The Big Chill: “Freezing Out” Minority Shareholders in Georgia Corporations
Ms. Smith is the majority owner of ABC Company, a privately held Georgia corporation. Mr. Jones owns the remaining outstanding shares of ABC Company. After a falling-out, Mr. Jones goes to work for ABC Company's largest competitor, XYZ Company. Ms. Smith suspects that Mr. Jones is using his ownership interest in ABC Company to gain access to company information which he is using to further the interests of XYZ Company to ABC Company's detriment. Ms. Smith wishes to terminate her economic relationship with Mr. Jones, but Mr. Jones isn't willing to sell his shares and she has no contractual right to force him to do so. Ms. Smith has heard about something called a "freeze-out" merger, but isn't sure if it will help her situation.
Ms. Smith is the majority owner of ABC Company, a privately held Georgia corporation. Mr. Jones owns the remaining outstanding shares of ABC Company. After a falling-out, Mr. Jones goes to work for ABC Company’s largest competitor, XYZ Company. Ms. Smith suspects that Mr. Jones is using his ownership interest in ABC Company to gain access to company information which he is using to further the interests of XYZ Company to ABC Company’s detriment. Ms. Smith wishes to terminate her economic relationship with Mr. Jones, but Mr. Jones isn’t willing to sell his shares and she has no contractual right to force him to do so. Ms. Smith has heard about something called a “freeze-out” merger, but isn’t sure if it will help her situation.
This hypothetical scenario is not at all uncommon. While not anticipated at the outset of the relationship, small business owners often find themselves in rocky business relationships with their minority shareholders for a variety of reasons. A minority shareholder may die and leave his shares to a third person, or a minority shareholder who was previously active in the business may no longer be actively contributing to the business’s success, perhaps triggered by changes in the minority shareholder’s personal life.
This problem is exacerbated in cases like the hypothetical described above. This is because by statute, shareholders in a Georgia corporation, regardless of how few shares they own, have certain information rights. For example, even privately held Georgia corporations must provide annual financial statements to their shareholders upon request.1 The statute does permit a corporation to limit (but not eliminate) the inspection rights of shareholders holding less than 2% of a company’s shares.
In addition, under certain circumstances, shareholders have the right to inspect and copy minutes of board of directors meetings, records of any actions taken by the board of directors, and the accounting records of the corporation. A shareholder may inspect and copy such records only if it is done in good faith and for a proper purpose that is reasonably relevant to his or her legitimate interest as a shareholder, and such records are directly connected with this purpose. It should be noted that furthering the interests of a competitor is not a “proper purpose.”2
Good legal planning during the startup of a business will eliminate many types of problems, such as the one Ms. Smith is facing. A properly drafted shareholders agreement will often contain provisions for the redemption of a minority shareholder’s shares upon death, termination of employment and other circumstances. Unfortunately, many businesspeople like Ms. Smith go into business without getting good legal advice, often because of budget constraints which are typical for a startup business.
One technique available to Ms. Smith and others who find themselves in similar situations is the use of a freeze-out merger.
What Is a Freeze-out Merger?
A freeze-out merger is a strategic merger transaction that is accomplished for the purpose of eliminating unwanted minority shareholders. A freeze-out merger can be used by one or more majority shareholders to eliminate one or more minority shareholders. Freeze-out mergers can be structured in a number of different ways. In fact, while beyond the scope of this article, there are a number of other transactions that can also be effected to accomplish the elimination of unwanted minority shareholders. Some examples include reverse stock splits, share exchanges, recapitalizations, and amendments to a corporate charter to make shares redeemable at the option of the corporation.
The structure of a typical freeze-out merger involving the hypothetical ABC Company may look something like this:
Ms. Smith forms a new company, NewCo, and contributes her ABC Company shares to NewCo in exchange for 100% of the stock of NewCo. As a result, Ms. Smith is the sole owner of NewCo, and NewCo becomes the majority owner of ABC Company.
NewCo then causes the merger of ABC Company with and into NewCo, with NewCo as the surviving corporation in the merger. This involves the adoption of a plan of merger by the companies’ respective boards of directors, the filing of a certificate of merger with the Georgia Secretary of State and the publication of a notice of merger in an appropriate newspaper.
If NewCo owns at least 90% of ABC Company, approval of the merger by the shareholders of NewCo and ABC Company will not be required pursuant to Section 14-2-1104 of the Georgia Business Corporation Code (a so-called “short-form” merger). Conversely, if NewCo owns less than 90% of ABC Company, approval of the merger by the shareholders of NewCo and ABC Company will be required (referred to as a “long-form” merger). As a general rule, Georgia law requires approval of a merger by a majority of the votes entitled to be cast. Therefore, the minority shareholder will, by definition, be unable to veto unilaterally the merger. It should be noted, however, that a higher threshold for approval may be contained in a Georgia corporation’s articles of incorporation, bylaws or its board of directors’ authorizing resolutions.3 Under these circumstances, a minority shareholder, depending upon his level of ownership, could have the power to veto the merger unilaterally. Thus, these documents should be carefully reviewed at the outset to ensure that the shareholder will not be able to prevent the merger from occurring.
The plan of merger will be structured such that Mr. Jones, as minority shareholder of ABC Company, is given cash in exchange for his shares of ABC Company stock. Mr. Jones will then have the option of accepting the amount of cash proposed in the plan of merger or contesting the offering price and seeking to establish the fair value of his shares by exercising his dissenters’ rights. (This topic is addressed in greater detail below.)
The end result is: Ms. Smith is the sole shareholder of NewCo as the surviving corporation; NewCo is vested with all of the assets and becomes subject to all of the liabilities of ABC Company; and Mr. Jones receives cash in exchange for his previous ownership stake in ABC Company. As he is no longer a shareholder, Mr. Jones will no longer have access to ABC Company’s information, or have any future relationship with the company.
A properly structured freeze-out merger will not result in any tax consequences to the majority shareholder and other continuing shareholders. An upstream merger of an 80% or more owned subsidiary into its corporate parent will be treated as a liquidation under Internal Revenue Code (IRC) Section 332 as to the parent. Neither the subsidiary nor the parent will recognize gain or loss on the transfer of assets by the subsidiary to the parent. A minority shareholder who is cashed out in an upstream merger is treated as having sold his shares in a taxable transaction. A downstream merger of a parent corporation into its subsidiary will generally be treated as a tax-free merger under IRC Section 368(a)(1)(A). A minority shareholder who is cashed out in a downstream merger would also be treated as having sold his shares in a taxable transaction. Anyone contemplating a freeze-out merger should consult with a tax attorney prior to the merger, in order to avoid potential tax liability.
From a fairness standpoint, freeze-out mergers are not without controversy. Certainly, there will be situations (such as the hypothetical scenario described above) where a freeze-out merger would seem to be justified from a fairness standpoint. Their use is not, however, limited to such situations.
The primary argument against permitting freeze-out mergers is that they allow majority shareholders to decide not only whether to eliminate minority shareholders, but also to dictate the timing of elimination. Often, minority shareholders feel that they are being eliminated for financial reasons. For example, a majority shareholder may be aware that the company’s financial performance might be trending upwards for the first time, and he or she may want to eliminate the minority shareholder before the valuation of his shares increases dramatically. In other words, the use of a freeze-out merger effectively gives a majority shareholder a “call option” on the minority shareholder’s shares on very favorable terms, even though the option was not bargained for at the inception of the relationship. In addition, forcing minority shareholders to sell their shares may cause them to incur capital gains taxes or transaction costs associated with reinvesting their proceeds.
To ameliorate the risk of unfairness, Georgia, like most other states, has adopted a “dissenters’ rights” statute, designed to protect minority shareholders. Georgia’s Dissenters’ Rights statute is contained in Sections 14-2-1301 through 14-2-1332 of the Georgia Business Corporation Code. This statute provides that, in response to certain mergers, asset sales or amendments to a company’s articles of incorporation, a shareholder has the right to dissent from the transaction and instead be cashed out at fair value.
The parent-subsidiary merger described in the preceding section would trigger dissenters’ rights under the statute.
Under Georgia’s Dissenters’ Rights statute, a shareholder who disagrees with a corporation’s action that gives rise to the shareholder’s right to dissent must follow certain procedures, or risk losing the protection of the statute. Any shareholder that votes in favor of the corporation’s action forfeits any subsequent claims to dissenters’ rights regarding that action. The corporation must, within 10 days of the action, give all eligible shareholders notice of their right to dissent. This dissenters’ notice must: inform the shareholders where a demand for payment must be sent and where and when shares must be deposited; inform shareholders of any restrictions on transfer of shares after demand for payment is made; and set a deadline for demanding payment, such deadline to be between 30 and 60 days after the date of the notice. A shareholder who wishes to exercise dissenters’ rights must demand payment and deposit shares in accordance with the terms of the corporation’s dissenters’ notice.
Within 10 days of receiving a demand for payment, the corporation must offer to pay the shareholder the corporation’s estimate of fair value for the shares. The shareholder then has 30 days either to accept or reject the corporation’s offer. If the shareholder fails to respond within 30 days, the shareholder is deemed to have accepted the corporation’s offer.
If the shareholder does not accept the corporation’s estimate of fair value, the shareholder may reject the corporation’s offer and instead demand payment of the shareholder’s own estimate of fair value. The corporation then has 60 days to accept the shareholder’s demand or commence a court proceeding to resolve the issue.
If a corporation commences a court proceeding, it does so in Superior Court. The court’s jurisdiction over the proceeding, known as a nonjury equitable valuation proceeding, is exclusive. After the corporation names as parties to the proceeding all those dissenting shareholders whose demands have not been resolved, the court then decides how much each dissenting shareholder is entitled to as fair value for his or her shares.
Although each party usually provides expert testimony as to the value of the dissenter’s ownership, the court may use its discretion in appointing independent experts to help the court determine fair value. The court will not apply minority or marketability discounts in determining a shareholder’s fair value; rather, fair value is determined based on a proportionate interest in the value of the corporation as a whole.4
As part of its decision, the court will also assess reasonable appraisal fees and court costs to the corporation. However, if one side has acted in bad faith, the court may assess the other side’s attorneys’ fees and expenses against that party.
While a minority shareholder cannot prevent a freeze-out merger from taking place under the Georgia Dissenters’ Rights statute, the statute is designed to allow a minority shareholder to maximize the amount of cash that he or she will receive in exchange for his or her shares under the plan of merger.
Pre-1989 Legality of Freeze-out Mergers
Historically, dissenters’ rights statutes were but one tool available to minority shareholders when responding to a freeze-out merger. Minority shareholders have attacked freeze-out mergers based upon a variety of theories, such as breach of fiduciary duty of the corporation’s directors or majority shareholders toward the minority shareholders, fraud or corporate misconduct. Remedies available to minority shareholders, in addition to fair value for their shares, included monetary damages and injunctions to stop the merger.
In particular, minority shareholders often attacked freeze-out mergers in court as lacking any business purpose other than the elimination of the minority interests. Courts were sympathetic to this argument, and minority shareholders historically were successful in preventing these mergers. This “business purpose” rule, requiring a legitimate business purpose to corporate actions, was widely adopted by the states.
Georgia, like other states, has traditionally not allowed the use of freeze-out mergers without an underlying legitimate business purpose. For example, in Bryan v. Block & Blevins, Inc., 490 F.2d 563 (5th Cir. 1974), the majority shareholders of a corporation attempted to freeze out a minority shareholder after business differences followed the minority shareholder’s resignation as a corporate director. The minority shareholder sued to enjoin the merger, alleging that the merger plan was a “device, scheme, and artifice to defraud him of his status as a shareholder.” The United States Court of Appeals for the Fifth Circuit interpreted Georgia law as requiring a legitimate business purpose. Finding no legitimate business purpose to the corporate actions, the court called the corporation’s actions a “sham,” done to circumvent the rule of law prohibiting a majority of shareholders in a corporation from forcing minority shareholders to surrender their shares.
Due to the business purpose requirement and the other tools available to minority shareholders, the viability of freeze-out mergers as a method for eliminating minority shareholders in a Georgia corporation was limited until 1989.
1989 Amendment of the Georgia Dissenters’ Rights Statute
In 1989, the Georgia General Assembly amended the Dissenters’ Rights statute to prohibit a dissenting shareholder from challenging, in the absence of fraud or deception, an underlying corporate action.5 In amending the statute, the clear intent of the legislature was to limit the remedies available to a shareholder to the exercise of dissenters’ rights:
“[W]hen a majority of shareholders has approved a corporate change, the corporation should be permitted to proceed even if a minority considers the change unwise or disadvantageous, and persuades a court that this is correct. Since dissenting shareholders can obtain the fair value of their shares, they are protected from pecuniary loss. Thus in general terms an exclusivity principle is justified.”6
The courts have consistently interpreted this amendment as statutorily eliminating the “business purpose” requirement, effectively prohibiting a minority shareholder from challenging a freeze-out merger. For example, in Magner v. One Securities Corp., 258 Ga. App. 520, 574 S.E.2d 555 (2002), a husband and wife owned two-thirds of two separate Georgia corporations. A third party owned the other third of both corporations. In order to freeze out the third party, the husband and wife set up two new corporations, then merged the existing corporations into the two new ones. The admitted purpose of the mergers was to cash out the third party’s interest in both corporations, which was to be done as part of both mergers. The corporations notified the third party of his dissenters’ rights under the statute and offered to pay him fair value for his stock, as determined by an independent appraiser.
Rather than accepting the offer or demanding payment according to the Dissenters’ Rights statute, the third party sued to stop the merger on the grounds that the corporations failed to comply with Georgia’s statutory merger requirements. In reviewing the third party’s claims, the court found no illegality in the corporations’ actions, and held that, in the absence of fraud or illegality, the exclusive remedy available to the third party was to dissent and seek fair value for his shares in accordance with the statute. The court further held that the third party failed to perfect his dissenters’ rights.7
As this case illustrates, with the 1989 amendment of the Dissenters’ Rights statute, unless a corporation fails to follow proper procedure, or acts fraudulently or deceptively, the exclusive remedy available to a minority shareholder of a Georgia corporation in a freeze-out action is to seek fair value for his or her shares under the Dissenters’ Rights statute.8
A Useful Business Strategy
Since 1989, Georgia law has recognized the validity of freeze-out mergers to eliminate unwanted minority shareholders. The minority shareholder’s sole remedy in this case is the exercise of dissenters’ rights. As a result, while this problem could have been avoided by proper planning initially, Ms. Smith does have a tool available to her to remedy her difficult business situation. To avoid any undesirable legal or tax consequences, Ms. Smith should seek the advice of tax and legal counsel to ensure that her freeze-out merger is properly implemented.
O.C.G.A. § 14-2-1620. ↩
See Official Comment to O.C.G.A. § 14-2-1602. ↩
O.C.G.A. § 14-2-1103(e). ↩
Blitch v. Peoples Bank, 246 Ga. App. 453, 540 S.E.2d 667 (2000). ↩
O.C.G.A. § 14-2-1302(b), amended by 1989 Ga. Laws 567. ↩
Commentary to O.C.G.A. § 14-2-1302(b) (emphasis added). ↩
See also, Grace Bros., Ltd. v. Farley Indus., Inc., 264 Ga. 817, 450 S.E.2d 814 (1994)(in merger, absent fraud, deception, or failure to follow proper procedure, statutory remedy is exclusive remedy to minority shareholders); Matthews v. Tele-Systems, Inc., 240 Ga. App. 871, 525 S.E.2d 413 (1999) (exclusive remedy to minority shareholder for matters affecting the price of shareholder’s stock related to cashout is statutory appraisal remedy); Lewis v. Turner Broad. Sys., Inc., 232 Ga. App. 831, 503 S.E.2d 81 (1998) (in merger, absent fraud or misrepresentation, statutory remedy is exclusive remedy to minority shareholders). ↩
Unlike Georgia, Delaware draws a distinction between short-form mergers and long-form mergers with regard to the remedies available to a minority shareholder facing a freeze-out merger. Under Delaware law, in the absence of fraud or other misconduct, the only remedy to a minority shareholder in the context of a short-form merger is dissenters’ rights (known as appraisal rights in Delaware). See Glassman v. Unocal Exploration Corp., 777 A.2d. 242 (Del. 2001). However, long-form mergers can be challenged on other grounds and are evaluated under a more stringent standard known as the “entire fairness” test. See Rabkin v. Philip A. Hunt Chemical Corp., 498 A.2d 1099 (1985). ↩