Duties Among Members of Closely Held Businesses - Current Issues in Closely Held Businesses Series: Part 1

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During the COVID-19 pandemic and shelter-in-place orders, many topics arose related to disputes among members of closely held businesses. When the interests of the owners diverge and litigation results, a variety of issues are confronted. Quite often the business is owned by family members. With the overlap of family relationship issues and business decisions, the disputes that arise will involve very emotional components that impact both the behavior of the parties as well as potential outcomes.

In this blog and in several to follow, the typical issues will be discussed, including the existence of fiduciary duties among the owners, relationship of the termination of employment with shareholder-employee claims, the existence of a claim for and the varying definitions of shareholder "oppression," impact of the behavior surrounding decisions, the frequent use of the remedy of a buyout and the standard of value to use in a buyout.

The discussions are not meant to be exhaustive treatments of the topics. Rather, the intent is to highlight issues to consider, some of the considerations that affect the outcomes and an occasional commentary.

Key Issues that Arise from Closely Held Businesses

Aside from Delaware and a couple of jurisdictions that follow the Delaware approach, most states have recognized that in closely held businesses, those in control have fiduciary duties owed to the minority. Generally, the view is that such direct duties do not exist among shareholders in the Delaware approach.

The foundation for the direct duties approach arose from the fact that such businesses were controlled by majority ownership, and the minority may have no effective voice in the affairs of the business. In addition, the notion of "free alienation of property" – that property interests should not be perpetually restricted from transfers – suggests that in the face of an absence of a market for the minority, the minority's interest should be protected from being abused. Unlike a public company or one in which a ready market for the interests exists, an interest in a closely held company does not have the alternative to express displeasure or be protected by choosing to sell. It is locked in capital.

Early in the development of imposing fiduciary duties, an analogy to the duties among partners was used. In effect, the situation was referred to as "incorporated partnerships," characterized by the lack of market and close nature of the relationships. In partnerships, the law has long recognized the direct duties of loyalty, care and good faith that exist among partners.

More recently, the use of the partnership analog has been easing, and the nature of the relationships has been directly seen as including a duty of the majority to use the "utmost good faith" in dealing with the other shareholder interests.

Examples of a breach by the majority have been found in the following situations:

  • sale of control of the business to a known looter (likely both direct duty breach as well as a derivative action)
  • paying excessive compensation to those in control or related parties
  • excluding a shareholder from corporate information or denying access to inspect records
  • eliminating a minority interest from pre-existing participation in management and decision making
  • physically locking out a shareholder-employee
  • failure to follow corporate formalities in notice and holding of meetings
  • paying personal expenses of majority or related parties with corporate funds
  • eliminating dividends or benefits to force a buyout at an unfair price
  • appropriation of corporate assets to benefit only majority, favorable loans and leases for majority that are detrimental to business
  • diversion of corporate opportunities
  • denying appraisal rights
  • diluting the minority at unfair or manipulated prices, particularly in an attempt to force a buyout
  • issuing voting shares to force an elimination of the minority at low prices
  • redeeming interests in a manner to provide unfair benefit to those in control

Most often, the matter will involve multiple examples, such that the combination of what might otherwise not rise to the level of a breach, may be found.

It is important in each instance to determine if the conduct produces a "direct" versus a "derivative" claim. The first is related to the directness of the action and harm to the minority, and the other is a harm to the enterprise that affects all interests, although frequently claims may be both.

The distinction is important in terms of who has standing to complain, the procedural requirements and the types of remedies.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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