Duties of the Shareholders in Close Corporations

Close corporations are corporations with a few shareholders

What does this mean?

  • Little established market for shares, most likely transfer restrictions
  •       Value of shares is in dividends (maybe salary), not residual claim
  •       Shareholders are often undiversified
  •       Often a majority shareholder (or the possibility of a majority shareholder bloc) with ability to exert unilateral control

 

In sum, significant potential for oppression of minority shareholders

 

Possible solutions:

  •  Enhanced fiduciary duties of majority shareholders and/or boards
  •        Rely only on ex ante shareholder agreements (if minorities want protection, they must negotiate it)
  •   Buyout procedure
  •   Mandatory protections (e.g. guaranteed dividends)
  •   Cumulative voting and/or voting agreements

 

This is largely the DE/NY approach

 

Freeze-outs

 

Shareholders in a close corporation violate fiduciary duties when they freeze out other shareholders without legitimate business reason. Frozen-out shareholder is required to demonstrate that a “less harmful” alternative can be used to achieve the same objective. This legal requirement effectively imposes the same fiduciary duties on the shareholders in close corporations as exist in partnerships. That is being a duty of “utmost good faith” when dealing with each other. At the same time the court will not fashion additional protection for which the parties didn’t bargain for. Each person makes a decision to become a shareholder of a closed corporation, if that person wants some protections, he should negotiate it. Such protections may include buy-out provisions, voting rights, long-term employment agreement and other.

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