BUSINESS DIVORCES IN TEXAS: Recent Case On “Disguised Dividends,” Alleged “Squeeze Out,” Improper Buy-Out, and Shareholder Oppression

By Shain A. Khoshbin – November 2, 2010

Dallas, TX – (WiredPRNews.com) You are a minority shareholder in a closely-held company, as well as an employee of the company. After a few years of hard work, the company is now “in the black.”

Just about then, you are fired, and the company does not make an offer to buy-out your shares in accordance with the shareholder agreement you signed. Subsequently, the company pays other employees (who happen to also be shareholders) “bonuses” – rather than making dividend distributions (which would have included you). To make matters worse, you now default on loans to you by the company, think you were fired as part of a minority shareholder squeeze-out, and feel you have otherwise suffered from self-dealing by the major shareholder.

So – despite the company doing quite well – you end up with no job, no payments for your shareholder interests in the company, nothing to say about how the company is run, and demands to pay off thousands of dollars of loans.

This was the scenario reported in the recent case of Four Seasons Equip., Inc. v. White (In re White), 429 B.R. 201 (Bankr. S.D. Tex. 2010), wherein the Court ultimately held:

oRichard White (”White”) was an at-will employee of Four Seasons Equipment, Inc. (”Four Seasons”), and legally terminated;

oWhite remained an 8% shareholder in Four Season because the company did not properly exercise its option to purchase his shares, such that Four Seasons had to either pay White future dividends or buy-out White’s 8% equity interest;

oFour Seasons improperly paid dividends to its employee-shareholders as “bonuses,” thereby excluding White from such payments and entitling White to damages caused by paying such “disguised dividends” ($235,200);

oGeorge Nevins (”Nevins”), a major shareholder, director and officer of Four Seasons, improperly received interest free loans from Four Seasons, and had to compensate Four Seasons for its loss on the loans;

oThe facts demonstrated “shareholder oppression” under Texas law; and

oWhite had to pay $14,000.00 on account of loans made to him.

SUMMARY OF CIRCUMSTANCES AS REPORTED IN FOUR SEASONS CASE

Richard White, George Nevins and Dave Keim (“Keim”) worked together at ComEquip, a heavy construction equipment company. After the sale of ComEquip, Keim decided to form Four Seasons – – and asked Nevins to join him. Four Seasons owns, leases and sells heavy construction equipment. The owners initially capitalized Four Seasons with minor equity infusions, and with a $1 million loan from a company owned by Nevins’ family members. White purchased 8% of the shares of Four Seasons, and was employed by Four Seasons as a salesman.

The company and all of its employee-shareholders contemplated working for below market salaries, and receiving bonuses to make up the difference. According to the Court’s opinion, “the amount of each shareholder-employee’s bonus was to be established in proportion to the shareholder-employee’s ownership interest in the company. Nevins’ bonus would be measured by the proportionate ownership of his family entities.” Four Seasons, 429 B.R. at 205.

After the company terminated White, Four Seasons and Nevins sued White and his wife for defaulting on a $4,000 note to Four Seasons, and $10,000 note to Nevins and his wife. They also sued White for breach of the Four Seasons’ shareholder agreement. White counterclaimed for wrongful termination, breach of contract and fraud, alleging Four Seasons failed to properly exercise its buy-out option, the company paid “disguised dividends” as bonuses to the remaining employee-shareholders to exclude him from the benefits of his 8% shareholder interest, and Nevins fraudulently made loans to himself and diverted business opportunities to entities he wholly or partially owned. Four Seasons, 429 B.R. at 204.

COURT REJECTS WRONGFUL TERMINATION CLAIM

The lengthy Four Seasons’ opinion began by explaining that, absent an express agreement to the contrary, an employer generally may terminate an at-will employee for a good reason, a bad reason, or no reason at all in Texas. 429 B.R. at 205 (citing Fed. Exp. Corp. v. Dutschmann, 846 S.W.2d 282, 283 (Tex. 1993) and Exxon Mobil Corp. v. Hines, 252 S.W.3d 496, 502 (Tex. App.–Houston [14 Dist.] 2008, pet. denied)). Nonetheless, the opinion did note some exceptions to this rule – – such as being fired as retaliation for filing a harassment charge. 429 B.R. at 205.

The Four Seasons’ Court rejected White’s “conjectures that Nevins wanted to force him out of the business in order to hide various loans that Nevins had taken, and otherwise to terminate White for impermissible reasons.” 429 B.R. at 206. It found that White failed to prove anyone at the company was trying to squeeze him out or cover-up anything. Although the Court found certain loans to Nevins had not been properly authorized, the loans had been repaid by the time the White dispute arose – and there was “no evidence indicating that White’s knowledge of the loans played a role in White’s termination.” Id. Moreover, the Court noted that another employee-shareholder who asked for a buy-out of his shares was satisfied with the purchase price, and other similarly-situated minority shareholders were not “forced out” of the company. Therefore, the Court found that “the motive for White’s termination was not driven by any attempt to rid Four Seasons of minority shareholders.” Id.

Rather, the Court found that Four Seasons terminated White “because he disrupted the working environment by disparaging Four Seasons, its owners and management.” Id. Namely, White believed he was entitled to a “spiff,” or a bonus typically paid to a commission salesperson directly by a manufacturer. When the spiff was paid to White’s supervisor (who happened to be Nevin’s son), White began “‘bad mouthing’ the Nevins family and Four Season’s management. As a result of his conduct, White was terminated.” Id.

COURT FINDS BONUSES WERE “DISGUISED DIVIDENDS”

The Four Seasons Court found that during the company’s early years, the employee-shareholders intended to focus on accumulating capital to buy equipment. Therefore, during this period, the board would authorize the company to pay employee bonuses each year out of 10% of sales – – with amounts determined in the board’s discretion. The Court also found that, prior to White’s termination, no material bonuses were awarded. 429 B.R. at 207.

Even after becoming “very successful,” the Court found that the company never declared any dividends. “Instead, beginning in 2006, Four Seasons attempted to avoid the double taxation of corporate profits by paying profits out as bonuses to the employee-shareholders, who were insiders.” 429 B.R. at 207. The Court explained that the “diversion of dividends into bonuses would work to the disadvantage of a non-employee-shareholder, a person who would have no basis for a bonus payment.” 429 B.R. at 208.

Then, the Court analyzed the bonuses paid in 2006 and 2007 by Four Seasons to its employee-shareholders or Nevins, and found that bonuses always were paid according to each employee-shareholders’ proportionate equity interest based on the company’s earnings (except for White and Nevins, since Four Seasons incorrectly assumed Nevins had acquired White’s shares). The Court found that – – “remarkably” – – this proportionate distribution was the intent of the board, to allow the employee-shareholders to share in Four Seasons’ profitability while avoiding double taxation and paying nothing to White. 429 B.R. at 209.

The Court concluded that the “bonus” payments were disguised dividends, and that White was entitled to his proportionate share. In so holding, the Court relied on Fifth Circuit precedent explaining how to recognize a disguised dividend:

Substantial bonuses declared at the end of the year when the earnings of a business are known usually indicate the existence of disguised dividends. Moreover, this Court has previously determined that, especially in the context of closely held corporations, “it is in the tax interest of all parties to characterize the amounts distributed to shareholders/officers as compensation rather than dividends.” Because the “[d]istribution of profits through compensation payments to shareholder/officers avoids the double tax on corporate profits which are distributed to shareholders as dividends,” the concern arises where corporations distribute their profits through the payment of unreasonably large salaries and bonuses to those controlling shareholder/officers. Therefore, it is necessary to “carefully scrutinize the payments to ensure that they are not disguised dividends.”

429 B.R. at 209-210 (quoting Brewer Quality Homes, Inc. v. Comm’r., 122 Fed. Appx. 88, 94-95 (5th Cir. 2004)) (citations omitted); see also Owensby & Kritikos, Inc. v. Comm’r., 819 F.2d 1315, 1329 (5th Cir. 1987).

FOUR SEASONS FAILED TO STRICTLY COMPLY WITH ITS BUY-OUT OPTION

The Four Seasons’ shareholder agreement (“Agreement”) provided that, if a shareholder was terminated as an employee, then the company had the option to purchase all of his/her stock – which option had to be exercised within 90 days after written notice of the termination. The Agreement also provided the valuation method for calculating the purchase price, which was “the Total Fixed Asset Value, less Total Long Term Liabilities, as of the most recent month end Balance Sheet.” Four Seasons, 429 B.R. at 212. Instead of offering a fixed price for White’s shares based on this calculation method, Four Seasons offered a provisional payment to White and a “true up” arrangement that would be based on an audit proposed by the company. Id.

Although the Court found the proposed “true up” arrangement was fair, it held “the original shareholders’ agreement was also fair and had no such ‘true up’ arrangement. The agreement signed by the parties required payment based on the most recent month end Balance Sheet, with payments commencing within 90 days of the termination date. At no time did Four Seasons make such an offer or tender funds based on any offer at all.” Id.

The Court noted that Texas strictly construes option rights. Id. (citing Mensa-Wilmot v. Smith Intern., Inc., 312 S.W.3d 771, 774 (Tex. App.–Houston [1st Dist.] 2009, no writ)). Therefore, it held that a party has not properly exercised an option if it proposes a change in the terms of the option. Id. (citing Tex. State Optical, Inc. v. Wiggins, 882 S.W.2d 8, 10-11 (Tex.App.–Houston [1st Dist.] 1994, no writ)). Thus, the Court held that White still owned his 8% of the company’s shares because Four Seasons attempted to modify the terms of the option and failed to tender the purchase price within 90 days. 429 B.R. at 212-13.

COURT CONCLUDES FACTS DEMONSTRATE SHAREHOLDER OPPRESSION

The Court found a number of corporate transactions between Four Seasons and Nevins affiliates. However, with “one notable exception, these affiliate transactions were profitable to Four Seasons. The notable exception concerned a $ 2,000,000 loan from Four Seasons to Nevins to pay a personal judgment against him…. Nevins promptly repaid the loans in full, but paid no interest on the loans.” 429 B.R. at 213.

Nevertheless, as a Four Seasons director and officer, the Court found Nevins owed fiduciary duties to the company. Id. (citing Loy v. Harter, 128 S.W.3d 397, 407 (Tex. App.–Texarkana 2004, pet. denied) and Gearhart Indus., Inc. v. Smith Int’l, Inc., 741 F.2d 707, 719 (5th Cir. 1984)). Thus, although the loss to the company was minimal, the Court held Nevins’ fiduciary duty precluded him from – unilaterally and without board approval – having Four Season give him interest free loans. Id. Hence, the Court held White was entitled to a judgment against Nevins for approximately $ 4,900 (White’s pro rata amount of the loss). Id.

In addition, although it believed “the issue is close,” the Court concluded that the facts of the case demonstrated shareholder oppression. Id. Focusing on the 1988 case of Davis v. Sheerin, 754 S.W.2d 375 (Tex. App.–Houston [1st Dist.] 1988, writ denied), the Court recognized that there is no set standard in Texas for determining whether shareholder oppression has occurred. Rather, examining the facts as a whole, a court had to determine whether the company’s conduct deprived a minority shareholder of his/her reasonable expectations as an equity holder. 429 B.R. at 213 (citing Davis, 754 S.W.2d at 382-83).

In that regard, the Court stated that the:

Texas Business Organizations Code informs the Court as to when the Court should impose equitable relief on behalf of a minority shareholder. The Code provides that a receiver should be appointed when “the actions of the governing persons of the entity are illegal, oppressive or fraudulent.” TEX. BUS. ORG. CODE. § 11.404(a)(1)(C). The same Code provides that the Court should appoint a receiver only if “all other available legal and equitable remedies . . . are inadequate.” TEX. BUS. ORG. CODE. § 11.404(b)(3).

There is no controlling case law on the meaning of the phrase “illegal, oppressive or fraudulent.” However, there was no evidence of any fraud in this case. The Court has concluded that the dividends were disguised dividends in derogation of federal tax law. In that sense, they were illegal.

Furthermore, the Court concludes that a corporation that operates in a manner intended to deprive a shareholder of its reasonable expectations to share in the corporation’s profits has operated in an oppressive manner. See Patton v. Nicholas, 154 Tex. 385, 279 S.W.2d 848, 854 (Tex. 1955). The payment of $4,900,000 in disguised dividends–when White was paid nothing–was an extraordinary act by the corporation in derogation of White’s rights as a shareholder. One of a shareholder’s fundamental expectations is to share in the corporation’s profits. Id. By diverting all of those profits for the benefit of the other shareholders (or the families that own them), the corporation obviously denied White his expectations as a shareholder of Four Seasons.

Four Seasons, 429 B.R. at 214.

In so holding, the Court found that such “conduct could be excused–and White would only be entitled to past damages–if it were unlikely to continue in the future. Because the corporation might have mistakenly believed that it had exercised its right to purchase White’s shares, the Court must consider whether the Court’s declaration that White is a shareholder and the award of actual damages for past conduct is sufficient to protect White’s future expectations.” Id. Then, the Court held that three (3) “major facts force[d] the Court to conclude that White is entitled to some form of equitable relief to protect his future expectations.” Id.

1.Four Seasons did not limit its defense of the disguised dividends to its belief that White was no longer a shareholder. Rather, it defended the disguised dividends as a method to avoid double taxation, and so that profits would be paid to current employees. Since White had been terminated, the Court noted that this situation would not change with the issuance of its opinion. “These conclusions are exacerbated by the absence of the declaration of any dividends by the corporation. If some reasonable judgment had been applied to divide the distributions into bonuses for jobs well done and dividends for profits earned, the Court might have been persuaded as to the bona fides of these corporate decisions. Left with a dividend-less corporation and no expectation of future dividends, the Court finds that it must fashion equitable relief.” 429 B.R. at 214.

2.The Court noted Nevins’ personal use of corporate assets. “At a time of great capital needs, Nevins diverted $ 2,000,000 (albeit temporarily) to his personal use. The only measure of damages proven was the interest cost of the money. But, the opportunity costs associated with this activity serves to convince the Court that the corporation is not being operated for the benefit of all shareholders.” 429 B.R. at 215.

3.Four Seasons paid the disguised dividends, and then imposed a capital call on all shareholders. “As a result of the capital call, White was forced either to pay an additional $ 56,000 or to be diluted by 50%. Had the corporation really needed the capital, this would not have been problematic. But, it makes no sense for the corporation to have paid $ 4,900,000 in disguised dividends and then to call capital from shareholders in a manner that would potentially dilute White with no foreseeable upside.” Id.

As a result, the Court held that Four Seasons could elect to purchase White’s shares for an amount calculated pursuant to the formula agreed upon by the parties in the Agreement (as calculated by the Court in its opinion based on the company’s most recent balance sheets introduced into evidence). 429 B.R. at 216-18. In the alternative, the Court held:

[I]f the company does not elect to buy-out White’s interest, then it will be permanently enjoined as follows:

1. Except as set forth in paragraphs 2 and 3, Four Seasons may pay funds (whether as compensation, bonuses, commissions, loans, advances, dividends or otherwise) to its shareholders, any family member of any shareholder, or any affiliate of a shareholder only as follows:

An amount that is equal to the average compensation (exclusive of the disguised dividends described in this opinion and the commissions set forth below) paid to such person during the period July 1, 2006 through June 30, 2009, adjusted for the annual rate of inflation as reported by the United States Department of Labor Consumer Price Index; plus Commissions, calculated on the same basis as was in effect on June 30, 2009.

2. Four Seasons may pay any additional amount to its shareholders, any family member of any shareholder, or any affiliate of a shareholder, if such amount is pursuant to an agreement approved in writing in advance by White and on such conditions as set forth in the agreement approved in writing by White.

3. If Four Seasons pays any funds (whether as compensation, bonuses, commissions, loans, advances, dividends or otherwise) to its shareholders, any family member of any shareholder, or any affiliate of a shareholder in excess of the amounts set forth in paragraphs 1 or 2, then an amount equal to 8% of any such payment must simultaneously be paid to White, in cash.

4. Four Seasons shall provide to White, not later than the last day of each calendar month, a report showing all payments made to its shareholders, any family member of any shareholder, or any affiliate of a shareholder during the preceding calendar month.

5. If Four Seasons violates the terms of this injunction, White may sue to enforce the injunction in any court of competent jurisdiction and should be awarded all of his costs and attorneys fees expended in enforcement of the injunction.

Four Seasons, 429 B.R. at 218-19.

THE “MORAL TO THE STORY”

“Business divorces” often involve many emotionally-charged allegations, legal issues and equitable considerations – – especially when they concern the “divorce” of a minority shareholder-employee from a closely-held company.

When facing such circumstances, the parties involved should consider the consequences of such a separation from both an employment point of view and a corporate/shareholder point of view. They should carefully consider the employment relationship, and any agreements regarding that relationship. Concurrently, they should consider any effects that the termination/departure may have on the employee’s shareholder status, and any agreements regarding same – such as shareholder agreements concerning equity interests in the company and buy-out options.

In that regard, the circumstances surrounding the “divorce” as a whole should be considered, as they arguably may deprive the minority shareholder of his/her reasonable expectations as an equity holder. In the Four Seasons case, the Court found that a company which operates in a manner intended to deprive a shareholder of its reasonable expectations to share in the company’s profits has operated in an oppressive manner. In fact, it concluded that the “payment of $4,900,000 in disguised dividends–when White was paid nothing–was an extraordinary act by the corporation in derogation of White’s rights as a shareholder.” Moreover, the Court found Nevins’ interest free personal loans from Four Seasons equated to the company “not being operated for the benefit of all shareholders.” It also was critical of the company paying the disguised dividends, and then imposing a capital call on all of its shareholders – “in a manner that would potentially dilute White with no foreseeable upside.”

If you would like a copy of any of the cases discussed in this article, or to discuss the issues raised in further detail, please do not hesitate to contact Shain Khoshbin at Clouse Dunn Khoshbin LLP.

Shain A. Khoshbin

CLOUSE DUNN KHOSHBIN LLP

1201 Elm Street, Suite 5200, Dallas, Texas 75270-2142

Main: (214) 220-3888 Direct Dial: (214) 239-2749 Mobile: (214) 893-6308 Fax: (214) 220-3833

Direct Email: [email protected] Website: www.cdklawyers.com/shain.php

THIS ARTICLE IS FOR INFORMATIONAL PURPOSES ONLY. IT DOES NOT, AND IS NOT INTENDED TO, CONSTITUTE LEGAL ADVICE. EACH CASE DEPENDS ON ITS FACTS, AND LAWS SOMETIMES CHANGE OVER TIME. FOR LEGAL ADVICE, CONTACT LEGAL COUNSEL LICENSED IN YOUR STATE.

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