Closelyheld Corporations and the Problem of Minority Oppression

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Closely-held Corporations and the Problem of
Minority Oppression
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Closely Held Corporations
Small number of shareholders
No market for shares
Shareholder
Shareholder
Shareholder
Corporation
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Closely Held Corporations
Small number of shareholders
Shareholder
Shareholder
Shareholder
Corporation
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Closely Held Corporations
Small number of shareholders
No market for shares
Shareholders participate in management
Shareholder
Shareholder
Shareholder
Corporation
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Plight of the Minority Shareholder
Majority exerts control
Shareholder
Shareholder
Shareholder
Corporation
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Plight of the Minority Shareholder
Majority exerts control
No means of exit
Shareholder
Shareholder
Shareholder
Corporation
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Pressure Points in Closely-Held Corporations

• Benefits of stock ownership include
• Dividends
• Participation in management
• Employment
• Why close corporations pay salaries, not
  dividends
• Reasonable salaries are deductible as expenses
• Dividends are not deductible (double taxation)
• Terminating employment may be equivalent to
  withholding the benefits of stock ownership

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Freeze-out

• Terminate minority shareholders employment
• Remove the minority shareholder from board
• Refuse to declare dividends
• Increase salaries and employment-related
  perquisites to majority shareholder
• Buy the minority shareholders shares at a
  discounted price (often called a squeeze out)

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Responses

• Judicial response fiduciary law
• Allow direct suits
• Partnership-like fiduciary duties (Meinhard)
• Legislative response special dissolution
  statutes
• Broaden the grounds to include oppression
• Provide additional remedies for dissolution,
  including buyout, appointment of a custodian,
  ordering a dividend, or other equitable remedy

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Donahue

• Closely held corporations is like a partnership
• Because of the fundamental resemblance of the
  close corporation to the partnership, the trust
  and confidence which are essential to this scale
  and manner of enterprise, and the inherent danger
  to minority interests in the close corporation,
  we hold that stockholders in the close
  corporation owe one another substantially the
  same fiduciary duty in the operation of the
  enterprise that partners owe to one another.
• Why are partners often subject to stricter
  fiduciary duties than directors?
• Does the imposition of partnership duties in
  closely held corporations make sense?

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Wilkes

• Nervous about Donahue
• We are concerned that untempered application
  of the strict good faith standard enunciated in
  Donahue to cases such as the one before us will
  result in the imposition of limitations on
  legitimate action by the controlling group in a
  close corporation which will unduly hamper its
  effectiveness in managing the corporation in the
  best interests of all concerned.

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Wilkes

• Refining Donahue
• It must be asked whether the controlling group
  can demonstrate a legitimate business purpose for
  its action. 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. It must have a large measure of
  discretion, for example, in declaring or
  withholding dividends, deciding whether to merge
  or consolidate, establishing the salaries of
  corporate officers, dismissing directors with or
  without cause, and hiring and firing corporate
  employees.

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Legitimate Business Purpose

• Courts have cited various purposes as legitimate
• Misconduct by the minority shareholder
• Incompetence of the minority shareholder
• Poor business or economic conditions
• Change in technology or business plan

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Legitimate Business Purpose

• Wilkes allows minority to show that an
  alternative course of action would be less
  harmful
• Courts have rarely employed this prong
• Nevertheless, it suggests that courts should
  balance the interests of the parties

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Leslie v. Boston Software Collaborative, Inc.
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Utmost Good Faith Requirement

• With an ordinary employee, not entitled to
  partner-like treatment, the termination of Leslie
  was justified. Given Leslies enhanced status as
  an owner, however, Khayter and Goulart did not
  act in a manner demonstrating the utmost good
  faith.

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Less Harmful Alternatives

• Leslies administrative functions could have
  been modified such that he could have been
  insulated from direct contact with the BSC
  employees by using Follansbee as the
  intermediary. Leslie could have been encouraged
  and assisted in becoming more extensively
  involved in off-site, time-and-materials billing
  projects. He could have been directed to take
  courses and training to upgrade his technical
  skills. Other incentives through the use of
  creative compensation techniques could have been
  explored.

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Remedy

• Return to prior position? No
• Buyout? No
• Three attributes of an equitable remedy
• Fair compensation for loss of employment
• Fair compensation for any amounts received by
  Khayter and Goulart in the nature of a dividend
• Provision for Leslie, for so long as he remains a
  shareholder, to be able to monitor the management
  of BSC and participate in the returns to
  shareholders, without interfering unduly therein