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Archive for January, 2013

Keep Your Shareholders Close, But Your Shareholder Employees Closer

Posted on: January 22nd, 2013 by admin No Comments

It is well recognized that the shareholders of a Massachusetts closely held corporation are fiduciaries of each other, and owe each other a duty of the utmost good faith and fair dealing in the operation of the business, similar to that of partners. Brodie v. Jordan, 447 Mass. 866, 869 (2006).

A closely held corporation is defined as one which has a small number of stockholders; there is no ready market for its stock; and there is substantial majority stockholder participation in the management and direction and operations of the corporation.  Donahue v. Rodd Electrotype Co. of New England, 367 Mass. 578, 586 (1975).

Despite the existence of the “partnership” standard, the controlling/majority shareholders in a closely held corporation must have some room to maneuver in establishing the business policy of the corporation and effectively managing the corporation.  Wilkes v. Springside Nursing Home, Inc., 370 Mass. at 851-52.  In Wilkes v. Springside Nursing Home, Inc., the Supreme Judicial Court determined the standard to be applied relating to the termination of an employee minority shareholder.  See id.  The Court adopted a two step process to balance these competing interests: (1) the majority must demonstrate a “legitimate business purpose” for its decision to terminate the minority shareholder; and (2) the minority shareholder employee must prove that the same legitimate purpose could have been achieved through less drastic measures than a discharge.  See id.  Ultimately, the trial court must balance the business purpose against “the practicality of a less harmful alternative.”  Id. at 852.

Nevertheless, if a majority shareholder of a closely held corporation decides to terminate a minority shareholder, it often leads to litigation by the minority shareholder(s).  In many cases, minority shareholders depend on their employment as the primary benefit of their ownership interest.  Therefore, termination of a minority shareholder can lead to fiduciary duty claims, in addition to the usual panoply of employment-related claims.  For that reason, the majority shareholders will need to prove that they had no “less harmful alternative” to termination in the case of an employee-shareholder.  Thus, there is a delicate balance between majority shareholders exercising reasonable discretion to advance legitimate business purposes of the corporation while abstaining from interfering with the rights of minority shareholders who are also employees.

Accordingly, it is imperative for majority shareholders of closely held corporations to maintain open channels of communications regarding the company’s business needs, and where minority (employee) shareholders need to focus their energy, and improve their performance.  It is also imperative that any shareholder agreements are carefully drafted to help avoid any potential pitfalls.  By taking these two steps, closely held companies can minimize the risk of a lawsuit for breach of a shareholder agreement, and maintain a healthy partnership within their business.