Freezeouts involve controlling shareholders forcing the minority shareholders to relinquish their equity position in the corporation. Usually, the shareholders receive cash for their shares but they also may receive other non-voting securities. In a publicly held corporation, the result is usually that the corporation becomes a privately held corporation.
While the courts and state legislatures were intiially hostile to such freezeouts, the law today is generally permissive. Many of the freezeouts involve the pratice of using large amounts of debt to finance the freezeout and are described as leverage buyouts.
The mechanics of freezeotus may vary but the common means is to use a shell corporation As, which is setup a as wholly owned corporation of th controlling shareholder (e.g., A Inc.) ,which in turn controls the public corporation (B Inc.). A Inc. uses its control of the broad of directors of B Inc. to enter into a merger agreement where by B Inc. merges in As. A Inc. votes their controlling shares in favor of the merer. The plan of merger provides that hte minroity sharehodlers of B INc. receive cash or debt sercurities for their shares, resulting in elimination of their ownership of B Inc. After the merger, A Inc. owns 100& of B Inc.
State Law[]
In order to facilitate a freezeout the control group must comply with a state's statutory scheme of regulation for mergers and case law on fiduciary obligaitons. The statutory requirements for a merger involve approval by the board of directors and a shareholder vote.
Corporate statutes permit the use of cash or securities other than common stock as consideration, resulting in a freezeout merger. When a vote is required, most statutes require a majority vote, which is easily obtainable for those in actual or de facto control of the corporaion. The short form merger provisions require no shareholder vote when the control group owns a large percentage of stock, usually 90% of more.
In the 1960s the state began to amend their merger statutes to allow the use of cash (as opposed to securities which usually meant shares) as consideration in mergers. When cash became available as consideration, the freezeout merger became more prevalent. Freezeouts result from the control group eliminating the public shareholders from future ownership, usually by paying cahs.
In general the courts will scrutinize freezeouts by control groups as a duty of loyalty issue requiring
- entire fairness (fair dealing and fair price).
- business purpose - in some cases, a business purpose for the transaction is required.
Approval of an unfair transaction can also create liability for the directors who approve the merger.
Given the conflict of interest, an issue arise as to whether an appraisal is the appropriate and exclusive remedy for the minority sharehodlers or whether the courts may fashion other remedies based upon fiducairy principles. Minroity sharehodlers have attempted to avoid the appraisal procedure because of its limitations. Generally, the minority shareholders would prefer using shareholder litigation through the federal securities laws or state fiduciary duty doctrine to enjoin the transaction or seek damages greater than the limited appraisal remedy. Through litigation, they hope to force the control group to offer a higher prrice. Some courts have used their equitable power to closely scrutinize the transaction and either enjoin the transaction or award higher dmaages or other equitable relief. Other courts have only allowed for the use of an apprisal, but have expanded and modernized that remedy.