Stockholder's Rights - Module 2 of 5
Module II-Stockholder’s Rights
Stockholders enjoy certain intrinsic rights that stem from their ownership of a company’s stock. The nature and scope of these rights are defined by documents such as the articles of incorporation, bylaws and provisions of the stock certificate. Together, these documents form a contract between the company and the stockholder. The nature and scope of a shareholder’s rights are also defined by applicable law.
Generally, and unless limited by law or agreement, a stockholder’s rights include the rights to:
(1) vote on important matters,
(2) receive dividends,
(3) sell shares,
(4) share in the company’s assets if the company dissolves,
(5) inspect company records, and
(6) sue to enforce their rights.
This module will discuss the scope and limitations of each of these six rights.
Right to Vote
Stockholders do not have the right to manage a company’s day-to-day affairs. However, stockholders do have the right to vote on important company matters. The fundamental matters that a stockholder has the right to vote on vary based on the applicable state law and the terms of the company’s bylaws and Articles of Incorporation.
Some common important matters that stockholders have the right to vote on include: mergers, amendments to the company’s Articles of Incorporation, and election of company directors. These general rights may be limited by law. For example, under the laws of some states, stockholders can only vote to a amend a company’s Articles of Incorporation if the proposed amendment would impact the number of shares that a company is allowed to issue. While the stockholder’s right to vote is very important, generally, stockholders do not have the right to unilaterally present matters for voting.
Voting on important matters occurs at the shareholders’ annual meeting or during a special shareholders’ meeting. Before a meeting is held, the company must provide the shareholders with notice. Most states require that the notice be given no less than 10 days before the meeting and no more than 60 days before the meeting.
The required contents of the notice are defined by state law and the company’s agreement with the stockholders. However, at a minimum, the notice must include information such as date, time and place of the meeting. Also, if the company has called a special shareholders’ meeting, the company may be required by law to provide additional information. For example, some states require special meeting notice to include a description of the purpose of the meeting. Additionally, if an amendment to the Articles of Incorporation is being proposed, state law may require that the notice contain:
(1) An express statement that proposed amendments are being considered, and
(2) A complete copy or summary of the proposed amendment.
If a stockholder cannot attend the annual meeting, he can delegate his voting authority to another party. This is referred to as proxy voting. For public companies, the proxy voting process is governed by federal law and is regulated by the Securities and Exchange Commission. If a stockholder wants to vote by proxy, she may need to complete a proxy card. The proxy card will designate a third party to attend the meeting and to vote on the stockholder’s behalf. This third party is selected by the company and is usually an officer of the company. Under SEC regulations, the proxy card must include the following:
(1) It must clearly identify each matter to be voted on,
(2) It must state whether the matter being raised is conditional on anything, such as the approval of other matters, and,
(3) It must state whether the matter was proposed by the company or the stockholders.
A stockholder’s right to vote can be limited or abolished by agreement or law. For example, it is not uncommon for a company to limit or abolish the right to vote for preferred stockholders. Issuing nonvoting stock does not violate any rule of the common law or public policy, and a company is free to vest the right to vote solely in the hands of the common stockholders. Similarly, the company is free to vest voting rights solely in the hands of the preferred stockholders. A company may also choose to limit the preferred stockholders’ rights to vote to the occurrence of certain events such as the company’s failure to pay dividends.
Economic gain is the primary motivation for the stockholder’s investment in a company. As such, economic rights are a fundamental right of the stockholder. The right to receive dividends is an example of a common economic right. The stockholder’s right to receive dividends can also be limited by law or the company’s Articles of Incorporation.
Dividends are not issued automatically. By law, a stockholder can only receive dividends that are declared by the company’s board of directors. State law determines how dividends are paid. For example, under Delaware law, dividends may be paid out of the company’s surplus funds. The amount of a company’s surplus funds is calculated by determining the amount of the company’s net assets above the amount designated as capital by the company’s directors. “Net assets” means the extent to which the company’s assets exceed its total liabilities. If the company does not have any surplus funds, dividends may be paid out of the company’s net profits for the fiscal year that the dividends are declared or the company’s net profits from the previous year.
Preferred stockholders may be entitled to receive priority over common stock holders in the allocation of dividends. This often means that the company must pay dividends to preferred stockholders before paying dividends to other classes of shares.
The right to sell shares is another type of economic right enjoyed by stockholders. Shares of stock are a type of personal property and stockholders generally have the right to sell or transfer this property at will.
While, by default, a stockholder can sell or give his shares to whomever he pleases, this right can be limited by law or agreement. For example, federal securities law prohibits engaging in criminal activity, such as insider trading, while buying or selling securities. A stockholder has engaged in insider trading when he has used non-public information, such as information about a merger or negative news, to avoid losses or gain profits when trading securities.
In addition to legal constraints on the right to sell shares, a stockholder’s right to sell or transfer may be limited by agreement. For example, if the stockholder is a participant in his company’s employee stock purchase plan, his stock is to be designated as “restricted.” Restricted stock cannot be sold on the open market by the stockholder until the stock has been held for a “vesting” period, usually 6 months or a year. After the vesting period has passed, the stocks may be sold on the open market.
For example, imagine that Susan owns stock in Foods Company. Susan’s friend Arnold works for a law firm that is representing Foods Company who is defending against allegations that its food is the source of a salmonella outbreak. Before the negative news becomes public, Arnold discloses confidential information related to the allegations to Susan. Susan then sells all of her shares of Foods Company. Susan’s sale of her shares is unlawful because she used confidential non-public information to avoid a loss. In fact, it may be a federal crime called insider trading. Conversely, if Susan had sold her shares merely because she was unhappy with the growth of the company’s stock or wanted to sell her holdings and use the proceeds to purchase stock in a different company, she can do so, provided that her shares were not restricted.
Restrictions are common in small companies, where the shareholders want to make sure the ownership of the company stays in a small group of people. They may, for example, write into the company bylaws that, before stock can be sold, the selling shareholder must offer the other shareholders a “right of first refusal,” which means the first option to purchase the shares at a given price or at market price at the time (or, for example, at the price that a third party purchaser is willing to pay). Note that an exceedingly broad restriction, such as a prohibition on re-sale of a company’s stock in all cases, may be invalidated by a court as being against public policy.
Right to Share in Company Assets upon Dissolution
When a company voluntarily or involuntarily dissolves, the stockholders have a right to share in the company’s assets upon dissolution. Voluntary dissolution of the company is a matter that requires a vote by the stockholders. State law determines how many votes are required for dissolution. For example, some states require that a majority of the stockholders vote in favor of the dissolution. The reasons why a company may dissolve voluntarily vary. Some common reasons for voluntary dissolution include: (1) the business no longer serves its purpose; (2) the business is no longer profitable; or (3) the directors of the company can no longer agree on matters related to the company. After the dissolution has been approved, the company can begin paying off any outstanding debts, liquidating company assets, and distributing assets to stockholders.
A company usually dissolves involuntarily because it is insolvent, which means that it cannot pay its debts. The dissolution is often preceded or accompanied by the company filing for bankruptcy. Creditors must be paid before the stockholders can receive any distributions. Therefore, in involuntary dissolution cases, it is not likely that the stockholders will receive distributions, as bankrupt companies do not usually have assets beyond what they owe to creditors.
Right to inspect company records
Stockholders have a qualified right to inspect nonpublic company information. This right is important because access to nonpublic information can help stockholders make informed decisions that are necessary to protect their economic interests. Under Delaware law, a stockholder may request documents such as the corporation’s stock ledger, list of stockholders and other books and records. However, the shareholder can only exercise his right to information for a “proper purpose,” which is defined as “a purpose reasonably related to such person's interest as a stockholder.”
Some examples of a proper purpose for a request to inspect company records include efforts to:
(1) ascertain the financial condition of the corporation,
(2) learn the propriety of dividend distribution,
(3) calculate the value of stock,
(4) investigate management’s conduct, and
(5) obtain information in aid of legitimate litigation.
Examples of an improper purpose include:
(1) to discover business secrets to aid a competitor of the corporation,
(2) to secure prospects for personal business,
(3) to find technical defects in corporate transactions to institute “strike suits”, and
(4) to locate information to pursue one’s own social or political goals.
Demands for the inspection of books and records are very common. However, simply stating a proper purpose for inspection is insufficient. The stockholder has the burden of stating specific facts and circumstances that demonstrate the stockholder’s proper purpose. Simply stating that the stockholder wants to review company documents is insufficient, but inspection necessary to determine the value of stock may be enough. However, it is important to note that when the purpose of the inspection is to investigate mismanagement or wrongdoing, some evidence may be required to support the right to inspect.
If a company denies a request for document review based on improper purpose, the stockholder can sue the company to compel production of the documents. The court will only compel disclosure of the documents if the stockholder can show that his request is being made for a proper purpose.
Stockholders have certain litigation rights that are incidental to their stock ownership. First, stockholders can bring an action to enforce rights under the law or agreements with the company. For example, the stockholder can ask a court to compel the company to pay declared dividends or distribute dissolution dividends. Stockholders can bring an action called a shareholder derivative suit.
While a corporation’s directors are typically tasked with representing the corporation in legal actions, a shareholder derivative lawsuit allows shareholders to sue on behalf of the company in limited cases, alleging that the company’s directors have breached their fiduciary duties to the corporation and its shareholders. For example, a derivative action may allege that the company’s directors intentionally misled stockholders about the company’s growth and the stockholders may bring a derivative lawsuit.
Derivative lawsuits are complicated because of procedural hurdles, which are governed, in federal court, under Rule 23.1 of the Federal Rules of Civil Procedure. Before the stockholder’s claim can move forward, he must show that he has standing to bring his claim which, in this case, begins with the plaintiff showing that he is a stockholder. Rule 23.1 also requires that the plaintiff state “with particularity:” “(A) any effort by the plaintiff to obtain the desired action from the directors or comparable authority and, if necessary, from the shareholders or members; and (B) the reasons for not obtaining the action or not making the effort.”
Even if the stockholder overcomes the procedural hurdles, he must still succeed on the merits. Shareholder derivative suits are very difficult to win because directors of a company have broad discretion in making decisions for the company. Directors are also entitled to a presumption known as the “business judgment rule,” a bedrock principle of corporation law. Under the business judgment rule, courts will not overrule directors’ decisions that:
(1) are made in good faith;
(2) are made with the care that a reasonably prudent person would use, and
(3) are made with the reasonable belief that they are acting in the best interests of the corporation.
As long as the directors’ actions are protected by the business judgment rule, they are shielded from liability even if their decisions turn out to be poor and cost the shareholders and the company money. Generally, absent evidence of fraud, bad faith, overreach, or an unreasonable failure to investigate, the directors’ decision will be upheld under the business judgment rule. However, where the directors are found to have acted with undue haste or without due diligence, the protections of the business judgment rule may not be afforded.
In our next module, we will focus on how stocks are purchased, including broker-dealer transactions, direct stock plans, direct reinvestment plans and mutual funds.
 Id.; See also Julian Velasco, The Fundamental Rights of theShareholder, 40 U.C. Davis L. Rev.407, 419, 423 (2006).
 Velasco, supra note 2, at 418.
 Ky. Rev. Stat.Ann. §271B.10-040(1)(a).
 Velasco, supra note 2, at 419.
 Id. at (3).
 J. Robert Brown, Jr., The Proxy Rules and Restrictions on Shareholder Voting Rights, 47 Seton Hall L. Rev. 45, 50-54 (2016), https://scholarship.shu.edu/cgi/viewcontent.cgi?article=1578&context=shlr
 Id. at 53.
 18A Am. Jur. 2d. Corporations § 857 (2015).
 Id. at § 858.
 Velasco, supra note 2, at 414; see also 8 Del. Code. Ann. tit. 8 § 170.
 Velasco, supra note 2, at 415.
 Rule 144: Selling Restricted and Control Securities, U.S. Securities and Exchange Commission,https://www.sec.gov/reportspubs/investor-publications/investorpubsrule144htm.html ; Restricted Stock Unit – RSU, Investopedia, https://www.investopedia.com/terms/r/restricted-stock-unit.asp
 Right of First Refusal, Investopedia, https://www.investopedia.com/terms/r/rightoffirstrefusal.asp
 Velasco, supra note 2, at 413, fn. 18.
 Ky. Rev. Stat. Ann. § 271B.14.020, 8 Del. Code. Ann. tit. 8 § 275.
 8 Del. Code. Ann. tit. 8 § 280-81.
 Matthew Frankel, “What happens to shareholders after a Company Declares Bankruptcy?,” USA Today, (July 26, 2018), https://www.usatoday.com/story/money/markets/2018/07/26/what-happens-to-shareholders-after-company-declares-bankruptcy/36278137/.
 8 Del. Code. Ann. tit. 8 § 220.
 Joseph O. Larkin, Court of Chancery’s Guidance on Credible Basis Standard for Obtaining Books, Harvard Law School Forum on Corporate Governance and Financial Regulation, (May 23, 2017), https://corpgov.law.harvard.edu/2017/05/23/court-of-chancerys-guidance-on-credible-basis-standard-for-obtaining-books/.
 8 Del. Code. Ann. tit. 8 § 220(c).
 Velasco, supra note 2, at 422.
 See “Robbins Arroyo LLP: Philip Morris International Inc. (PM) MisledShareholders According to a Recently Filed Shareholder Lawsuit,” Marketwatch, (Sept. 19, 2018)
 Fed R. Civ. Pro. R.23.1.