Chapter 23 Closely Held Corporations

Chapter 23 Closely Held Corporations Outline (last updated 04 Oct 06)

Chapter 23 Closely Held Corporations A. Close Corporation Dilemma B. Realignments of Shareholder Control 1. cumulative voting 2. class voting 3. shareholder voting arrangements B. Restrictions on Board Discretion 1. shareholder agreements: common law o Triggs v. Triggs 2. statutory authorization of restraints on board discretion 3. high voting requirements 4. Fiduciary duties in exercising veto rights o Smith v. Atlantic Properties, INC C. Contractual Transfer Provisions 1. Purposes and legality of transfer provisions 2. Types of transfer provisions 3. valuation of restricted shares 4. Judicial interpretation of transfer provisions o Concord Auto Auction, INC. v. Rustin D. Oppression: Liquidity Rights and Dispute Resolution 1. Dissension and oppression in the close corporation 2. Fiduciary protection of minority interests o Wilkes v. Springside Nursing Home, INC 3. Equality versus majority control o Nixon v. Blackwell 4. Basis for judicial scrutiny 5. statutory remedies for oppression o Matter of Kemp & Beatley, INC. 6. Oppression of shareholder-employee o Bonavita v. Corbo 7. Meaning of “oppression” 8. Valuation of Minority shares 9. Non-discussion remedies in oppression cases 10. Dissolution in the limited liability company o Haley v. Talcott

Corporations: Law & Policy Page 1 Chapter 23 – Closely Held Corporations Class notes C. Restrictions on Board Discretion Traditional attitude to shareholder agreements

McQuade v. Stoneham Close corporation concerns -- (NY 1934)  continuity of the business Three entrepreneurs decide to turn around the  extracting a return on their investment New York Giants baseball team after the without draining the business scandals in baseball during the World Series of  certainty in management responsibilities and 1919. They each will contribute capital; they salaries will each have a role in management. What  assured stability in management and capital should they worry about? Consider the structure principal elements in any business  limited liability organization. What are they likely worried about?

Does a corporation achieve their purposes? If Traditional off-the-shelf management structure? they choose a corporation --  Who runs day-to-day operations?  Who supervises them? Do these roles work for Stoneham, McQuade  Who sets salaries? and McGraw?  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 NC Bus Corp Act § 55-8-01 or optional (default)? 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

Corporations: Law & Policy Page 2 Chapter 23 – Closely Held Corporations 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: Shareholders' agreement What happened? A RIFT (It always happens in Agreement between: closely-held firms.) Stoneham and McGraw get Charles Stoneham 55% Sh tired of McQuade (who also happens to be a John McGraw 5% Sh city magistrate). The two first take away his Francis McQuade 5% Sh office and salary, and then kick him off the As shareholder, each will vote his shares: board. McQuade argues they had a binding, to elect 3 parties as directors holy contract. to elect remaining 4 Stoneham nominees  Did McQuade breach the agreement? As director, each votes to elect:  What do Stoneham and McGraw Stoneham as president - $45,000 argue? McGraw as vice president - $7,500  Who does the agreement actually McQuade as treasurer - $7,500 hurt? Our agreement has unlimited duration.  Remember: The three parties agreed to It cannot be circumvented by amending the articles it and the other minority shareholders or changing the capital structure. never griped. Who does the contract /s/ Stoneham theoretically hurt? /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 NY Court of Appeals: If the contractual control on the board might "Stockholders may, of course, combine to elect theoretically hurt non-party shareholders or directors. That rule is well-settled ... creditors-- Does this invalidate the whole agreement? What about the parties' agreement to vote their shares to elect themselves as directors? Can the offending

Corporations: Law & Policy Page 3 Chapter 23 – Closely Held Corporations management stipulations be severed?

Emerging attitude toward shareholder agreements

Clark v. Dodge NY Court of Appeals: (NY 1936) "... as director Dodge should continue Clark as Dodge (75%) and Clark (25%) agree as follows: general manager, so long as he proved faithful (1) Clark will be director and general efficient and competent -- an agreement that manager so long as "faithful, efficient, could harm nobody ..." competent" "... Clark should always receive salary or (2) Clark will receive 1/4 of corporation's dividends one-fourth of "net income" ... it is just to net income as dividends or salary construe that phrase as meaning whatever was (3) Dodge will not circumvent agreement left for distribution after the directors had ... set THE RIFT: Dodge gets tired of Clark and uses his aside whatever they deemed wise ..." 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?

Benintendi v. Kenton Hotel, Inc. NY Court of Appeals (NY 1945) " ... by-law 3 .... seems to flout the plain purpose Dondero (67%) and Benintendi (33%) agree to a of the Legislature in passing [statute that fixes bylaw -- quorum at between 1/3 and majority] "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?

What is the law of New York on shareholder Distinguish agreements? McQuade v. Stoneham! Clark v. Dodge Benintendi v. Kenton Hotel, Inc

Modern Appraoch

Triggs v. Triggs NY Court of Appeals: (NY 1978) No argument is made that the stock purchase option, Frederick Sr. wanted to leave his three standing alone would be invalid .... The critical issue is sons the family printing business. He whether, because of ... the provisions said to fetter the gave each a 14% interest, keeping 58% authority of the board, the stock purchase provision is now for himself. Over time he came to unenforceable. believe his son Ransford was the one .... following the signing of the agreement, the asserted who should take over. Frederick Sr. illegal provisions of the agreement were ignored .... the began to groom Ransford for his role, agreement "did not in any way sufficiently stultify the Board

Corporations: Law & Policy Page 4 Chapter 23 – Closely Held Corporations giving him another 14% block. Then of Directors in the operations of this business" father and son entered into an Fuchsberg (dissenting): agreement under which Frederick Sr. I am of the opinion the parties entered into an would be board chair (with a guaranteed enforceable agreement. .... the agreement was not salary) and Ransford would be president ambiguous and ... terminated in accordance with its (also with a salary). The agreement terms during the father's lifetime. also gave to Ransford the right to buy ...... so long as an agreement between the Frederick Sr.'s shares on his death. stockholders relating the management of the But then there was a falling out. cooperation bears no evidence of an intent to Frederick Sr. changed his will so his defraud other stockholders or creditors, deviations shares would go to his other sons. Then from precise formalities should not automatically he died. Is the share purchase call of a slavish enforcement of the statute. ... agreement valid? Are the provisions Available to [minority stockholders] are the that related to management of the equitable remedies ... for violations of [managers'] business valid? If not, do they affect the trust boications (Meinhard v. Salmon) share purchase provisions? Gabrielli (dissenting): Consider how the case would come out It has long been the law in this State that a under -- corporation must be managed by the board of  MBCA directors ... who serve as trustees for the benefits of  NC Bus Corp Law 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 MBCA § 7.31 Voting Agreements incorporate a business. Each (a) Two or more shareholders may provide for the manner in which receives 1/3 of shares. Anna they will vote their shares by signing an agreement for that purpose. and Bertha agree to the A voting agreement created under this section is not subject to the following: provisions of section 7.30 [which imposes notice requirements and "If our corporation's business 10-year limit for voting trusts] 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?

Corporations: Law & Policy Page 5 Chapter 23 – Closely Held Corporations  MBCA?  North Carolina's Business Corporation Act?

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,

Corporations: Law & Policy Page 6 Chapter 23 – Closely Held Corporations 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 Shareholder purchase agreement - drafting issues (D Mass 1986)  who buys? o corporation / Shs? Three entrepreneurial siblings, -- o first-refusal / contingencies - death, brother Cox, sister Thomas and withdrawal sister Powell -- invest in the exciting  kind of right - must / may? and glamorous business of auto o call or put? auctioning. They want an agreement o contingencies - withdrawal, outside offer, to provide liquidity on death. If you death were drafting for them, what issues  how funded? should you address in the o insurance / self-funded agreement? o payment in installments? o repurchase account  price? o book value o annual re-set o arbitration / appraisal

Are shareholder buy-sell agreements NC BCA § 55-6-27 Restriction on transfer of shares and other

Corporations: Law & Policy Page 7 Chapter 23 – Closely Held Corporations valid? 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? Shareholders' agreement Was it their agreement - or ¶2 If any shareholder dies, the shareholder's representative something a lawyer had drafted for shall within 60 days tender all his shares and the corporation them? 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

Corporations: Law & Policy Page 8 Chapter 23 – Closely Held Corporations Thomas Powell Corporation

Sure enough Cox dies. Two years Judge Young ago, at the last revaluation, the value ... [Defendant argues] his performance is excused because of his shares was set at $374,976 the surviving parties failed to review and adjust upward the and the corporation bought $375,000 price worth of insurance. Cox's estate ... failure to review and revalue constitutes "unclean hands" says the shares are easily worth and breach of fiduciary duty twice as much. It refuses to comply with the contract - why? Judge Young (interpreting Massachusetts law): What does the estate argue? "... contracts must be interpreted and enforced exactly as Remember Zion v. Kurtz (NY 1980). written...." Kurtz agreed to file for close "... the Agreement covers precisely the situation before the corporation status and the court Court: no revaluation occurred, therefore the price remains estopped him from denying the lack as set forth in the Agreement ..." of such status. What does Rustin "... intrusion into the private ordering of commercial affairs (Cox's administrator) contend? What offends both good judgment and good jurisprudence ... does the court decide about Rustin's "... agreements will be upheld absent any fraud, attempt to avoid the (now unfair) overreaching, undue influence, duress, mistake ..." contract?

HYPOTHETICAL - REASONABLE Are there ever any special corporate duties? 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 Cox developed 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.

Corporations: Law & Policy Page 9 Chapter 23 – Closely Held Corporations They then did nothing. Cox goes to the great car lot in the sky. What does his estate get?

Opportunistic dismissal - contract rights or fiduciary protection?

Gallagher v. Lambert SUMMARIZE APPROACHES (cut-throat real estate broker - NY 1989)  Full contractual freedom. No Pedro v. Pedro fiduciary rights, unless contract provides (family leather business - Ct App Minn 1992) for them. Two cases, one set of facts. You join Happy Cohorts,  Limited contract freedom. Fiduciary Inc. under an at-will employment arrangement. To rights (good faith duties), unless entice you, management offers you stock in the agreement clearly specifies otherwise. business. You remember law school and ask, "What  Measured fiduciary protection. The about liquidity?" Not to worry, you are told. Your stock majority must show legitimate reasons for comes with a spangling shareholders' agreement, which its action, regardless of agreement. requires the corporation to buy your stock at book value  Strong fiduciary protection. The when you leave (or are terminated - an unlikely event). majority must show fairness; the court can What is book value, you wonder, as you sign. Are you substitute its own business judgment (and safe against majority opportunism? Sure enough. The contractual terms) for that of the parties. 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?

Judge Bellacosa (NY Court of Appeals): Minn Ct App: "Plaintiff not only agreed to the particular buy-back "The [trial] court's findings of fact contain formula, he helped write it and he reviewed it with his many examples where [majority attorney .... shareholders] did not act openly, honestly, "These agreements define the scope of the relevant and fairly with the [minority shareholder]. fiduciary duty and supply certainty of obligations to each  not implement payments under side...." SRA  interfered with Alfred's responsibilities Judge Kaye (dissenting - NY Court of Appeals):  fabricated accusations of neglect "Here, plaintiff does question the duty the corporation  told employees Alfred had a owes him as a shareholder. He does contend that the nervous breakdown corporation undervalued his shares and that it did not "... depleting a corporation's value is not offer a fair price for his equity interest. ... The court's the exclusive method of breaching one's insistence that the rationale of the .... at-will employment fiduciary duties. ... Moreover, the cases must be carried over --- lock stock and barrel -- measure of damages [fair value less

Corporations: Law & Policy Page 10 Chapter 23 – Closely Held Corporations even to the fiduciary obligations owed minority amounts received under SRA formula] shareholders in close corporations, plainly represents an was proper. extension of the law to a different jural relationship. "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 OPERATING AGREEMENT NEXT GENERATION MEDIA, LLC On December 31, you will have been at Next Generation Media for 5 years. Under the (c) The Company may exercise the right to shareholders' agreement, you get "senior" status, purchase all or a portion of a Defaulting and your shares are valued at 10 times earnings Member’s interest pursuant to this Section 13.3 (no longer paltry book value). On December 30, a by delivery of written notice to the Defaulting "senior" member of management walks in your Member no later than sixty (60) days after the office, hands you a pink slip, and says "so long, last to occur of (i) the occurrence of the event sucker." You are shocked. The "senior" manager giving rise to the purchase right, and (ii) actual points to the shareholders' agreement, which receipt by the Company of written notice of the says: "Either party may terminate the occurrence of such event. Upon delivery of such employment relationship at will. The employee's notice to purchase, the Company shall have the rights to have his shares repurchased arise right and obligation to purchase the Defaulting exclusively out of the attached shareholders' Member’s interests, and the Defaulting Member agreement." shall be required to sell such interest at a purchase price equal to the balance in the Can the parties opt out of fiduciary protection? Defaulting Member’s Capital Account on the date the purchase right is exercised.

E. Oppression: Liquidity Rights and Dispute Resolution Roadmap to close corporation cases What has been the judicial response to --  Party agreement inconsistent with corporate statute / traditional corporate structure  Party agreement defective - failure to comply with statutory opt-out, drafting mistake  Party agreement incomplete - not provide for important terms, such as liquidity  Party agreement clear, but produces unfair results - mandatory stock purchase clause

Zidell v. Zidell (Oregon Sup Ct 1977) After WWII, Sam built up a business scrapping ships. Sam brought Jack into his business, made him a partner and gave him a 25% interest. Sam's sons, Emery and Arnold, eventually got into the business and received equally Sam's 75% share of the partnership. Over time, the three partners (Emery, Arnold and Jack) incorporated their businesses. Why? Did they intend a change? What happened to this control structure? Did Sam anticipate it?

Corporations: Law & Policy Page 11 Chapter 23 – Closely Held Corporations Jack sold his 25% interest (corporate shares) to Emery's son, Jay. The result, two camps: Arnold - 37.5% Emery - 37.5% Jay - 25.0% (financed by Emery) Did Sam intend that one of his sons would acquire a 62.5% (majority) interest? What happened? What always happens? THE RIFT - The inevitable!!! The brothers had a falling out. Emery became unhappy with Arnold. The feeling was mutual, and Arnold demanded a big salary. When Emery said no, Arnold quit. Then Emery (like Cain to Abel) voted his brother off the board. Did Sam ever expect that one of his sons would remove the other from the business?

Comparison of Partnership Corporation ownership rights (37.5% owner)

Financial rights RUPA § 401. Partner's Rights and NC Bus Corp Act § 6.40 Distributions (participate in Duties. to shareholders. profits) (b) A partnership shall credit each (a) A board of directors may authorize partner's account with an equal share and the corporation may make of the partnership profits. distributions to its shareholders subject to restriction by the articles of incorporation and the limitation in subsection (c).

Management RUPA § 401. Partner's Rights and NC Bus Corp Act § 55-8-01. rights Duties. Requirement for and duties of board of (f) Each partner has equal rights in directors. the management and conduct of the (b) All corporate powers shall be partnership business. exercised by or under the authority of, (j) A difference arising as to a matter and the business and affairs of the in the ordinary course of business of corporation managed under the a partnership may be decided by a direction of, its board of directors, majority of the partners. An act except as otherwise provided in the outside the ordinary course of articles of incorporation or in an business of a partnership and an agreement valid under G.S. 55-7- amendment to the partnership 31(b). agreement may be undertaken only with the consent of all of the partners.

Liquidity rights RUPA § 401. Partner's Rights and NC Bus Corp Act § 55-14-02 (withdrawal / Duties. Dissolution by board of directors and sale) (i) A person may become a partner shareholders. only with the consent of all of the (a) A corporation's board of directors partners. may propose dissolution for

Corporations: Law & Policy Page 12 Chapter 23 – Closely Held Corporations ***§ 801. Events Causing Dissolution submission to the shareholders. and Winding up of Partnership (b) For a proposal to dissolve to be Business. adopted: A partnership is dissolved, and its (1) The board of directors must business must be wound up, only recommend dissolution to the upon the occurrence of any of the shareholders ... and following events: (1) in a partnership (2) The shareholders entitled to vote at will, the partnership's having notice must approve the proposal to from a partner ... dissolve ... ***§ 807. Settlement of Accounts and Contributions Among Partners. (a) In winding up a partnership's business, the assets of the partnership must be applied to discharge its obligations to creditors, including partners who are creditors. Any surplus must be applied to pay in cash the net amount distributable to partners in accordance with their right to distributions under subsection (b). (b) ... In settling accounts among the partners, the profits and losses that result from the liquidation of the partnership assets must be credited and charged to the partners' accounts.

The CHC dilemma

"My, oh my. What can I do?" moans Arnold. Two of the fundamental rights of share ownership are effectively dead letter in a close corporation: (1) Even though he can sell his shares, he has no realistic liquidity since there is no market. (2) He has no right to participate in profits since declaration of dividends are within the board's discretion. You represent Arnold. Advise him. What kind of lawsuit? Who pays litigation costs? What must Arnold argue? Aren't Emery and Jay's purposes private?

 Derivative (Arnold sues on behalf of corporation to enforce fiduciary claim against Emery)  Arnold (Arnold sues corporation directly to enforce claim against corporation)

What must a minority shareholder prove in a suit against a majority shareholder in a freeze-out?

Corporations: Law & Policy Page 13 Chapter 23 – Closely Held Corporations What's a freeze-out? What must a minority shareholder prove? What were the majority’s proofs in Zidell v. Zidell for their dividend policy? Was the board's business plan certain / speculative? Supported by documented financial analysis? What is a "squeeze-out"?  intense hostility  exclusion from employment  high salaries to majority shareholders  the majority's desire to buy out the minority In the case, the directors presented evidence that in setting the dividend policy they considered --  future need for physical improvements  need for cash to pay large inventory orders  need to renovate obsolescent dock  need for cash, if banks called loans ******* Oregon Supreme Court: "We have recognized that those in control of corporate affairs have fiduciary duties of good faith and fair dealing toward the minority shareholders. Insofar as dividend policy is concerned, however, that duty is discharged if the decision is made in good faith and reflects legitimate business purposes rather than the private interests of those in control. " "... It is not in the province of the court to act as general manager of a private corporation ... If there are plausible business reasons supportive of the decision of the board of directors .... a court will not interfere with a corporate board's right to make that decision ...." “Plaintiff had the burden of proving bad faith on the part of the directors in determining the amount of corporate dividends.”

HYPOTHETICAL #1 There are a number of ways to getting money out of a close corporation. You represent Emery, who tells you: "I'd like to take out 100 grand a year. Make sure Arnold takes nothing!" Advise.

HYPOTHETICAL #2 Recycling is a profitable business. Zidell Inc earns more money that Emery knows what to do with. Emery ("famed Portland industrialist") decides to spend the company's profits (and the board goes along with him) on a non-profit windmill power project in Portland -- the first of its kind in the country. The New York Times runs a glowing story on Emery's grand civic philanthropy. Arnold wishes that Emery had, instead, paid bigger dividends. Does Arnold have any rights?

Policy Analysis - Solutions to CHC dilemma Sam incorporates a family business, and gives equal shares to his three daughters -- Anna, Bertha and Carla. What should be the default rule on withdrawal: Majoritarian / penalty / default?  Easy withdrawal -- o any shareholder can withdraw and demand payment of her fair share.

Corporations: Law & Policy Page 14 Chapter 23 – Closely Held Corporations o Heatherington & Dooley - mandatory buyout right (no opt-out). o Create market for full CHC stock by legislative fiat.  Hard withdrawal -- o no easy out / only majority can set dividends or get $$ on withdrawal. o Easterbrook & Fischel - assume no partner-like rights except as negotiated. o Corporation is corporation is corporation.  Tailored withdrawal -- o any shareholder who is denied her reasonable expectations can withdraw and get paid. o Close corporation = incorporated partnership!!

Should it make a difference when Sam incorporated his business --  in the 1960s and before -- when courts treated close corporations under the continuity rules of public corporations  in the 1970s and 1980s -- when courts treated close corporations as incorporated partnerships  in the 1990s -- when business participants have many choices, including LLCs 

HYPOTHETICALS1. Harry sells his 45 shares to his children at $800 per share. Euphemia wants the Rodds to buy from her at the same price. Must they? 2. Harry and his children sell their majority interest to Mega Print, Inc. They each receive $1000 per share. Mega Print does not buy from Euphemia and Robert Donahue. The Donahues claim that the Rodds have not shared their control premium. Must the Rodds share? 3. The Rodds decide to issue to themselves 147 new shares, at $800 per share. Charles, Frederick and Phyllis are the only purchasers. This changes the ratio of ownership:

Before After Rodds 153 shares (76%) 300 shares (86%) Donahues 50 shares (24%) 50 shares (14%) Must the Rodds make the opportunity equal? 4. Harry sells his 45 shares to the corporation for $800 per share. They represent approximately 25% of all the outstanding shares of the majority. Euphemia says she wants to sell her 45 shares. They represent 90% of the outstanding minority shares. Must the corporation buy -- (1) all Euphemia's shares (2) 25% of her shares What if Robert Rodd also wants to be bought out? What if Harry had only sold 25 shares? 5. Euphemia remarries into Knob Hill wealth. Her Rodd Electrotype investment is a thorn in her side because of her high tax bracket. She wants the Rodds to stop paying dividends. Must they? 6. Robert Donahue went to business school and earned a CPA. The Rodds hired him to work at the company as treasurer. To entice him, they also gave him a 5% stake in the company. The Rodds change their mind, fire Robert and stop paying dividends. Can he demand equal employment

Corporations: Law & Policy Page 15 Chapter 23 – Closely Held Corporations treatment? 7. Quinn, Riche and Connor argue that they can't get along with Wilkes. "It's just a personality thing and we can't seem to get our work done like we did before," they say. Wilkes argues they could work on getting along, go to counseling sessions, with Dr. Ruth a leading expert in workplace happiness, and minimize their workplace interaction. Who wins? 8. The court agrees the majority participants can exclude Wilkes from employment. So the three insiders set up a "key man" life insurance policy that covers each of them, but not Wilkes. On death the corporation will have money to buy back their shares, but not necessarily those of Wilkes. What standard of review -- (1) equal opportunity? (2) balancing?

ROADMAP What has been, should be, the judicial response -- Party agreement inconsistent with corporate statute / traditional corporate structure Party agreement defective - failure to comply with statutory opt-out, drafting mistake Party agreement incomplete - not provide for important terms, such as liquidity Party agreement clear, but produces unfair results - mandatory stock purchase clause

Donahue v. Rodd Electrotype Co (Mass 1975) Harry Rodd bought an typesetting business. He was majority shareholder (80%) and Joseph Donahue became a minority shareholder (20%). They had no agreement on management or liquidity. Rodd managed the business. What were Donahue's expectations when he invested? Harry was getting along in years, and his health was failing him. His children -- Charles, Frederick and Phyllis -- thought their father should bow out. Harry has 45 shares. How might Harry withdraw from the business? Harry transfers his shares -- He gives 153 shares to his children -- each ending up with 51 shares He sells 45 shares to the corporation at $800 per share. Is this a good deal for the Donahues, who own 50 shares? Is this sale a self-dealing transaction? Was it unfair? What is Donahue's claim? ************** Massachusetts Supreme Court: "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 ... that partners owe to one another .... of "utmost good faith and loyalty." "... if the stockholder whose shares were purchased was a member of the controlling group, the controlling stockholders must cause the corporation to offer each stockholder an equal opportunity to sell a ratable number of shares to the corporation at an identical price."

HYPOTHETICAL #1 Harry sells his 45 shares to his children at $800 per share. Euphemia wants the Rodds to buy from

Corporations: Law & Policy Page 16 Chapter 23 – Closely Held Corporations her at the same price. Must they?

HYPOTHETICAL #2 Harry and his children sell their majority interest to Mega Print, Inc. They each receive $1000 per share. Mega Print does not buy from Euphemia and Robert Donahue. The Donahues claim that the Rodds have not shared their control premium. Must the Rodds share?

HYPOTHETICAL #3 The Rodds decide to issue to themselves 147 new shares, at $800 per share. Charles, Frederick and Phyllis are the only purchasers. This changes the ratio of ownership:

Before After Rodds 153 shares (76%) 300 shares (86%) Donahues 50 shares (24%) 50 shares (14%) Must the Rodds make the opportunity equal?

********** NC Bus Corp Act § 55-6-30 Shareholders' preemptive rights. (a) The shareholders of a corporation do not have a preemptive right to acquire the corporation's unissued shares except to the extent the articles of incorporation or subsection (d) of this section so provide. (b) A statement included in the articles of incorporation that "the corporation elects to have preemptive rights" ... (1) The shareholders of the corporation have a preemptive right ... to acquire proportional amounts of the corporation's unissued shares upon the decision of the board of directors to issue them.

HYPOTHETICAL #4 Harry sells his 45 shares to the corporation for $800 per share. They represent approximately 25% of all the outstanding shares of the majority. Euphemia says she wants to sell her 45 shares. They represent 90% of the outstanding minority shares. Must the corporation buy -- (1) all Euphemia's shares (2) 25% of her shares? What if Robert Rodd also wants to be bought out? What if Harry had only sold 25 shares?

Corporations: Law & Policy Page 17 Chapter 23 – Closely Held Corporations

HYPOTHETICAL #5 Euphemia remarries into Knob Hill wealth. Her Rodd Electrotype investment is a thorn in her side because of her high tax bracket. She wants the Rodds to stop paying dividends. Must they?

HYPOTHETICAL #6 Robert Donahue went to business school and earned a CPA. The Rodds hired him to work at the company as treasurer. To entice him, they also gave him a 5% stake in the company. The Rodds change their mind, fire Robert and stop paying dividends. Can he demand equal employment treatment? **************** Wilkes v. Springside Nursing Home (Mass 1976) Four investors went into the nursing home business. Each became a 25% shareholder; each became a director; each received equal salaries. They divided up managerial duties -- Quinn general manager Riche kitchen Pipkin (later Connor) medical Wilkes maintenance There was no formal agreement. What was the parties' understanding? One day Quinn, Riche and Connor dump Wilkes. Is this action protected by the business judgment rule? What can Wilkes do? ****************** Massachusetts Supreme Court: "... when stockholders in a close corporation bring suit against the majority alleging a breach of the strict good faith duty ... it must be asked whether the controlling group can demonstrate a legitimate business purpose for its action .... the controlling group ... must have some room to maneuver in establishing the business policy of the corporation ..." "When an asserted business purpose for their action is advanced by the majority, .... we think it open to minority to demonstrate that the same legitimate objective could have been achieved through an alternative course of action less harmful to the minority's interest ".. our courts must weigh the legitimate business purpose, if any, against the practicality of a less harmful alternative...."

HYPOTHETICAL #7 Quinn, Riche and Connor argue that they can't get along with Wilkes. "It's just a personality thing and we can't seem to get our work done like we did before," they say. Wilkes argues they could work on getting along, go to counseling sessions, with Dr. Peter a leading expert in workplace happiness, and minimize their workplace interaction. Who wins?

HYPOTHETICAL #8 The court agrees the majority participants can exclude Wilkes from employment. So the three insiders set up a "key man" life insurance policy that covers each of them, but not Wilkes. On death the corporation will have money to buy back their shares, but not necessarily those of Wilkes. What standard of review -- (1) equal opportunity? (2) Balancing?

Nixon v. Blackwell (Del. 1993) EC Barton founded a lumber business. He wanted the business to be run by employees; he wanted his family to share in profits. What did he do? Barton & Co was set up with two classes of shares, with special provisions for the Class B shares. Can the same common shares have different classes? When EC died -- 100% of voting Class A went to eight trusted employees (outright and in trust) 82% of non-voting Class B went to his wife, daughter and granddaughter -- some ended up in the hands of his wife's children, Guy and Owen Blackwell.

Dual-class Employee Stock Ownership Key man insurance policies common Plan (ESOP)  On death, key  Class A  Corporation pays employees can turn in voting cash to the plan / their Class A shares shares representing and get Class B (25% of employee accounts shares total  Plan buys Class B  Board says will use equity) stock from insurance money to  Class B corporation / buy employee's Class nonvoting allocating to B stock (at price equal shares employee accounts to 80% of ESOP value) (75% of  When employee total equity) leaves, she gets Note: The corporation Class B stock or pays more in policy cash equivalent premiums than it does (based on appraisal) in dividends!

Corporations: Law & Policy Page 19 Chapter 23 – Closely Held Corporations Is there a market in Class B stock -- for Guy and Owen? For other Class B shareholders? Guy and Owen refused to sell their Class B shares to the corporation in 1975 at $45 per share, in 1977 at $205 per share, in 1985 at $615 per share. Guy and Owen -- non-employee Class B shareholders -- argue that they don't get the same liquidity that Class B employees get by virtue of the ESOP and that Class A shareholders get under the "key man" insurance policies. They point out the board was dominated by shareholders who owned 47.5% of Class A, and a significant amount of Class B shares. What remedy do they want -- and get? What does the Delaware Supreme Court say on appeal? ************ Vice Chancellor: "I find it inherently unfair for defendants to ... provide liquidity for themselves while providing no method by which plaintiffs may liquidate their stock at fair value. ************ Vice Chancellor (remedy):: (1) The majority will buy Class B stock from Guy and Owen -- in an amount equal to all key man premiums paid to date (2) Whenever the ESOP or the corporation buy back Class B shares, they must offer to buy Guy and Owen's Class B shares. **************** Delaware Supreme Court: "... stockholders need not always be treated equally for all purposes ... To say that fiduciary principles require equal treatment is to beg the question whether investors would contract for equal or even equivalent treatment ....." "... the minority stockholders were not (a) employees of the Corporation, (b) entitled to share in the ESOP, (c) qualified for key man insurance, or (d) protected by specific provisions in a stockholders' agreement. "The directors' actions following Mr. Barton's death are consistent with his plan. An ESOP is normally established for employees"

IMPLICATIONS What is the meaning of the Delaware holding?  public corporation BJR in all cases?  case-by-case analysis of whether equality expectations? Should it make a difference when EC Barton set up the dual-class structure --  in the 1960s and before -- when courts treated close corporations under the continuity rules of public corporations  in the 1970s and 1980s -- when courts treated close corporations as incorporated partnerships  in the 1990s -- when business participants have many choices, including LLCs

Corporations: Law & Policy Page 20 Chapter 23 – Closely Held Corporations In re Kemp & Beatley, Inc (NY 1984)

Dissin and Gardstein worked a total of 77 years for Kemp & Beatley, a tablecloth manufacturer. Then management dumped them: Dissin saved face and resigned; Gardstein was terminated. The two continue to own the K&B shares they had accumulated, but management authorizes no dividends. Nor do the two get annual bonuses tied to profits, as they had before. What can they do?

DEADLOCK PRIMER

Would it change things if Dissin and Gardstein own 50% of Kemp & Beatley? Assume they own 50% of the voting shares and have half the board seats on the company's four-person board. What can they do? Assume they deadlock the company: (1) The shareholders can't elect a new board -- so the incumbent directors stay on. (2) The incumbent board cannot agree on anything - including paying dividends. But the business still churns out profits. Advise Dissin and Gardstein. ****************** NC Bus Corp Act § 55-14-30 Grounds for judicial dissolution. The superior court may dissolve a corporation: (2) In a proceeding by a shareholder if it is established that (i) the directors or those in control of the corporation are deadlocked in the management of the corporate affairs, the shareholders are unable to break the deadlock, and irreparable injury to the corporation is threatened or being suffered, or the business and affairs of the corporation can no longer be conducted to the advantage of the shareholders generally, because of the deadlock; (iii) the shareholders are deadlocked in voting power and have failed, for a period that includes at least two consecutive annual meeting dates, to elect successors to directors whose terms have expired;

What if, as were the facts of the case, Dissin and Gardstein only have 20% of the company's stock? What does "oppressive" mean in the deadlock statute? Does ejusdem generis help? Consider the other words -- "illegal, oppressive or fraudulent". What are the different ways of interpreting the term? Is it a tailored default term that permits court to take into account corporate parties' specific understandings? Is it a generic default term that directs court to construct general close corporation understanding? Why not demand these expectations -- like other commercial dealings over $500 -- to be in writing?

************* MBCA § 14.30 Grounds for judicial dissolution. The [court] may dissolve a corporation: (2) In a proceeding by a shareholder if it is established that (ii) the directors or those in control of the corporation have acted, are acting, or will

Corporations: Law & Policy Page 21 Chapter 23 – Closely Held Corporations act in a manner that is illegal, oppressive or fraudulent ...

************** Chief Judge Cooke (In re Kemp & Beatley) "A shareholder who reasonably expected that ownership in the corporation would entitle him or her to a job, a share of corporate earnings, a place in corporate management, or some other form of security, would be oppressed in a very real sense when others in the corporation seek to defeat those expectations and there exists no effective means of salvaging the investment."

**************** Justice Lonschein (Gimpel v. Bolstein) The second definition [of oppression] is derived from British law, and describes “oppressive conduct” as burdensome, harsh and wrongful conduct; a lack of probity and fair dealing in the affairs of a company to prejudice of some of its members; or a visible departure from the standards of fair dealing; and a violation of fair play on which every shareholder who entrusts his money to company is entitled to rely. **************** NC Bus Corp Act § 55-14-30 Grounds for judicial dissolution. The superior court may dissolve a corporation: (2) In a proceeding by a shareholder if it is established that (ii) liquidation is reasonably necessary for the protection of the rights or interests of the complaining shareholder; ...

HYPOTHETICAL Dissin and Gardstein often told themselves and their families that they expected an "extra compensation bonus" if the company was profitable. Sometimes they received one, sometimes not. They're fired. No dividends, no bonuses. Oppression?

HYPOTHETICAL When Dissin and Gardstein joined the company, they knew there was no certainty they would ever receive distributions on their shares. Over time, however, the company began paying "extra compensation bonuses" whenever the business at year's end was profitable. They're fired. No dividends, no bonuses. Oppression?

Corporations: Law & Policy Page 22 Chapter 23 – Closely Held Corporations HYPOTHETICAL Kemp & Beatley had a longstanding policy of paying "extra compensation bonuses" based on share ownership when the business was profitable. There was, however, nothing in writing. The company changed this policy when Dissin and Gardstein left. Assuming this is oppression, what remedy should the court order? What remedy does the statute envisage? What is the real effect of a dissolution order? What has been the trend in judicial remedies? Consider alternatives:  order reinstatement of company policy  order payment of dividends  order buyout  order dissolution

************** MBCA § 14.30 Grounds for judicial dissolution. The [court] may dissolve a corporation: (2) In a proceeding by a shareholder if it is established that (ii) the directors or those in control of the corporation have acted, are acting, or will act in a manner that is illegal, oppressive or fraudulent ... ********************** "Involuntary dissolution" cases  what kinds of corporations?  what jurisdictions?

1960-76 1984-85 1990-2000

No relief 27 (50.0%) 4 (10.8%) 55 (36.9%)

Dissolution order 16 (29.6%) 10 (27.0%) 42 (28.2%)

Buyout order 3 ( 5.6%) 20 (54.1%) 42 (28.2%)

Other relief 8 (14.8%) 3 ( 8.1%) 10 (6.7%)

54 (100%) 37 (100%) 149 (100%) TOTAL

3.4 cases/yr 18.5 cases/yr 13.5 cases/yr AVERAGE *************** Chief Judge Cooke: "A court has broad latitude in fashioning alternative relief, but when .... there has been a complete deterioration of relations between the parties, a court should not hesitate to order dissolution.

"Every order of dissolution, however, must be conditioned upon permitting any shareholder of the corporation to elect to purchase the complaining shareholder's stock at fair value. See

Corporations: Law & Policy Page 23 Chapter 23 – Closely Held Corporations NY BCL § 1118(a)."

HYPOTHETICAL Dissin and Gardstein, long-time loyal shareholders (20%) bring an action for involuntary dissolution. They claim they have reasonable expectations to a return on their investment. The majority shareholders worry that if the court orders dissolution, somebody else might buy up the business. They want to buy out Dissin and Gardstein. But Dissin and Gardstein refuse to sell. What is the MBCA solution? Is the MBCA buyout right a "default" term or is it mandatory? Is it appropriate to force buyouts in a close corporation?

***************** MBCA § 14.34 (compare NC BCA) Election to Purchase in Lieu of Dissolution (a) In a proceeding under 14.30(2) to dissolve a [close corporation] ... the corporation may elect or ... one of more shareholders may elect to purchase all shares owned by the petitioning shareholder at the fair value of the shares. (b) An election to purchase ... may be filed with the court at any time within 90 days after the filing of the petition under 14.30(2) .... (d) If the parties are unable to reach an agreement [as to fair value within 60 days after the election], the court ... shall determine fair value ... (e) ... the court shall enter an order directing the purchase ... as the court deems appropriate, which may include payment of the purchase price in installments ... and any additional costs, fees, and expenses as may have been awarded ...

Gimpel v. Bolstein (Sup Ct NY 1984) Gimpel Farms Inc is inherited by brothers Robert and George, and cousin Diane. Everyone in the family works on the family dairy farms, except Robert who was caught stealing $85,000 and was fired! The company has never paid dividends. You represent Robert -- what do you argue? Originally, when Grandpa Louis gave his shares to Papa David and Uncle Moe, the understanding was that everyone would work on the farm and draw a salary -- a good salary. Papa David gave his shares to Robert. Does Robert have reasonable expectations? Robert is a pariah. His father gave him his inheritance and he squandered it. In just retribution, the family refuses to hold shareholders' meetings, to issue his stock certificates, or to show him the company books. Is this harsh and burdensome? Can Robert, like the prodigal son, claim his place in the family? What is the "dolt rule" -- a modified business judgment rule for CHCs? Where do CHC "default terms" come from -- the Old Testament? the New Testament? Is this what the parties would have agreed to? What is the result under new MBCA § 14.34? ************** Justice Lonschein: "... after [the founder's] death, the surviving shareholders would not be bound to employ any

Corporations: Law & Policy Page 24 Chapter 23 – Closely Held Corporations dolt who happened to inherit his stock ..." "... Robert cannot be forever compelled to remain an outcast. Even Cain was granted protection from the perpetual vengefulness of his fellow man (Genesis 4:12-15). ... there is a limit to what [Robert] can be forced to bear, and that limit has been reached. The other shareholders ... must by some means allow him to share in the profits. "... the majority must make an election: they must either alter the corporate financial structure so as to commence payment of dividends, or else make a reasonable offer to buy out Robert's interest."