On July 22, 2010, the Washington State Supreme Court dealt a serious blow to the prospects of minority shareholders who are forced out of corporations through corporate restructuring techniques that are expressly allowed under the Washington Business Corporations Act (WBCA). One of those techniques is the reverse stock split.
RCW 23B.10.020(4)(b) allows a corporation to amend its Articles of Incorporation to decrease the number of outstanding shares of stock by requiring all shareholders to exchange a certain number of shares of stock for a single share of stock. For example, shareholders might be required to exchange 100 shares of stock owned for a single share of stock. This would be referred to as a 1-for-100 reverse stock split. Since the share exchange is by all shareholders, ownership percentages don’t change.
What happens, however, if a shareholder owns fewer than 100 shares of stock to begin with? Well, as a result of the reverse stock split that shareholder would end up owning less than a single share of stock, even though their relative ownership percentage remained unchanged. And this is precisely the situation in which minority shareholders can find themselves evicted from a corporation. RCW 23B.06.040(1)(a) expressly authorizes a corporation to “pay in money the value of fractions of a share.” So, instead of allowing the owner of a fractional share of stock to remain a shareholder, the corporation has the option to pay that shareholder the cash value of their fractional share of stock instead of issuing the fractional share. As a result, the shareholder is no longer a shareholder. Obviously, this can be a useful tool for corporations that want to rid themselves of troublesome shareholders. Of course, it is also important to consider how the shareholder is to be paid. When Articles of Incorporation are amended to reduce the number of authorized shares of stock in order to conduct the reverse stock split, shareholders are automatically granted the right to dissent and receive the “fair value” of their shares. “Fair value” can be very different than what majority shareholders might believe to be fair market value.[1. “Fair Value”, not to be confused with Fair Market Value, is defined as the value of the shares immediately before the effective date of the corporate action to which a dissenting shareholder objects, excluding any appreciation or depreciation in anticipation of the corporate action unless such exclusion would be inequitable. RCW 23B.13.010(3); Robblee v. Robblee, Wn. App 865, 873 (2002). In addition, Washington courts do not allow considerartion of certain discounts when calculating “fair value,” such as lack of control or minority discounts or discounts for lack of marketability.]
Obviously, some minority shareholders may not like being squeezed out through a reverse stock split. Some disgruntled minority shareholders go on to assert legal claims based on the alleged “oppression” of the majority shareholders who authorized the reverse stock split. The minority shareholder typically alleges that those in control of the corporation were motivated by greed or some other alleged improper motive in acting to squeeze out the shareholder. Understood correctly, the minority shareholder is essentially claiming there are limits to a corporation’s right to engage in transactions expressly authorized by statute and to the realities of corporate governance, including the reality that majority shareholders often control the corporation.
Across the country, courts considering whether majority shareholders have the right to force out minority shareholders through a reverse stock split have come down on both sides of the issue. Some courts have ordered minority shareholders be reinstated as shareholders when the reverse stock split is found to have had no compelling business purpose. Other courts have ruled that because the reverse stock split and cash-out of fractional shares is permitted by statute, the motives behind the reverse stock split are largely irrelevant, so long as there is no fraud. Washington now joins this latter group.
In a close 5-4 decision, a majority of the Washington Supreme Court ruled in Sound Infiniti v. Snyder, Inc. that (1) the appraisal proceeding in RCW 23B.13.020 is a dissenting shareholder’s exclusive remedy unless a corporate action is procedurally defective or fraudulent; and (2) a divested shareholder does not have standing in a derivative suit.
In short, freezing out a minority shareholder through a reverse stock split followed by a fractional share redemption is not improper precisely because it is expressly authorized by statute. There is no breach of fiduciary duty where the letter of the law is followed.
It gets worse for minority shareholders. Once a minority shareholder is forced out through this process, they are a “divested shareholder” and technically no longer an active shareholder of the corporation. Thus, divested shareholders have no standing to bring a derivative claim on behalf of the corporation to undo the transaction because they are no longer shareholders. A derivative suit is a lawsuit brought by a shareholder on behalf of a corporation against a third party, usually an officer, director or shareholder. Derivative lawsuits are brought when the company refuses to pursue the lawsuit itself or the shareholder believes it would be futile to demand the company file the lawsuit. The Sound Infiniti Court flatly rejected case law from other jurisdictions, including Delaware and Oregon, that allow exceptions[2. E.g., (1) where the divested shareholder alleges fraud in corporate action that resulted in the divestiture of his shares (Delaware); or (2) where the divested shareholder did not acquiesce in the corporate action that resulted in the divestiture of his shares (Oregon).] to the requirement that a person have a present proprietary interest in a corporation (i.e., be a shareholder) to bring a derivative claim. Once cashed out, the minority shareholder is out for good. It’s quick, but it’s not painless.
The bottom line is that Sound Infiniti is great news for majority shareholders and corporate boards of directors. Performed correctly, reverse stock splits are an effective tool to restructure a company and eliminate troublesome shareholders, so long as the transaction is performed correctly, without fraud, and the company has the money to pay the “fair value” of the minority’s interest. Minority shareholders are now dramatically less able to pursue claims of oppression for being forced out of a company in that way. Extending the logic of Sound Infiniti, a considerable amount of risk is now eliminated from related transactions in Washington, such as a reverse stock split that is immediately followed by a forward stock split. The purpose of such a transaction is plainly to eliminate minority shareholders through the reverse stock split, and then through the forward stock split return the company to its original capital structure, now without the minority shareholders.
Of course, all of this is possible only while Sound Infiniti remains good law in Washington. Sound Infiniti is a 5-4 decision and there is always the possibility of a similar case finding its way to the Washington Supreme Court with a different result. The Dissenting Opinion in Sound Infiniti is particularly strong in its criticism of the five justices in the majority. In particular, the four dissenting justices attacked the Majority’s decision that shareholders who have been forced out through a reverse stock split lose their right to pursue derivative claims against the majority shareholders. It is highly likely the Dissenting Opinion will provide fuel for arguments by other ousted shareholders that they should retain rights to pursue derivative actions to oppose transactions that resulted in their losing shareholder status.