Think Twice Before Offering a Minority Position in a Closely Held Company
October 2024
In Ferrucci Russo Dorsey’s Business Calendar litigation practice, we often encounter intra-company ownership disputes or what some of us old guys generally refer to as “Shareholder Disputes”. One scenario is familiar. An entrepreneur starts a closely held company and offers a small percentage of ownership to someone who is expected to play a role in company operations. Everyone is excited about starting the venture and the folks involved all consider themselves to be friends. As a result, the documents forming the company are stock documents at best. As time goes by, the personal/business relationship turns ugly. The entrepreneur calls counsel and states “I want him/her out”. The minority owner is an employee and an owner. Therefore, it can be complicated. An offer to unwind the relationship is met with an unreasonable “buyout” demand, the entrepreneur reacts by firing the minority owner, and a breach of fiduciary duty/minority shareholder oppression case is filed. The costs involved could cripple the business.
The Rhode Island Superior Court Business Calendar in Grady v. Grady, 2012 R.I. Super. LEXIS 9 (R.I. Super. Ct., January 17, 2012, C.A. No. PB 09-0367, C.A. No. PB 09-0372 (consolidated)) (J. Silverstein), outlines how the business calendar treats disputes between shareholders in close corporations regarding the termination of a minority shareholder’s employment within the context of shareholder oppression and breach of fiduciary duty. A large part of the Court’s analysis focused on whether the minority shareholder has a reasonable expectation of employment. The Court outlined that minority shareholders in a closely held company have a reasonable expectation of employment when the minority shareholder’s employment goes hand-in-hand with ownership.
The next strategic question becomes whether the entrepreneur can elect to avoid the shareholder oppression cause of action by purchasing the minority’s ownership interest. We are all familiar with the fact that the Rhode Island corporations statute allows a buyout election to avoid a dissolution proceeding. Therefore, if the hypothetical scenario involves a closely held corporation, there is the possibility of arguing that the shareholder oppression case triggers the statutory election to buyout a minority shareholder for “fair value”.
In the case of Quinn v. Yip, 2015 R.I. Super. LEXIS 141 (R.I. Super., December 11, 2015, C.A. No. KC-2015-0272), the Rhode Island Superior Court Business Calendar ruled that a minority shareholder oppression claim can trigger a statutory election. However, that issue has not been addressed by the Rhode Island Supreme Court and there has been some inconsistency in applying Quinn v. Yip. In addition, there is no corresponding election provision in the Rhode Island Limited Liability Company Act. Therefore, litigation issues may well proceed and ultimately the client, as guided by counsel, must consider the benefits of mediation ordered by the Business Calendar Justice.
In the end, a practical observation arising from this scenario necessitates careful consideration at the time of company formation. Transactional counsel and entrepreneurs forming a closely held company and offering a minority position as a form of incentive or compensation have to carefully consider a Shareholder Agreement or an Operating Agreement that provides for a buyout mechanism that is triggered by defined events. In turn, the mechanism that allows the entrepreneur to terminate the business relationship should also address the formula for determining the purchase price to be paid as the Rhode Island Superior Court Business Calendar has clearly established that “fair value” essentially equates to the minority owner’s proportionate share of the fair market value of the entity without any discounts for minority status or lack of marketability.
There are issues that can be commonplace in litigation, but a great deal of transactional expense and even the business, itself, can be saved by anticipating these types of issues.
To learn more about how the Rhode Island Superior Court Business Calendar works, or to speak with an experienced business litigation attorney, please visit https://www.frlawri.com or call Mark Russo, Ferrucci Russo Dorsey, P.C. at 401-455-1000.
