Close Corporations

Close corporations in many ways look more like

LLCs, LLPs, and Partnerships than corporations, they just happen to be organized as corporations. The vast majority of closely-held corporations would probably be better off if they were organized as LLCs. Most likely they would have been had they been organized recently. The only public notice of the existence and operation of a close corporation is an annual filing with the Secretary of State to identify the corporation and identify its address & registered agent.

Michaels holds

close corporations that purchase their own stock must disclose to the sellers all information that meets the standard of "materiality." That is, there is a "substantial likelihood that the omitted fact would have assumed actual significance in the deliberations of the reasonable shareholder" and "would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available." A failure to disclose an important event is a violation even if things later go sour. However, then the plaintiff must establish that they would have still altered their actions despite the failed endeavor.

Liquidation

is an extreme remedy. In a sense, forced dissolution allows minority shareholders to exercise retaliatory oppression against the majority. Absent compelling circumstances, courts often are reluctant to order involuntary dissolution.

Massachusetts

shareholders in closely held corporations are like partners and owe each other fiduciary duty of loyalty, good faith, candor. (Wilkes; Donahue; Smith). Shareholders may not act out of avarice in derogation of loyalty to other shareholders (cf. Meinhard v. Salmon). . . . The continued viability of St Benjamin's 90-year old opinion. In many cases this is interpreted as prohibiting the majority or controlling shareholders from acting in bad faith to frustrate the minority's reasonable expectations of a return on its investment. Expectations are reasonable when: (1) were reasonable under the circumstances, (2) known or should have been known to the majority, and (3) central to the petitioner's decision to join the venture. A control block of stock could not be used to give the majority benefits that were not shared with the minority. Note that an action depleting a corporation's value is not the exclusive method ofbreaching one's ficuiary duties.

Methods for dealing with abuse of control in close corporations by controlling shareholders:

• Stock classes with varying voting power (Stroh; Stuparich) • Staggered board pursuant 141(d) • Super-majority voting requirements (Smith v. Atlantic Properties) o Note breached of duty of good faith by creating a deadlock that was caused by his own personal interests. • Prohibition on director interference with shareholder voting (Blasius note to come) • Cumulative voting (Ringling Bros.) • Class voting for directors • Voting trust • Irrevocable proxies • Vote pooling agreements (Ringling, Clark) o May be enforced via a force sale clause. • Shareholder agreements (Ramos) • Forced sale agreements (Jordan to come) • Transfer restrictions (Why are these a concern??) • Exit strategy/Buy out option • Involuntary dissolution • Prohibition on transfer • Right of first refusal & tag-along rights • Appraisal rights • Valuation provisions and formulae • Sale on death, bankruptcy, or incompetence • Del §§ 342-356 define close corporations and how they are governed or structured. • §342 - Articles of incorporation must identify as close corporation; no more than 30 shareholders in Del (states vary this number); stock must be subject to some restriction on transfer. • §351 - Management by stockholders.

Differences between basic corporate form and closely held corporations

• The term "close corporation" refers to a firm organized as a corporation but (1) having relatively few (usually fewer than 30-50) shareholders who are often family members; (2) significant shareholder participation in the operation of the business; (3) firm is the primary source of income for the shareholders, usually because they hold officer or other employment positions with the firm; (4) illiquidity of shares. • The (primarily) public corporations we have been considering until now generally (1) have thousands of shareholders who are unrelated except through their common ownership of the firm; (2) shareholders are passive investors, not active managers or employees of firm; (3) the firm is not the primary source of shareholder income; (4) shares are freely transferable.

The proper remedy for a freeze-out

"to restore [the minority shareholder] as nearly as possible to the position [s]he would have been in had there been no wrongdoing." Because the wrongdoing in a freeze-out is the denial by the majority of the minority's reasonable expectations of benefit, it follows that the remedy should, to the extent possible, restore to the minority shareholder those benefits which she reasonably expected, but has not received because of the fiduciary breach.

Constructive dividends:

A constructive dividend is an undeclared dividend by the Corporation's Board of Directors. It can be defined as any payment to a shareholder which is not classified as a dividend by the company. These payments are considered dividend and are taxable.

Freeze out:

A freeze out occurs when the majority shareholders deprive the minority shareholders of their reasonable expectations in the corp, forcing them to 'sell out at less than fair value, by refusing to declare dividends; they may drain off the corporation's earnings in the form of exorbitant salaries and bonuses to the majority shareholder-officers and perhaps to their relatives, or in the form of high rent by the corporation for property leased from majority shareholders; they may deprive minority shareholders of corporate offices and of employment by the company (especially when the shareholder has done nothing to merit termination or denial of the position); they may cause the corporation to sell its assets at an inadequate price to the majority shareholders. By excluding her from corporate decision-making (often by not being notified of meetings and being blocked from the board), denying her access to company information, and hindering her ability to sell her shares in the open market.

Right to employment

A minority shareholder in a close corporation who contractually agrees to the repurchase of his shares upon termination of his employment for any reason, acquires no right from the corporation or majority shareholders against at-will discharge. It is necessary in this case to appreciate and keep distinct the duty a corporation owes to a minority shareholder as a shareholder from any duty it might owe him as an employee. One cannot argue that even if they are an at-will employee, an action properly lies for the respondents' breach of fiduciary duties (duty of loyalty and good faith) and for wrongful interference with his employment simply because they were fired. Such an action may arise where one is fired out of spite or an attempt to frustrate the shareholders reasonable expectations. Even though a member is "at will," still owe duty of good faith. Can't take opportunistic advantage.

Control

Because the principal concern of members of a close corporation is maintaining control and avoiding (being the shareholder subjected to) oppression, a variety of practices have been developed to address this fundamental issue.

Remedy:

From a dissatisfied shareholder's point of view, the most successful remedy is likely to be a requirement that the corporation buy his or her shares at their fair value. Ordinarily, there are four ways in which this can occur. First, there may be a provision in the articles of incorporation or by-laws that provide for the purchase of shares by the corporation, contingent upon the occurrence of some event, such as the death of a shareholder or transfer of shares. Second, the shareholder may petition the court for involuntary dissolution of the corporation upon a showing that (1) "the acts of the directors or those in control of the corporation are illegal, oppressive or fraudulent," (2) "corporate assets are being misapplied or wasted", or (3) [t]he liquidation is reasonably necessary for the protection of the interests of any substantial number of the shareholders. Third, upon some significant change in corporate structure, such as a merger, the shareholder may demand a statutory right of appraisal. Finally, a purchase may be justified as an equitable remedy upon a finding of a breach of a fiduciary duty. (Most statutes also provide two further grounds for dissolution (look at MBCA § 14.30): Deadlock among the directors (1) The directors must be evenly divided and therefore unable to make corporate decisions, (2) the shareholders must be unable to resolve the deadlock, (3) and the deadlock must threaten irreparable injury to the corporation or prevent the business of the corporation from being conducted to the advantage of the shareholders) and shareholder deadlock (1) The shareholders must be evenly divided and (2) because of their division the shareholders must be unable to elect a board of directors for two years running).

Shareholder agreements:

Shareholder agreements are often necessary for the protection of those financially interested in the close corporation. The shareholder of a public corporation may readily sell his shares on the open market should management fail to use, in his opinion, sound business judgment, while shareholders of a close corporation, who often have large capital invested in the business, have no ready market for his shares should he desire to sell. Without a shareholder agreement, a large minority shareholder might find himself at the mercy of an oppressive or unknowledgeable majority. Generally speaking a shareholder may exercise wide liberty of judgment in the matter of voting, and it is not objectionable that his motives may be for personal profit, so long as he violates no duty owed his fellow shareholders. Shareholder agreements may not restrict the board's authority; however, where the parties to the agreement are the sole stockholders, the agreement is enforceable.

Delaware:

Shareholders do not owe each other fiduciary duties. If the minority needs protection, they must bargain for that protection prior to investing. (Nixon) A stockholder who bargains for stock in a closely held corporation... can make a business judgment of whether to buy into such a minority position, and if so on what terms." "The tools of good corporate practice are designed to give a purchasing minority stockholder the opportunity to bargain for protection before parting with consideration. It would do violence to normal corporate practice and our corporation law to fashion an ad hoc ruling which would result in a court-imposed stockholder buy-out for which the parties had not contracted..."

Test for improper freeze-out under the Massachusetts standard (identical to director's breach analysis):

a. Minority pleads and proves prima facie case of breach of duty of good faith by majority. b. Control group must demonstrate a legitimate business purpose for its actions. 1. The majority, concededly, have certain rights to what has been termed 'selfish ownership' in the corporation which should be balanced against the concept of their fiduciary obligation to the minority. In asking this question, we acknowledge the fact that the controlling group in a close corporation must have some room to maneuver in establishing the business policy of the corporation. c. Burden shifts to minority to demonstrate a less harmful alternative