The Misguided Doctrine of Stockholder Fiduciary Duties
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Hofstra Law Review Volume 33 | Issue 1 Article 4 2004 The iM sguided Doctrine of Stockholder Fiduciary Duties Paula J. Dalley Follow this and additional works at: http://scholarlycommons.law.hofstra.edu/hlr Part of the Law Commons Recommended Citation Dalley, Paula J. (2004) "The iM sguided Doctrine of Stockholder Fiduciary Duties," Hofstra Law Review: Vol. 33: Iss. 1, Article 4. Available at: http://scholarlycommons.law.hofstra.edu/hlr/vol33/iss1/4 This document is brought to you for free and open access by Scholarly Commons at Hofstra Law. It has been accepted for inclusion in Hofstra Law Review by an authorized administrator of Scholarly Commons at Hofstra Law. For more information, please contact [email protected]. Dalley: The Misguided Doctrine of Stockholder Fiduciary Duties THE MISGUIDED DOCTRINE OF STOCKHOLDER FIDUCIARY DUTIES PaulaJ. Dalley* I. IN TRODU CTION ............................................................................... 176 II. THE LAW OF CONTROLLING STOCKHOLDERS' FIDUCIARY D U TIE S ....................................................................................... 177 A. Closely Held Corporations ................................................. 177 B. General Corporate Law, Including Publicly Held C orporations ....................................................................... 181 III. JUSTIFICATIONS FOR CONTROLLING STOCKHOLDER FIDUCIARY D UTIES .................................................................... 186 A. Close Corporations Are Like Partnerships ......................... 186 B. Controlling Stockholder Fiduciary Duties Reflect Econom ic R ealities ............................................................. 193 C. Controlling Stockholder Fiduciary Duties Are a "Settled R ule of L aw "...................................................................... 199 D. Fiduciary Duties Accompany Control ............................... 201 IV. CONFLICT WITH BASIC PRINCIPLES OF AMERICAN LAW ............. 202 A . C ontract L aw ...................................................................... 202 B . C orporate Law .................................................................... 206 C . Fiduciary Law .................................................................... 207 V. THE REAL BASES FOR CONTROLLING STOCKHOLDER L IAB ILITY ................................................................................... 2 11 A. Direct Liability as Officers or Directors ............................ 211 B. Indirect Liability for Acts of Directors ............................... 217 C. Policy Considerations ......................................................... 220 V I. C ON CLUSION ................................................................................ 222 * Professor of Law, Oklahoma City University. A.B., Princeton; J.D., Harvard; LL.M., New York University. The author gratefully acknowledges research support from Kerr Foundation and the Oklahoma City University Alumni Fund. Published by Scholarly Commons at Hofstra Law, 2004 1 Hofstra Law Review, Vol. 33, Iss. 1 [2004], Art. 4 HOFSTRA LA W REVIEW [Vol. 33:175 I. INTRODUCTION By now, most courts and commentators have accepted the proposition that controlling stockholders1 owe fiduciary duties to the other stockholders of the corporation. In close corporations, the premise is described as arising from the partnership-like nature of the close corporation,2 the need to protect stockholders in light of the economic realities of investments in close corporations, 3 and "settled rule[s] of law."4 In public corporations, duties are said to arise from the fact of control . In fact, none of these arguments support imposing a fiduciary duty on controlling stockholders. Rather, such a fiduciary duty violates basic principles of American law. Moreover, basic principles of corporate and agency law, properly understood, provide all the protection stockholders need and provide6 a more workable framework for evaluating stockholder behavior. 1. The definition of a controlling stockholder includes a stockholder owning a majority of the voting power of the corporation, a stockholder owning less than a majority but a sufficiently large block to exercise de facto control (for example, where the other shares are widely held), and a stockholder with effective control of the board of directors by contract. See Kahn v. Lynch Communication Sys., Inc., 638 A.2d 1110, 1114-15 (Del. 1994) [hereinafter Lynch 1];Citron v. Steego Corp., Civ. A. No. 10171, 1988 WL 94738, at *6 (Del. Ch. Sept. 9, 1988). The ALL Principles of Corporate Governance define controlling stockholder as one who either (1)owns and has the power to vote more than fifty percent of the stock, or (2) otherwise exercises a "controlling influence over the management or policies of the corporation or the transaction in question by virtue of the person's position as a shareholder." ALl, PRINCIPLES OF CORPORATE GOVERNANCE: ANALYSIS AND RECOMMENDATIONS § 1.10(a)(2) (Proposed Final Draft 1992) (hereinafter PRINCIPLES OF CORPORATE GOVERNANCE). A stockholder who controls more than twenty-five percent of the stock is presumed to exercise a controlling influence unless there is a larger stockholder. Id. § 1.10(b). Even a small minority stockholder may become a "controlling" stockholder in some cases, such as where the certificate of incorporation required an eighty percent supermajority for any action by the stockholders. See Smith v. Atlantic Props. Inc., 422 N.E.2d 798, 799 (Mass. App. 1981). The twenty-five percent holder, who was exercising his veto power to create deadlock, was therefore treated as a controlling stockholder in the circumstances. See id. at 802 n.6; see also Med. Air Tech. Corp. v. Marwan Inv., Inc., 303 F.3d 11, 20-21 (1st Cir. 2002); Mary Siegel, The Erosion of the Law of ControllingShareholders, 24 DEL. J. CORP. L. 27, 34-38 (1999) (arguing that control should be determined on a transaction-by-transaction basis, not in general). 2. See infra Part III.A. 3. See infra Part III.B. 4. Singer v. Magnavox Co., 380 A.2d 969, 976-77 (Del. 1977). 5. See HARRY G. HENN & JOHN R. ALEXANDER, LAWS OF CORPORATIONS § 240 (3d ed. 1983). 6. See Edward B. Rock & Michael L. Wachter, Waiting for the Omelet to Set: Match Specific Assets and Minority Oppression in Close Corporations,24 J. CORP. L. 913, 921-24 (1999) (noting that other features of corporate laws protect minority investors). http://scholarlycommons.law.hofstra.edu/hlr/vol33/iss1/4 2 Dalley: The Misguided Doctrine of Stockholder Fiduciary Duties 2004] STOCKHOLDER FIDUCIARY DUTIES Part II of this Article briefly describes the current state of the law of controlling stockholders' fiduciary duties. Part III describes the purported bases for those rules and the problems therewith. Part IV describes the ways in which imposing fiduciary duties on stockholders violates basic principles of American law. Part V suggests other, too- frequently ignored, legal doctrines that accomplish the desired results without straining corporate law. II. THE LAW OF CONTROLLING STOCKHOLDERS' FIDUCIARY DUTIES The imposition of fiduciary duties upon controlling stockholders derives from two separate legal principles. The first, and much older source of stockholder duties, is the principle that one who exercises power over the assets of another ordinarily owes a fiduciary duty in the exercise of that power. Thus, because a controlling stockholder controls the corporation, which is also property of the minority stockholders, the controlling stockholder owes the minority a fiduciary duty. As discussed at greater length below, this principle is unobjectionable as far as it goes, but it tends to be misapplied in the corporate context. The second, more recently developed basis for stockholder duties is the nature of the relationship between stockholders in closely held corporations, which requires, in equity, that they be held to a fiduciary standard. Under this principle, controlling stockholders in publicly held corporations would not owe fiduciary duties to the public minority. Thus, the law applicable to controlling stockholders in publicly held corporations tends to differ in both substance and rhetoric from the law applicable to stockholders in closely held corporations. Most of the scholarly attention has focused on closely held corporations. A. Closely Held Corporations Since Donahue v. Rodd Electrotype Co.,7 many courts have held stockholders in closely held corporations to the high fiduciary standards applicable to partners.8 As the Donahue court described it, controlling stockholders "may not act out of avarice, expediency or self-interest in derogation of their duty of loyalty to the other stockholders and to the 7. 328 N.E.2d 505 (Mass. 1975). 8. In Donahue, the court contrasted the "strict good faith standard" applied to partners with the "less stringent" standard applicable to corporate directors, although its basis for concluding that the corporate fiduciary duty was less strict is not clear. See id. at 515-16. Published by Scholarly Commons at Hofstra Law, 2004 3 Hofstra Law Review, Vol. 33, Iss. 1 [2004], Art. 4 178 HOFSTRA LA W PEVIEW [Vol. 33:175 corporation." 9 In that case, the fiduciary duty was held to prohibit a controlling stockholder from using its position to obtain "special advantages and disproportionate benefit."' 0 In later cases, the Massachusetts courts relaxed the duty sufficiently to provide some managerial flexibility to controlling stockholders, such that the controlling stockholder may assert a legitimate business purpose