SPECIAL PROBLEMS OF CLOSE CORPORATIONS

June 20, 2007

Class Agenda
Introduction, including definition of close corporation and the true plight of close corporation minority shareholders Shareholder Voting Arrangements Agreements Relating to Board Discretionary Matters Fiduciary Duty of Shareholders Restrictions on Transfer Dissolution

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What is a close corporation?

Shares held by a relatively small number of holders Ownership, i.e., capital invested, is relatively illiquid because it cannot be transferred easily

Owners typically manage and interpersonal relationships are close

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What is a close corporation?

Small business corporations share the same characteristics of other forprofit corporations generally, but they are distinguished by the number of shareholders, size of balance sheet and income statement, and level of business activity. There are, however, special problems associated with them, especially vis-a-vis minority shareholders.

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What is a close corporation?

In a close corporation, the stockholders generally participate actively in the management of the corporation and make policy for the corporation. Oftentimes, the salaries paid to the management/shareholders/directors of a close corporation represents their primary source of income.

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What is a close corporation?

Management of a close corporation is typically very cynical about transfers of ownership in the corporation because of the threat of a change in management at the behest of the controlling stockholders. Close corporation management desires stable and predictable behavior by the stockholders and techniques may be employed to derive this objection that may not be employed in a public corporation.

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What is a close corporation?

Alabama, Delaware, and numerous other states have had separate statutory provisions relating to close corporations. Under Alabamas 1980 Business Corporation Act, 102A-300 to-313 had special requirements for them, including a maximum of 30 shareholders and public notice of their close corporation status.

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What is a close corporation?

These 1980 Act provisions remain applicable to corporations organized prior to January 1, 1995. The distinguishing features of these small businesses now relate primarily to case law (in some states) concerning fiduciary duties of close corporation constituencies and statutory provisions relating to shareholder agreements and dissolution.

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Close Corporation Structure

SHAREHOLDERS DIRECTORS MANAGEMENT

What are some of the problems when they are all the same people?

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Close Corporations
What is the true plight of the minority stockholder in a close corporation? If he is dissatisfiedin a more legal sense, this means that he is oppressed by the majority owners or he is a dissident minority shareholderhe cannot readily sell his interest and he cannot readily cause a dissolution as he could were the business organized as a partnership.

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Donahue v. Rodd Electrotype Co. (Mass. 1975)

FACTS

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Donahue v. Rodd Electrotype Co. (Mass. 1975)

Sale of 45 shares @ $800 per CORPORATION

CONTROLLING STOCKHOLDER (Mr. Rodd)

Refusal to purchase at a like price

Fiduciary Duty

BOARD OF DIRECTORS [Rodd, Rodd, FIDUCIARY and DUTY? Magnuson (lawyer)]

MINORITY STOCKHOLDER (Ms. Donahue)

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Close Corporations
Shareholders of close corporations owe a more rigorous duty to one another that is akin to the fiduciary duty of partners of a partnership. It is a duty of good faith and a duty of the finest loyalty. See Meinhard v. Salmon.

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Close Corporations
It has been said that a close corporation is nothing more than an incorporated partnership because of the relationships among the corporation constituencies.

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Close Corporations
Close corporations are subject to substantially the same statutory regime that applies to other corporations, except for special provisions and practical opportunities for highly flexible shareholder agreements and voting agreements as well as the law of fiduciary duties applicable to them.

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Close Corporations
Common law and statutory law have contractualized close corporations. Given the recognition of contracts governing relationships in close corporations, advance planning is extremely important in the representation of small businesses and their constituencies.

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Special Voting Arrangements of Shareholders

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Voting Agreements
Ringling Bros.-Barnum & Bailey Combined Shows v. Ringling (Del. Ch. 1947) recognized that shareholders may enter agreements to vote their stock jointly, but the court did not specifically enforce the terms of the agreement in this case.

As a result of this and other similar cases, most states have enacted statutes for the specific enforceability of shareholder voting agreements.

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Voting Agreements
Ala. Code 10-2B-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 10-2B-7.30. (b) A voting agreement created under this section is specifically enforceable

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Voting Trusts
Likewise, the RMBCA authorizes voting trusts whereby shareholders transfer their shares into a trust and a trustee votes such shares in accordance with the terms of the trust. Alabama Code section 10-2A-7.30 is identical to the RMBCA provision, which was derived from Delaware and California provisions.

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Voting Agreements
Stockholders may invoke arrangements that enhance the voting requirements to obtain certain voting results and make it more difficult to carry action without broad support from the stockholder base. For example, remember that the general requirement is that a quorum for a stockholder or director meeting is a majority of the votes or members entitled to vote on the action. But the requirement for a stockholder or director quorum may be increased in the articles or bylaws.

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Voting Agreements
Therefore, a superquorum or supervotvote might be used to increase the percentage required above a mere majority. For example, the articles or bylaws might require the presence of 80% of the outstanding shares entitled to vote on the action to constitute a quorum for a stockholders meeting.

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Agreements Relating to Matters Within the Discretion of the Board of Directors

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Board Discretionary Matters

The traditional corporation model (where directors were responsible for management of the corporation) and the modern corporation model (where all corporate powers are exercised by or under the authority of, and the business and affairs of the corporation are managed under the direction of, the board of directors) both contemplate that there are certain matters that are within the sole domain of the board.

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Board Discretionary Matters

To what extent may shareholders of a close corporation contractually agree to curtail the discretion of the board of directors?

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Board Discretionary Matters

McQuade v. Stoneham (NY Court of Appeals 1934) sets forth the traditional view that shareholder agreements that limit the discretion of the board of directors are invalid. This traditional view also invalidated shareholder agreements to the extent that they limited a shareholders discretion as a director.

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Board Discretionary Matters

Clark v. Dodge (NY 1936) (see Text Note on page 274) expressed a modified view that, where an agreement does not sterilize the board and limits board discretion only so slightly that it is negligible, it is valid.

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Board Discretionary Matters

Galler v. Galler (Ill. Sup. Ct. 1964) reflects the modern trend toward recognizing that close corporations are so named for a reason:

The people involved are usually CLOSE!

Unfortunately, this closeness often leads to oppressive, arbitrary relations between controlling and minority stockholders and courts should provide protections against this.

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Board Discretionary Matters

Galler v. Galler is a classic case and in it the Illinois Supreme Court upheld a shareholder agreement encompassing matters within the authority of shareholders and matters clearly within the authority of directors on grounds there was no "objecting [shareholder] minority" interest or demonstrated prejudice to creditors or the public.

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Voting Agreements
An agreement entered into by corporation directors, or between a director and a stockholder, committing the director to vote a certain way at a directors meeting is not, however, valid. It is because of a theory that a corporation is entitled to the unfettered discretion of directors to vote in what they believe to be the best interests of the corporation. However, agreements that narrowly dictate a director vote are generally valid.

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Voting Agreements
For example, a director agreement regarding the declaration of dividends or the election of officers is generally valid.

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Proxies
The agency relationship created by the delivery of a proxy gives rise to the problem of the irrevocability of the proxy since a principal can terminate the authority of an agent at will, even if the termination constitutes a breach of contract.

The exception is where the agent holds a power coupled with an interest.

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Proxies
Alabama Code section 10-2B-7.22 expressly authorizes voting of shares by proxy. It also states that an appointment of a proxy is revocable by the shareholder unless the appointment form conspicuously states that it is irrevocable and the appointment is coupled with an interest.

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Proxies
Under the statute, appointments coupled with an interest include the appointment of: (1) a pledgee; (2) a person who purchased or agreed to purchase the shares; (3) a creditor of the corporation who extended it credit under terms requiring the appointment; (4) an employee of the corporation whose employment contract requires the appointment; or (5) a party to a voting agreement created under Alabama Code section 10-2B-7.31.

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Close Corporation Statutes

Alabama is one of those states that have adopted close corporation provisions in their business corporation statutes which authorize shareholders to assume responsibility for corporate management and control. These close corporation statutes ( 10-2A-300 to 313) were part of the 1980 corporate code, they were not carried forward in the 1984 ABCA, and they now apply to corporations formed before January 1, 1995 or elected to so treated before that same date.

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Statutory Shareholder Agreements

As an alternative to pre-1975 close corporation status, Alabama Code section 10-2B-7.32 provides for general shareholder agreements covering a wide range of matters within the statutory authority of both shareholders and directors.

This statute provides the vehicle for advance planning for foreseeable events.

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Statutory Shareholder Agreements

These agreements may supercede statutory provisions to the extent that they relate to matters listed in the statute. Such agreements are limited to corporations whose shares are not publicly traded and, thus, they are available only to those corporations that are generally thought of as close. There are further important requirements for such agreements, with which you should be familiar.

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Fiduciary Obligations of Stockholders of Close Corporations

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Fiduciary Obligations
An important subject concerning close corporations pertains to the fiduciary duty, if any, of one shareholder-owner to another and, in particular, the duty of majority shareholders, when acting in the capacity of shareholders, to minority shareholders. Naturally, this is the primary area for litigation concerning close corporations.

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True Example
A, B, and C organize a corporation 20 years ago for the purpose of owning and operating a health care facility A, B, and C are the only members of the board A, B, and C each own 1/3 of the outstanding stock and they enter a shareholder agreement with customary provisions A serves as president, B serves as VP and treasurer, and C serves as VP and secretary

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True Example
The business does reasonably well and A, B, and C enjoy harmonious relations for 20 years A dies As surviving spouse (Spouse) inherits his 1/3 interest in the corporation and B and C (reluctantly) elect Spouse to the board to fill the vacancy created by the death of A B and C do not have harmonious relations with Spouse

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True Example
Within 3 years of As death, the business begins to suffer financially, it lacks management attention, it neglects marketing efforts, all of which appear suspicious to Spouse and her lawyer B and C never vote in favor of proposals by Spouse, fail to provide requisite notice of meetings, and upon independent observation appear to treat Spouse disrespectfully, chauvinistically, and cavalierly Spouse now wants to sell the business

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True Example
This is a common fact pattern.

What fiduciary duty is owed by B and C to Spouse? In the event of a shareholder vote on whether to sell the business, which Spouse can veto if she disapproves of the terms, what fiduciary duty is owed by Spouse to B and C?

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Fiduciary Duty
If B, C, and Spouse were in business as a partnership, the duty among them would be one of utmost good faith and loyalty. They would each have a duty to act in the interest of their partners with the same zeal with which they each would act in pursuing their own personal interest. Courts have demonstrated difficulty in balancing the interests of controlling shareholders and protecting against the oppression of minority shareholders.

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Fiduciary Obligations
Most jurisdictions, including Alabama, have traditionally followed the view that directors and shareholders of close corporations are subject to a duty of "good faith and inherent fairness" that is applicable to large, publicly held corporations. See, e.g., Smith v. Burton, 283 Ala. 391, 217 So.2d 540 (1968).

Massachusetts is a notable exception to the majority approach and has applied a duty more akin to the higher standard for partnerships.

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Fiduciary Obligations
Some relatively recent decisions by the Alabama Supreme Court suggest that there may be a movement toward the Massachusetts partnership standard, at least in cases involving freeze-outs of minority holders by the majority, including board and officer removals, non-payment of dividends or remuneration, and other oppressive conduct.

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Stock Transfer Restrictions

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Stock Transfer Restrictions

Stock transfer restrictions that are reasonable and do not otherwise offend public policy are generally binding when they are imposed by statute, by the articles of incorporation or bylaws, or by a shareholders agreement, and are noted conspicuously on the stock certificate or an information statement required for uncertificated shares.

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Stock Transfer Restrictions

Alabama Code section 10-2B-6.27 provides that such restrictions are enforceable and authorized for those purposes listed in the statute or [f]or any other reasonable purpose. However, shares subject to restrictions not comporting with the statute are nevertheless transferable as personal property. This provision from the RMBCA is derived from section 202 of the Delaware General Corporation Law.

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Stock Transfer Restrictions

Rights of first refusal: An agreement may grant the corporation or the other shareholders a right to acquire stock for sale at the proposed selling price before its sale to others is generally deemed to be a reasonable restriction on alienability. Courts generally require that the period of time to exercise the right to purchase be relatively short, e.g., 60 days or so.

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Stock Transfer Restrictions

Rights to purchase upon a stated event: Such a restriction requires a stockholder to sell his shares to the corporation or to other stockholders upon the occurrence of a certain event. An example might be the termination of employment by the corporation. This is called a right of redemption.

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Stock Transfer Restrictions

Director of stockholder veto: Agreements that restrict transfer absent approval of the directors or of the other stockholders are generally deemed unreasonable and invalid. However, some states expressly authorize consent restraints.

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Stock Transfer Restrictions

Alabama Code section 10-2B-6.27 provides:
(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 corporation. A restriction does not affect shares issued before the restriction was adopted unless the holders of the shares are parties to the restriction agreement or voted in favor of the restriction.

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Stock Transfer Restrictions

Alabama Code section 10-2B-6.27 provides:
(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 including an executor, administrator, trustee, guardian, conservator or other fiduciary entrusted with like responsibility for the person or estate of the holder, provided the restriction is authorized by this section and its existence is noted conspicuously on the front or back of the certificate or is contained in the information statement required by Section 10-2B-6.26(b). Even if not so noted, a restriction is enforceable against a person with actual knowledge of the restriction.

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Stock Transfer Restrictions

Alabama Code section 10-2B-6.27 provides:
(c) A restriction on the transfer or registration of transfer of shares is authorized:
(1) To maintain the corporation's status when it is dependent on the number or identity of its shareholders; or (2) To preserve exemptions under federal or state securities law; or (3) For any other reasonable purpose.

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Stock Transfer Restrictions

Alabama Code section 10-2B-6.27 provides:
(d) A restriction on the transfer or registration of transfer of shares may include, but shall not be limited to, a restriction that: (1) Obligates the shareholder first to offer the corporation or other persons (separately, consecutively, or simultaneously) an opportunity to acquire the restricted shares; (2) Obligates the corporation or other persons (separately, consecutively, or simultaneously) to acquire the restricted shares;

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Stock Transfer Restrictions

Alabama Code section 10-2B-6.27 provides:
(3) Requires 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) Prohibits the transfer or registration of the restricted shares to or in the name of designated persons or classes of persons, if the prohibition is not manifestly unreasonable; or (5) Requires the corporation to refuse to transfer the shares.

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Stock Transfer Restrictions

Alabama Code section 10-2B-6.27 provides:
(e) For purposes of this section, "shares" includes a security convertible into or carrying a right to subscribe for or acquire shares.

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Dissolution

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Dissolution
Ala. Code 10-2B-14.30 through -14.34: Note the special dissolution and shareholder-initiated purchase election procedures applicable to close corporations that are set forth in -14.34.

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END OF SLIDES 6/20/2007