Risky Business: Messing with a Shareholder’s Interest in Stock of a Privately-Held Company
Consider the following scenario that comes up frequently in a growing, private company.
You are an officer of the company. A few years ago, the company issued stock options to officers and directors as part of their incentive compensation plans. The company recently had a falling out with one of its former directors. You receive a demand from her exercising her rights to purchase stock in the company pursuant to her option contract. The contract states the former director’s option rights expire three years from the date of the option agreement, but the date on the demand letter is three years and six months after the date of the option agreement.
This may seem like a pretty easy decision. There appears to be a bona fide reason to send the former director a letter rejecting her claim to the shares she seeks. But this is a much more nuanced and risky situation than most private companies and their officers and directors realize. If they deny the demand for stock, they better be right.
California law treats failure to recognize ownership interest in company stock as a form of theft. In legal terms, wrongly interfering with someone’s ownership interest in stock is called conversion. And the law of conversion carries penalties and risks that should not be ignored.
The basics of conversion are straightforward. Conversion is “an act of willful interference with personal property, done without lawful justification, by which any person entitled thereto is deprived of the use and possession of the personal property.” See 13 California Forms of Pleading and Practice--Annotated § 150.10 (Matthew Bender 2018). The history of conversion dates back many centuries to English common law. Some of the earliest known cases involve claims that a neighbor stole another neighbor’s livestock.
There are several factors that make disputes and decisions involving corporate stock interests especially risky.
First, although, historically, conversion claims generally could not be made relating to intangible property, modern courts have expanded the law of conversion to include a wide range of fact patterns relating to stock and business ownership. For example, companies’ and shareholders’ failure to transfer, issue, record, certify, buy, or sell stock pursuant to properly exercised contractual rights may constitute conversion regardless of whether share certificates exist. Conversion can also apply to partnership interests.
There are a few common fact patterns. One involves disputes over the validity of a claim to ownership of shares. Another common type of conversion claim involves disputes over the value of shares such as where a right to shares is exercised but there is a dispute over whether the amount tendered for the shares is proper. For instance, in Applied Medical Corp. v. Thomas, decided in 2017, a corporation filed suit against a former director alleging the corporation had validly exercised a contractual right to repurchase shares set forth in the former director’s stock incentive plan. The former director had refused to tender the shares at issue back to the corporation due to a seemingly good faith dispute regarding the value of the shares based on competing valuation methods. Nevertheless, the California Court of Appeal for the First District held that the former director could be liable for failure to honor the corporation’s repurchase right.
In addition to these more common factual situations, courts have applied the law of conversion in many more unusual situations involving interference with stock ownership interests. Duke v. Superior Court, decided in 2017, involved a convoluted fact pattern whereby a founder of a company maintained a claim for conversion of stock against investors of the company who levied upon and sold the founder’s stock via a post-judgment writ of execution and sheriff’s sale. In the 2009 case Swingless Golf Club Corp. v. Taylor, the shareholders of a company brought a successful conversion claim against the executives of the company personally where the executives dissolved the company without compensating the shareholders of the company for their stock interests.
Second, conversion is a strict liability tort, which means that bad intent is generally irrelevant and is not required to find liability. If, for example, it can be shown that the company took steps that caused ownership interests to be wrongfully denied, then conversion has taken place. Defenses such as good faith and lack of knowledge will generally not save the defendant. Moreover, a conversion may occur even if the property is later returned.
The facts of Schneider v. Union Oil Co., decided in 1970, are instructive. Schneider, a shareholder, brought a conversion claim against Union Oil after the corporation canceled the shareholder’s stock, removed her name from its share register, and refused to acknowledge the shareholder’s demand for recognition and confirmation of her stock ownership. The corporation’s cancellation of the stock and refusal to recognize the shareholder’s stock rights was based on the corporation’s good faith reliance on documents purporting to transfer the shares to a third-party. It turned out, however, that the document the company relied upon was forged. The court ruled that the Union Oil could be liable for conversion because “the corporation's…ignorance that a certificate is stolen and the signature forged, no matter how excusable, does not relieve the corporation of liability for the wrongful transfer.” This is what strict liability means. Your conduct matters; not your intent.
Third, and most importantly, if a company is found liable for conversion involving stock or other business ownership rights, the potential penalties are severe and wide ranging. They go far beyond the damages that would typically apply in a more standard breach of contract claim. Specifically, a plaintiff bringing a conversion claim may recover the fair market value of the shares at the time of the conversion. A plaintiff may also recover attorneys’ fees and costs where the conversion claim is based on an ownership interest pursuant to a contract containing an attorneys’ fees provision. In addition, individual officers and directors can be held personally liable for conversion claims. And if a company’s actions are deemed to be extreme, such that they constitute oppression, fraud or malice, a plaintiff may recover punitive damages. In certain situations, a plaintiff may even recover treble damages and attorneys’ fees pursuant to California Penal Code sections 484 and 496(c).
Fourth, interference with stock ownership rights doesn’t have to be recent to be actionable. The statute of limitations for conversion is generally three years from the time of conversion. But the running of the statute of limitations may be delayed in certain situations where the plaintiff does not find out about the conversion until later. At least one court has even held that California’s four-year statute of limitations may apply in certain situations.
Considering all of this, the decision in our initial fact pattern regarding whether to send the former director a letter rejecting her demand isn’t as easy as it initially seemed.
Stock options, warrants, put/call agreements and other agreements involving business ownership rights are often used by growing privately-held companies and that is not likely to change in the foreseeable future. Businesses and their directors and officers should, however, think twice before taking any action that could interfere with shareholders’ ownership interests in stock. And individuals who feel that they have been treated unfairly in connection with a potential claim regarding a business ownership interest may have more rights than they may realize.
As you now know, decisions involving stock ownership interests are a risky business.