The most common form of business organization in the United States involving two or more people seeking limited liability remains the corporation. The reader is invited to review the article on Limited Liability Entities in the Articles section of this website as well as the Corporate Formalities and Structure article in the Retainer Articles section to understand the basic structure of the California nonpublic corporation. For the purposes of this article, it will be assumed that the reader has already reviewed those two articles.
The corporation is the oldest of the limited liability entities, a brilliant invention that was largely responsible for the amazing growth of business in the world. Given the aggressive and acquisitive personalities of the initial capitalists, it should come as no surprise that much effort was expended by the first owners of corporations in obtaining the positions of power and control within the various corporate structures. Indeed, the history of capitalism in America is often a history of what corporate owner was able to seize control of the corporate power structure and achieve dominance within the corporation to the dismay of the other owners.
Thus there is well over a hundred years of statutes and case law providing in remarkable detail as to what person within a corporation can achieve what power by what methods.
To own a corporation without understanding the reins of power available is to miss much of the purpose of ownership and to invite disaster if one of the other owners seeks to obtain increased control or if new owners come into the picture. Further, the death or disability of a shareholder can suddenly result in a new owner, a relative or spouse for instance, with more aggressive criteria for ownership, coming into the corporation thus each shareholder should have a thorough knowledge of the workings of corporate power even if friendship and trust exists between the current shareholders.
Publicly traded corporations have extremely different criteria for achieving and maintaining control and are not discussed in this article. This article shall concentrate on the typical California corporation not traded on a public exchange and not owned by more than thirty five shareholders (husband and wife counting as one shareholder.)
THE BASIC STRUCTURE
As discussed in the web article on Corporate Structure, the typical California corporation has Shareholders who elect the Board of Directors who, in turn, appoint the corporate Officers, usually a President (CEO), a Secretary, and a Treasurer (CFO). Typically, the Shareholders meet annually to elect the Directors and approve their actions; the Board of Directors meets annually or quarterly to review the Officers’ actions and the Officers meet as often as necessary to run the entity. Day to day operations are run either by the Officers or by managers hired by the officers.
Officers and Directors have a fiduciary duty to the company and its Shareholders, the highest duty of loyalty known to law. Breach of that duty imposes personal liability on them in favor of the corporation or the Shareholders. The Shareholders, absent also occupying a position of Director or/and Officer, do not have a fiduciary duty to the company unless a particular Shareholder owns a majority of the stock in which case in the event of sale of the stock, said Shareholder is required to obtain the same price per share for the minority Shareholders (in California only).
Both Officers and Directors have a duty of care in regard to running the corporation and this includes the duty to inquire. This means that they are personally liable if they fail to take appropriate action to protect the company and they remain liable even if they were unaware of the problem facing the company if their ignorance as to what action to take is predicated on negligent failure to investigate a problem in the company. Good faith errors in judgment do not necessarily create liability absent negligence or dereliction of duty. There is a duty to actively investigate to determine problems facing the company.
Shareholders can be Directors and Officers but need not be. Officers can be Directors and vise versa...but, again, need not be.
Since Shareholders elect the Directors and Directors elect the officers, it is apparent that Shareholders hold the ultimate position of authority in a company. If one controls how the Shareholders will vote, one can determine who will be the Directors who, in turn, will determine who will be the Officers who will, in turn, determine who will be the managers of the company.
THUS THE FIRST RULE OF CORPORATE POWER IS QUITE SIMPLE:
THE PERSON WHO CONTROLS THE VOTES OF THE SHAREHOLDERS ULTIMATELY CONTROLS THE CORPORATION.
Thus let us examine the details of Shareholder voting.
Voting the Shares
Shareholders determine action to be taken by the company, from election of directors to approval of corporate actions, by voting and normally each share allows one vote. Thus if a person owns fifty shares, that person has fifty votes, if the person has sixty shares, that person has sixty votes.
In California, majority vote controls in votes of shareholders. Thus, if a shareholder has fifty one percent of the stock, that person effectively controls the corporation. This is probably the most important single lesson the business owner must learn: in terms of control, whether one has ten percent or forty nine percent matters little. The person who has fifty one percent can elect a majority of the Directors and they, in turn, can appoint the officers and managers. While certain rights do exist to protect minority shareholders in specified areas, discussed below, the simple fact is that the shareholder who controls 51% of the stock is able to run the company pretty much as he or she wishes.
This is particularly important when one recalls that there is no State law obligation of the company to hire Shareholders (who would thus earn salaries) or declare dividends at any particular level of income. Thus, a hostile Shareholder owning 51% of the stock can seize control of the Board of Directors, fire all Officers except those he or she wishes, fire all minority Shareholders who are employed by the company, hire him or herself as President, pay him or herself a good salary, and never declare dividends, using profits to pay bonuses to employed managers...and him or herself. Absent salaries or bonuses of truly stupendous proportions, the court will NOT limit this type of use of power by a majority shareholder and the minority Shareholder will find him or herself literally locked out of the ability to earn money from the company.
Only in two instances does the minority shareholder have a legal right to receive a portion of the proceeds of the company. If the company is sold, the minority shareholder must receive the same price per share as the majority shareholder. Secondly, if a dividend is declared, the minority shareholder must receive the same dividend per share as the majority shareholder.
But since there is no duty to either sell the company or declare a dividend on the part of the majority Shareholder, it is typical in such situations for the minority Shareholder to own essentially worthless stock for years, watching salary and bonuses be paid, while the majority Shareholder refuses to declare dividends, or sell the company. Obviously, no other person will buy the minority interest, thus the minority Shareholder is in a powerless situation despite the ownership of stock.
Assuming the corporation is Sub S in tax status (in which case each shareholder is taxed on corporate profits personally) then the situation for the minority Shareholder can be desperate since the majority Shareholder can bonus him or herself enough to pay the taxes, but not declare any dividends and the minority Shareholder is in the impossible situation of paying taxes on money he or she never even receives! (Thus if a Sub S company earns $100,000 in net profit and you own thirty percent of the stock, you must pay taxes on $30,000.00 as your share of the income. If the company declares no dividend, you still must pay that tax.)
The above "squeeze play" on a minority Shareholder is a very typical maneuver in corporate fights and ultimately forces the minority shareholder to sell his or her interest at any price to the majority Shareholder in an effort to avoid economic ruin.
The minority Shareholder in California does have the right to attend Shareholder meetings, to obtain certain corporate records, to vote for Directors, and to insist that the Directors and Officers act in the best interest of the company as a whole (which does NOT mean the power to force dividends or sale of the company.) The more stock the minority Shareholder owns, the more records are available for his or her review and the easier it is for the shareholder to call a meeting.
Further, under the rules of cumulative voting, a minority shareholder with a certain amount of stock can assure him or herself of being able to elect a minority on a Board of Directors (at least elect one out of three) even if control still remains in the hands of the majority shareholders.
But these rights are minor, indeed, and do not really give any protection or control to the minority Shareholder. If you are destined to become a minority Shareholder, you must protect yourself in other ways: either by creating a unique type of stock structure allowing certain veto rights or by obtaining contractual rights in a separate written agreement, either of employment, or in terms of who will serve on the Board or act as an Officer. Realistically, such agreements are seldom possible once a fight begins since the majority shareholder would never give up such power.
It is thus at the formative stage of the corporation where minority shareholders must either seek some type of increased share holdings or contractual protection, as discussed at the end of this article. The two methods to protect minority rights are Stock Structure (and related voting agreements) and Employment Contracts. We will now discuss those in order.
CLASSES OF STOCK; EQUAL OWNERSHIP DANGERS; VOTING AGREEMENTS
It is possible even in a nonpublic corporation in California to create quite a complex stock structure though the benefits of simplified corporate filings and tax returns are surrendered as the structure becomes more complex. A common and usually misunderstood method of stock structure is to issue two classes of stock, "Common" and "Preferred." Under California law, "Preferred stock" is simply stock that has a preference in payment in the event of liquidation of the company and payment of dividends. Clearly neither benefit pertains to the power element of the corporation thus will not be further discussed herein.
Of more interest for the purposes of this article are classes of stock which are nonvoting versus classes of stock which are voting. It is possible to have classes in which there is no right to vote or in which the right to vote is a fraction of the common stock (e.g. each share counts for one quarter or one hundredth in terms of voting power versus common stock.) By use of such classes, parties wishing to own most of the company can still end up without 51% of the voting power and, of course, voting power is what corporate struggles are all about. A typical structure of this type is to have Class A common stock owned 50-50 and Class B nonvoting stock owned with the majority in the hands of some stockholder.
Another typical stock ownership method to avoid the danger of majority control is to issue stock in equal amounts, giving each side a "veto" right on the other. This is often done in family companies or in partnerships which incorporate. The benefit of such a method of stock ownership is that no single shareholder can dominate. The danger is deadlock of the company since there will be even numbers of votes. If there is a deadlock in the voting of the shareholders or the Board of Directors which endangers the company, any director or shareholder has the right to petition the court to break the deadlock by appointing a receiver to run the company for a specified period of time, presumably long enough to break any deadlock. This process is expensive, due to the court appearances necessary, and often extremely expensive since the receiver must be paid. Further, the receiver seldom is expert at the business (usually being a lawyer) and it is seldom that a company can survive long under the auspices of a receiver.
Our office has developed its own manner of seeking to avoid the danger of deadlock. We have had success when stock is owned equally by creating a contractual method of breaking tie votes in which the shareholders agree in advance on a provisional director to serve automatically if a tie vote is encountered, said provisional director breaking the tie vote and if the director is required more often than three times a quarter, said director will serve for one year. Not only does this cost far less than engaging in court proceedings, but the practical effect is that the shareholders almost always find a way to resolve their differences for the simple reason that the practical effect of the tie breaking methodology is that BOTH shareholders lose control whenever a provisional director is appointed since he or she will have the swing vote. Realizing this, each of the shareholders invariably agree on a compromise vote. The very threat of this provisional director being available creates consensus in almost every case.
While a receiver seems to create the same threat, in reality the court process will cost tens of thousands of dollars before the shareholders realize that the ultimate result of their efforts is to lose control: the provisional director method costs next to nothing.
Voting Agreements are simply agreements between two or more shareholders by which they agree on how to vote or agree on when a super majority vote will be necessary. Further, the shareholders can agree on when a unanimous vote will be needed on certain types of decisions to protect the minority shareholder. There are various restrictions on permitted agreements on voting set by the Corporations Code, but most voting restrictions to protect minority rights are allowed.
The By laws of the company, created at the time of incorporation, but subject to amendment if enough shareholders so vote, will normally provide when and if a super majority vote is necessary.
It is also possible to set up what is called a Statutory Closed Corporation which is a nonpublic corporation which replaces the normal Board of Directors and Officers with a written Shareholder’s Agreement as to how to run the company. While popular before Limited Liability Companies ( LLCs) were allowed into California, they are little used today since the main advantage of the corporate structure (strict and long established methodologies for operations and required record keeping of use to a judge and jury if a fight occurs) is lost without really saving time or money since the agreement must be negotiated and adhered to. Most persons now seeking that type of structure now use Limited Liability Companies and the reader is directed to that Article on the Web.
By far the easiest method to protect a minority stock interest and one accomplished without amending the Bylaws, is having employment contracts entered into between the stockholder and the company. Typically, an officer will sign a multi year agreement which does not allow him or her to be terminated except for cause and guarantees a income and perhaps a bonus based on performance. This agreement is binding on the company and can create a situation in which even a minority stock holder will have assurance of retaining the benefit of income and the like.
But it must be noted that the contract will only protect the minority shareholder in the sense of income and possible bonuses. The minority shareholder still cannot force a sale or a dividend and once the contract is over, loses all the protection. Contractual protection is vital but is still not the same as the permanent and all pervasive protection of majority ownership of stock.
CORPORATE STRUGGLES AND ADVANCE PLANNING
When relations within a company begin to deteriorate, it is common for the various owners to begin to assess what powers they possess. Invariably by that time it is too late to engage in the type of planning necessary to achieve either protection or control-you have what you already created. Competent legal advice is urgently needed immediately since quite often shareholders will begin to take actions in anger or without advice which constitute breach of fiduciary duty or perhaps a violation of the bylaws, actions which give powerful weapons to the other shareholders. A careful and objective analysis and game plan is necessary before action is taken...both to determine appropriate moves in the "chess game" of corporate power, and to prepare for the inevitable countermoves of the other shareholders.
Perhaps a typical example will suffice to indicate why such care is necessary. One stockholder, angry at another for refusing to expand the business in a particular way by hiring a vendor in a new territory, decided to seize control of the Board of Directors, remove the other as President, elect himself, and fire the other as an employee of the company. Since he owned 70% of the stock, he felt confident he could do that.
Unfortunately, the contract he was proposing that the company execute with a vendor to allow this expansion involved a company already owned in part by himself. When he called the meeting of the Board, the minority shareholder pointed out that both the bylaws and the corporate law required that the majority shareholder must recuse himself from all voting since he was in a conflict of interest. Angry, the majority shareholder refused to do so, went ahead with the vote, and after removing the other shareholder, assumed the mantle of president and executed the contract.
The minority shareholder immediately went to court, charging the majority shareholder with breach of fiduciary duty and conflict of interest and the court, rightfully, upheld the petition and voided the vote. This caused chaos to the vendor who refused to continue with the contract costing the company tens of thousands of dollars due to penalties imposed due to the failure of the company to perform and, further, the minority shareholder promptly sued the majority shareholder for causing the loss since the company had executed the agreement illegally in the first place.
Two years later, after perhaps one hundred thousand dollars in attorney fees, the majority shareholder agreed to settle the matter by buying out the minority shareholder for an inflated price: and this disaster was caused to a stockholder who owned 70% of the stock! With better planning, he could and should have easily assumed control of the company and could have achieved his ends by expanding the number of directors on the Board, electing a Board subject to his influence but not his control, recused himself from the actual vote, and thus allowed a vote that was legal but which would outvote his minority shareholder. It would have taken an extra ten days or so but would have assured him of a victory in his struggles.
BEFORE taking action, even if your position seems remarkably powerful, get legal advice and plan your strategy well.
TIMING OF THE BATTLES AND THE VICTORIES
Another factor often overlooked by the novice shareholder is that it takes time, often years, to achieve control of a corporation. Directors normally serve for a year. Assuming one is two months into a term, even a 90% shareholder cannot remove a Director (absent wrongdoing) for another ten months and during that time the minority shareholder, realizing that his days as director are numbered, may take aggressive action to better his or her position or change the company. Conversely, knowing that a majority shareholder is waiting to seize upon any error one makes and remove a Director can create atmosphere in a company so unfavorable to success that the company begins to fail. All these factors must be carefully considered before the shareholders take aggressive steps to asset their powers.
The corporate power structure has survived for well over a century because it is a brilliant way to do business. One of its most powerful assets is found in its excellent manner of handling disputes...but the methods and weapons available must be carefully considered and applied and it must be understood that errors made in use of them are not easily corrected. It is vital to know what one can and can not do and that knowledge is as basic to running a company as knowing the customers and the product. The most important time to make the structural provisions that are appropriate is at the creation of the company since once the battle is joined there is little chance to alter the structure to achieve particular ends.
In short, set up the company to protect yourself, learn the structure so that you can achieve your ends, and if it becomes necessary to use the power you have, prepare to do so carefully and with competent advice ahead of time. And, if you know you have the power, quite often you will never need to use it: you may mirror the dictum of Theodore Roosevelt who quoted an old African proverb: "Speak softly but carry a big stick".