Corporations Law: Close Corporations outline

 Close Corporations study guide

A. Introduction

What are the common attributes of a close corporation?

1. A close corporation is owned by a small number of persons.
2. There is often a high overlap between the shareholders and managers and employees of the business.
3. Shareholders are undiversified in their investments since most of their money is invested into the corporation. Therefore, they have little investment liquidity.
4. Shares are not traded on the public market so the value of an ownership interest in a close corporation is hard to value.
5. Shareholders care about the identities of their fellow shareholders (because of personality interests, high level of risk in being undiversified, and risk in not being liquid) and there is a high level of reliance on fellow shareholders.
6. Deadlocks may arise because of the small number of shareholders and they may have required higher than majority vote to resolve contested issues.

Del. § 342 defines a close corporation by reference to three elements:

1. All of the corporation’s issued shares must be held by not more than 30 persons;
2. All of the issued shares must be subject to one or more authorized restrictions on transfer; and
3. The corporation cannot make any “public offering” of its shares within the meaning of the Securities Act of 1933.

Del. § 344 states that close corporation status can be obtained by an amendment to the certificate of incorporation approved by a two-thirds class vote of the shareholders.

Del. § 345 states that close corporation status ends if one of the three prerequisities is breached.

Del. § 346 states that voluntary termination of close corporation status requires a two-thirds class vote, although the certificate may require a greater vote.

B. Restrictions on Transferability

Del. § 202 established the permissible types of restrictions of transfer of securities.

The most common restriction is the “right of first refusal”, which grants the corporation and/or the remaining shareholders a first option to buy the shares of a shareholder who wishes to sell (or dies, becomes disabled, leaves the corporation’s employ, etc.).

Other types of restrictions are first options, buy/sell agreements, and consent requirements.

Allen v. Biltmore Tissue Corp. (N.Y. 1957)

• The court held that “more than a mere disparity between option price and current value” must be shown to invalidate a transfer restriction.
• The court also held that the law does not condemn a restriction on transfer, a provision merely postponing sale during the option period, but an effective prohibition against transferability itself.
• In this case, the corporation had the right for a limited time period (90 days). After that, the shares could be sold to anyone.

Rafe v. Hindin (N.Y. 1968)

• Two shareholders each owned 50% of the corporation’s stock.
• There was a legend on each certificate, signed by the parties, which made it non-transferable except to the other stockholder; and written permission from the other was required to transfer the stock to a third party.
• The plaintiff wanted to sell his shares to a third party, but the defendant refused to buy them himself or consent to the sale to the third party.
• The court held that this was an invalid restriction on transferability.
• The defendant was given arbitrary power to forbid a transfer of the shares to a third party. He could always say no.
• The legend should have included that consent could not be unreasonably withheld.

Del. § 349 states that even when a restriction is held to be invalid, the corporation still has an option for thirty days after the judgment to buy the shares for an agreed upon price or fair value as determined by the court.

C. Shareholder Agreements

Del. § 218(c) states that “an agreement between two or more shareholders, if in writing and signed by parties thereto, may provide that in exercising any voting rights, the shares held by them shall be voted as provided by the agreement, or as the parties may agree, or as determined in accordance with a procedure agreed upon by them”.

Ringling v. Ringling Bros.-Barnum & Bailey Combined Shows, Inc. (Del. 1947)

• A group of shareholders may, without impropriety, vote their respective shares so as to obtain advantages of concerted action. They may lawfully contract with each other to vote in the future in such a way as they determine.
• The shareholders in this case had a provision for submission to an arbitrator as a deadlock-breaking measure whose decision “shall be binding upon the parties”.
• What was the defect in the agreement? There was no enforcement mechanism. The arbitrator can make a ruling, but if the party doesn’t comply, the other party is left with a breach of contract claim, which doesn’t help at the moment of election. So make sure you put in an enforcement mechanism to the arbitration ruling.

D. Voting Trusts

A voting trust is a device established by the formal transfer of voting shares, usually for a designated period, from their owners to trustees. The trustee has legal title to the shares, as well as the right to vote in the manner agreed on. The shareholders are usually issued voting trust certificates for their shares, which carry the right to dividends and other asset distributions and in turn are exchanged for the shares on termination of the trust.

Del. § 218(a) authorizes the creation of and governing of voting trusts. The shareholder must file the trust with the corporation so there can be no secret voting trusts. Moreover, on the face of each stock certificate it says it is restricted by a voting trust.

Delaware has no time limit, but RMBCA jurisdictions have a 10-year maximum.

Abercrombie v. Davies (Del. 1957)

• The court states that an essential characteristic of a voting trust is the separation of voting rights of stock from the other attributes of ownership.
• An additional element is that the voting rights given are intended to be irrevocable for a definite period.
• To all these elements should be added that the principal object of the grant of voting rights is voting control of the corporation.
• The court says these elements were met in this case. This was a voting trust and the statutory provisions, including filing the trust in the corporation’s principal office, were not complied with.
• Court was upset that they were trying to create a secret voting trust. Because a voting trust can transfer control so dramatically, you need to file and disclose it to the other shareholders.

Lehrman v. Cohen (Del.1966)- In any recapitalization involving the creation of additional voting stock, the voting power of the previously existing stock is diminished, but a voting trust is not necessarily the result.

E. Agreements Respecting Actions of Directors

The business and affairs of a corporation shall be managed by a board of directors and not the shareholders. However, this section deals with attempts by shareholders to have some role in more detailed matters, such as who the corporation’s officers and employees are to be, how much they are to be paid, when and in what proportion profits are to be divided, etc.

McQuade v. Stoneham (NY 1934)

• McQuade, Stoneham, and McGraw agreed to elect each other as directors. However, they further agreed that Stoneham would be president; McGraw, vice president; and McQaude, treasurer, at specified salaries.
• The court held the agreement to be void.
• The business of a corporation shall be managed by its board of directors.
• Stockholders may of course combine to elect directors. The power to unite is, however, limited to the election of directors and is not extended to contracts whereby limitation are placed on the power of the directors to manage the business of the corporation by the selection of agents at defined salaries.

Del. § 709 states that the certificate of incorporation may contain provisions that (1) increase the number of directors that constitute a quorum and (2) increase the number of votes of directors necessary for the transaction of business.

Del. § 715 states that the certificate of incorporation may provide that all officers or that specified officers shall be elected by the shareholders instead of the board.

Clark v. Dodge (NY 1936)

• Same court, but different result than in McQuade.
• Two shareholders (Clark and Dodge) had an agreement that the 75% shareholder (Dodge) would vote for the 25% shareholder (Clark) as director and general manager for as long as he remained “faithful, efficient, and competent”. In addition, Clark would also receive ¼ of net income either in profits or dividends.
• Different than McQuade, in which there were other shareholders not party to the agreement. In this case, there is unanimity among the shareholders.
• The test for whether an agreement is valid is: (1) there can be only slight impingement on the board and (2) there can be no actual or possible harm to minority shareholders, bona fide purchasers of stock, or to creditors).
• In this case, there was only a negligible invasion of the board’s powers and there is no damage suffered or threatened to anybody.
• The broad statements in the McQaude opinion, applicable to the facts there, should be confined to those facts.

Long Park, Inc. v. Trenton-New Brunswick Theatres Co. (NY 1948)

• All three shareholders agreed that one of them, owning half the shares, should have full authority to manage the corporation’s business for 19 years.
• The court held this agreement to be void.
• This agreement is not slight impingement, but completely sterilizes the board. The directors may neither select nor discharge the manager, to whom the supervision and direction of the management and operation of the theatres is delegated with full authority and power.

F. Majority’s Fiduciary Duties to the Minority

Wilkes v. Springside Nursing Home, Inc. (Mass. 1976)

• The court held that shareholders in a close corporation owe each other the duty of “utmost good faith and loyalty”.
• This is important because in close corporations, the majority can oppress, disadvantage or “freeze-out” the minority, since there is no ready market for minority shares in a close corporation.
• What is the test for whether there is a violation of this fiduciary duty?
  • It must be asked whether the controlling group can demonstrate a legitimate business purpose for its action.
  • The minority group can then show that this objective could have been accomplished through an alternative course of action less harmful to the minority’s interest.
  • It is up to the court to weigh both sides and decide.
• In this case, the court held that there was no legitimate purpose for severing Wilkes from payroll or refusing to reelect him. There was no showing of misconduct and it is clear that the attempt was to “freeze out” Wilkes.
• Most important is the fact that the cutting of Wilkes’s salary, assured that Wilkes would receive no return at all from the corporation.

Zidell v. Zidell, Inc. (Or. 1977)

• Minority is challenging the purchase of one shareholder’s shares by another.
• There were three shareholders (37.5%, 37.5%, and 25%). One of the 37.5% bought the 25%.
• Plaintiff wants the stock to be offered to and purchased by the corporation. Then there would be no change in power. The two 37.5% are supposed to be in balance.
• The court refuses to implement this remedy.
• As a general rule, the director violates no duty to the corporation in dealing with the corporation’s stock on his own account (except for insider trading).
• The exceptions would be if there was an agreement to maintain proportionate control or evidence that there was a policy for the corporation to buy back stock whenever it becomes available.

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