Sery v. Federal Business Centers, Inc., Slip Copy, 2008 WL 4934034 (D.N.J. November 14, 2008).
The United States District Court for the District of New Jersey has released an opinion disposing of summary judgment motions on a claim that a minority shareholder's sale of shares is a breach of fiduciary duties where that sale destroys the corporation's subchapter S tax status. The case arose out of a dispute among the shareholders of a closely-held New Jersey corporation. The minority shareholders originally sued for shareholder oppression and breach of fiduciary duties. The court relates that it had granted summary judgment on those claims and that the minority shareholders intended to appeal; however, that opinion is not currently available. During the course of the litigation, the minority shareholders disclosed that they had pledged some of their shares to a lender to finance the litigation and intended to transfer those shares, which transfer would destroy the corporation's subchapter S status. The majority shareholders counterclaimed for breach of fiduciary duties based on that intended transaction. Ultimately, the court dismissed the counterclaims as not ripe because, in the period of more than a year that the counterclaim had been on file, the transaction still had not taken place.
The situation presents a very interesting application of the concept of fiduciary duties in a closely-held corporation. Typically courts hold that officers, directors, and controlling shareholders owe duties to minority shareholders because these individuals are in a position to control the corporation so as to disadvantage the minority. However, the ability of any minority shareholder to destroy a corporation's Subchapter S tax status by transferring his shares to a non-qualified person or entity is one of the very rare instances in which a minority shareholder, acting solely in that capacity, has the ability to detrimentally affect the corporation and the other shareholders. If a minority shareholder transfers his shares to a foreign national, or to a corporation, or any other person or entity not qualified to own a corporation having elected to be taxed under subchapter S, then the corporation will become a subchapter C corporation; it will pay taxes on its income rather than being taxed on a pass-through basis like a partnership; losses will no longer be treated as tax deductions by the shareholders, and distributions to shareholders will be subject to double taxation. Therefore, a minority shareholder acting to further self-interest by selling his shares can cause significant financial loss to the other shareholders. Does the minority shareholder have an obligation to put the interests of the other shareholders first? Usually fiduciary duties are applied in the closely-held corporation context to protect the ownership interests of minority shareholders. What could be more central to the ownership interests of any shareholder than the ability to sell his property?
In A.W. Chesterton Co., Inc. v. Chesterton, 128 F.3d 1 (1st Cir. 1997), the First Circuit, applying Massachusetts law, had held that a minority shareholder does violate fiduciary duties in entering into a transaction that causes the corporation to lose its subchapter S status. In that case, a minority shareholder became disenchanted with the management of a closely-held corporation which was consistently losing money. The minority shareholder sought to buy out the other shareholders in order to restructure the corporation and make it profitable, but the other shareholders declined. The minority shareholder then sought to sell his shares to the other shareholders or to an outside party but was unsuccessful. Finally, the minority shareholder came up with a scheme to force the corporation or other shareholders to purchase his shares. He created two corporations, wholly owned by himself, and proposed to transfer his shares to those corporations. The effect of the transaction would be to destroy the corporation's subchapter S status. Pursuant to a shareholder's agreement granting the corporation a right of first refusal, the minority shareholder offered his shares to the corporation, but the corporation was financially unable to exercise the option. The minority shareholder then proceeded to consummate the transaction. See id. at 3-5. The other shareholders sued to enjoin the transaction. The Massachusetts federal district court granted the injunction, and the First Circuit affirmed.
The First Circuit held that, under the law in Massachusetts, shareholders in a closely-held corporation owe enhanced fiduciary duties of utmost good faith and loyalty to each other to the same extent as partners do in a partnership. Id. at 5, citing Donahue v. Rodd Electrotype Co. of New England, Inc., 367 Mass. 578, 328 N.E.2d 505 (Mass. 1975). The court noted that the Massachusetts courts had held that these duties apply to minority shareholders just as they do to controlling shareholders. 128 F.3d at 6, citing Zimmerman v. Bogoff, 402 Mass. 650, 524 N.E.2d 849 (Mass. 1988), and Smith v. Atlantic Properties, Inc., 12 Mass. App. Ct. 201, 422 N.E.2d 798 (Mass. App. 1981). The court held that the reasonable expectations of the shareholders arising from the Subchapter S election had to be taken into account in determining the scope of the duties owed, notwithstanding the fact that the plaintiffs had originally argued that the a contract restricting the transfer had been created by the election but subsequently had abandoned that claim. See 128 F.3d at 6-7, citing Wilkes v. Springside Nursing Home, Inc., 370 Mass. 842, 353 N.E.2d 657, 663 (Mass. 1976). The minority shareholder argued that the conduct of a non-managing shareholder should be judged by a lower standard and the transaction should be permitted if a "legitimate business purpose" could be demonstrated. The court held that Massachusetts law did not recognize this lower standard, and that a "legitimate" albeit self-interested purpose would not excuse a breach of the duties of utmost good faith and loyalty by harming the interests of the other shareholders. 128 F.3d at 7, citing Smith, 422 N.E.2d at 800 (holding that minority shareholder's misuse of veto on dividend to the disadvantage of the other shareholders was not excused by his own asserted "legitimate" purpose of tax avoidance). This is perhaps a bit of an overstatement, as the same court later clarified: "The Massachusetts Supreme Judicial Court (SJC) has articulated a two-part test for determining if this fiduciary duty has been violated. First, the defendant must show a legitimate business purpose for its action that allegedly is a breach. If the defendant makes such a showing, the burden shifts to the plaintiff to show that 'the proffered legitimate objective could have been achieved through a less harmful, reasonably practicable, alternative mode of action.' Zimmerman, 524 N.E.2d at 853. Then the court 'must weigh the legitimate business purpose, if any, against the practicability of a less harmful alternative.' Wilkes v. Springside Nursing Home, 370 Mass. 842, 353 N.E.2d 657, 663 (1976)." Medical Air Tech. Corp. v. Marwan Inv., Inc., 303 F.3d 11, 20 (1st Cir. 2002). However, the court also clearly held that there was no evidence in the record of any legitimate purpose on the part of the minority shareholder. 128 F.3d at 7-8.
Other courts have disagreed. In Hunt v. Data Management Resources, Inc., 26 Kan.App.2d 405, 985 P.2d 730, 732-33 (Kan. App. 1999), the court held that under Kansas law (which follows Delaware) a minority shareholder was under no special duty that would prevent a transfer that would destroy subchapter S tax status. "The law does not impose a strict fiduciary duty on a shareholder to act in the best interests of the corporation; a shareholder is free to act in his or her own self-interest." Id. at 732. In Merner v. Merner, 129 Fed.Appx. 342, 2005 WL 658957 (9th Cir. 2005), the Ninth Circuit, in an unpublished opinion applying California law, held that a minority shareholder's sale of his shares did not violate any fiduciary duties even though the sale destroyed the corporation's subchapter S status. The court reasoned that California law did not follow the Massachusetts rule and does not recognize any fiduciary duties on shareholders of closely-held corporations that are different from those duties on shareholders in other corporations. Id., citing Stephenson v. Drever, 16 Cal.4th 1167, 69 Cal.Rptr.2d 764, 947 P.2d 1301, 1302, 1307-08 (Cal. 1997).
I have argued that the logic and consequences of the Massachusetts analysis are not satisfying and would not be followed under Texas law. [read article] This is a good example. A shareholder owns his shares and holds his ownership rights and interests arm's length to all other owners and those rights and interests are not subverted by any duty to the corporation or other shareholders. I believe the only party that owes duties is the corporation to the shareholder—in so far as the rights and interests inherent in stock ownership are concerned. Officers, directors and controlling shareholders may be liable to minority shareholders only to the extent that they misuse their power over the corporation to cause the corporation to violate duties owed individual shareholders. Therefore, absent a contract restricting the transferability of shares, a minority shareholder should be able to transfer ownership of his shares without regard to his motive or the effect of the transfer on the other shareholders or corporation. In Medical Air Tech. Corp. v. Marwan Inv., Inc., 303 F.3d 11, 20 (1st Cir. 2002), the First Circuit faced a situation in which the majority shareholders sued a minority shareholder for voting against a merger. Even though the case was decided under the Massachusetts rule, the court struggled with the notion that other shareholders could second-guess or limit the ability of a minority shareholder to vote. The court ultimately held that, even though the other shareholders were disadvantaged by the vote, the minority shareholder had not violated any fiduciary duties in casting his vote against the merger. Nevertheless, the facts presented in A.W. Chesterton Co., Inc. v. Chesterton, 128 F.3d 1 (1st Cir. 1997), are extremely troubling. Why should a minority shareholder, having agreed to the subchapter S election, be permitted to blackmail the remaining shareholders for his financial advantage? I think the best solution is to acknowledge that there are situations in which a minority shareholder may be placed in a position where he is able to control the corporation's relationship to its other shareholders, and the minority shareholder use of that power will be subject to fiduciary duties if it infringes on the ownership rights and interests of the other shareholders. Therefore, ordinarily, absent an agreement to the contrary, every shareholder has the right to transfer or sell his shares, but as in A.W. Chesterton Co., Inc. v. Chesterton, 128 F.3d 1 (1st Cir. 1997), if the minority shareholder is in a position of control over the corporation by his ability to nullify the corporation's subchapter S election, which would directly affect the financial interests of the other shareholders, then fiduciary duties would govern the transaction if the facts established that maintenance of the subchapter S status was an objectively reasonable expectation of the shareholders. In that case, the minority shareholder would breach his fiduciary duties if the transaction were undertaken in bad faith or for the purpose of depriving other shareholders in order to benefit the minority shareholder. Likewise, if a minority shareholder has been given a contractual right to veto dividends, then the use of that control in bad faith or for the purpose of harming the other shareholders will be a breach of fiduciary duties. See Smith v. Atlantic Properties, Inc., 12 Mass. App. Ct. 201, 422 N.E.2d 798 (Mass. App. 1981). However, the right of a shareholder to dissent a fundamental change in the corporation is solely a right of the shareholder and not a matter of controlling the relationship of the corporation to the other shareholders. Therefore, a minority shareholder should always have the right to withhold consent to a merger, dissolution, or sale of substantially all the assets of a corporation without having to justify his motives, even if the other shareholders contend that they were harmed by the inability to complete the transaction. See Medical Air Tech. Corp. v. Marwan Inv., Inc., 303 F.3d 11, 20 (1st Cir. 2002),
The New Jersey federal court in Sery v. Federal Business Centers, Inc., Slip Copy, 2008 WL 4934034 (D.N.J. November 14, 2008), acknowledged that a New Jersey appellate court had held that New Jersey would follow the Massachusetts rule of applying enhanced fiduciary duties to shareholders of closely-held corporations based on partnership law. See Balsamides v. Perle, 313 N.J. Super. 7, 712 A.2d 673 (N.J. App. 1998), aff'd in part, reversed in part on other grounds, 160 N.J. 352, 734 A.2d 721 (N.J. 1999). However, the federal court expressed some reluctance in following the Massachusetts authorities because the New Jersey Supreme Court had not yet spoken on the issue. The court reasoned: "Here, Defendants would have the Court hold that the duties of good faith and loyalty imposed upon all shareholders of a close corporation would be breached by any sale or transfer of stock that would have the effect of destroying the S corporation's Subchapter S status, regardless of whether the sale was executed in good faith for a reasonable business purpose. This Court does not predict that the New Jersey Supreme Court would find that New Jersey common law is so broad. Conversely, the Court is unwilling to accept Plaintiffs' argument that any fiduciary duties that may normally apply are completely abrogated by provisions of the NJBCA. The Court sees no reason why the common law duties of good faith and loyalty cannot complement the statutory provisions governing restrictions on the transferability of S corporation stock. Indeed, the Court is satisfied that the New Jersey Supreme Court would hold that the fiduciary duties of good faith and loyalty restrict the sale or transfer of S corporation stock to the extent that these duties bar a shareholder from entering into a bad faith or sham transaction which destroys the corporation's Subchapter S status for the primary purpose of injuring fellow shareholders. However, where the shareholder sells or transfers their S corporation shares in good faith in an economically reasonable manner, even if that entails a sale to an unqualified entity, this Court is satisfied that the New Jersey Supreme Court would uphold the sale." The court noted that there were allegations of bad faith on the part of the minority shareholders, that these shareholders had threatened to "go nuclear," by causing the corporation to lose its favored tax status and diminishing the value of the corporation to all the shareholders. However, the court held that until the minority shareholders actually did enter into a real transaction, any holding would merely be advisory.
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