Pitfalls for Minority Shareholders

Pitfalls for Minority Shareholders

Becoming a minority owner of an LLC or corporation (an owner of less than 50% of the business) is obviously a declaration of faith in the majority owner’s business savvy. It is also a declaration of faith in the majority owner’s good will, because control of a majority interest gives the majority owner great power that can cause difficulty for the other owners.

A 2021 decision from the Minnesota Court of Appeals, Ross v. Dianne’s Custom Candles, LLC,[1] illustrates several pitfalls that minority shareholders can encounter when their relationship with the majority owner sours. The results in Ross are not exceptional. Other minority shareholders can expect similar outcomes in their own situations, if they end up in court having not taken precautions to prevent or avoid these pitfalls.

In Ross, two related LLCs each had the same controlling majority owner, Lenzen, and a handful of minority owners, one of whom was Ross. Ross left his employment with the LLCs in 2010 but kept an ownership interest in both companies. When he left employment, he owed one of the LLCs more than $50,000, for money used to offset personal income tax liability on past company earnings. In past years, Lenzen as majority owner had caused the LLCs to not pay profit distributions to the owners. As a result, Ross had owed taxes on company earnings even though he didn’t receive cash from the company to pay the taxes, forcing him to borrow money to pay his tax liability.

Eventually, Ross demanded the LLCs provide him with certain business records, but they refused. In 2019 Ross filed a lawsuit seeking company dissolution or a buyout of his ownership interests, based on alleged oppressive conduct by the majority owner. But Ross’s lawsuit encountered a series of problems, and both the trial court and the Court of Appeals rejected his claims.

Derivative Claims Dismissed

One of Ross’s complaints was that the companies allegedly paid money to the other owners but not to him. The improper payments to the other owners, he said, were disguised as compensation, expense reimbursements, or interest on loans. This was done, in his view, to try to force him to surrender his ownership interests in the LLCs.

However, in Minnesota an owner of a company ordinarily may not file a lawsuit based on improper payments made by the company to others. If improper payments are made, the loss of money is suffered by the company itself, not directly by the owner. Therefore, any claim to recover improper payments must be brought by the company, not by the shareholder, unless the shareholder fulfills certain special requirements, stated in Minnesota Rule of Civil Procedure 23.09, and unless the shareholder brings the claim as a “derivative” action. See In re Medtronic, Inc. S’holder Litig., 900 N.W.2d 401, 406 (Minn. 2017).

Ross had not complied with the requirements for a derivative action. As a result, the trial court dismissed his improper-payment-related claims, and the Court of Appeals affirmed that this decision was correct. Ross attempted to argue that an exception to the derivative rules applied to him, but the court disagreed. “Here, Ross has alleged that funds were inappropriately taken and distributed to other shareholders. These funds are corporate assets that do not belong to Ross, but rather to the corporation; therefore, the injury alleged by Ross is an injury to the corporation, not a ‘separate, distinct, and independent’ injury suffered by him individually.”[2]

The idea that a partial owner of a company cannot sue the other owners directly for allegedly stealing from the company may seem strange, but it is firmly established in the law of Minnesota, and other states.

Claims Barred by Statute of Limitations

Before Ross filed his lawsuit, more than eight years had passed since he left employment at the LLCs. The Court of Appeals decided that Minnesota’s six-year statute of limitations for certain claims applied to his claims for oppressive conduct (under Minn. Stat. § 322C.0701) and breach of the duty of good faith and fair dealing. As a result, any misconduct that occurred more than six years before he filed the lawsuit could not be used to support his claims.

Ross argued that an exception, the “continuing-violation” doctrine, saved his claims from the six-year rule, but the Court of Appeals decided the continuing-violation exception did not apply in this kind of situation.[3]

As time passes, the ability to sue can be lost. Shareholders should act promptly if they believe they have been wronged.

Expectations Not Reasonable

Some of the alleged misconduct that Ross complained of was recent enough that the statute of limitations did not bar him from suing. But the Court of Appeals agreed with the trial court that Ross’s complaints did not justify the relief he asked for, considering the undisputed facts of what had happened.

To succeed on his claim, Ross had to prove that the other owners had engaged in “oppressive” conduct toward him, essentially meaning that they had treated him in a way that violated his reasonable expectations for how he should be treated, and that his reasonable expectations were meaningful to his decision to become or stay an owner. Ross argued that Lenzen had violated his reasonable expectation to be paid income or profit from the businesses, and to receive information about the businesses. But there were not any provisions to require such things, in the company’s operating agreement or other agreements between the owners. Therefore, Ross could not reasonably expect or demand that the companies distribute payments to the owners.[4] Moreover, Minnesota LLCs are allowed to decline to provide information requested by a member, if they have reason, so the court allowed the companies to refuse his information requests based on their fear that Ross would use the information to help his new employer compete with them.[5]

Minnesota automatically provides owners of LLCs with some rights by law, but other rights that a part owner might consider essential are not guaranteed. To secure specific rights concerning the business, the owners should put them in a written agreement when the business is first established.  See, e.g., Minn. Stat. § 322C.0110.

Take Note

The pitfalls that Ross’s case fell into are subtle – not obvious to an ordinary owner of a small interest in a company. That is, perhaps, why these pitfalls are common problems in minority shareholder litigation. It can be surprising to learn that a part owner might not be able to directly sue the controlling shareholder for taking money wrongfully from the company. It can be surprising to learn that waiting a few years to see how things go might create insurmountable problems in court. It can be surprising to learn that a company has no obligation to pay out profits to the owners or give them access to its business information, unless a written agreement specifies these things.

Co-owners of a business should insist, before the business is formed, on writing an operating agreement that explains what the business will pay out each year in profits or distributions, what access to information each person will have, and what other rules should apply to the operation of their business. They should not wait for years before resolving disputes that arise. And when a dispute arises about the operation of the business, they should remember to identify whether it is a derivative claim – often it is! – and if so comply with the rules governing derivative claims.

Are you a minority shareholder facing litigation or do you need assistance with an operating agreement? Parker Daniels Kibort can help. Give us a call at 612.355.4100.

[1] The decision is non-precedential, and available at the repository of Minnesota Court of Appeals opinions. Ross v. Dianne’s Custom Candless, LLC, no. 27-CV-20-1 (Minn. Ct. App. Aug. 30, 2021).

[2] Ross at 9.

[3] Ross at 11-13.

[4] Ross at 16-17.

[5] Ross at 18-19.