Protection of Shareholders in Family Businesses and Close Corporations

Family businesses often organize themselves as “close” corporations.  The benefits of doing so include: (1) a Maryland close corporation cannot issue or sell stock without the affirmative approval of all of its shareholders (who typically are members of the same family); (2) shareholders cannot transfer their stock unless all shareholders give prior approval; and (3) any merger or transfer of assets also requires unanimous shareholder approval.  A Maryland corporation may elect to be a “close corporation” by including a statement of this election in its corporate charter, or by amending its corporate charter through a unanimous vote of all shareholders.

Close corporations typically do not have boards of directors, and instead are managed directly by the family members/shareholders themselves. When there is no board of directors, the shareholders are responsible for taking actions (by shareholder vote or resolution) that more typically would be handled by directors, in non-close corporations.  Shareholders in a close corporation may (and often do) enter into written shareholder agreements to regulate the affairs of the corporation, which may place restrictions on the transfer of stock, the payment of dividends, the division of profits, or the allocation of shareholder voting power. Courts enforce these unanimous shareholders agreement by injunctive relief, or in some circumstances by ordering dissolution of the corporation.

Each shareholder in a Maryland close corporation has a statutory right to receive an annual statement of corporate affairs, and a right to inspect key corporate documents such as bylaws, meeting minutes, the stock ledger, and books of account. Once a year, every shareholder in a Maryland close corporation has a right to receive, within twenty days of request, a statement of corporate affairs that sets forth the corporation’s assets and liabilities in reasonable detail, verified under oath by a company officer.

By their very nature, if majority interest holders are willing to use oppressive tactics, a minority shareholder can effectively be frozen out of decision making, or even from the economic benefits of ownership. Since there is a limited market for shares in closely held corporations, especially for the purchase of a non-controlling interest in a closely held corporation that is experiencing dissention among the shareholders, a minority shareholder’s interest can effectively be held hostage by the controlling shareholder(s).

The only remedy for oppressive shareholder conduct expressly stated in Maryland statutory law is involuntary dissolution by judicial action, but the Maryland appellate courts in recent years have held that, before ordering dissolution of a corporation, trial courts should first consider whether equitable remedies are available to rectify the oppressive conduct. The appellate courts have suggested equitable remedies such as ordering corporate dissolution at a specified future date, to become effective only if the shareholders fail to resolve their differences by that date. They also have suggested appointment of a receiver to operate the corporation for the benefit of the shareholders until differences are resolved, or retention by the court of jurisdiction over the case for the protection of minority shareholders. Other judicial options include injunctive relief to prohibit oppressive conduct or to require the declaration of dividends; or ordering the corporation or the majority shareholders to purchase the stock of minority shareholders at a fair and reasonable price; or an award of damages to minority shareholders as compensation for injuries suffered as a result of oppressive conduct by the majority shareholders. These court decisions have expanded the “toolbox” of remedies available to Maryland trial courts when confronted with majority interest holders in close corporations oppressing their fellow shareholders.

Under Maryland law, conduct is considered oppressive if it defeats objectively reasonable expectations that were central to the minority shareholder’s decision to join the corporation.  Courts are not required to match a remedy to the subjective expectations of a particular minority shareholder, however. For example, a minority shareholder that is also an an-will employee of a closely held corporation typically will not be successful in asking a court to order the company to reinstate terminated employment, even if the shareholder/employee had a subjective expectation that the company would continue to employ him indefinitely into the future.

Although a minority shareholder’s at-will employment status does not create a legal right to ongoing employment, he or she can still ask the court to craft appropriate equitable relief to overcome oppressive conduct by the majority, and the court must consider not only the defeated expectations of the terminated shareholder/employee, but also the interests of other shareholders, company management, employees and customers. For example, if a closely held corporation terminates a minority shareholder’s employment, and stops distributing profits to the minority shareholder through dividends at the same time that majority shareholders receive high salaries and/or valuable personal use of company assets, the minority shareholder can seek equitable relief from the court.

The same situation may also give rise to a cause of action under Maryland law for breach of fiduciary duty by the majority shareholders. Although there is a statutory presumption that a majority shareholder acts in good faith, in a manner that the director reasonably believes to be in the best interests of the corporation, and with the level of care that an ordinarily prudent person would exercise in the position of a corporate director would use under similar circumstances – this presumption may be overcome by contrary evidence.  Overcoming the presumption requires more than simply showing that the company refused to authorize a dividend to shareholders during periods when the company was profitable. It requires circumstances more akin to a majority shareholders looting the company, either by directly taking corporate funds for personal use or by paying themselves excessive compensation. Typically, an action for breach of fiduciary duty must be brought on behalf of the corporation in a corporate derivative action, and not directly by one shareholder against another – though there are circumstances where a direct action will be permitted if majority shareholders or directors have breached a duty owed directly to the minority shareholder, causing the minority shareholder to suffer an injury that is separate and distinct from any injury suffered by the corporation.  Claims of excessive compensation to majority shareholder/employees or other misuses of corporate funds belong to the corporation, and not to individual shareholders, and must be brought through a derivative action.

Maryland’s “close” corporation structure can have real benefits for family businesses, and may be the best way to structure this type of company. While the inherent risks of this structure must always be considered, the Maryland appellate courts in recent years provide a means to protect minority shareholders’ rights and expectations when majority owners try to oppress minority shareholders.