Shareholder Risks in Mergers and Acquisitions

Corporate mergers and acquisitions can disproportionately affect minority shareholders and members of closed corporations. Those effects may include the dilution of the value of shares, the loss of the holder’s voting rights, or, in the context of family legacy shares, the total loss of the originating family’s interest in the corporation. This is why owners of these shares should scrutinize their shareholder rights while confronting any proposed merger or reorganization of the corporation. This article identifies some of the tools and procedures available to the minority shareholder to protect its interest during a corporate merger or other reorganization.

THE FIDUCIARY DUTY OF OFFICERS, DIRECTORS, AND CONTROLLING SHAREHOLDERS

Established fiduciary duty law offers a common place of assurances to minority shareholders facing merger or other reorganization. States generally recognize two key duties: Officers and directors owe a fiduciary duty to all shareholders; and controlling shareholders owe a fiduciary duty to minority shareholders. The rule of thumb is that officers, directors, and majority shareholders should act with the utmost good faith in the interest of the corporation and its shareholders. For example, California has adopted a comprehensive rule of “‘inherent fairness from the viewpoint of the corporation and those interested therein.’ The rule applies alike to officers, directors, and controlling shareholders in the exercise of powers that are theirs by virtue of their position and to transactions wherein controlling shareholders seek to gain an advantage in the sale or transfer or use of their controlling block of shares.”²

In the context of a merger or reorganization, the fiduciary duty laws require officers, directors, and majority shareholders to:

• Act in the utmost good faith;
• Refrain from unqualified self-dealing;
• Follow all corporate bylaws to approve a proposed transaction; and,
• Follow all statutory procedures for dissenting shareholder rights.

A violation of any one of these standards may cause a minority shareholder to go along with a merger or reorganization to which it otherwise would have dissented or about which it would have made further inquiries. An action for damages may be available for such breaches of an officer’s, director’s or majority shareholder’s fiduciary duty.

DISSENTING RIGHTS

In most states, shareholders with statutory dissenters’ rights may opt for a buyout at either the fair market value³ or fair value⁴ of the shares determined prior to the announcement of the merger or other reorganization. These statutory rights typically apply to minority shareholders with some voting right in the corporation. Reasons for forcing a buyout include the lack of appetite for the economic risks of the proposed transaction, an unwillingness to invest in an enterprise that will be fundamentally different post-transaction, or a distrust in a takeover entity.

State statutes protect dissenting rights by forcing the corporation to make fair offers to purchase these shares at a price established pre-transaction. In California, for example, a corporation must provide written notice to the shareholders that includes:

• a copy of designated sections of California statutory provisions governing dissenters’ rights,
• a statement of the price determined by the corporation to represent the fair market value of the dissenting shares, and
• a brief description of the procedure to be followed if the shareholder desires to exercise the shareholder’s rights to have the corporation purchase the shares under those provisions.

When a corporation undervalues the dissenting shares, the minority shareholder can file a civil action to appraise the fair market value of the shares. The appraisal right is fundamental to a minority shareholder’s ability to receive fair compensation in place of going along with the proposed merger or other reorganization.

ATTACKING RIGHTS FOR COMMON-CONTROL MERGERS

Generally, appraisal rights are a minority shareholder’s exclusive remedy to obtain a fair buyout—that is, minority shareholders cannot ordinarily challenge or attack the corporation’s proposed merger. An exception to this rule applies when one party to the merger is directly or indirectly controlled by, or under common control with, another party to the merger. This type of “common-control merger” may occur when a majority shareholder attempts to dilute a minority shareholder’s interest by having a corporation under its common control acquire the corporation. Such a transaction often leaves the majority shareholder in full control of the primary assets through the common-control corporation but leaves the minority shareholder greatly undervalued or completely diluted of its interest.

In such a common-control merger, a shareholder that does not demand a cash buyout may institute an action to attack the validity of the merger or to have the proposed transaction set aside or rescinded. To further protect against self-dealing, the law requires that the commonly controlled party carries the burden to prove that the transaction is just and reasonable as to the shareholders of any party so controlled.

In conclusion, a minority shareholder possesses rights and remedies pre-merger or preceding other reorganization. Any minority shareholder in such a situation should exercise its statutory rights of inspection to investigate its options to challenge the transaction or proceed with a fair buyout. Each of the procedures available to the minority shareholder must be exercised timely, making early action by the minority shareholder very important.