Opinion: Shareholders' roles differ in closely held corporations

The success of close corporations is as important to the U.S. economy as that of publicly traded corporations.

Close corporations possess unique characteristics that make goodwill, mutual respect, trust and ethical conduct important to their success.

Intimately connected

Close corporations have few shareholders, and the shareholders are often intimately connected.

Friends and family members commonly own the stock. Unlike the shareholders of public corporations, close corporations’ shareholders actively share in the company’s management and often serve as directors, officers and employees.

Power, however, is not always shared equally. A single shareholder owning more than 50 percent of the corporate shares can control the business. Shareholders with each fewer than 50 percent of the shares also can gain control if they align together.

The close relationships among shareholders make their companies vulnerable to personal disputes. Families sometimes break apart and friendships end, raising fairness issues between controlling and minority shareholders.

Controlling shareholders can freeze out minority shareholders, end minority shareholders’ employment or withhold bonuses and dividends, or restrict access to important company documents.

“Freeze-outs” oppress minority shareholders who are almost defenseless against such measures. Unlike the stock of public corporations, there exists no ready market for close corporation shares. Minority shareholders also cannot unilaterally dissolve the corporation to get back their investments. Such limits force minority shareholders to turn to the courts for relief.

Reasonable expectations in court

In resolving disputes between controlling and minority shareholders, courts closely examine the controlling shareholders’ conduct.

Many courts hold controlling shareholders to the high fiduciary standard that exists between business partners. Such courts view close corporations as merely incorporated partnerships. Controlling shareholders owe minority shareholders the fiduciary duties of loyalty, due care and avoiding self-dealing.

This differs from public corporations where no fiduciary duty exists between shareholders.

Instead of the partnership fiduciary standard, a growing number of courts use the “reasonable expectations” analysis to resolve disputes between controlling and minority shareholders. They recognize that close shareholders enter the business with certain expectations, including power of ownership, the right to share in business decisions and lifetime employment.

In determining whether controlling shareholders oppressed a minority shareholder, a few courts use a pure “reasonable expectations” analysis. They consider only the minority shareholder’s expectations. Frustration of those expectations by controlling shareholders entitles the minority shareholder to judicial relief.

For example, if a minority shareholder entered the business expecting lifetime employment, he gets to keep his job regardless of poor job performance. If the controlling shareholders fire him, a court can reinstate him and order the corporation to pay him lost wages and damages.

Fortunately for controlling shareholders, many courts use a modified “reasonable expectations” analysis that considers the expectations of all the shareholders. While a minority shareholder may expect lifetime employment, controlling shareholders can reasonably expect a good job performance. If, however, the minority shareholder is fired, it is reasonable for the minority shareholder to expect to receive other compensation for his investment, such as dividends.

The possibility of conflict within close corporations underscores the importance of shareholders understanding their duties to one another. It is also wise to put everyone’s expectations in writing before incorporation.

John D. Copeland, J.D., LL.M., Ed.D., is an executive in residence at The Soderquist Center for Leadership and Ethics and professor of business at John Brown University in Arkansas.