In the many years I have been working as outside counsel to closely held businesses, one of the frequent pitfalls leading to costly litigation and operational conflicts is the failure of shareholders to adequately document and formalize their expectations, especially as it relates to minority shareholders.  The first question I ask when contacted by a business owner who is dealing with shareholder conflicts is “What does your shareholders’ agreement say?”  Unfortunately, too often, the answer is “What shareholders’ agreement?”   

Many small businesses are formed by a group of people who share a collective belief at the time of formation.  There are often unwritten understandings as to the division of roles within the business.  Almost universally, the expectation is that all of these founding shareholders will devote ongoing resources to the business.  Conflicts arise when those expectations diverge, when one shareholder fails to perform within the business, or even when a shareholder exits the company.   
 
When conflict does arise, mechanisms for resolution can be limited, complex and expensive.  Certainly a transfer of a non-performing shareholder’s stock seems like a simple straightforward course of action.  However,   in the absence of an agreement providing for transfer upon specified events, the business has no absolute right to remove a shareholder or force a transfer of the share ownership interest.  Even a shareholder who has ceased to be actively involved in the business continues to enjoy all of the rights attendant to the ownership of the shares: the shareholder need not come to work, need not contribute capital, need not pursue business opportunity in the name of the company.  Employment may end, but the right to enjoy distribution of profits does not, as long as share ownership persists.  As most small businesses are organized as subchapter “s” corporations, profits must be distributed in accordance with share percentage. 

Ownership of stock gives rise to all of the rights provided by statute.  Minority shareholders enjoy the right to obtain information about the performance of the company, attend and vote at shareholders’ meetings, and receive distributions of profits derived from corporate operations.  Minority shareholders can be an impediment to stock transfers, anchors against change and obstacles to capital expenditures. Such situations are a constant bone of contention among owners of small businesses. 
 
Of course, the best solution is an agreement that accurately reflects the understandings of the shareholders at the time the shares are assigned, or the company is formed.  Such agreements can provide clearly defined roles within the business, mandatory transfer upon termination of employment, death or disability, valuation mechanisms and provisions restricting transfer.  Adopting an agreement, at minimum, provides a foundation for the business relationship, and may provide a roadmap in the event of disagreement.    

In the absence of an agreement, a dispute with a minority shareholder requires careful management. The majority must take care to avoid vesting a minority shareholder with breach of fiduciary duty claims or shareholder oppression.   Compliance with corporate formalities is imperative. While there is no guaranty of continuing employment for a minority shareholder (with exceptions), distributions or profits in accordance with ownership percentages is required if the company has elected “s” corporation treatment.  Certainly, majority and employed shareholders may receive compensation for services rendered, but an artificial manipulation of corporate profits would certainly be relevant to a minority shareholder oppression claim.  

Pennsylvania Business Corporations Law provides little relief to a majority shareholder who continues to run a profitable business without the assistance of his or her minority shareholders. The statute provides no right to extract a non-performing shareholder against his/her will at any price, and provides no absolute right of liquidation. Even the nuclear option of judicial corporate liquidation requires that the complaining shareholder allege irreparable harm to the company; an allegation which may be impossible if the business is successful as a result of the majority’s efforts.

Formation of an appropriate and workable shareholders’ agreement requires legal representation; as does management of divergent goals between shareholders.  Owners of s corporations with minority shareholders would be wise to review their governing documents and take proactive steps to safeguard the future value of their shares, and avoid crippling and costly litigation. Antheil Maslow and MacMinn business attorneys are highly experienced in such matters and leverage a team of professionals in differing disciplines to navigate these complex waters.       

By Thomas P. Donnelly, Esquire, Reprinted with permission from October 11, 2013 issue of The Legal Intelligencer. (c)
2013 ALM Media Properties. Further duplication without permission is prohibited.

Senior Judge Anita Brody of the United States District Court for the Eastern District of Pennsylvania recently presided over a non- jury trial in the matter of Lehman Brothers Holdings, Inc. v. Gateway Funding Diversified Mortgage Services, L.P. Judge Brody is expected to render a decision in the coming weeks.  Lehman Brothers represents the first occasion for the District Court to consider the legal principal of de facto merger under Pennsylvania law following the Pennsylvania Supreme Court’s landmark decision in Fizzano Brothers Concrete Products, Inc. v. XLN, Inc., 42 A.3d 951 (Pa. 2012).  In Fizzano Brothers, the Supreme Court substantially modified the application of the de facto merger doctrine allowing trial courts far greater flexibility in the application of the doctrine to a broader set of facts.

Before Fizzano Brothers, Pennsylvania courts were constrained to a mechanical application of four elements: (1) continuation of the enterprise of the seller corporation; (2) continuity of shareholders; (3) cessation of ordinary business operations on the part of the selling entity; and  (4) assumption of those obligations of the seller ordinarily necessary for the uninterrupted continuation of normal business operations.  In practical application, the “continuity of shareholders” requirement was nearly impossible to satisfy where sophisticated business people with legal representation structured the transaction as a sale of assets to a new entity.  Consequently, mechanical application of the continuity of shareholders element was the stumbling block in the de facto merger analysis.

The Fizzano Brothers court substantially modified the analysis by discarding the mechanical application of continuity of shareholders.  Citing public policy and recognizing the sophistication of business transactions in the current climate, the court ruled that “where the underlying cause of action is rooted in a cause of action that invokes important public policy goals, the continuity of ownership prong may be relaxed.”  Fizzano Brothers, 42 A.3d at 966.  The question of successor liability should first be viewed in light of “whether, for all intents and purposes, a merger has or has not occurred between two or more corporations, although not accomplished under the statutory procedure.”  Id. at 969.

The Supreme Court went on to hold that the shareholders of the predecessor company were no longer required to become shareholders of the successor to meet the requirements of de facto merger. The court concluded such a holding would be “incongruous” with provisions of the Pennsylvania Business Corporation Law stating; “because a de facto merger analysis tasks a court with determining whether, for all intents and purposes, a merger or consolidation of corporations has occurred, even though the statutory procedure had not been used, the continuity of ownership prong of the de facto merger analysis certainly may not be more restrictive than the relevant elements of a statutory merger as contemplated by our legislature.”  Id. at 968.

The court then adopted a more flexible approach. After Fizzano Brothers, cases rooted in breach of contract and express warranty no longer require strict transfer of ownership.  Rather, the de facto merger doctrine now requires “’some sort of’ proof of continuity of ownership or stockholder interest. . . . However, such proof is not restricted to mere evidence of an exchange of assets from one corporation for shares in a successor corporation.” Id. at 969 (internal citations omitted).

The Fizzano Brothers factors are at issue in Lehman Brothers Holdings, Inc. v. Gateway Funding where Lehman Brothers raised claims of successor liability relating to indemnification agreements with Gateway’s alleged predecessor.  At trial, evidence was admitted indicating that  Gateway had specifically and intentionally purchased all assets that were necessary to the continuation of the mortgage origination business formerly conducted by the predecessor.  Such evidence included direct testimony on the part of Gateway’s management team that the acquisition was designed to acquire not only the current “pipeline” of loans in progress, but also the potential for continued loan origination.  Contemporaneously, Gateway also undertook to acquire debt obligations owed by the predecessor which were necessary to loan origination including securing warehouse lines of credit utilized to temporarily fund mortgage loans until sold on the secondary market.  Finally, documents related to the transaction reflected the intention that the business operations of the predecessor entity were to be “wound down”.  In that regard, restrictions against competition imposed upon the former principals of the predecessor, now Gateway employees, were permitted to “compete” only for the purpose of effectuating that wind-down.

While evidence was admitted as to each element of the de facto merger doctrine, continuity of ownership was specifically contested.  The transaction at issue was characterized by the buyer and seller as an asset transaction with no stock transfers. However, the four shareholders of the predecessor entity were provided compensation in a variety of ways which Lehman Brothers argued were illustrative of ownership.  The four shareholders received employment agreements with Gateway which included substantial severance benefits, a right to share in the profits of the same operations as had been conducted by the predecessor, and cash considerations.  One former shareholder indicated the cash component was paid, at least in part, as a result of his equity position in the predecessor.

In contrast, Gateway argued that the four shareholders were valuable and experienced revenue generating employees with corresponding compensation arrangements following the acquisition.  Objectively, the four shareholders of the predecessor were not granted stock in the acquiring entity.  Further, although certain of the agreements between the four shareholders and Gateway referenced the shareholder’s equity stake in the predecessor, no provision for consideration set forth in the language of the agreements was expressly tied to that equity position. 

The Lehman Brothers trial is the first test of the new more relaxed application of the continuity of ownership prong of the de facto merger analysis.  Judge Brody’s decision will provide guidance to both transactional practitioners in structuring transactions where liabilities may remain post-closing, and to litigators when faced with claims against a defunct entity where assets were transferred leaving a hollow shell.

The author served as local trial counsel to Lehman Brothers Holdings, Inc.