.00] for her stock, the amount she had paid for it, and thus be in a position to have complete ownership of the corporation and the lawful right to operate the corporation business as he was doing without lawful right. He refused to cooperate in the sale of the business property to the ultimate financial detriment of both shareholders. He retained all rental receipts from the storage units and gave no accounting therefore. He has totally failed to give a proper accounting of his stewardship of the business affairs.

 

The Court of Appeals went on to hold that there was "sufficent evidence supporting the trial court's determination that [Appellant-Defendant] breached his fiduciary duty to Respondent in his dealings with her and in his operation of the affairs of [the company]"  and upheld the trial court's finding of minority shareholder oppression.

For the entire decision, click here.

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Shareholder Oppression in New York

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Applicable Statute

New York State’s corporate dissolution statute, NY Business Corporations 1104-a, provides for the involuntary dissolution of a corporation when the “directors or those in control of the corporation have been guilty of illegal, fraudulent or oppressive actions toward the complaining shareholders” in a company that is not publicly traded.

New York courts have held that oppressive conduct is distinct from illegal or fraudulent conduct, and thus also a reason for corporate dissolution. 

What is Oppressive Conduct?

In an “oppression” case, the first inquiry of a New York court will be to determine whether the complained of acts are actually “oppressive.”  Though the dissolution statute does not define what oppressive acts are, one of the leading cases on the subject, Matter of Kemp & Beatley, Inc., interprets them as actions which “substantially defeat shareholder expectations that, objectively viewed, were both reasonable under the circumstances and were central to the petitioner’s decisions to join the venture.”  This standard is widely followed.

Oppressive conduct is most often found when there are a number of actions that, when taken together, have the effect of denying the minority shareholder benefits from the company that he or she had the reasonable expectation of.  Often the Court will look at what is motivating the majority’s actions and whether there is an effort to “freeze out” or “squeeze out” the minority. 

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What is Shareholder Oppression?

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The “shareholder oppression” doctrine is a set of legal principles that protect minority shareholders from abuse by the majority.  As such, these principles stand in direct contradiction to the central rule of corporate decision making that the will of the majority governs.  The doctrine also runs contrary to and can prevail over several other well established legal principles, including the business judgment rule, the employment at will doctrine and derivative claims distinction.  More on these later.

The principles protecting the rights of minority equity owners are articulated and implemented differently from state to state, and their implementation often involves a balancing of the rights of the majority to control the business entity’s destiny and the rights of the minority to receive the often unarticulated benefits they anticipated when they joined the enterprise.  The rules may vary within a state depending on the type of entity, as well. 

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Limitations on Majority Rule in the Management of Business Entities

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The general rule in the corporate governance of business entities -- including corporations, limited liability companies and partnerships -- is that absent an agreement or statutory requirement to the contrary, majority rule governs.  Indeed, majority equity owners often assume that they can do pretty much anything they want with regard to the business entity. 

However, this is an erroneous assumption.  Over the years, many legal principles have evolved which limit the freedom of the majority  to do as they wish.