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Most business people appreciate that partners in a partnership owe each other a high level of

trust and loyalty with respect to their business venture: after all, the partners are personally liable for the liabilities of their common enterprise. Many business people do not realize, however, that although there are obvious legal distinctions between a partnership and a corporation—such as tax treatment and the extent of liability for the actions and debts of the enterprise—when it comes to the fi duciary duties among co-owners, the law does not always draw a bright line between a partnership and a corpora-tion that is closely held (that is, owned by a small number of shareholders). In determining whether a fi duciary duty exists among shareholders, the law recognizes certain similarities between partnerships and closely held corporations (also known as “close corporations”), such as the small number of owners; the involvement by owners in management; and the relative non-transferability of ownership interests. Co-owners of a business venture cannot simply avoid “partnership-like” duties simply by choosing to create the entity as a corporation instead of a partnership. So what is this fi duciary duty and what does it mean for a shareholder in a close corporation? An evocative defi nition comes from the venerable Chief Judge Cardozo in the seminal 1928 case, Meinhard v. Salmon: “Joint adventurers, like co-partners, owe to one another, while the enterprise

What shareholders should know about their duties to other shareholders

continues, the duty of fi nest loyalty. Many forms of conduct permissible in a work-a-day world for those acting at arm’s length, are forbidden to those bound by fi duciary ties . . . Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.” Courts have turned to this case many times over the years to justify the imposition of standards of loyalty, good faith, equal treatment, reasonable expectations and, most importantly, fairness among co-owners of close corporations. Not surprisingly, courts seem to apply these standards in cases when they fi nd shareholders engaging in

actions that constitute oppression, bad faith, disparate treatment and unfairness to the other shareholders. There are certain forks in the road of a close corporation’s life where a shareholder needs to be acutely aware of his duties to fellow shareholders. Here are some common examples:

When redeeming stock Care must be taken in buy-backs of shares by a corporation. As a general matter, the controlling or majority shareholder cannot directly or indirectly cause the corporation to buy back his shares if it would leave remaining shares of the corporation worthless or

Professional Insurance Agents/April 2005 1www.piaonline.org

Duty bound: What you owe fellow shareholders

by Nicholas SanFillipo IV and Liwayway A. Reilly

2 Professional Insurance Agents/April 2005 www.piaonline.org

if the other shareholders are not allowed the same opportunity to sell back their shares on the same terms.

When issuing or withholding dividends A majority group of shareholders may be breaching its fi duciary duty if it uses its voting power or infl uence to withhold dividends in order to “encourage” minority shareholders to permit the corporation to redeem their shares (i.e., force them out at a low buy-back price). There also may be a breach of a fi duciary duty if the majority group declares an unreasonable dividend that depletes the corporation’s cash reserves particularly when the members of the majority group own large blocks of stock and the other shareholders have insignifi cant holdings.

When selling or refusing to sell the corporation Sometimes there are differences among shareholders relating to their liquidity needs. Some shareholders use their business investment as a source of income, other owners are looking for growth and a strategic exit. A majority shareholder group may breach its fi duciary duty if it intentionally hinders the sale of the corporation without considering, or in frustration of, the liquidity needs of the minority.

When terminating a shareholder as an employee If the employment of shareholders is a long-standing policy of the corporation or the minority shareholder otherwise has a reasonable expectation of employment, a controlling shareholder may be held in breach of his fi duciary duty if he fi res or denies employment with the corporation to a minority shareholder.

When exercising veto power as a minority shareholder It’s not only the majority share-holders who have a fi duciary duty. If a minority shareholder has veto power, he is a de facto controlling shareholder.

Most closely held corporations will have a shareholders’ agreement in place, not unlike a partnership agreement or limited liability company operating agreement. These agreements, or the corporation’s charter or by-laws, often contain super-majority voting provisions, whereby certain actions by the corporation require the approval of shareholders holding more than a simple majority. The most typical example is when the charter requires that the sale or merger of the corporation (or some other major decision) be approved by shareholders holding at least 80 percent of the outstanding shares. If there are four shareholders holding equal percentages of the corporation, a single shareholder could hold out on a merger that has the approval of the other shareholders. If the decision to withhold approval is for reasons that are arbitrary, personal and/or unfair, such withholding could be considered a violation of the duty of good faith and loyalty.

When dissolving the corporation Shareholders must be careful when seeking to dissolve a corporation. In one case, when a close corporation was having fi nancial issues due to a large tort liability, a group of controlling shareholders created a new corporation and slowly started to transfer the business from the old corporation to the new, by selling assets and moving accounts. While the business decision to run the business through a new entity may have been a wise one, the decision not to tell the minority shareholders about it, and give them an opportunity to participate or be bought out fairly, was not. Without knowledge of the new business, the majority group easily convinced the minority shareholders to dissolve the initial corporation and sell the remaining assets. In effect, the decision to dissolve allowed the majority group to take over the business without having to compensate or include minority shareholders. The court ordered the majority shareholders to buy out the minority shareholders at a valuation of

the old corporation prior to the start of misappropriation to the new corporation. If a controlling shareholder is sued by another shareholder and loses the fi duciary fi ght, the judicial remedies for breach of a fi duciary duty are often punitive. Judicial remedies range from mandatory buy-outs of the aggrieved shareholders, forced distribution of corporate earnings or, in extreme deadlock cases, dissolution of the enterprise and liquidation of the assets. A majority shareholder, by virtue of his controlling interest in a corporation, almost always has a more infl uential say in the management of the corporation’s business. When it comes to crucial corporate governance decisions and potentially disparate treatment of minority shareholders, adherence to fi duciary duties is paramount. Unfortunately, there are no bright lines drawn for guidance. Nevertheless, a controlling shareholder usually can apply a “smell test” to a potential action—if it would look, sound or feel bad, if it smacks of unfairness or, if it could be considered self-serving, there is a good chance that any such action could be found to be in breach of a fi duciary duty.

This article contains gereral information, it is not intended to provide legal advice.

Nicholas San Filippo IV, is a partner and Liwayway A. Reilly is counsel in the corporate department of Lowenstein Sandler PC (www.lowenstein.com), a nation-ally ranked law firm based in Roseland, N.J. They can be reached at (973) 597-2572 or at nsanfilippo@lowenstein.com and (973) 597-2384 or lreilly@lowenstein.com, respectively. Lowenstein Sandler PC is a nationally recognized law firm in New Jersey and New York, providing a full range of legal services to clients. Recently recognized as “New Jersey’s premier law firm” it has been ranked first overall in the state by the Chambers USA Guide to America’s Leading Business Lawyers.

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