When a closely-held business is profitable, self-interested owners naturally want a bigger slice of the pie, especially where the personal relationships among the owners are frayed. Perhaps that’s why we often discuss the value of freeze-out mergers as a mechanism for those in control of a closely-held corporation or limited liability company to squeeze a minority owner out of the business’ future profits.
Equity dilution is another common method by which those in control of a corporation or LLC attempt to squeeze out a minority owner. For one, stock dilution impairs the minority owner’s ability to influence company action by voting his shares, and it lessens the owner’s right to participate pari passu in the distributions or dividends of the company. Perhaps more importantly, a minority owner can see his or her ownership interest diluted below certain critical thresholds—for instance, the 20% ownership required to petition for dissolution under BCL 1104-a.
Despite the potentially drastic consequences of stock dilution, many closely-held businesses we encounter fail to adequately address the issue of dilution in their governing documents. And New York caselaw on the issue leaves plenty to be desired. Let’s interpret those factors as an invitation to review the basics, key caselaw, and the current status of the improper dilution claim.
Protections Against Dilution
Whether a minority owner can avail himself of certain statutory or common law protections to avoid dilution depends on the nature of the business, the terms of the owners’ agreement, and the context of the dilutive event. Some of the most common protections against improper dilution include:
In pre-1997 corporations, BCL 622 provides that a minority shareholder shall have the right to purchase additional shares to avoid dilution of his interest when the corporation intends to issue new shares that would adversely affect either the dividend rights or the voting rights of that shareholder. In post-1997 companies, the BCL expressly states that a shareholder does not have preemptive rights unless they are provided for in the corporation’s certificate of incorporation.
New York limited liability companies are subject to LLC Law 502(c), which states that the operating agreement may “provide that the membership interest of any member who fails to make any required contribution shall be subject to specified consequences of such failure. Such consequences may include, but are not limited to, reduction or elimination of the defaulting member’s interest.”
Shareholders and LLC members are of course free to negotiate and memorialize protections against dilution in the business’ governing agreements. Absent unconscionability or an overriding public policy concern (like the one discussed here), those provisions are likely to be enforced.
A practice pointer: We often encounter LLC operating agreements that authorize the majority to make capital calls, then provide that when a member fails to meet a capital call, the ownership interests will be reshuffled in proportion to the members’ capital accounts. Consider that a trap for the unwary, because the members’ capital accounts might have little relation to the actual value of the business (especially if many years have passed between the execution of the operating agreement and the capital call). By readjusting ownership percentages based on capital accounts, every dollar not contributed in the capital call could cost thousands of dollars in fair value dilution.
Even assuming that an additional share issuance or membership interest reallocation is authorized by the governing statute or the owners agreement, a to-be-diluted owner may appeal to the majority’s common law fiduciary duties. Such a challenge is subject to the framework set forth by the 1975 Court of Appeals decision, Schwartz v Marien, 37 NY2d 487, 492 :
- Departure from precisely uniform treatment of stockholders (i.e., dilution) may be justified where a bona fide business purpose indicates that the best interests of the corporation would be served;
- Where a prima facie case of unequal treatment is made out, the burden of coming forward with proof of such a bona fide business purpose shifts to those in control of the corporation;
- In a closely held corporation, those in control must show a special justification of the corporate interest: “not only must it be shown that it was sought to achieve a bona fide independent business objective, but as well that such objective could not have been accomplished substantially as effectively by other means which would not have disturbed proportionate stock ownership.”
Dilution and Excessive Compensation
Challenges to dilutive equity awards commonly focus on equity that the company elects to award its employees or officers as compensation. BCL 505 expressly allows a corporation to issue shares as consideration for service. And the LLC law does not prohibit an LLC’s use of equity-based compensation.
Former New York County Justice Herman Cahn gets credit for the most-cited decision concerning a challenge to compensation-based dilution with his 2008 decision in Dingle v Xtenit, Inc., 20 Misc 3d 1123(A) [Sup Ct 2008] (discussed here). In Dingle, Justice Cahn employed the above framework to conclude that the majority shareholder’s issuance of shares over a three-year period that diluted the plaintiff from a 15% shareholder to a less-than-1% shareholder failed to satisfy the bona fide business purpose requirement.
How does an owner show that the equity compensation awarded to certain owners is excessive? Many times, that exercise requires two fields of expert testimony: (i) a reasonable compensation analysis to determine the market rate for the officer’s services and (ii) an appraisal to determine the value of the equity awarded.
A member might also take guidance from the First Department’s decision in Lemle v Lemle, 92 AD3d 494, 497 [1st Dept 2012]. While it’s not a dilution case, the First Department in Lemle concludes that the plaintiff adequately stated an excessive compensation claim by alleging (1) the officers’ acknowledgments of a flimsy basis for the salary, (2) the officers’ refusal to permit an outside auditor’s review of the compensation packages, and (3) that salary and benefits were paid to individuals who did no work at all for the corporation. Any of those factors might also carry the day in a challenge to dilution from equity-based compensation.
Dilution and Mergers/Recapitalizations
The second setting in which dilution claims often are litigated is in connection with a corporate merger or recapitalization that has the effect of diluting the pre-recapitalization interests of certain equity holders. In these cases, if the diluted owner can show that those who orchestrated the merger or recapitalization stand to benefit from the dilution, the transaction is subject to “entire fairness” review (the entire fairness standard is discussed in greater detail here).
For a successful challenge to a dilutive recapitalization, consider the 2021 decision of New York County Justice Andrew Borrok, 15882 Can., Inc. v Money.Net, Inc., 2021 N.Y. Slip Op. 30516[U], 11-12 [New York County 2021], which granted the plaintiffs summary judgment on their claim for breach of fiduciary duty in connection with a recapitalization of the company that reallocated 70% of the company’s equity to those in control. Justice Borrok found:
The Company Defendants did not explain how it decided on a 70% allocation of new shares to its officers and there was no advice from outside consultants in reaching this percentage allocation. Indeed, as discussed above, the record indicates that Mr. Van Arnem and Ms. Christofano decided to award themselves 70% of the Company stock and pursuant to the Director’s Consent, Mr. Van Arnem and his mother “blessed” the transaction. Although the Shareholders Consent disclosed the 70% equity transfer, three out of six of the shareholders who executed the Shareholders Consent were clearly not disinterested.”
Direct or Derivative?
To make matters more complicated, there is mixed authority on whether a claim for improper dilution is direct or derivative. On the one hand, a claim for improper dilution has a distinctly derivative flavor: the company is damaged to the extent it issued ownership interests for less than adequate consideration. On the other hand, the diluted owners are individually harmed: they suffer weakened voting power and a smaller share of pari passu distributions.
The confusion in the caselaw stems from the Delaware case of Gentile v Rossette, 906 A2d 91, 98 [Del 2006], which held that a dilution claim could be both direct and derivative. Fifteen years later, in 2021, the Delaware Supreme Court overruled Gentile in Brookfield Asset Mgt., Inc. v Rosson, 261 A3d 1251, 1280 [Del 2021], holding that a dilution claim stemming from the corporate entity receiving less than full value for the issuance of new shares is exclusively derivative.
In the interim though, New York Courts followed Gentile, holding that a dilution claim could be direct or derivative, “because the harm to the [members], namely, diluting their interest to weaken their voting rights and revoking their rights to pari passu distributions, is separate from the harms allegedly suffered by the nominal defendant limited liability companies as a result of issuing the preferred equity shares for allegedly insufficient consideration” (Beatrice Investments, LLC v 511 9th LLC, 177 AD3d 551, 551 [1st Dept 2019]).
Whether Beatrice is still good law recently came before the First Department in Hemingway Group LLC v i80 Group LLC, 2023 NY Slip Op 06229 [1st Dept Dec. 5, 2023]. But rather than directly address the issue, the First Department distinguished the plaintiff’s claims—a challenge to allegedly dilutive restructuring—from those in Beatrice (and therefore, arguably suggested that Beatrice remains good law):
Plaintiff’s reliance on [Beatrice] is misplaced as the amended complaint in the case at bar does not allege that Helwani diluted plaintiff’s interest to weaken its voting rights. Plaintiff may not merely allege in conclusory terms that it was diluted; claims for breach of fiduciary duty must be pled with particularity”
We’ve barely scratched the surface of a complex issue that often sits at the intersection of complicated transactions, wordy statutes, and unclear caselaw. Those considering diluting their co-owners, or those mounting a challenge to a dilutive equity issuance would be wise to catch up on our posts concerning fiduciary duties (here) and dilution litigation (here).