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Duties of Stockholders of Close Corporations

Many smaller business owners elect to conduct their enterprise in the form of a corporation or limited liability company.  In doing so, they recognize the benefits this form of entity provides such as limited liability and perpetual existence, among others.  However, what may be underappreciated is the nature of the obligations and duties stockholders of close corporations and members of limited liability companies owe to one another and to the entity itself.  These obligations and duties are fiduciary in nature. Business owners would be well-served to give careful consideration to these obligations as they order the affairs of their close corporation under its articles of organization, bylaws, stockholders’ agreements and other organizational documents, particularly as to matters such as governance and stockholder liquidity.  For example, before embarking on a plan to offer shares of stock to employees as a bonus or incentive, or discussing a possible investment from friends and family members as start-up capital for their enterprise, business owners should proceed with due deliberation.  Unintended consequences can arise in light of the obligations and duties shareholders of close corporations owe to one another. 

In addition, it is important to understand that these obligations and duties. which are described more fully below, are not limited to close corporations.  Recent case law in this area suggests that these obligations and duties extend to closely-held, non-corporate entities such as business trusts, limited partnerships and limited liability companies.  In Butler, et al. v. Moore, et al. (Lawyers Weekly No. 02-144-15), the United States District Court for the District of Massachusetts recognized that although no Massachusetts court “appears to have clearly and explicitly held that the members of a closely held LLC owe one another fiduciary duties analogous to the duties imposed on the shareholders of a closely held corporation” logic and fairness dictates that “there is no reason why the fiduciary duties of members of a closely held LLC should be materially different from those of stockholders of a closely held corporation”.  Accordingly, the choice of entity does not release the majority from these duties.

In order to understand the obligations and duties stockholders of close corporations owe to one another under Massachusetts law, one must be familiar with the case of Donohue  v. Rodd Electrotype Company of New England, Inc. & Others, 367 Mass. 578 (1975); 328 N.E.2d 505.  The Rodd Electrotype Company of New England, Inc. was a family business as to which certain members of the Rodd family held 80% of the outstanding stock of the corporation and controlled its board of directors, while certain members of the Donohue family held the minority shares of the corporation’s stock.  Following the retirement from the corporation of Harry Rodd, the Rodd family patriarch as well as the former president of the corporation and its most dominant influence, the board of directors authorized the corporation to purchase from Mr. Rodd 45 shares of the corporation’s stock at a price of $800 per share (or $36,000.00 in total).  Shortly thereafter, the parties entered into an agreement and the transaction was consummated on July 15, 1970.  The Donohues, who first learned of the stock purchase transaction at a special meeting of stockholders in March, 1971, raised questions about the purchase. The Donohues subsequently offered their shares to the corporation on the same terms at which Mr. Rodd’s shares were purchased and were denied by the corporation.  The Donohues then filed suit.  They viewed the purchase of Mr. Rodd’s shares by the corporation as an unlawful distribution of corporate assets to controlling stockholders and a breach of the fiduciary duty owed by the Rodds, as the controlling stockholders, to the minority stockholders, none of whom were afforded an equal opportunity to sell their shares to the corporation.  The court agreed with the plaintiff, Euphemia Donohue, and required either that the corporation provide the Donohues an opportunity to sell their shares to the corporation at the same price per share offered to Mr. Rodd or that Mr. Rodd buy his shares back from the corporation for the sale price plus interest.            

In finding for Donohue, the court recognized that close corporations often possess a unity of identity between ownership and management such that it is often the stockholders themselves who occupy most of the management positions and are therefore dependent upon one another for the success of the enterprise.  The Donohue court defined a close corporation as being typified by: (1) a small number of stockholders; (2) no ready market for the corporate stock; and (3) substantial majority stockholder participation in the management, direction and operations of the corporation.  Moreover, the court viewed close corporations as resembling a partnership and described this resemblance as follows: “Just as in a partnership, the relationship among the stockholders must be one of trust, confidence and absolute loyalty if the enterprise is to succeed. Close corporations with substantial assets and with more numerous stockholders are no different from smaller close corporations in this regard. All participants rely on the fidelity and abilities of those stockholders who hold office. Disloyalty and self-seeking conduct on the part of any stockholder will engender bickering, corporate stalemates, and, perhaps, efforts to achieve dissolution.” 

As the Donohue case illustrates, the unity of identity of management and the interdependence of stockholders which are hallmarks of close corporations provide fertile ground for mischief. Minority stockholders may find themselves vulnerable to oppression by the majority stockholders.  By virtue of their majority position, majority stockholders of close corporations have the ability to marginalize and disadvantage minority stockholders; to in effect “freeze-out’ the minority stockholders not only from the management of the corporation but also from enjoying the economic benefits generated by it.  For example, the majority stockholders of a close corporation may choose to monopolize management, to deny dividends, and to siphon off corporate assets by paying themselves exorbitant salaries.  Faced with such actions, the minority stockholder can be left with little redress, absent costly and time consuming litigation.  A minority stockholder cannot easily sell his shares since there is no ready market for them, nor can he force a change in management.  In a very real sense, the minority stockholder of a close corporation can be trapped in a bad situation.    

To protect minority stockholders from this vulnerability and potential for oppression by their majority brethren, Massachusetts courts have fashioned a standard of conduct among stockholders of close corporations that is strict and exacting.  The Donohue court described it as the same fiduciary duty in the operation of the enterprise that partners in a partnership owe to one another.  It is a duty of the “utmost faith and loyalty”.  In describing the rigors of this standard, the Donohue court cited the words of then Chief Judge Cardozo of the New York Court of Appeals: “… not honesty alone but the punctilio of an honor the most sensitive, is then the standard of behavior”.  This standard is higher than and stands in contrast to the less stringent “good faith and inherent fairness” standard of fiduciary duty to which directors and stockholders of all corporations must adhere in the discharge of their corporate responsibilities. 

 So what are the planning opportunities for business owners in light of Donohue and its progeny?  First, be careful about whom you propose to allow into the shareholder tent.  These persons will become your partners not only in a business sense but also in a legal sense, at least with respect to the duties and obligations owed to one another in the discharge of corporate responsibilities. Accordingly, words such as trust, confidence, ability, loyalty and fidelity are more than mere words; they are, in fact, prerequisites that one must satisfy to qualify for ownership.  Second, when considering employee incentives, one should focus first on plans that do not entail actual stock or equity ownership such as a so-called “phantom stock plan” or similar plan where employees can participate in the appreciation in the value of the enterprise’s equity capital without actually becoming an equity holder.  Third, make certain that the organizational documents of your company – articles of organization, bylaws, stockholders’ agreements, partnership agreements, operating agreements, and the like – clearly articulate the requirements and obligations with respect to such matters as stock repurchases, voting agreements, employment and compensation, among others.  While the provisions of the entity’s organizational documents do not preempt the Donohue duties, they may by-pass or modify such duties to the extent that such organizational documents and the actions that led to them do not constitute a breach of these duties.     

 

This newsletter is designed for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship. For further information please contact one of our attorneys. Information contained herein has been abridged from laws, court decisions and administrative rulings, and should not be construed as legal advice or legal opinions on specific facts.  The enclosed material is provided for education and information purposes by MacLean Holloway Doherty Ardiff & Morse, P.C. to clients and others who may be interested in the subject matter. 

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