DILUTING SHARES
Throughout this series we will detail some of the common methods that majority shareholders use to destroy a minority shareholder's value in the company and what rights a minority shareholder has when this happens. In this post we address the diluting of a minority shareholder's share value by issuing new shares.
What is Dilution of Shares?
Dilution of shares occurs when majority shareholders create new shares in the company to be controlled by themselves. This diminishes the minority shareholder's proportionate voting rights and earnings.[1] As often is the case, these new shares will be issued at the majority shareholders command for significantly less than market value.
As the majority shareholders control the board of directors and, through that, the power to issue new shares, a minority shareholder is constantly at risk from this method of squeeze-out. With the value of a minority shareholder's shares near nothing, majority shareholders can easily buy up the minority shares for a fraction of the price.
Giving Majority Shareholders a Super Majority
Another way in which issuing additional shares can tip the balance of power is that it can give the majority shareholder a super majority necessary to overcome some particularly onerous voting requirements in the company. Examples of these include votes on mergers, amending the bylaws of the company, and making fundamental changes to the company's structure.
It is important to make sure that a majority shareholder does not achieve this super majority without your consent, as once they achieve this, the only thing protecting you is the majority shareholder's fiduciary duty to you.
Defending Against Distribution of Shares
A method by which a minority shareholder can defend themselves against distribution of shares to the majority shareholder is to demand preemptive rights to the issuance of any new shares. This gives the minority shareholder "an option to subscribe to a new allotment of shares before new shares are offered to other persons."[2] Language creating this right may be included in the company's articles of incorporation.[3]
As mentioned above, also protecting minority shareholders is the idea of fiduciary duty and the business judgment rule described in the previous entry, Post #3: Withholding of Dividends and the Tax Burden it Creates. Courts will often look to see if the issuance of new shares was reasonable under these two tests.
However, make sure that you stay knowledgeable about your rights in the company regarding the issuance of new shares. These rules are not easily found to be breached by majority shareholders absent egregious conduct.
This concludes our miniseries concerning minority shareholder squeeze-outs. Please maintain a sharp grasp of your rights as a minority shareholder and check back for more updates soon.
[1] F. Hodge O'Neal & Robert B. Thompson, Oppression of Minority Shareholders and LLC Members, § 3:20 (rev. 2nd ed. 2004).
[2] F. Hodge O'Neal & Robert B. Thompson, Oppression of Minority Shareholders and LLC Members, § 3:20 (rev. 2nd ed. 2004).
[3] F. Hodge O'Neal & Robert B. Thompson, Oppression of Minority Shareholders and LLC Members, § 3:20 (rev. 2nd ed. 2004).