Business Divorces – Stockholders’ Rights in Closely Held Companies

By James L. Rudolph, Esq.

Many companies are initially organized as a “close” corporation, in which shareholders and decision makers are often one in the same. Under most state laws, the shareholders in a close corporation enjoy certain rights and have obligations that are unique.  Therefore, a basic knowledge of these rights and obligations is indispensable for the shareholder, as well as for all those who contemplate the close corporation as a model for their business entity.

Generally, a close corporation is a company where the number of shareholders is small; where there is no ready market for the corporate stock; and where there is substantial majority stockholder participation in the management, direction and operations of the firm. By contrast, in an ^“open^“ corporation there are many shareholders, the stock is usually publicly traded, and the shareholders do not necessarily participate in the management of the company.

Most (if not all) “family businesses” that incorporate, fall within the definition of a close corporation. Unlike shareholders in “open” corporations (who have a duty of good faith towards the corporation, but no special obligations towards each other), shareholders in a close corporation owe each other a fiduciary duty to deal with each other with the utmost good faith and loyalty.

While the concept of a duty of utmost good faith and loyalty is one that historically was applied to partnerships, many courts have made it applicable to the dealings among shareholders in closely-held corporations.  Accordingly, shareholders in a close corporation (unlike the shareholders in an open corporation) have a right to sue each other for acts which may constitute a breach of a shareholder’s duty of utmost good faith and loyalty.  It appears that the rules established in this area will apply to Limited Liability Companies (LLC) and Limited Liability Partnerships (LLP).

Special concerns arise where, as is often the case, stock ownership in the close corporation is held in unequal proportions by the shareholders. In this respect, there is ample recognition of the fact that a minority shareholder in close corporations is particularly susceptible to abuse or oppression by a majority shareholder.

A fairly frequent breach occurs when the majority shareholder employs certain tactics to cut off the minority shareholder from any benefits that he or she may derive from the corporation, to force the minority shareholder out of the company. Such actions are called “freeze-outs” or ^“squeeze-outs.^”  A freeze-out may take different forms:

• the majority shareholder’s refusal to declare dividends;
• the payment of exorbitant salaries to the majority shareholder;
• the payment of the personal expenses of the majority shareholder;
• the deprivation of the minority shareholder’s employment;
• the sale of corporate assets at less than fair market value; or
• the sale or offer of stock to the majority shareholder without equal offer to the minority shareholder.

No matter the method, the expected result is often the same and that is driving the minority shareholder out of the company. Where a breach of duty has occurred, the courts normally will tailor the remedy to return the shareholders to the position they were in prior to the breach. In certain other cases, where the breach involved the granting of a disparate benefit (for example, stock at a low price), the courts may require the corporation to make the benefit also available to the minority shareholder.

Shareholders also have the right to initiate a lawsuit on behalf of the corporation, where the corporation (not the shareholder) has suffered a wrong and where the company directors refuse to enforce the corporation’s right to seek a remedy. This is referred to as a “derivative” action.

Shareholders in both open and close corporations have the right to demand that a company take legal action to remedy a perceived wrong, such as the payment excessive benefits and compensation to majority stockholders. Generally, a shareholder may initiate a derivative action only when the corporate directors refuse to pursue an appropriate remedy after demand by the minority shareholder, unless it would be futile because the majority of the directors are not disinterested.

Here are some of the things that a Court can order when it finds there has been a freeze out:

• Rescission of a stock sale
• Purchase of minority shareholder’s interest on same terms as majority or based on “reasonable expectations”
• Realignment of stock ownership
• Payment of money damages to the company and/or individual shareholders

Frequently some of the problems that exist between shareholders could have easily been addressed in advance by the drafting of good Shareholder Agreements.  Some of the provisions that often are in such agreements relate to sale of shares, termination of employment, confidentiality, non-competition, non-solicitation and non-hiring issues.

When the economy is bad, shareholder disputes in close companies are much more prevalent.  Everyone is looking to cut expenses. Majority shareholders are more likely to terminate minority shareholders from their employment. Shareholders are looking to cut unnecessary personal expenses, especially for majority shareholders, that are paid for by the company.  Owners of shares in the typical small closed corporation must be aware of the unique and extraordinary fiduciary duty that governs their dealings with fellow shareholders.  More importantly, those who find themselves in the position of a minority shareholder should be aware that in most states, they do have legal rights against a majority shareholder’s attempt to force them out.