Owners of small corporations often inquire about the pros and cons of voting versus non-voting stock. They want to know how to limit the number of persons who can influence business decisions and reduce some of the administrative costs. A simple solution is to create specific agreements among shareholders at the time the stock is issued, thereby preventing costly or strategic mistakes in the future.
In many instances, having two categories of shares, voting and non-voting, makes sense. The ability to vote on company affairs is restricted to a select few shareholders who have primary responsibility for growing the business. While others, who are passive investors, hold a minority position or play a minor role in the company and will not have the ability to vote.
A California corporation shareholder who has non-voting shares, however, does not necessarily give up all rights to influence the corporation’s strategic direction. Therefore, California business owners should be aware of the rules dealing with this subject since granting non-voting shares might inadvertently create the very rights that were intended to be prevented.
Background – California Corporations Code Section 400(a) allows corporations to issue one or more classes or series of shares that can have “full, limited or no voting rights.” As a condition to issuing shares with limited or no voting rights, however, corporations must ensure that there exists a class or series of shares that has full voting rights. Based on existing law, holders of non-voting shares are precluded from voting on routine corporate matters like the election of directors or other material transactions requiring shareholder approval, thereby eliminating their voice from management and control.
The Problem –Despite the non-voting label, the California Corporations Code creates two exceptions. If these exceptions are overlooked and left unaddressed, non-voting shareholders may in fact find that they have veto rights in certain critical situations.
California Corporations Code Section 903(a), which describes the procedures of amending a corporation’s articles of incorporation, requires that certain amendments must be approved by holders of outstanding shares of a class, “whether or not such class is entitled to vote” as per the articles. This exception could pose a problem when a corporation seeks to raise new capital and create new classes of shares that often trigger the need to amend the articles, and the terms are not favorable to the holders of non-voting shares.
A similar situation arises in the context of corporate reorganizations that include a variety of merger transactions and that call for shareholder approvals. Section 1201(a) of the California Corporations Code states that the principal terms of a reorganization must be approved by holders of “each class” of shares. The rules provide some comfort by noting that different series within the same class do not constitute different classes for purposes of the required approval – thereby allowing the (majority) voting stock to control the approval process notwithstanding the (minority) non-voting position. There could be, however, situations, particularly in closely held businesses, where the voting and non-voting shares represent equal ownership of the business, and thus the non-voting shareholders would be able to block a reorganization.
A Solution – What is otherwise expressly prohibited under the Corporations Code can be mitigated by having contractual commitments between shareholders. As a condition to granting non-voting shares to shareholders, the holders of voting shares can require the holders of non-voting shares to agree in advance to vote along with the holders of voting shares in amending the articles, reorganization transactions and other specified situations. The agreement among shareholders could also provide for serious consequences if a shareholder were to breach the agreement, which, if structured carefully, would serve as a strong deterrent. Such agreements can be set forth in voting agreements among the shareholders, which are permitted under California Corporations Code Section 706.
Conclusion – It is important to consider the limitations of non-voting shares and address them, ideally before using non-voting shares, to ensure there are no surprises at a critical moment.
 “Reorganizations” are defined in Section 181 of the California Corporations Code and includes mergers.