In a nonpublic California corporation, the question can arise as to whether the profits the company generates must be paid to the shareholder-owners as dividends. This often becomes a heated issue as owners, some of whom may not be employed by the company or may have inherited the shares from now deceased former operators of the business, want the asset to generate income while the officers and directors, who may or may not also be shareholders and/or employees, may want to use any profits for reinvestment or even bonuses or increased salaries for the officers and employees. It can lead to intra company disputes, litigation and in extreme cases can result in the company failing.
This article shall discuss the rights shareholders have to expect an income flow from a nonpublic California corporation.
The Basic Law:
Courts are loath to involve themselves in business decisions of executives and give wide latitude to the business officers to determine appropriate business activities including reinvestment of profits. Judges do not consider themselves expert on the operations of a business and will only substitute their own decision making process for the executives if statute requires it or the decisions of the executives are so outrageous that they would make no business sense and show a likely breach of duty to the company.
While corporate officers and directors owe a fiduciary duty to the corporation, that duty does not necessarily mean they must pay out as dividends all or, indeed, any profits of the corporation. In various circumstances, paying out all profits may be a violation of that fiduciary duty. As an example, assume that the CEO of a company finds that important machinery needs to be replaced within six months if production is to continue and thus the company must set aside hundreds of thousands of dollars to purchase new machinery. It could be argued that he would violate his duty to the company if he paid out profits rather than retaining them to purchase the equipment. His duty is to the entity and its continued viability, not necessarily to the cash flow of the shareholders who own the entity.
As discussed in other articles, shareholders can vote in new directors if they own a majority of the outstanding shares and those directors can, in the absence of contractual provisions prohibiting, replace officers, including the CEO. That process, however, can take months or years and if the shareholder objecting to the lack of proceeds is a minority owner of stock, that stockholder could not necessarily control the board or impose the replacing of the CEO.
In short, there is no statutory or precedential law that requires all profits to be paid out to the owners of the corporation unless failure to do so would constitute a breach of fiduciary duty on the part of the officers. Even if the CEO is “wrong” in his or her decision, if there is any business rationale for that “wrong” decision, the court is unlikely to agree that there is a breach of fiduciary duty demonstrated.
A typical dispute is when the CEO declares bonuses to key employees, often including the CEO, rather than distribute profits to owners. The owners are outraged, and demand distribution of profits and the CEO responds that quality employees, including him or herself, require adequate compensation. The CEO argues that the continued economic health of the company necessitates the bonuses. The issue before the court would be whether the compensation was so exorbitant as to be unjustifiable and a looting of corporate profits. The burden of showing that would be on the aggrieved shareholder.
No statute or precedent in California requires a specific amount of income to flow to the shareholders of the corporation unless the company is sold, at which point they must receive their prorata share of the net proceeds. Further, if dividends are declared, the shareholder must receive his or her prorata distribution of dividends. But paying out dividends is not required.
While the company continues in existence, it is up to the officers and directors to determine when and if distributions as dividends will be made. Few courts are going to second guess a decision on profits or bonuses unless the CEO has declared bonuses far beyond those available to people of equivalent expertise in the industry.
Powers of the Shareholders as to Income:
What can the shareholders do to assure income?
If the shareholder owns a majority of the shares, eventually he or she can replace the CEO by electing new directors and having the new directors elect new officers. The new officers may be hired with a written commitment as to what salaries and bonuses can be paid and when dividends will be declared. That would be an employment agreement with the CEO that is binding and provides that he or she can be terminated immediately if violated.
The voting for new directors and/or officers can occur at the regularly scheduled shareholder’s meeting or a specially noticed one, depending on the Bylaws of the company.
For those companies just starting out, at the creation of the corporation it is possible for the shareholders to enter into a voting agreement or to require a super majority vote for specified actions, such as election of directors or a CEO. That can be by agreement or in the bylaws. Sadly, such foresight and planning at the creation of companies seldom occurs, with most companies merely adopting standard template forms.
If the angry shareholder is only a minority owner, then he or she can attempt to convince other shareholders to vote with him or her to replace management. If that is unsuccessful, then the relief is to attempt to convince a court that the directors and/or officers are violating their duty to the corporation by using all profits for salaries, bonuses or unnecessary capital improvements.
That is an uphill struggle since the courts will normally support decisions of management. Uphill, but not impossible.
The usual case made by the minority shareholders is that the salaries paid greatly exceed the average salaries in the industry and that the performance of the corporation or the particular employee did not warrant a bonus. Most courts will still not support the minority owners unless the situation is extreme. If a CEO pays him or herself three times the going wage or declares massive bonuses to employees who did not demonstrate particular excellence, the courts may step in, but if management can develop any rational argument to support their decision making, most courts will not second guess them.
Where courts are more likely to step in is when a company is losing money and the CEO still announces bonuses or pay raises of significance. Management will have to have a convincing argument to justify that step.
Keep in mind that the relief available requires a proof of violation of fiduciary duty. That is harder to prove than just poor judgment. It requires extreme neglect or clear conflict of interest and if a CEO simply errs in decision making but had rational reasons for the decision, the court is unlikely to consider that a breach of fiduciary duty. Nor is a pay raise necessarily a conflict of interest, even if the raise is to the CEO if the CEO can demonstrate that his or her salary is in accord with others of like expertise and experience.
The argument relies on facts and the facts must point to actions of officers that are extreme. If no dividend to shareholders has been declared for five years despite the company making sizable profits for that period of time and the CEO had declared for him or herself sizable bonuses each year, then that argument has a greater chance of success than if only a year of mediocre profits was generated and the CEO is paid within ten percent of others in the field.
The Subchapter S Trap:
A subchapter S corporation is a corporation that has elected with the Internal Revenue Service to have its shareholders taxed as if the entity was a partnership. Thus, if one owns twenty percent of the stock outstanding, one pays twenty percent of the profits of the company on one’s personal income tax. There is no legal requirement for a company to declare dividends or make distributions to pay the particular tax due for a shareholder. Thus, a shareholder can end up paying taxes on money never received.
This is a powerful weapon in the hands of a majority shareholder to force a minority shareholder to sell his or her shares at a discount. All that the majority shareholder must do is not declare any dividends, use the profits to build a reserve, and the minority owner will face large tax costs each year with no benefit. In one case known to the author, a minority shareholder simply surrendered his stock to the company for free rather than face continued tax costs.
One can enter into an agreement with the company to at least make distributions equal to tax costs but in such “power” situations the majority shareholder will make sure no such an agreement is made. Since the subchapter S status can only be altered on a vote of the shareholders, the minority shareholder is unlikely to get the status changed.
The Management’s Point of View:
Operating a business is a difficult task and disputes within the company make it that much more difficult. Few managers want to incur the wrath of disgruntled shareholders and are aware that fighting in court over what is appropriate conduct is expensive and distracting. They understand that ultimately, they will be judged by the owners for the profits distributed and do their best to achieve appropriate sharing of profits.
And some courts will make it clear to management that never paying dividends when profits exist in the company may not yet rise to a breach of duty but if it continues, the court will be open to changing its mind. Managers should be careful to have valid reasons not to declare dividends or sooner or later they may face the wrath of the court as well as the shareholders.
That said, many managers in such situations complain that the minority shareholders are not expert in the business, do not understand the challenges of finding qualified people or maintaining inventory and equipment and want short sighted income rather than the longer term benefits that reinvesting in the company can develop. This is particularly true in those instances in which the minority shareholder has never operated a business.
One experienced manager put it well: “I have competitors and tax people to fight. I can’t spend all my time being distracted by fighting other owners. Better to buy them out and get on with business.” While he said that, he drove a hard bargain as to the price he paid, arguing with force that while he would pay out some profits, he would not pay out all profits and if the shareholder wanted that, then this was not the company for him.
Owning minority interest in a company does give one some powers, as discussed in other articles, but not the power to control distribution of profits. One must adjust expectations accordingly and work with other owners to determine if a block of stock can be established to influence management. It will require careful planning and advice to achieve goals when a minority owner but absent such planning, one is likely to exacerbate an already difficult position.