RIGHTS OF MINORITY SHAREHOLDERS IN A CLOSELY-HELD CORPORATION

What is a Close Corporation?

Under Ohio law, a “close corporation” is defined as a corporation with a relatively small number of shareholders, whose shares are generally not traded on national securities exchanges or regularly quoted on over-the-counter markets.[1] A close corporation is also frequently characterized by an identity of management and ownership,[2] being comprised of a small number of people who depend on each other for the success of the enterprise.[3] In other words, close corporations will usually bear an unmistakable resemblance to a partnership, with shareholders considering themselves partners in business while utilizing the advantages that the corporate form has to offer.[4] As a result, it is typical that the shares of a close corporation are rarely bought and sold and, usually, there are restrictions on a shareholder’s ability to transfer their shares.[5] The intent of such restrictions is to preserve the partnership as it stands, limiting the ability of an “outsider” to participate in the business venture.

Often, however, the close corporate form results in an imbalance as to the controlling power between majority and minority shareholders. This has been viewed as a drawback to the nature of a close corporation, as majority shareholders can easily abuse their corporate control to the disadvantage of minority shareholders.[6] Minority shareholders in close corporations often realize their particular vulnerability, as they are small in number, lack voting power in the corporation, and have no readily available market for their shares. Thus, it becomes easy for majority shareholders to exert their voting power to bully minority shareholders, who may find difficulty in protecting their own financial interests.[7] Such misuse of the close corporate form by majority shareholders is commonly referred to as a “squeeze-out” or “freeze-out”—that is, manipulative or abusive uses of corporate control to eliminate minority shareholders or otherwise unfairly deprive them of advantages or opportunities to which they are entitled.[8] Minority shareholders, then, having limited options to either dispose of their shares or assert their rights due to lack of voting power, are left in a futile position.

Fiduciary Duty of the Controlling Shareholder

Courts have responded to this problem by borrowing a rule from partnership law (intuitively so, because of that resemblance between close corporations and partnerships) to impose on majority shareholders a heightened fiduciary duty of good faith and loyalty toward their minority counterparts.[9] Following this rule, “[w]here majority or controlling shareholders in a close corporation breach their heightened fiduciary duty to minority shareholders by utilizing their majority control of the corporation to their own advantage, without providing minority shareholders with an equal opportunity to benefit, such breach, absent a legitimate business purpose, is actionable.”[10]

Interestingly, under traditional common law (which developed under the English Code of Chivalry and laws aimed toward fiduciaries involved in trusts and estates), there is no higher duty or “heightened duty” greater than the traditional fiduciary duties of good faith, loyalty and fair dealing.[11] Therefore, whether or not jurisdictions such as Delaware—and Ohio, for that matter[12]—impose “heightened” fiduciary duties, it is traditionally a meaningless distinction. Nevertheless, courts have insisted on a “heightened” standard in this context, as disadvantaged minority shareholders may suffer individual harm.[13]

What is a Breach?

A majority shareholder breaches their fiduciary duty when they manipulate their control over the close corporation to unfairly acquire personal benefits not otherwise available to the minority shareholders.[14] By virtue of their superior position to minority shareholders, a fiduciary majority shareholder must demonstrate that their actions were fair, reasonable, and based on a full disclosure of relevant information.[15]

For example, in several cases, courts have found majority shareholders to have breached their fiduciary duty toward the minority by paying themselves excessive compensation.[16] In another case, applying close corporation fiduciary rules, the court found that a dominating shareholder who had unfairly usurped minority shareholders’ voting power and used corporate funds to support his other enterprises to the detriment of the corporation was in breach of his fiduciary duty to those shareholders.[17] In a final example, a majority shareholder was found to have breached his fiduciary duty to the minority shareholder when he failed to attend a shareholder meeting, thus preventing a quorum, which effectively precluded a minority shareholder from being able to exercise his own voting power as to the election of new corporate directors.[18]

The case law is replete with numerous examples of what is (and also what is not) a breach of a majority shareholder’s fiduciary duty. But, the bottom line is this: if a shareholder utilizes their control of a corporation for their own benefit without a legitimate business purpose—while preventing other shareholders from the same opportunity to benefit—they may be in violation of their fiduciary duties.

Close Corporation Agreement and the LLC

The issues surrounding close corporations and the abuse of corporate control by majority shareholders are preventable through the execution of a Close Corporation Agreement between the shareholders of a close corporation. This document should clearly outline the responsibilities and obligations of the parties involved in the enterprise and, if properly drafted, can limit a majority shareholder’s ability to exert their corporate control to a minority shareholder’s disadvantage. A Close Corporation Agreement may also be executed in conjunction with a Buy-Sell Agreement, which controls the distribution of shares and designates an agreed-upon method of the shares’ transfer and valuation. Parties to a new business enterprise may also consider forming a limited liability company (an “LLC”). In relatively recent years, the LLC form has surged in popularity among business owners, due in part to its ability to circumvent the type of aforementioned control issues of a close corporation.

Taking Action

Should a minority shareholder of a close corporation nevertheless find themselves subject to the types of control issues discussed in this article, know that courts have gone out of their way to provide protections for such a shareholder’s interests. Because of a minority shareholder’s lack of control in the corporation and vulnerability to a “squeeze-out,” they have been deemed by courts to be particularly disadvantaged. Courts have thus attempted to balance these inequities by allowing direct action by an injured shareholder.

Generally, actions for breach of fiduciary duties are to be brought in derivative suits—that is, suits brought by shareholders on behalf of a corporation.[19] One nuanced exception to this rule, however, is where the action involves claims by shareholders in a close corporation.[20] In such cases, direct actions may be brought by minority shareholders in their individual shareholder capacities to assert their rights against majority shareholders where there has been an injury “separate and distinct” from an injury to the corporation,[21] and are not subject to the normal rules of procedure.[22]  If not for an injured minority shareholder’s ability to bring such direct action for breach of fiduciary duty, then any recovery in a derivative suit would accrue to the corporation and remain under the control of the very parties who are defendants in the litigation.[23] Thus, direct action may be brought by the aggrieved shareholder, providing a more effective remedy.

Conclusion

Close corporations often present issues of control between shareholders. In responding to such issues, courts have imposed fiduciary duties upon majority shareholders, requiring their actions to be taken in utmost good faith and loyalty toward their minority counterparts. This fiduciary duty is often determined to be breached when a majority shareholder asserts their control to their own advantage, while not providing the opportunity for a minority shareholder to benefit in the same way.

When engaging in a new business venture, consider the aforementioned risks and liabilities before assuming a minority shareholder interest in a close corporation. These risks may be mitigated through a Close Corporation Agreement or the formation of a different type of business entity, such as an LLC. Otherwise, know that the law has provided protections for such minority shareholders to help protect their interests.

[1] Crosby v. Beam, 47 Ohio St.3d 105, 107, 548 N.E.2d 217, 219 (1989).

[2] Gigax v. Repka, 83 Ohio App.3d 615, 620, 615 N.E.2d 644, 648 (2nd Dist. 1992).

[3] Edelman v. JELBS, 2015-Ohio-5542, 57 N.E.3d 246, at ¶ 29 (10th Dist. 2015).

[4] Gigax, 83 Ohio App.3d at 620, 615 N.E.2d at 648.

[5] Id.

[6] Id.

[7] Id.

[8] Id.

[9] Id.

[10] Crosby, 47 Ohio St.3d at 109, 548 N.E.2d at 221.

[11] See generally, Black’s Law Dictionary (10th ed. 2014) (defining a fiduciary duty as “a duty to act with the highest degree of honesty and loyalty toward another person and in the best interest of the other person (emphasis added)); see also, Yenchi v. Ameriprise Financial, Inc., 639 Pa. 618, 632-33, 161 A.3d 811, 819-20 (2017).

[12] See, e.g., Crosby, 47 Ohio St.3d at 109, 548 N.E.2d at 220; see also Herbert v. Porter, 165 Ohio App.3d 217, 2006-Ohio-355, 845 N.E.2d 574 (3rd Dist. 2006).

[13] See Crosby, 47 Ohio St.3d at 109, 548 N.E.2d at 221.

[14] Edelman, 57 N.E.3d 246 at ¶ 30 (citing Yackel v. Kay, 95 Ohio App.3d 472, 478, 642 N.E.2d 1107 (8th Dist. 1994).).

[15] Id. at ¶ 31 (citing Biggins v. Garvey, 90 Ohio App.3d 584, 597, 630 N.E.2d 44 (11th Dist. 1993).).

[16] See, e.g., id. at ¶¶ 30-33; see also Crosby, 47 Ohio St.3d at 106, 548 N.E.2d at 218.

[17] McLaughlin v. Beeghly, 84 Ohio App.3d 502, 507-08, 617 N.E.2d 703, 706 (10th Dist. 1992).

[18] See Vontz v. Miller, 2016-Ohio-8477, 111 N.E.3d 452 (1st Dist. 2016).

[19] Grand Council v. Owens, 86 Ohio App.3d 215, 220, 620, N.E.2d 234 (10th Dist. 1993).

[20] Hanko Nestor v. Hanko, 2019-Ohio-2256, 2019 WL 2406724, ¶ 19 (6th Dist. 2019).

[21] Crosby, 47 Ohio St.3d at 107, 548 N.E.2d at 219.

[22] Id. at 218 (referring to Civ.R. 23.1 “Derivative actions by shareholders.”).

[23] Yackel v. Kay, 95 Ohio App.3d 472, 476-77, 95 Ohio App.3d 1107, 1110 (8th Dist. 1994) (citing Crosby, 47 Ohio St.3d 105, 109-110, 548 N.E.2d 217, 220-22.).