Chapter 23Closely Held Corporations

Chapter 23Closely Held Corporations

Outline

(last updated 04 Oct 06)

Chapter 23Closely Held Corporations

Close Corporation Dilemma
Realignments of Shareholder Control
cumulative voting
class voting
shareholder voting arrangements
Restrictions on Board Discretion
shareholder agreements: common law
Triggs v. Triggs
statutory authorization of restraints on board discretion
high voting requirements
Fiduciary duties in exercising veto rights
Smith v. Atlantic Properties, INC
Contractual Transfer Provisions
Purposes and legality of transfer provisions
Types of transfer provisions
valuation of restricted shares
Judicial interpretation of transfer provisions
Concord Auto Auction, INC. v. Rustin
Oppression: Liquidity Rights and Dispute Resolution
Dissension and oppression in the close corporation
Fiduciary protection of minority interests
Wilkes v. Springside Nursing Home, INC
Equality versus majority control
Nixon v. Blackwell
Basis for judicial scrutiny
statutory remedies for oppression
Matter of Kemp & Beatley, INC.
Oppression of shareholder-employee
Bonavita v. Corbo
Meaning of “oppression”
Valuation of Minority shares
Non-discussion remedies in oppression cases
Dissolution in the limited liability company
Haley v. Talcott

Class notes

Restrictions on Board Discretion

Traditional attitude to shareholder agreements
McQuade v. Stoneham
(NY 1934)
Three entrepreneurs decide to turn around the New York Giants baseball team after the scandals in baseball during the World Series of 1919. They each will contribute capital; they will each have a role in management. What should they worry about? Consider the principal elements in any business organization. What are they likely worried about? / Close corporation concerns --

continuity of the business
extracting a return on their investment without draining the business
certainty in management responsibilities and salaries
assured stability in management and capital structure
limited liability

Does a corporation achieve their purposes? If they choose a corporation --
Do these roles work for Stoneham, McQuade and McGraw? / Traditional off-the-shelf management structure?

Who runs day-to-day operations?
Who supervises them?
Who sets salaries?
Who sets distribution of profits / dividends?
Who changes capital structure / issues or repurchases shares?

Traditional off-the-shelf role of shareholders?

What right do shareholders have to seek dissolution / liquidity?
Who elects, removes, and replaces the directors?
What matters do shareholders vote on?

Is the traditional corporate structure mandatory or optional (default)? / NC Bus Corp Act § 55-8-01
Requirement for and duties of board of directors.
(a) Except as provided in subsection (c), each corporation must have a board of directors.
(b) All corporate powers shall be exercised by or under the authority of, and the business and affairs of the corporation managed under the direction of, its board of directors, except as otherwise provided in the articles of incorporation or in an agreement valid under G.S. 55-7-31(b).
NC Bus Corp Act § 55-8-40
Officers.
(a) A corporation has the officers described in its bylaws or appointed by the board of directors in accordance with the bylaws.
NC Bus Corp Act § 55-6-40
Distributions to shareholders.
(a) A board of directors may authorize and the corporation may make distributions to its shareholders subject to restriction by the articles of incorporation and the limitation in subsection (c).
The three NY Giants parties agree as follows:
What happened? A RIFT (It always happens in closely-held firms.) Stoneham and McGraw get tired of McQuade (who also happens to be a city magistrate). The two first take away his office and salary, and then kick him off the board. McQuade argues they had a binding, holy contract.

Did McQuade breach the agreement?
What do Stoneham and McGraw argue?
Who does the agreement actually hurt?
Remember: The three parties agreed to it and the other minority shareholders never griped. Who does the contract theoretically hurt?

/ Shareholders' agreement
Agreement between:
Charles Stoneham 55% Sh
John McGraw 5% Sh
Francis McQuade 5% Sh
As shareholder, each will vote his shares:
to elect 3 parties as directors
to elect remaining 4 Stoneham nominees
As director, each votes to elect:
Stoneham as president - $45,000
McGraw as vice president - $7,500
McQuade as treasurer - $7,500
Our agreement has unlimited duration.
It cannot be circumvented by amending the articles or changing the capital structure.
/s/ Stoneham
/s/ McGraw
/s/ McQuade
Why is the agreement invalid? / NY Court of Appeals:
"... stockholders may not, by agreement among themselves, control the directors in the exercise of judgment vested in them ... to elect officers and fix salaries."
"Directors may not by agreement .... abrogate their independent judgment."
Effect of invalidity
If the contractual control on the board might theoretically hurt non-party shareholders or creditors-- Does this invalidate the whole agreement? What about the parties' agreement to vote their shares to elect themselves as directors? Can the offending management stipulations be severed? / NY Court of Appeals:
"Stockholders may, of course, combine to elect directors. That rule is well-settled ...
Emerging attitude toward shareholder agreements
Clark v. Dodge
(NY 1936)
Dodge (75%) and Clark (25%) agree as follows:
(1) Clark will be director and general manager so long as "faithful, efficient, competent"
(2) Clark will receive 1/4 of corporation's net income as dividends or salary
(3) Dodge will not circumvent agreement
THE RIFT: Dodge gets tired of Clark and uses his majority control to can him as general manager. Dodge argues the agreement "sterilized the board." What does this mean? What does the NY court say? / NY Court of Appeals:
"... as director Dodge should continue Clark as general manager, so long as he proved faithful efficient and competent -- an agreement that could harm nobody ..."
"... Clark should always receive salary or dividends one-fourth of "net income" ... it is just to construe that phrase as meaning whatever was left for distribution after the directors had ... set aside whatever they deemed wise ..."
Benintendi v. Kenton Hotel, Inc.
(NY 1945)
Dondero (67%) and Benintendi (33%) agree to a bylaw --
"All actions by shareholders shall be taken by unanimous vote."
"All decision by the board of directors shall be taken by unanimous vote."
What are the reasons for such a voting scheme? What are the dangers? Who does the bylaw hurt? / NY Court of Appeals
" ... by-law 3 .... seems to flout the plain purpose of the Legislature in passing [statute that fixes quorum at between 1/3 and majority]
What is the law of New York on shareholder agreements? / Distinguish
McQuade v. Stoneham!
Clark v. Dodge
Benintendi v. Kenton Hotel, Inc
Modern Appraoch
Triggs v. Triggs
(NY 1978)
Frederick Sr. wanted to leave his three sons the family printing business. He gave each a 14% interest, keeping 58% for himself. Over time he came to believe his son Ransford was the one who should take over. Frederick Sr. began to groom Ransford forhis role, giving him another 14% block. Then father and son entered into an agreement under which Frederick Sr. would be board chair (with a guaranteed salary) and Ransford would be president (also with a salary). The agreement also gave to Ransford the right to buy the Frederick Sr.'s shares on his death.
But then there was a falling out. Frederick Sr. changed his will so his shares would go to his other sons. Then he died. Is the share purchase agreement valid? Are the provisions that related to management of the business valid? If not, do they affect the share purchase provisions?
Consider how the case would come out under --

MBCA
NC Bus Corp Law

/ NY Court of Appeals:
No argument is made that the stock purchase option, standing alone would be invalid .... The critical issue is whether, because of ... the provisions said to fetter the authority of the board, the stock purchase provision is now unenforceable.
.... following the signing of the agreement, the asserted illegal provisions of the agreement were ignored .... the agreement "did not in any way sufficiently stultify the Board of Directors in the operations of this business"
Fuchsberg (dissenting):
I am of the opinion the parties entered into an enforceable agreement. .... the agreement was not ambiguous and ... terminated in accordance with its terms during the father's lifetime.
...... so long as an agreement between stockholders relating the management of the cooperation bears no evidence of an intent to defraud other stockholders or creditors, deviations from precise formalities should not automatically call of a slavish enforcement of the statute. ... Available to [minority stockholders] are the equitable remedies ... for violations of [managers'] trust boications (Meinhard v. Salmon)
Gabrielli (dissenting):
It has long been the law in this State that a corporation must be managed by the board of directors ... who serve as trustees for the benefits of the corporation and all its shareholders. The disparities consideration must always be the possibility of harm to either the other shareholders or to the general public. .... Indeed it appears that the illegal parts of the agreement were an intrinsic part of the covenant between the parties.
Legislative response
Anna, Bertha and Clara incorporate a business. Each receives 1/3 of shares. Anna and Bertha agree to the following:
"If our corporation's business is not profitable by the end of the second fiscal year, then --
(1) as directors, we will recommend a proposal to dissolve the corporation
(2) as shareholders, we will approve the dissolution."
Valid under --

New York common law?
MBCA?
North Carolina's Business Corporation Act?

/ MBCA § 7.31 Voting Agreements
(a) Two or more shareholders may provide for the manner in which they will vote their shares by signing an agreement for that purpose. A voting agreement created under this section is not subject to the provisions of section 7.30 [which imposes notice requirements and 10-year limit for voting trusts]
Valid under the MBCA? / MBCA § 7.32 Shareholder Agreements
(a) An agreement among the shareholders ... that complies with this section is effective among the shareholder and the corporation even though it is inconsistent with one or more other provisions of the Act in that it --
(1) eliminates the board ... or restricts the discretion ... of directors ...
(5) requires dissolution of the corporation at the request of one or more the shareholders or upon the occurrence of a specified event or contingency ....
(b) An agreement authorized by this section shall be --
(1) set forth
(A) in the articles or bylaws and approved by all shareholders
(B) in a written agreement signed by all shareholders .... and made known to the corporation ...
(3) valid for 10 years, unless the agreement provides otherwise.
NC Bus Corp Act § 55-8-01
Requirement for and duties of board of directors.
(c) A corporation may dispense with or limit the authority of a board of directors by describing in its articles of incorporation or in an agreement valid under G.S. 55-7-31(b) who will perform some or all of the duties of a board of directors ...
What about North Carolina? / NC Bus Corp Act § 55-7-31
Shareholders' agreements.
(a) An agreement between two or more shareholders, if in writing and signed by the parties thereto, may provide that in the exercise of any voting rights of shares held by the parties ... such shares shall be voted as provided by the agreement ... Such agreement shall be valid as between the parties thereto for not more than 10 years from the date of its execution.
(b) Except in the case of a public corporation, no written agreement to which all of the shareholders have actually assented, whether embodied in the articles of incorporation or bylaws or in any side agreement in writing and signed by all the parties thereto, and which relates to any phase of the affairs of the corporation, whether to the management of its business or division of its profits or otherwise, shall be invalid as between the parties thereto, on the ground that it is an attempt by the parties thereto to treat the corporation as if it were a partnership or to arrange their relationships in a manner that would be appropriate between partners. A transferee of shares covered by such agreement who acquires them with knowledge thereof is bound by its provisions.
(c) A written agreement between all or less than all of the shareholders, ... is not invalid as between the parties thereto on the ground that it so relates to the conduct of the affairs of the corporation as to interfere with the discretion of the board of directors. *** The effect of any such agreement shall be to relieve the directors and impose upon the shareholders who are parties to the agreement the liability for managerial acts or omissions which is imposed on directors ...
Duties of close corporation participants
Smith v. Atlantic Properties Inc (Mass App 1981)
Four investors get together. They require that action be taken by 80% vote - giving each an effective veto. One refuses to allow the payment of dividends. The business accumulates cash and cash, until the IRS says too much!

D. Contractual Transfer Provisions

Enforcing unfair agreements
Concord Auto Auction v. Rustin
(D Mass 1986)
Three entrepreneurial siblings, -- brother Cox, sister Thomas and sister Powell -- invest in the exciting and glamorous business of auto auctioning. They want an agreement to provide liquidity on death. If you were drafting for them, what issues should you address in the agreement? / Shareholder purchase agreement - drafting issues

who buys?
corporation / Shs?
first-refusal / contingencies - death, withdrawal
kind of right - must / may?
call or put?
contingencies - withdrawal, outside offer, death
how funded?
insurance / self-funded
payment in installments?
repurchase account
price?
book value
annual re-set
arbitration / appraisal

Are shareholder buy-sell agreements valid? / NC BCA § 55-6-27 Restriction on transfer of shares and other securities.
(a) The articles of incorporation, bylaws, an agreement among shareholders, or an agreement between shareholders and the corporation may impose restrictions on the transfer or registration of transfer of shares of the corporation. ...
(b) A restriction on the transfer or registration of transfer of shares is valid and enforceable against the holder or a transferee of the holder if the restriction is authorized by this section, it is not unconscionable under the circumstances, and its existence is noted conspicuously ... (d) A restriction authorized by G.S. 55-6-27(c) may:
(1) Obligate the shareholder first to offer the corporation or other persons (separately, consecutively, or simultaneously) an opportunity to acquire the restricted shares;
(2) Obligate the corporation or other persons (separately, consecutively, or simultaneously) to acquire the restricted shares;
(3) Require the corporation, the holders of any class of its shares, or another person to approve the transfer of the restricted shares, if the requirement is not manifestly unreasonable;
(4) Prohibit the transfer of the restricted shares to designated persons or classes of persons, if the prohibition is not manifestly unreasonable;
(5) Contain any other provision reasonably related to an authorized purpose.
What did the threesome agree to? Was it their agreement - or something a lawyer had drafted for them? / Shareholders' agreement
¶2 If any shareholder dies, the shareholder's representative shall within 60 days tender all his shares and the corporation shall repurchase the decedent's shares at a price set by the parties as provided in paragraph 6.
¶6 The price is $672. It shall be reviewed at least annually no later than the annual shareholders' meeting ... All parties may agree to a new price ... [which] shall remain in full force until changed...
¶7 To fund the corporation's repurchase obligation, the corporation shall annually purchase life insurance in a face amount equal to the price set by the parties.
Signed,
Cox
Thomas
Powell
Corporation
Sure enough Cox dies. Two years ago, at the last revaluation, the value of his shares was set at $374,976 and the corporation bought $375,000 worth of insurance. Cox's estate says the shares are easily worth twice as much. It refuses to comply with the contract - why?
What does the estate argue? Remember Zion v. Kurtz (NY 1980). Kurtz agreed to file for close corporation status and the court estopped him from denying the lack of such status. What does Rustin (Cox's administrator) contend? What does the court decide about Rustin's attempt to avoid the (now unfair) contract? / Judge Young
... [Defendant argues] his performance is excused because the surviving parties failed to review and adjust upward the price
... failure to review and revalue constitutes "unclean hands" and breach of fiduciary duty
Judge Young (interpreting Massachusetts law):
"... contracts must be interpreted and enforced exactly as written...."
"... the Agreement covers precisely the situation before the Court: no revaluation occurred, therefore the price remains as set forth in the Agreement ..."
"... intrusion into the private ordering of commercial affairs offends both good judgment and good jurisprudence ...
"... agreements will be upheld absent any fraud, overreaching, undue influence, duress, mistake ..."
HYPOTHETICAL - REASONABLE EXPECTATIONS
The parties had each year reset the companies' value, until last year. Cox called a meeting to reset value, but Thomas and Powell failed to show. Cox dies. What does his estate get?
HYPOTHETICAL - BAD FAITH?
The parties had religiously reset the companies' value, until last year when Coxdeveloped acute and irreversible carbon monoxide poisoning. This year when it came time to reset the value, the other two sisters looked at each and winked. They then did nothing. Cox goes to the great car lot in the sky. What does his estate get? / Are there ever any special corporate duties?
Opportunistic dismissal - contract rights or fiduciary protection?
Gallagher v. Lambert
(cut-throat real estate broker - NY 1989)
Pedro v. Pedro
(family leather business - Ct App Minn 1992)
Two cases, one set of facts. You join Happy Cohorts, Inc. under an at-will employment arrangement. To entice you, management offers you stock in the business. You remember law school and ask, "What about liquidity?" Not to worry, you are told. Your stock comes with a spangling shareholders' agreement, which requires the corporation to buy your stock at book value when you leave (or are terminated - an unlikely event).
What is book value, you wonder, as you sign. Are you safe against majority opportunism? Sure enough. The majority fires you and offers to buy your stock at book value -- way below fair value. You go to court: What is your claim? What is your argument? What about fiduciary duties to minority shareholders in a CHC? How did the courts in the two cases react to your argument? / SUMMARIZE APPROACHES
 Full contractual freedom. No fiduciary rights, unless contract provides for them.
 Limited contract freedom. Fiduciary rights (good faith duties), unless agreement clearly specifies otherwise.
 Measured fiduciary protection. The majority must show legitimate reasons for its action, regardless of agreement.
 Strong fiduciary protection. The majority must show fairness; the court can substitute its own business judgment (and contractual terms) for that of the parties.
Judge Bellacosa (NY Court of Appeals):
"Plaintiff not only agreed to the particular buy-back formula, he helped write it and he reviewed it with his attorney ....
"These agreements define the scope of the relevant fiduciary duty and supply certainty of obligations to each side...."
Judge Kaye (dissenting - NY Court of Appeals):
"Here, plaintiff does question the duty the corporation owes him as a shareholder. He does contend that the corporation undervalued his shares and that it did not offer a fair price for his equity interest. ... The court's insistence that the rationale of the .... at-will employment cases must be carried over --- lock stock and barrel -- even to the fiduciary obligations owed minority shareholders in close corporations, plainly represents an extension of the law to a different jural relationship. / Minn Ct App:
"The [trial] court's findings of fact contain many examples where [majority shareholders] did not act openly, honestly, and fairly with the [minority shareholder].

not implement payments under SRA
interfered with Alfred's responsibilities
fabricated accusations of neglect
told employees Alfred had a nervous breakdown

"... depleting a corporation's value is not the exclusive method of breaching one's fiduciary duties. ... Moreover, the measure of damages [fair value less amounts received under SRA formula] was proper.
"The unique facts in the record support the trial court's finding of an agreement to provide lifetime employment to [minority shareholder].
REAL-LIFE HYPOTHETICAL
On December 31, you will have been at Next Generation Media for 5 years. Under the shareholders' agreement, you get "senior" status, and your shares are valued at 10 times earnings (no longer paltry book value). On December 30, a "senior" member of management walks in your office, hands you a pink slip, and says "so long, sucker." You are shocked. The "senior" manager points to the shareholders' agreement, which says: "Either party may terminate the employment relationship at will. The employee's rights to have his shares repurchased arise exclusively out of the attached shareholders' agreement."
Can the parties opt out of fiduciary protection? / OPERATING AGREEMENT
NEXT GENERATION MEDIA, LLC
(c) The Company may exercise the right to purchase all or a portion of a Defaulting Member’s interest pursuant to this Section 13.3 by delivery of written notice to the Defaulting Member no later than sixty (60) days after the last to occur of (i) the occurrence of the event giving rise to the purchase right, and (ii) actual receipt by the Company of written notice of the occurrence of such event. Upon delivery of such notice to purchase, the Company shall have the right and obligation to purchase the Defaulting Member’s interests, and the Defaulting Member shall be required to sell such interest at a purchase price equal to the balance in the Defaulting Member’s Capital Account on the date the purchase right is exercised.

E. Oppression: Liquidity Rights and Dispute Resolution