A corporate “freeze-out” occurs when a company’s majority shareholders or members deprive a minority shareholder or member of the reasonable expectations and benefits of ownership, often, though not always, in an effort to induce the minority to sell its ownership interest at a steeply discounted price. In Massachusetts, such conduct by the majority can constitute a breach of the fiduciary duties that owners of closely held corporations owe to one another.
A freeze-out, sometimes referred to as a “squeeze-out,” rarely takes the form of a single overt act. More often, it consists of a pattern of conduct that falls into one or more of the categories described below.
1. Employment Termination
One of the most common ways majority owners deprive a minority owner of the benefits of ownership is by terminating the minority’s employment with the company. In closely held corporations, founders and owners are frequently also employees and often have a continuing expectation of employment. When a majority terminates the minority’s employment not because it serves the best interests of the company, but to gain leverage over the minority owner, that conduct can constitute a breach of fiduciary duty. This tactic is frequently paired with other freeze-out strategies.
2. Use of Salaries and Bonuses to Avoid Distributions
Majority owners may attempt to redirect company profits to themselves by paying unsupportable salaries or bonuses, effectively converting what should be profit distributions to owners, which are typically required to be made on a pro rata basis, into purported employment compensation for the majority. The result is that the majority receives substantial funds from the company while the minority receives little or nothing. This strategy is particularly effective when combined with the next tactic.
3. Withholding Tax Distributions
Owners of pass-through entities are taxed directly on the company’s profits, regardless of whether those profits are actually distributed. A majority seeking to gain leverage may withhold distributions needed to cover tax liabilities while continuing to pay itself high salaries or bonuses. In that situation, the majority is able to satisfy its tax obligations, while the minority may be left facing significant tax liabilities with no corresponding income. Faced with that pressure, minority owners may feel compelled to sell their ownership interests at deeply discounted prices.
4. Self-Dealing
Majority owners may also freeze out minority owners through self-dealing, that is, causing the company to enter into transactions that primarily benefit the majority owners rather than the company itself. Common examples include related-party transactions such as purchasing goods or services at above-market rates from entities owned or controlled by the majority.
5. Dilution
Another freeze-out tactic involves diluting the minority’s ownership interest. This often occurs through the issuance of new shares or membership units on short notice, leaving the minority scrambling to secure funds to participate, while the majority, having advance knowledge of the issuance, is positioned to acquire the new equity and increase its ownership and control.
6. Information Embargo
Owners of closely held corporations generally have the right to access company information, particularly financial records. A majority attempting to freeze out a minority will often obstruct access to that information to prevent the minority from discovering the extent of the misconduct. Without visibility into salaries, bonuses, or related-party transactions, a minority owner may not even realize that they are being deprived of the economic benefits of ownership. In many cases, restrictions on information access are among the earliest warning signs of a freeze-out.
Freeze-out cases rarely involve only one of these tactics. More commonly, a majority engaging in a freeze out employs a combination of strategies to retain corporate profits, consolidate control, or force a buyout at an artificially low valuation. Recognizing these patterns early can be critical to protecting ownership rights and avoiding lasting damage to both the company and its owners.
Search Terms: Closely held, Dilution, Excessive compensation, Fiduciary, Freeze out, Majority shareholder, Minority shareholder, Self-dealing, Shareholder, Squeeze out