While today’s political buzz phrase, “class warfare,” seems unlikely to spill over into corporate governance jurisprudence, it arguably and only half-facetiously fits in the sizeable body of law addressing shareholder disputes in closely held corporations. In fact, courts, legislatures, and scholars considering the unique characteristics of close corporations have long used a term with similar overtones—“oppression”—to describe exploitive efforts by controlling shareholders to freeze minority shareholders out of the management or profits of a close corporation. Attention to shareholder oppression has spawned enhanced fiduciary duties owed to shareholders in close corporations that have no analogue in the context of publicly traded firms, along with direct common-law and statutory causes of action to enforce them.
Close Corporations Are Different
The advent of enhanced fiduciary duties stems from the courts’ recognition that close corporations, which constitute the overwhelming majority of U.S. businesses, differ materially from public corporations in ways that empower majority shareholders and can leave minority shareholders vulnerable to abuse. Definitions of “close corporation” vary, but the relevant characteristics here are that they are owned by only a small number of shareholders, the shareholders participate actively and substantially in managing the enterprise, and there is no public securities market to trade shares of the corporation’s stock.
Close corporation investors are often tied by family or other personal relationships, and often expect employment by the corporation and a meaningful role in management, as well as financial return on their investment. In contrast, the shareholder investing in a public corporation typically contributes no labor to the enterprise and plays no management role. More important, he can readily liquidate his investment by selling shares in a public securities market if he becomes dissatisfied with the management’s actions. The typical minority close-corporation shareholder is locked into his or her investment. Illiquid, noncontrolling shares are unlikely to attract interest from private investors, and corporate governance documents frequently preclude or restrict a transfer of shares. And, unlike an investor in a general partnership, he or she cannot readily liquidate his or her investment by exercising a statutory right to dissolve the business.
These characteristics, in the context of traditional norms of governance devised to serve publicly traded corporations, often enable opportunistic majority shareholders to marginalize or freeze out minority shareholders. Traditionally, authority to manage and control the corporation vests in the board of directors, and authority to elect board members belongs to those who hold a majority of voting shares. Case law concerning oppression is filled with instances in which majority shareholders in a close corporation garner control by electing themselves, relatives, or other aligned individuals as directors, leaving minority shareholders vulnerable to board decisions concerning management, employment, compensation, dividend payments, and other matters material to minority owners.
In addition, although state legislatures have relaxed statutory bars to contractual arrangements that afford protections to minority shareholders or otherwise provide mechanisms to deal with governance disputes, close corporation investors seldom bargain in advance for such safeguards. Employment contracts, buy/sell agreements, supermajority provisions, and meaningful succession planning are rare. Commentators attribute minority owners’ frequent failure to negotiate adequate ex ante safeguards to many factors, including close family or personal ties to other investors and mutual trust, limited business or legal sophistication, reliance on forms or other expediencies, and the limits of human foresight. An absence of advance planning and contracting often facilitates opportunistic action by those in control.
Squeeze-Outs, Freeze-Outs, and Other Forms of Oppression
A large body of reported decisions illustrates various techniques controlling shareholders have used to freeze minority investors out of meaningful participation in a close corporation. Controlling shareholders are alleged to have improperly withheld dividends or other returns on the minority’s investment, improperly terminated employment and management positions and related benefits, or siphoned off disproportionate shares of corporate profits by paying themselves excessive salaries, bonuses, benefits, and perquisites. Others have allegedly committed the corporation to generous contracts with themselves or aligned parties made at less than arm’s length—often a lease to use real or intellectual property or a contract to obtain services from a closely affiliated person or entity—or a loan at nonmarket rates. See F. Hodge O’Neal & Robert B. Thompson, O’Neal and Thompson’s Oppression of Minority Shareholders and LLC Members, ch. 3–5 (detailing squeeze techniques and illustrative cases).
In combination with these techniques, controlling shareholders in many contested cases allegedly withhold corporate records and information or physical access to company premises and employees, keeping minority owners in the dark concerning the affairs of the business, its profitability and value, and the benefits enjoyed by those in control. In some instances, after cutting off the minority investor from information, meaningful participation in management, and financial returns, the majority attempts to buy out the minority at an unfairly low price. As some commentators observe, without a market, the minority shareholder may be locked in and frozen out, unable to escape abuses of power simply by selling his or her interest at a fair price.
The Common-Law Response: Enhanced Fiduciary Duties
Courts in many jurisdictions have responded to shareholder oppression by imposing enhanced fiduciary duties in close corporations and granting individual shareholders a direct, common-law action for breach of fiduciary duty when denied a fair share of benefits in the corporation. Two influential Massachusetts Supreme Judicial Court decisions are frequently cited.
In Donahue v. Rodd Electrotype Co. of New England, Inc., 328 N.E.2d 505 (Mass. 1975), the Massachusetts Supreme Judicial Court acknowledged that a minority shareholder, lacking a market for his shares, was powerless to challenge dividend and employment decisions by the majority. In light of the nature of close corporations, the court held that the applicable fiduciary duty was not the standard found in corporate law, but the standard existing in partnership law. It held:
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 [i.e., a duty of] the “utmost good faith and loyalty.” Stockholders in close corporations must discharge their management and stockholder responsibilities in conformity with this strict good faith standard. They may not act out of avarice, expediency or self-interest in derogation of their duty of loyalty to the other stockholders and to the corporation.
We contrast this strict good faith standard with the somewhat less stringent standard of fiduciary duty to which directors and stockholders of all corporations must adhere in the discharge of their corporate responsibilities.
328 N.E.2d at 515–16 (internal citations omitted).
A year later, the same court refined its analysis in Wilkes v. Springside Nursing Home, Inc., 353 N.E.2d 657 (Mass. 1976). It held that a close-corporation shareholder could not be frozen out from participating in the business absent a legitimate business reason. The court tempered its strict good-faith standard by imposing a balancing test centered on whether controlling defendants can show that the challenged conduct was narrowly tailored to further a legitimate business purpose.
Courts in many other jurisdictions have imposed similarly enhanced, partnership-like fiduciary duties on directors, officers, and at least some shareholders of close corporations. The advent of special fiduciary duties has materially altered the rights and duties of close corporate shareholders and has afforded new remedies. See, e.g., Galbreath v. Scott, 433 So. 2d 454, 456–57 (Ala. 1983); Hagshenas v. Gaylord, 557 N.E.2d 316 (Ill. App. Ct. 1990). Courts finding breaches of fiduciary duties in a close corporation have, for example, ordered corporations to employ minority shareholders who have no employment agreement, have ordered buyouts of minority owners’ stock without either contractual or statutory requirement, have barred controlling shareholders from selling their shares, or have forced selling shareholders to share a control premium.
The law concerning fiduciary duties in close corporations continues to evolve, and there is pointed scholarly disagreement concerning the extent to which the doctrine articulated in Massachusetts is accepted or represents the majority rule, as it is often characterized. Compare Robert B. Thompson, “The Shareholder’s Cause of Action for Oppression,” 48 Bus. Law. 699, 729 (1993) (noting “widespread judicial acceptance of the philosophy that applying an enhanced fiduciary duty in close corporations is beneficial”), with Mary Siegel, “Fiduciary Duty Myths in Close Corporate Law,” 29 Del. J. Corp. L. 377, 386 (2004) (“Delaware’s minority rule has garnered support from an ever-increasing number of states” and “many state courts have either yet to consider or decide their position on this topic.”).
Important variations occur from jurisdiction to jurisdiction and from case to case. Reported decisions differ concerning the scope and limits of the enhanced fiduciary duties, including whether they apply to all shareholders or only to those in control, whether they apply to all actions or only to those taken in a corporate capacity, and whether they apply to all closely held corporations or only to statutory close corporations.
Courts in “minority jurisdictions,” including Maine, Maryland, and, notably, Delaware, reject the principle that different rules apply to close corporations or that all shareholders in a close corporation, like all partners in a partnership, owe fiduciary duties to each other. Rather, they hold that, as with publicly traded corporations, only controlling shareholders owe fiduciary duties and only if acting in their corporate capacities. Under these authorities, controlling shareholders’ duties require them only to act in the best interest of the corporation, not in the best interest of other shareholders. They reason that the governing corporation statute allows shareholders to contract for their own protection and identifies no special duties owed to minority shareholders. See, e.g., Nixon v. Blackwell, 626 A.2d 1366, 1379 (Del. 1993).
Under the generally applicable corporate rules, moreover, courts do not measure fiduciary duties by the strict standard that exists among general partners. Rather, they apply either the business-judgment rule or the entire-fairness test. Here, however, in practice, the distinction between the majority and minority rules may begin to blur. When controlling shareholders oppress minority shareholders, courts are likely to find conflicts of interest sufficient to ignore the highly deferential business-judgment rule in lieu of the entire-fairness test, which requires a showing of “utmost good faith” and the “most scrupulous inherent fairness of the bargain.”
The Statutory Response: Direct Actions for Shareholder Oppression
In a development that parallels the advent of enhanced common-law fiduciary duties, legislatures in most states have, since the late 1970s, substantially broadened corporate dissolution statutes to provide a broad array of remedies to individual close corporation shareholders who establish oppression or other statutory grounds. Some commentators characterize the advent of the statutory cause of action and the direct common-law action for breach of enhanced fiduciary duties as two sides of the same coin—in other words, twin manifestations of the emergent minority shareholder’s cause of action for oppression. See, e.g., Douglas K. Moll, “Minority Oppression & the Limited Liability Company: Learning (or Not) from Close Corporation History,” 40 Wake Forest L. Rev. 883, 895 (2006); Douglas K. Moll, “Shareholder Oppression & Dividend Policy in the Close Corporation,” 60 Wash. & Lee L. Rev. 841, 852 (2003). It is indeed difficult in practice to distinguish judicial definitions of oppression in close corporations from breaches of the enhanced common-law fiduciary duties imposed in that context.
Under the expanded dissolution statutes, courts are authorized to grant a number of remedies short of dissolution when a close corporation shareholder establishes that a controlling director, officer, or shareholder has engaged in illegality, fraud, misapplication of assets, waste, or oppression. A deadlock between shareholders or directors may also trigger statutory relief. Many statutes specify a nonexhaustive menu of available remedies, including compulsory declaration of dividends, appointment of a receiver, or a court-ordered buyout of the minority shareholder at a fair price. More robust statutes, as in Illinois, identify additional remedies, such as cancellation or alteration of any provision of the articles of incorporation, bylaws, or a corporate resolution; directing or prohibiting specific acts by the corporation or control persons; removing officers or directors; requiring an accounting; or damage awards. In other states, such as California, the statute specifies no particular remedies but authorizes a court to provide any equitable relief that it deems appropriate. For an overview of the advent of the statutory remedy, see Charles W. Murdock, “The Evolution of Effective Remedies for Minority Shareholders and Its Impact Upon Valuation of Minority Shares,” 65 Notre Dame L. Rev. 425 (1990).
While expanded-dissolution statutes provide remedies for oppression, they seldom define the term. Here, the statutory and common-law actions sometimes coalesce. Some courts left with the task define oppression with express reference to the enhanced fiduciary duty of good faith and fair dealing owed among shareholders in a close corporation. Others define oppression as “burdensome, harsh, and wrongful conduct” that deviates materially from the “standards of fair dealing on which every shareholder who entrusts his money to a corporation is entitled to rely.” Perhaps the most widely used approach defines oppression as the frustration of the reasonable expectations of the shareholders. The definitions are not mutually exclusive, and it is unclear that they yield different results when applied to specific facts. Among other illustrations, courts will likely find oppression where minority shareholders employed by a corporation and actively involved in running the business are excluded from participation after dissension among the shareholders.
Direct Rights of Action
Alongside the advent of statutory and common-law rights of action for oppression of shareholders in close corporations, courts have modified their analyses of whether a shareholder’s claim for breach of fiduciary duty may be brought as a direct action or if it must instead be brought as a derivative suit in the name of the corporation. The distinction is important because treatment as a derivative action may impose a number of procedural impediments that effectively preclude a minority shareholder from controlling his or her claim or recovery.
Traditionally, a shareholder’s challenge to a control person’s diversion of corporate assets to himself or herself was deemed derivative because the injury is common to all shareholders and to the corporation. A direct action required a separate and distinct injury to the complaining individual shareholders. But many courts recognize that the derivative-direct distinction ill suits the circumstances of a close corporation and increasingly permit close-corporation minority shareholders to bring direct, individual causes of action for oppression, whether statutory or under the common law. Claims that would be deemed derivative in the context of a public corporation, including actions alleging improper diversion of assets in favor of controlling shareholders, are often treated as direct.
While “class warfare” perhaps overstates the issue, sharp conflict abounds among owners over the controls and profits of close corporations, often engendering minority shareholder claims of oppression. Courts and state legislatures have responded, recognizing the distinctive forces that operate in close corporations and fashioning common-law and statutory protections that provide a direct shareholder cause of action for oppression.
The practicing lawyer representing a close corporation or its owners is well served to understand the common-law fiduciary duties and statutory rights and obligations in the governing jurisdiction, and to apprise his or her clients. Although the doctrines are not new, they continue to evolve, and material variations exist between the common-law and statutory remedies, from jurisdiction to jurisdiction, and even from case to case.
Fortunately, a great deal of ground work has been laid. Shareholder oppression is the subject of excellent legal scholarship. This overview recommends and relies heavily on each the cited journal articles and the cited treatise devoted to shareholder oppression. Litigation over close corporation governance disputes exacts substantial costs on its participants and the businesses they own. In the author’s experience, optimal, rational resolutions are more readily achieved when negotiated by parties who better understand their respective rights and remedies, as well as the realities and limitations of litigation.
Keywords: litigation, business torts, shareholder oppression, close corporations, enhanced fiduciary duties