Close Corporations
I. Context of Close Corporations
A. Close corporation = business organization typified by
(1) a small number of stockholders,
(2) the absence of a market for the corporation’s stock,
(3) & substantial shareholder participation in the management of the corporation
B. There exists a more intimate and intense relationship between capital and labor
(1) Shareholders “usually expect employment and a meaningful role in management, as well as a return on the money paid for their shares
(2) Investors are often linked by family or other personal relationships that result in a familiarity among the participants.
C. Corporate law norms can lead to serious problems for the close corporation minority
(1) Corporate power is centralized in the board of directors
(2) & the board is ordinarily controlled by majority voting power
(3) Majority has ability to take actions harmful to the minority’s interests—Freeze-Outs
D. Freeze-Out = An indefinite future with no return on the capital the shareholder contributed to the enterprise
(1) Once a minority shareholder faces a freeze-out the majority often proposes to purchase the shares of the minority shareholder at an unfairly low price.
(2) Common Freeze-Outs: (often used in combination)
a) the refusal to declare dividends,
b) the termination of a minority shareholder’s employment,
c) the removal of a minority shareholder from a position of management,
d) and the siphoning off of corporate earnings through high compensation to the majority shareholder.
E. In a Public or Close Corp?
(1) Public: a minority shareholder can escape these abuses of power simply by selling his shares on the market.
(2) Close: there is no ready market
(3) Close: The context of the investment should be viewed as much broader than the components of a public corporation investment.
II. Shareholder Agreements
A. May Include: [§7.32(a)]
(1) Elimination of the board of directors or restricts the discretion or powers of the board of directors;
(2) Rules governing authorization or making of distributions whether or not in proportion to ownership of shares, subject to the limitations in section 6.40;
(3) Establishing who shall be directors or officers of the corporation
(4) Terms of office for directors & officers or the manner of their selection or removal;
(5) In general or in regard to specific matters, the exercise or division of voting power by or between the shareholders and directors or by or among any of them, including the use of weighted voting rights or director proxies;
(6) Terms and conditions of any agreement for the transfer or use of property or the provision of services between the corporation and any shareholder, director, officer or employee of the corporation or among any of them;
(7) Transfers to one or more shareholders or other persons all or part of the authority to exercise the corporate powers or to manage the business and affairs of the corporation, including the resolution of any issue about which there exists a deadlock among directors or shareholders;
(8) Requiring dissolution of the corporation at the request of one or more of the shareholders or upon the occurrence of a specified event or contingency;
(9) Other exercises of the corporate powers or the management of the business and affairs of the corporation or the relationship among the shareholders, the directors and the corporation, or among any of them, and is not contrary to public policy.
B. Requirements
(1) §7.32(g): Prior issuance of any shares after incorporation, incorporators or subscribers may do whatever “shareholders” can do under §7.32(b). If all of the incorporators or subscribers approve a shareholder agreement, it is valid.
(2) §7.32(b)(1): Must be unanimous
(3) In Writing
a) §7.32(b)(1)(A): in the articles of incorporation or bylaws
b) §7.32(b)(1)(B): Signed Separate Agreement
(4) Unless the Agreement Provides Otherwise:
a) §7.32(b)(2): subject to amendment only by all persons who are shareholders at the time of the amendment, unless the agreement provides otherwise
b) §7.32(b)(3): valid for 10 years
(5) §7.32(c): Notice to All Subsequent Shareholders
a) Noted conspicuously on the front or back of each certificate for outstanding shares
b) Does not require that the agreement itself appear on the certificate, only that the existence of such an agreement be noted
c) A shareholder who, at the time of purchase, did not have knowledge of the existence of the agreement shall be entitled to rescission of the purchase
d) Failure to receive notice will not affect the validity of the shareholder’s agreement or any action taken pursuant to it
(6) §7.32(d): Becomes invalid once the corp goes public
a) Shareholder approval not required to delete the agreement or any reference to it from the charter or bylaws in that circumstance
(7) §7.32(f): Shareholders will not face personal liability even if the effect of the agreement is to create a partnership
C. Agreemen
or simultaneously) to acquire the restricted shares
i. Most Common, usually enforced by courts
c) A “Prior Approval” or “Consent” Requirement: § 6.27(d)(3) require the corporation, the holders of any class of its shares, or another person to approve the transfer of the restricted shares, if the requirement is not manifestly unreasonable;
i. Normally enforceable, so long as approval may not be unreasonably withheld
d) § 6.27(d)(4) prohibits the transfer of the restricted shares to designated persons or classes of persons, if the prohibition is not manifestly unreasonable.
i. Viewed skeptically by courts, usually struck down as unreasonable
B. A restriction on the transfer or registration of transfer of shares is authorized
(1) to maintain the corporation’s status when it is dependent on the number or identity of its shareholders §6.27(c)(1)
(2) to preserve exemptions under federal or state securities law §6.27(c)(2)
(3) for any other reasonable purpose §6.27(c)(3)
C. Kosachuk v. Harper’s Unforeseen Consequences: Director alleged that a restriction on the transfer of his shares was invalid because it was tainted by self-dealing on the part of the controlling stockholder obligated to purchase his shares. In the alternative, he alleged the controlling stockholder’s false statements and misrepresentations fraudulently induced him to sign the agreement. (9-1, p.349-50)
(1) The validity of a buy-sell agreement cannot be challenged on the basis of fiduciary duty owed by a party to that agreement b/c the parties are acting as stockholders under a stockholder’s agreement
(2) ∏’s claim that he simply trusted the other party cannot constitute reasonable reliance for someone in the position of director.
(3) Very difficult to establish damages for the purposes of invalidating a shareholder’s agreement due to fraud b/c the restricted shares represented a minority position in a close corporation, were unregistered and ineligible for trading on any market.
IV. Voting Control
A. Voting Trust
