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Shareholder Oppression May Be Easier to Prove Than You Think – Which Should Worry Majority Shareholders

While most of my posts on this blog look at shareholder dispute issues from the perspective of the oppressed minority shareholder, I have represented numerous companies defending shareholder litigation, as well.  One corporate client  recently wanted to know how to avoid such litigation if the shareholder agreement has been long-ago agreed to, and there is little that can be done to get near-warring parties to agree to anything in writing.  He feared that shareholder dispute litigation was in his company’s future, and wanted to know how to avoid it.

At the point he asked this question, it was too late for him, and the lawsuit was filed less than a week later.  However, his question applies to thousands of companies across New Jersey.  And thinking about the issues reveals the vulnerability that many companies have, simply based on the way that small, closely-held businesses are generally run.

For example, it is extremely common for majority shareholders (or members, in the case of an LLC) to run personal expenses through the company.  Regardless of whether the expense is a legitimate business expense or not, everyone knows it happens all the time.  Cars of family members who do not work at the company; personal dinners and parties; family vacations – all are routinely expensed.  These expenses are so commonly taken that judges comment all the time that they expect such items to be an issue in a shareholder oppression case.  In fact, I am hard pressed to think of the last case I have handled representing a minority shareholder where I was not able to determine that the majority shareholders were improperly running personal expenses through the company.

A second vulnerability is overpayment of salaries at the expense of shareholder distributions.  For example, majority shareholders often take a salary in excess of what the job that he performs would be worth on the open market.  Because of this, there is less money – sometimes no money at all – to be distributed to shareholders.  As with personal expenses, these overpayments happen all the time.

Since these issues occur with such frequency, it seems odd to a business owner to hear an attorney warn that these practices could land you in shareholder dispute litigation.  I was told by one majority owner (a few months before he was sued) that I “didn’t understand” the way small businesses operate if I expected him to pay himself a market-based salary.  He was adamant that the inflated salary was why he was a business owner in the first place.  In fact, he specifically argued to me that he was “entitled” to take an above-market salary since he was “the owner.”

Since I am mentioning this occurrence in this article, you know, of course, how it turned out.  When he was sued, and came to me to represent him, he could not believe how the minority shareholder’s lawyer was “distorting things” and making him look like he was looting “his own” company.

Which leads to the point I was trying to make with him in the first place.  It was not “his company.”  And it is not “your company” when there are minority shareholders.  If your job is worth $150,000, every penny you pay yourself over that amount arguably should be distributed pro rata to the shareholders.  So, if your job is worth $150,000, and you pay yourself $250,000, then $100,000 of your salary likely should have gone to the shareholders.  If there is a 15% shareholder, he has the right to “cry foul” and complain that $15,000 of the extra money you paid to yourself should have gone to him.

The critical point of this is, by doing this repeatedly, likely over years, and frequently in larger amounts than a $15,000 dispute, you are handing the minority shareholder a shareholder oppression claim on a silver platter, possibly entitling her to a buyout (at least in New Jersey).  These claims are so easy to make that a majority of clients who come in for a consultation, not even knowing if they have a cause of action, probably have a decent claim just on one of these two bases alone (personal expenses and overpayment of salaries).  In other words, these practices are so prevalent that most companies – that I have run across, in any event – are vulnerable to attack if a forensic accountant went through all of the company’s books and records.

Since many companies simply cannot afford shareholder oppression litigation, or to buyout a minority shareholder, it is often much better strategically to simply go to great pains to treat all minority shareholders fairly.  Since what constitutes “fair” towards a minority shareholder may not be obvious, seeking legal advice on how to achieve this is often money well spent.

If you are a majority shareholder in New Jersey, just remember – if the minority shareholder of your company walked into my office, chances are pretty good that I would be able to find something that you have done wrong that just may constitute shareholder oppression.