A Corporation is a mini republic in which the shareholders are the voters and elect the board of directors who then elect the officers who run the company day to day. A shareholder who owns fifty one percent or more of the stock can normally elect the majority of the board of directors who, in turn, by majority vote, appoint the officers who operate the company.
Thus, power in the typical corporation is simple: the shareholder who owns a majority of the stock controls the board of director selection thus the officers who have power to run the company. The bylaws of the corporation normally set out the precise rules, but the basic structure is almost always as herein described.
Officers and directors have a fiduciary duty to the corporation. That means they must do no act which harms the company though errors in judgment are usually not grounds for personal liability. Shareholders do not have a fiduciary duty to the corporation, though a majority shareholder has some limited responsibility to minority shareholders in the event of sale of the company.
But because the majority shareholder ultimately has the power to control the board does not mean that such control can be achieved immediately. Subject to rules in the bylaws, removal of a director and election of a replacement can take a year or more and during that time the majority shareholder may be stymied in achieving the control.
How that works and what can be done to avoid such delay is the subject of this article.
The Term of the Director:
Most bylaws of the average California corporation provide that a director, once elected, serves for a term of a year or until a replacement is elected, whichever last occurs. Since most companies do not take time to have annual meetings, most directors are simply serving year after year without reelection. Most companies that do meet annually simply elect the same directors year after year.
Bylaws can be altered to change the length of the term, but most companies seldom even read the bylaws of the company until there is already a dispute within the company.
It can readily be seen that if a majority shareholder becomes dissatisfied with a director a month or two into the term, that director can not be removed until the next annual meeting, often ten or eleven months away. During that time, the director continues to serve.
The majority shareholder can ask the director to resign. Most directors will do so, realizing that a hostile majority shareholder may be seeking to find breaches of fiduciary duty. But unless the director has failed to perform his or her duties, the shareholder can not force the director out absent proof of wrongdoing and if the majority shareholder so alleges, he or she will have the burden of proof.
And recall that errors in judgment are not necessarily “wrongdoing,” sufficient to allow termination for cause. The courts have consistently ruled that so long as the director had reasonable cause to make a decision, there is no breach of duty even if that decision was in error. “Reasonable business judgment” is the test and most courts will not substitute their own judgment for that of the director.
Thus, having eventual control of the board of directors does not mean immediate control of the board and a majority shareholder may find him or herself saddled with a board that he or she detests and does not trust.
Nor can holding a “special meeting” of the shareholders solve the problem unless wrongdoing can be demonstrated at that meeting on the part of the director. The shareholders who decide to terminate the director before the end of the term may find themselves having to demonstrate to a court that they had good cause to do so, a process that can be expensive and a major distraction to the operation of the business.
Pro Active Steps:
The best place to avoid this danger is in the bylaws, either reducing the term of a director or granting the shareholder the right to replace the director even without cause upon a shorter notice. This would require specialized drafting of the bylaws which is not common, and one could expect some directors to object to serving at the discretion of the majority shareholder, and, indeed, they could insist that such a provision negates the advantage of having a director who must be able to contest errors in judgment on the part of the majority shareholder.
And most disputes occur long after the bylaws have been adapted and while they can be altered upon the proper vote of the shareholders, such alteration would not necessarily be allowed to be retroactive and would be contested by the director in many instances. (But such a change may make sense once that director is successfully removed.)
Converting the corporation to a limited liability company creates far more flexibility in structure for the company and, indeed, many new businesses begin as limited liability companies precisely to allow such flexibility. There could be adverse tax consequences to the conversion, however, and qualified accountants should be consulted before such a move is attempted.
It is also possible to have the directors subject to a written agreement with the company which would allow termination at the discretion of the shareholder. Note that California corporate law does limit various provisions in such an agreement. (One cannot negate the fiduciary duty, for example.) Once again, it is probably too late to enter into such an agreement once a dispute occurs since the director will refuse to execute the agreement.
As with most corporate disputes, subtle planning without emotion or haste is essential. Careful investigation of the acts of the director should be made, consultation with other shareholders achieved, and a plan for implementation of removal created and carefully applied. A key factor is the amount of time before the next annual meeting. If it is two or four months away, it makes good sense to simply wait, prepare for that meeting, and replace the director at that time. If it is further away, the attempt needs to be made to seek a voluntary retirement of the director or to determine if wrongdoing can be alleged.
What one should not do is leap into court without proof of wrongdoing or simply call shareholder meetings without a clear agenda and the power to remove. Often the best move is a private meeting with the director, explaining to him or her the law and the inevitable removal down the road and asking that the matter be resolved immediately rather than after months of turmoil and recriminations.
One experienced businessman sat down with his former son-in-law who he had foolishly made a director and explained to him that from that point on every action (or lack of action) would be examined by lawyers and accountants and that if he so much as made a single error, he would face immediate litigation. Why not end it now and skip the danger? His son in law left in a huff…but resigned the following week.
Another well-funded client simply fired the director for cause and decided if that led to a lawsuit, so be it. He told the writer that saving the company from a fool-director was more important than possibly wasting time in court if the director sued. That director, seeing that his possible damages were nil, elected to threaten to sue but not sue.
Most people are excited and optimistic when starting a company and such disputes do not occur to them as being likely. Indeed, they would not be starting a company if they were not enthusiastic. It is easy to simply use form bylaws and not even read them, assuming they will not really ever be used.
But when the fight begins, those bylaws are critical and fights within corporations are more common than one would imagine.
As an elderly lawyer once told the writer, “If things go badly, people fight over the dead body of the company. If things go very well, they fight over the money pouring in. You only avoid fights if things are mediocre.” An overstatement, of course, but much truth in it.