Often in the case of closely held New York companies, a majority interest-holder will wish to part ways with a minority interest-holder.
A common mechanism used to accomplish that goal is frequently referred to as a “freeze-out merger.”
A freeze-out merger can be an effective mechanism for ending this business relationship between interest-holders in a closely-held company, provided that it is carried out in accordance with the majority interest-holder’s applicable statutory, contractual, and fiduciary obligations.
Majority interest-holders wishing to employ this mechanism must be cognizant of their obligations and of minority interest-holders’ rights if they are to avoid (or at least prevail in) litigation.
Structure of a Freeze-Out Merger
A freeze-out merger is a merger by an entity’s majority interest-holders that forces the minority interest-holders to give up their equity in the entity in exchange for cash, while allowing the majority interest-holders to retain their equity in the surviving entity.
For example, the majority owner of OldCo (Owner) may form a new entity, NewCo, of which he or she is the sole owner, and then exercise his or her control over the two companies to effectuate a merger of OldCo into NewCo. Under the terms of the plan of merger, Owner will retain his equity in NewCo and the minority owner of OldCo will be offered cash for his or her shares in OldCo. While such an option may seem like an easy way to rid oneself of a troublesome business partner, there are limitations and requirements as to how and when such a transaction may be carried out.
Requirements for a Freeze-Out Merger
A majority interest-holder wishing to carry out a freeze-out merger must meet three basic requirements:
- Compliance with the procedures set forth in the Business Corporation Law (the BCL) or Limited Liability Company Law (the LLCL), as applicable.
- Compliance with the terms of the company’s certificate of incorporation or operating agreement, as applicable.
- Compliance with the fiduciary duties to which majority interest-holders in closely held companies are subject.
Statutory and Contractual Requirements
Both the BCL and the LLCL set forth requirements as to the process by which a merger may be effected. These statutes must, however, be read in conjunction with the certificate of incorporation or operating agreement, respectively.
For example, both statutes permit the adoption of a plan of merger without prior notice, without a meeting, and without a vote, by obtaining the written consent of at least as many interest-holders as would be required to approve such plan of merger by vote under the applicable formation document. (In the event a certificate of incorporation does not specify how many votes are required to approve a plan of merger, the BCL requires the holders of all outstanding shares entitled to vote to sign a written consent in lieu of a shareholder meeting and vote. The LLPL, however, contains no such default rule.)
Both statutes require that prompt notice be provided to those interest-holders who did not consent in writing to the merger.
Fiduciary Duties of Majority Interest-Holders
Majority interest-holders in closely held corporations have an obligation to all shareholders to adhere to fiduciary standards of conduct and to exercise their responsibilities in good faith when undertaking any corporate action, including a merger.
As fiduciaries, they must treat all interest-holders—majority and minority—fairly, and all corporate responsibilities must be discharged in good faith and with “conscientious fairness, morality and honesty in purpose.” Majority interest-holders have an obligation of candor and good and prudent management of the company.
Remedies Available to Minority Interest-Holders
In the event the minority interest-holder and the surviving company cannot agree on the fair value to be paid for the minority interests within a certain time period, the company must institute an appraisal proceeding to fix the fair value of the interests. If the company does not file such a proceeding within the allotted time period, the minority interest-holder may do so.
Generally speaking, the exclusive remedy of a minority interest-holder dissenting from a freeze-out merger is to obtain the fair value of his or her interests through the appraisal proceeding. An exception exists, however, when the merger is unlawful or fraudulent as to that shareholder, in which event an action for equitable relief is authorized. Thus, technical compliance with the BCL or LLCL and the certificate of incorporation or operating agreement, respectively, does not necessarily exempt a merger from judicial review.
The equitable relief that minority interest-holders may seek in connection with a freeze-out merger includes recission of the merger; enjoining of the merger; directing the majority interest-holder to terminate the merger agreement; directing specific performance of the certificate of incorporation or operating agreement, as applicable; and imposition of a constructive trust upon membership interests and assets of the company.
The primary relief sought by the minority interest-holder must be equitable in nature and money damages are only available if they are ancillary or incidental to equitable relief, such as for breach of fiduciary duty.
Standard of Judicial Review
In entertaining an equitable action to review a freeze-out merger, a court will view the transaction as a whole to determine whether it was tainted with fraud, illegality, or self-dealing; whether the minority interest-holders were dealt with fairly; and whether there exists any legitimate corporate purpose for the merger other than the forced buy-out of the minority interests.
When there is common directorship or majority ownership between the two companies being merged (which is the case in freeze-out mergers), there is an inherent conflict of interest and potential for self-dealing, requiring careful scrutiny of the transaction, with the burden on defendant to prove good faith and entire fairness of the merger.
The court will determine both whether the merger was procedurally fair to the minority interest-holders, i.e., whether there was complete and candid disclosure of all material facts and circumstances, and whether the price offered for the minority interests was fair.
The court will also determine whether there was a legitimate corporate purpose for the merger, such as attracting necessary outside capital investment, obtaining certain tax benefits, increasing the corporation’s profits, or improving its management structure.
The benefit need not be great, but it must be for the corporation. The removal of a minority shareholder or member is not itself a sufficient corporate purpose unless he or she has taken steps to harm the corporation, such as by competing with the company in violation of the company’s formation documents.
Steps the Majority Interest-Holder Can Take to Reduce Liability
There are certain steps that majority interest-holders can take in connection with a freeze-out merger to help avoid litigation or ensure that the transaction will withstand judicial scrutiny, including:
- Appointing an independent negotiating committee made up of neutral directors to evaluate the merger proposal and oversee the process of approval;
- Engaging an independent appraiser to evaluate and opine on whether the merger is fair to all parties; and
- Ensuring that the merger will serve a legitimate corporate interest, i.e., that it will inure to the benefit of the corporation—and not just the majority interest-holder—in some way.
Craig Weiner is a partner in the Robins Kaplan LLP New York office and is chair of the New York Commercial and Financial Litigation Group.
Lisa Coyle is counsel in the Robins Kaplan LLP New York office, and focuses her practice on complex business litigation.