Often, a closely-held company comprises a large portion of a person’s wealth. In some instances, the company initially generated much of the person’s wealth. And in others, the company is formed as a vehicle to pass wealth from one generation to the next. Whether the company is a partnership, limited liability company, or corporation, the owners of the company owe fiduciary duties of loyalty and care to one another. It is more common to learn of a majority owner’s abuse of minority owners. However, minority owners also owe duties to majority owners.
In A.W. Chesterton Company, Inc. v. Chesterton, Arthur W. Chesterton (the namesake grandson of the company’s founder) owned a 27.06% shareholder’s interest in a closely-held corporation. 128 F.3d 1 (1st Cir. 1997). The remaining shares were owned by other descendants of the founder, and family members operated the company. Sometime prior to the events causing the lawsuit, the company elected to be taxed as an “S-corp” rather than a “C-Corp,” resulting in significant federal income tax benefits.
Arthur became discontented with how the company was performing and sought to liquidate his shares. Arthur, however, could not find a buyer for his minority interest. Thinking that he would have better luck finding a buyer for an entire company, Arthur planned to transfer his shares in A.W. Chesterton Company to two corporations wholly-owned by him. Following the protocol prescribed in A.W. Chesterton Company’s articles of organization, Arthur provided the company with notice of his proposed transfer so that the company could exercise an option to buy the shares itself. The company declined to purchase Arthur’s shares. So he proceeded with the transfer to his wholly-owned corporations.
Despite his complying with notice and right of first refusal requirements in A.W. Chesterton Company’s articles of organization, the court found that Arthur breached his fiduciary duty to the company and to the other shareholders. Shareholders in a closely-held corporation in a majority of the states owe an elevated fiduciary duty to one another. Beyond the ordinary standard of “good faith and fair dealing,” shareholders in a closely-held corporation owe to each other a duty of “utmost good faith and loyalty.” This standard is sometimes referred to as the “strict good faith standard.” This standard is a common-law standard and is not grounded in contract. Therefore, even though Arthur satisfied his contractual requirements under the articles of organization, his fiduciary duties to the company and its other shareholders existed separate from the contract.
Under federal income tax law, Arthur’s transfer would have automatically terminated A.W. Chesterton Company’s advantageous tax treatment as an S-Corp. His transfer would result in millions of dollars in additional income tax to the corporation and the shareholders. Primarily for that reason, the court found that Arthur’s conduct did not meet the strict good faith standard and he was enjoined from consummating the transfer. Additionally, the court noted, if Arthur was unable to find a buyer for his minority interest in A.W. Chesterton Company, he was unlikely to find a buyer for a wholly-owned corporation that owned that minority interest.
Arthur found himself in an unenviable position: unhappy with A.W. Chesterton Company’s management and performance, but unable to divest himself of his holdings and reinvest the proceeds elsewhere. Perhaps he could have come up with a better solution, but Arthur most certainly felt constrained from dealing with his significant holdings in the company as he thought best.
Unfortunately, Arthur’s position is common in closely-held family companies. Advanced recognition that family members may not want to remain business partners indefinitely provides opportunities for amicable separation. Creating avenues for family members to find productive solutions to business disagreements reduces the likelihood that any owner will breach his fiduciary duties to the others. And, more importantly, failure to plan for an amicable business separation invites turmoil within the company as well as the undoing of family relationships—precisely what the founders of most family companies seek to avoid.