Issuance of Preferred Stock in Family Businesses to Shareholders Who Actively Participate in the Business

Franklin-auto_1920-0419.jpgA family businesses is generally defined as any business in which members of a family own a majority of the shares or control the company. In some family businesses, some family members keep on running the business, while others pursue other career paths. Fairly dividing the interest in a family business between actively-involved shareholders and those non-participating family members can be tricky. Corporate law, fortunately, provides a near-infinite range of possibilities for ensuring that active family members can continue to run the business while inactive members can continue to receive income. Creating classes of preferred stock is one option, although it carries certain risks.

Ownership of a corporation is represented as shares of stock. A corporation’s board of directors can issue shares in accordance with the corporation’s governing documents and state and federal law. The default form of stock is known as “common stock,” but corporations can authorize and issue other types of stock. “Preferred stock,” or “preferred shares,” give shareholders priority over holders of common stock regarding the corporation’s earnings and assets. Preferred shareholders might be entitled to fixed dividend payments, but in exchange, preferred shareholders often give up voting rights in the corporation.

Corporate law places several important limits on classes of preferred stock. A corporation cannot elect subchapter S status, for example, if it has more than one class of shares. Courts might treat issuance of preferred shares as a form of compensation that raises questions regarding directors’ fiduciary duties, as happened in New York in Lippman v. Shaffer, 15 Misc.3d 705 (N.Y. Sup. Ct., Monroe Co. 2006). The case involved a dispute between shareholders in a family-owned business over cash payments and issuance of preferred stock. The court granted summary judgment to the plaintiff on several counts and ordered the defendants to return various payments to the corporation.

The business in Lippman was a family-owned New York close corporation. The plaintiff’s grandfather bought the business sometime before 1975, when it was engaged in manufacturing. He converted its activities to investment management in 1998. The plaintiff began working for the company in 1975, and the defendant, his brother-in-law, joined in 1982. They entered into identical employment agreements in 1993.

In 1999, the plaintiff quit his employment after a dispute with his father. The company made a $650,000 severance payment to the plaintiff, in accordance with his contract, but paid the same amount to the defendant as well. They each received similar payments the following year. After the plaintiff complained, the company stopped making annual payments to the defendant, but began issuing preferred stock to him instead. The plaintiff sued, claiming breach of fiduciary duty and seeking damages equal to the amount of severance paid to the defendant and the preferred stock issued to him. The court ruled in favor of the plaintiff, finding no business justification for the payments or issuance of preferred stock to the defendant.

Business attorney Samuel C. Berger offers fixed-fee legal-service packages to New York and New Jersey entrepreneurs and businesses, representing clients in a variety of legal matters. Our goal is to enable our clients to understand their rights and obligations, to help their operations run smoothly, and to grow their businesses, and to realize their dreams. Contact us today online or at (212) 380-8117 to schedule a confidential consultation with a member of our legal team.

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Photo credit: By Franklin Car Company (Syracuse Journal) [Public domain], via Wikimedia Commons.