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| Preemptive Rights and Dilution |
| Resources >>Closely Held Corporations>>Preemptive Rights |
Dilution and Preemptive Rights
Shareholders tend to think of their ownership interests on a percentage basis: “I own 10% of the company.” But ownership is actually
measured by the number of shares, so that a 10% shareholder would own 100 shares out of 1000 shares issued. However, if the
corporation issues 1000 new shares, then the owner of the 100 shares is suddenly only a five percent owner. This is called dilution, and it
is often used as a mechanism to oppress and violate the rights of minority shareholders.
Shareholders are protected from dilution if they have preemptive rights, which enable the shareholders to protect their percentage
ownership, right to dividends and voting power. If a shareholder has preemptive rights, then that shareholder must be offered the
opportunity to acquire a proportionate number of additional shares on the same terms and conditions any time that new shares are issued.
However, in most states, shareholders do not have preemptive rights unless those rights have been granted in the articles of incorporation.
A handful of states, including Minnesota, Missouri, South Carolina, and Washington, grant preemptive rights as a matter of law unless such
rights are negated in the articles of incorporation.
Even when a shareholder does not have preemptive rights, a shareholder may still have a remedy based on breach of fiduciary duties or
shareholder oppression. Theoretically, a shareholder is not harmed by dilution if the corporation receives fair consideration for the new
shares. In the example above, if the corporation were issuing 1000 new shares in exchange for a cash infusion that doubled the value of
the corporation, then the 10% shareholder might now only own 5%, but that 5% is still worth the same as the 10% was before. In the real
world, this is rarely how things work out. Therefore, a minority shareholder who believes that he has been harmed by dilution may bring a
derivative action on behalf of the corporation against the officers, directors, or shareholders involved in the sale of stock for fiduciary
breaches. This action would seek damages requiring that the corporation be paid the amount that it should have been paid for the stock. If
the dilution was done in bad faith or for inadequate consideration, then a shareholder may also bring an action for shareholder oppression
and ask the Court to order a buy-out based on the value of the shareholder’s undiluted interest.
Even when the majority shareholder offers the minority shareholder the right to invest and preserve his percentage interest, the conduct
can still be oppressive. For example, if the majority shareholder knows that the minority shareholder cannot afford to buy more stock, then
offering the minority shareholder that opportunity is meaningless. In such a situation, the majority shareholder might even issue the new
stock at a bargain price, knowing that the minority shareholder could not participate and the majority shareholder would increase his interest
at an unfairly low price. This was the situation considered by the New York Court of Appeals in Katzowitz v. Sidler, 24 N.Y.2d 512 (N.Y.
1969), and the Court held that the majority shareholder had breached his fiduciary duties. It did not matter that the minority shareholder
“was also given a chance to purchase additional shares at bargain rate. The price was not so much a bargain aw it was a tactic, conscious
or unconscious on the part of the directors, to place [the minority shareholder] in a compromising situation. The price was so fixed to make
the failure to invest costly.” Id. at 521.
Shareholders tend to think of their ownership interests on a percentage basis: “I own 10% of the company.” But ownership is actually
measured by the number of shares, so that a 10% shareholder would own 100 shares out of 1000 shares issued. However, if the
corporation issues 1000 new shares, then the owner of the 100 shares is suddenly only a five percent owner. This is called dilution, and it
is often used as a mechanism to oppress and violate the rights of minority shareholders.
Shareholders are protected from dilution if they have preemptive rights, which enable the shareholders to protect their percentage
ownership, right to dividends and voting power. If a shareholder has preemptive rights, then that shareholder must be offered the
opportunity to acquire a proportionate number of additional shares on the same terms and conditions any time that new shares are issued.
However, in most states, shareholders do not have preemptive rights unless those rights have been granted in the articles of incorporation.
A handful of states, including Minnesota, Missouri, South Carolina, and Washington, grant preemptive rights as a matter of law unless such
rights are negated in the articles of incorporation.
Even when a shareholder does not have preemptive rights, a shareholder may still have a remedy based on breach of fiduciary duties or
shareholder oppression. Theoretically, a shareholder is not harmed by dilution if the corporation receives fair consideration for the new
shares. In the example above, if the corporation were issuing 1000 new shares in exchange for a cash infusion that doubled the value of
the corporation, then the 10% shareholder might now only own 5%, but that 5% is still worth the same as the 10% was before. In the real
world, this is rarely how things work out. Therefore, a minority shareholder who believes that he has been harmed by dilution may bring a
derivative action on behalf of the corporation against the officers, directors, or shareholders involved in the sale of stock for fiduciary
breaches. This action would seek damages requiring that the corporation be paid the amount that it should have been paid for the stock. If
the dilution was done in bad faith or for inadequate consideration, then a shareholder may also bring an action for shareholder oppression
and ask the Court to order a buy-out based on the value of the shareholder’s undiluted interest.
Even when the majority shareholder offers the minority shareholder the right to invest and preserve his percentage interest, the conduct
can still be oppressive. For example, if the majority shareholder knows that the minority shareholder cannot afford to buy more stock, then
offering the minority shareholder that opportunity is meaningless. In such a situation, the majority shareholder might even issue the new
stock at a bargain price, knowing that the minority shareholder could not participate and the majority shareholder would increase his interest
at an unfairly low price. This was the situation considered by the New York Court of Appeals in Katzowitz v. Sidler, 24 N.Y.2d 512 (N.Y.
1969), and the Court held that the majority shareholder had breached his fiduciary duties. It did not matter that the minority shareholder
“was also given a chance to purchase additional shares at bargain rate. The price was not so much a bargain aw it was a tactic, conscious
or unconscious on the part of the directors, to place [the minority shareholder] in a compromising situation. The price was so fixed to make
the failure to invest costly.” Id. at 521.
Author:
Eric Fryar
Eric Fryar
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| Last Updated: 2/20/2011 |