In my last post I looked at the decision of whether to create a corporation or an LLC from a minority shareholder’s point of view, and explained that minority owners may want to use an LLC. In this article, I will explain that, from a majority shareholder’s vantage point, the exact opposite often may be the case.
Before I explain how the corporate form may be better suited for majority shareholders, a caveat is in order. Using the LLC form may be better for everyone if the parties can agree on most everything at the outset. LLC’s are “creatures of contract,” and courts will usually respect whatever the parties themselves have agreed to. If the Operating Agreement says that a member may withdraw and be paid for his shares only if the Managing Member is convicted of a crime, that is likely exactly what a New Jersey court will enforce. The court will not rewrite the agreement for the parties. However, when not everyone can agree on such terms, the parties unfortunately either a) ignore the controversial issues, assuming they will be dealt with later (they never are); or b) never get around to signing any agreement at all.
With that said, let’s examine how to “get rid of” an unruly minority shareholder. It’s not always the majority owners that are the “bad guys.” What if a 33% owner is the one who runs the office, deals with the money, and is keeping everyone else in the company in the dark? Or awarding himself excessive bonuses? Yes, the majority owners can team up and make certain changes. But what if the minority owner is the only one who knows the critical end of the business? Or, worse, what if the minority owner is involved in a scandal that is hurting the company, and merely firing him as an employee is not a sufficient remedy? The majority owners cannot imagine staying in business with someone who did what he did, but what should the remedy be?
In an LLC, of course, a situation like this could have been specifically taken into account in the drafting process. However, if yours is one of the huge numbers of LLC’s that have no operating agreement, or at least one that does not address this, what is the remedy in an LLC?
In New Jersey, the LLC statute provides that, under certain circumstances, if “fault” can be proven on the minority owner’s part, he can be “dissociated” from the LLC. This means that he can be removed from management and all decision making. However, it does not mean that his shares may be purchased from him. He is still an owner, and still has the right to share in profits. In fact, there is a recent case in New Jersey that affirms just this result.
In a corporation, however, the result may be different. In New Jersey, courts have interpreted the oppression statute as permitting majority shareholders to sue minority shareholders, on the theory that minority shareholders may be just as oppressive as those in the majority. One New Jersey court even coined the phrase “tyranny of the minority” to describe it. If such “reverse oppression” can be established, then the majority shareholders may be able to force a buyout of the minority owner’s shares. This may be critical in a case where a minority owner has stolen from the company, and the company’s customers, vendors, and even its bank no longer wants that person to be an owner.
When trying to determine how to deal with an unruly minority owner, or even in planning for such an eventuality in the future, be careful what form (corporation or LLC) you select. It could make all the difference in the world.