Freeze Out: AKA a Squeeze Out, What it is, How it Works

What Is a Freeze Out?

A freeze out (also called a shareholder squeeze-out) is an action taken by a firm's majority shareholders that pressures minority holders to sell their stakes in the company. A variety of maneuvers may be considered freeze out tactics, such as the termination of minority shareholder-employees or the refusal to declare dividends.

Understanding Freeze Outs

Freeze outs usually occur in closely-held companies, wherein the majority shareholders can converse with one another. The majority shareholders will attempt to freeze out the minority from the decision-making process, rendering minority voting rights useless.

Such actions may be illegal and could be overturned by the courts after review and are often accomplished using an acquisition. Many states have defined what is permissible in freeze outs through their existing statutes on corporate mergers and acquisitions (M&A).

In a typical freeze-out merger, the controlling shareholder(s) may set up a new corporation that they own and control. This new company would then submit a tender offer to the other company, hoping to force the minority shareholders to give up their equity position. If the tender offer is successful, the acquiring company may choose to merge its assets into the new corporation.

In this scenario, non-tendering shareholders would essentially lose their shares as the company would no longer exist. While non-tendering shareholders would generally receive compensation (cash or securities) for their shares as part of the transaction, they would no longer retain their minority ownership stake.

Freeze Out Laws and Fiduciary Duty

Historically, freeze outs by controlling shareholders have faced differing levels of legal scrutiny.

In the 1952 case of Sterling v. Mayflower Hotel Corp., the Supreme Court in Delaware established a fairness standard that would apply to all mergers, including freeze outs. It ruled that when an acquiring company and its directors "stand on both sides of the transaction, they bear the burden of establishing its [the merger's] entire fairness, and it must pass the test of careful scrutiny by the courts."

Although the law was once hostile to freeze outs, they are generally more accepted in corporate acquisitions these days. Courts generally require that as part of a fair transaction, an acquisition should have both a business purpose and fair compensation for shareholders.

Corporate charters may contain a freeze out provision that allows an acquiring company to purchase the stock of minority shareholders for fair cash value within a defined period of time after the acquisition is completed.