Previous IC blog posts have discussed the concept of “fiduciary duties” in a closely held corporation (e.g., one whose stock is not freely traded and is held by only a few shareholders) in general terms. This post discusses just one of a whole host of business litigation claims that are brought in court on behalf of a minority shareholder who believes there has been a breach of fiduciary duty owed to him/her by the majority shareholder(s) – the freeze out. Check back often for posts about the plethora of other business litigation claims shareholders use to enforce the fiduciary duties owed by and between them.
The “Freeze Out”
Breach of the so-called Donahue fiduciary duty (the duty of “utmost good faith and loyalty” shareholders in a close-corporation owe to one another; see Donahue v. Rodd Electrotype Co. of New England, 367 Mass. 578 (1975)) can occur in a variety of circumstances particular to a closely held corporation. One of the more frequently encountered causes of action to enforce the Donahue fiduciary duty is the so-called “freeze-out” claim. A freeze-out claim can be brought based on any number of allegations, including:
- Refusing to declare dividends;
- Siphoning off corporate earnings in the form of exorbitant salaries and bonuses to the favored majority shareholders or officers;
- Depriving minority shareholders of corporate offices or employment;
- Causing the corporation to sell its assets at an inadequate price and without input from the minority shareholders; or even,
- Not providing reasonable access to corporate books and records upon request, even after a shareholder employee is “terminated.”1
While freezing out a minority shareholder may constitute a breach of the Donahue fiduciary duty, depending on the circumstances, the law here is not one-sided. Controlling stockholders also have a “large measure of discretion” and “some room to maneuver in establishing the business policy of the corporation” in matters such as “declaring or withholding dividends, deciding whether to merge or consolidate, establishing the salaries of officers, dismissing directors with or without cause, and hiring and firing corporate employees.” Wilkes v. Springside Nursing Home, Inc., 370 Mass. 842, 850-51(1976).
In Wilkes, the Commonwealth’s highest state court voiced its concern that the “untempered application of the strict good faith standard . . . will result in the imposition of limitations on legitimate action by the controlling group in a close corporation which will unduly hamper its effectiveness . . . . The majority, concededly, have certain rights to what has been termed ‘selfish ownership’ in the corporation which should be balanced against the concept of their fiduciary obligation to the minority.” Id.
So what does this mean in practice? The Wilkes decision has been used to effectively argue that in defending a Donahue fiduciary duty claim, the majority shareholder group is permitted to demonstrate a “legitimate business purpose” for the disputed action(s). The legitimate business purpose test is designed to prevent “the Donahue remedy [from placing] a strait jacket on legitimate corporate activity.” Id. Upon the controlling shareholder’s demonstration of such a “legitimate business purpose,” the burden shifts back to the minority shareholder to demonstrate that the same legitimate objective could have been achieved through an alternative course of action less harmful to its interests.2 The courts then weigh the legitimate business purpose against the practicability of the less harmful alternative to determine whether a particular freeze-out claim qualifies as a breach of fiduciary duty.
As with many business torts, determining whether a shareholder’s termination is an act of freeze-out that gives rise to a breach of fiduciary duty depends on the facts, circumstances, and peculiarities of the particular claim. For this reason, it is incumbent upon innovators and closely held corporate entities that may face these issues to seek the counsel of an experienced attorney to assist in making decisions about shareholder rights and responsibilities before taking action that could open up a breach of fiduciary duty/alleged freeze-out can of worms.