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E-MailBenjamin Means is a Professor of Law and the John T. Campbell Chair in Business and Professional Ethics at the University of South Carolina School of Law, and Douglas K. Moll is the Beirne, Maynard & Parsons, L.L.P. Professor of Law at the University of Houston Law Center. This post is based on their article forthcoming in the UC Davis Law Review.
In a closely held corporation, there are few shareholders, the stock is not publicly traded, and, typically, the principal shareholders take an active role in management. Without control rights or exit rights, however, minority shareholders are inherently vulnerable to mistreatment. The majority elects the board of directors, and the board calls the shots. Taken together, the minority’s lack of control and lack of liquidity empower majority shareholders to freeze out the minority owners from any return on their investment. Compounding this unfair treatment, the majority may then offer to repurchase the minority’s stock at pennies on the dollar, knowing that the minority has no choice but to capitulate.
Two pragmatic responses have emerged to protect minority shareholders from the majority’s abusive conduct. First, by the middle of the twentieth century, courts had created equitable exceptions to mandatory corporate law rules, permitting shareholders to alter the structure of the corporation by contract, even in ways that limited the statutory authority of the board of directors. Second, recognizing that minority shareholders would often lack the wherewithal to insist on contractual provisions sufficient to secure their investment, most jurisdictions eventually offered additional noncontractual protection for minority shareholders’ financial and participatory interests. Whether by common law or statutory provision, these jurisdictions now provide a remedy for minority shareholders who can establish “oppression.” See generally Douglas K. Moll & Robert A. Ragazzo, Closely Held Corporations §§ 7.01, 8.01-8.02 (LexisNexis 2023) (discussing in detail the cause of action for oppression as well as remedies for oppressive conduct).
Where do matters now stand? Courts in jurisdictions that still refuse to provide relief for shareholder oppression insist that minority shareholders are not helpless and must bargain for themselves before investing. In Delaware and Texas, for example, courts are not inclined to rewrite bargains after the fact. By contrast, courts in most other jurisdictions have been willing to monitor the corporate governance arrangement for evidence of abuse. Consequently, it would be understandable to perceive a fundamental split between contractual and noncontractual approaches to the judicial role. On one side, the familiar, formalistic refrain: you made your bed, now you must lie in it. On the other side, as an apparent alternative to contract, common law or statutory provisions that protect minority investors in closely held corporations from the improper exercise of majority control.
However, as we argue in an article recently published by the U.C. Davis Law Review, this distinction can be overstated. Although shareholder oppression law provides an equitable, noncontractual remedy for abuses of majority power, contractual analysis remains relevant because courts in most jurisdictions evaluate oppression claims by seeking to identify the parties’ “reasonable expectations.” See Benjamin Means, A Contractual Approach to Shareholder Oppression Law, 79 Fordham L. Rev. 1161, 1165 (2010) (“[A]lthough courts often describe the shareholder relationship in fiduciary terms, contract theory provides a more coherent explanation of current doctrine.”). For an expectation to be reasonable, it cannot be an idiosyncratic view held by one party when there is no basis for believing that other parties have assented to it. The question, therefore, is not whether contract law affects shareholder oppression law, but how it does so.
Two types of contractual analysis appear frequently in oppression cases: (1) pragmatic attempts to ascertain the minority’s reasonable expectations based on evidence of shared understandings between the parties; and (2) formalistic insistence that contract law rules place sharp limits on the minority’s reasonable expectations. By pragmatism, we mean theories that prioritize flexibility in the application of law to avoid injustice in the disposition of individual cases. By formalism, we mean methodological approaches that place greater weight on the ex ante values of consistency and certainty and that, accordingly, call for an application of law to fact without concern for fairness ex post.
We point out the potential absurdity of employing contractual formalism as a method for judging claims of shareholder oppression. Notably, formalism repositions the chief criticism of the shareholder oppression doctrine — that a corporation’s shareholders could have bargained for adequate protection before investing — as the doctrine itself. Courts that adopt a formalistic approach substitute an easier question for a harder one. Instead of asking whether an expectation was reasonable under the circumstances, they ask whether contract law principles preclude the plaintiff’s complaint. This wrongly converts the reasonable expectations standard into a limited, bright-line inquiry.
We further contend that a proper assessment of reasonable expectations should require consideration of all relevant evidence concerning the parties’ social or familial connections and the economic context of their venture. For example, if investors incorporate a business, divide its profits via salary in lieu of dividends, and proceed with that arrangement for years, a court should not need evidence of an employment contract to recognize that the investors have developed reasonable expectations of employment as the vehicle for a return on their investment. Nor should contract rules foreclose minority shareholders from asserting an expectation based on how the parties’ relationship has evolved over time. There is a crucial difference between (a) using contractual analysis to inform the court’s understanding of the parties’ reasonable expectations, and (b) allowing formalistic contract rules to substitute for a full evaluation of the parties’ bargain.
The law of shareholder oppression is viable today because, at every stage of the law’s development, courts have prioritized concrete facts over abstract theories. In doing so, courts have had to weather formalistic objections. For example, when courts first began to enforce shareholder bargains, they did so despite mandatory corporate law rules that, read literally and narrowly, seemed to preclude such bargains. Eventually, corporate statutes were revised to make clear that what was sensible was also lawful. Likewise, the potential benefit of the reasonable expectations approach to shareholder oppression law depends on how broadly it is interpreted. If given too little scope, the reasonable expectations analysis loses its pragmatic virtues and collapses back into the contractual formalism that it was meant to replace.
