I'm getting ready to go teach fiduciary duties of close corporation shareholders. In the new edition of KRB, we've included the Massachusetts Supreme Judicial Court's decision in Brodie v. Jordan. In doing so I'm puzzling over how the doctrine it announces interacts with the Wilkes standard.
In Wilkes, four investors--Wilkes, Riche, Quinn, and Pipkin (who was replaced by Connor)—formed a corporation to own and operate a nursing home. They each worked for the corporation, drew a salary, and owned equal shares in it. The firm did not pay dividends. A dispute arose and three of the inves¬tors fired the fourth, Wilkes. The three continued to collect their salaries (for which they did in fact perform some services), while Wilkes did not. They offered to buy Wilkes’s stock at a low price. Wilkes sued the corporation and the other three investors.
Held: Judgment for Wilkes; the other three investors breached their fiduciary duty to him. A close corporation is much like a partnership. Hence, the Massachusetts courts impose on shareholders in close corporations a fiduciary duty that approximates the duty that partners owe to each other (Donahue v. Rodd Electrotype). Yet because investors need some latitude in managing the firm, this Donahue rule is too strict. Accordingly, the following test applies:
- Shareholders in close corporations owe each other a duty of strict good faith.
- If challenged by a minority shareholder, a controlling group in a firm must show a legitimate business objective for its action.
- A plaintiff minority shareholder can nonetheless prevail if he or she can show that the controlling group could have accomplished its business objective in a manner that harmed his or her interests less.
In Brodie, Mary Brodie inherited one-third of the shares of Malden corp. from her husband, Walter. Two other shareholders, Jordan and Barbuto, each owned one-third of the shares. Walter had been a founder of the firm and had served from 1979 to 1992 as its president, but in 1992 was voted out as president; in the two years before his death in 1997 he was not receiving compensation of any sort from the corporation. Jordan received a salary. Barbuto received director fees until 1998 and owned “the building that houses Malden’s corporate offices and receive[d] rent from the corporation.” The corporation never paid dividends. Mary Brodie sought unsuccessfully to join the board of directors. Her request for “financial and operational information” was refused. “The defendants … failed to hold an annual shareholdler’s meeting for the … five years” preceding the filing, in 1998, of Ms. Brodie’s suit.
Held: The lower court finding of liability was not contested. Only the remedy was formally at issue. The SJC holds that a forced buyout of plaintiff's shares was not permissible, which seems correct.
The interesting wrinkle is presented by this passage in the opinion:
“[S]tockholders in [a] close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another” (footnotes omitted), [Donahue v. Rodd Electrotype Co. of New England, Inc., 328 N.E.2d 505 (1975)]...,, that is, a duty of “utmost good faith and loyalty,” id., quoting Cardullo v. Landau, 329 Mass. 5, 8, 105 N.E.2d 843 (1952).
Majority shareholders in a close corporation violate this duty when they act to “freeze out” the minority. We have defined freeze-outs by way of example:
The squeezers [those who employ the freeze-out techniques] may refuse to declare dividends; they may drain off the corporation’s earnings in the form of exorbitant salaries and bonuses to the majority shareholder-officers and perhaps to their relatives, or in the form of high rent by the corporation for property leased from majority shareholders ...; they may deprive minority shareholders of corporate offices and of employment by the company; they may cause the corporation to sell its assets at an inadequate price to the majority shareholders....Donahue v. Rodd Electrotype Co. of New England, Inc., supra at 588-589, 328 N.E.2d 505, quoting F.H. O’Neal & J. Derwin, Expulsion or Oppression of Business Associates 42 (1961). What these examples have in common is that, in each, the majority frustrates the minority’s reasonable expectations of benefit from their ownership of shares.
We have previously analyzed freeze-outs in terms of shareholders’ “reasonable expectations” both explicitly and implicitly. ... sA number of other jurisdictions, either by judicial decision or by statute, also look to shareholders’ “reasonable expectations” in determining whether to grant relief to an aggrieved minority shareholder in a close corporation.
In the present case, the Superior Court judge properly analyzed the defendants’ liability in terms of the plaintiff’s reasonable expectations of benefit. The judge found that the defendants had interfered with the plaintiff’s reasonable expectations by excluding her from corporate decision-making, denying her access to company information, and hindering her ability to sell her shares in the open market. In addition, the judge’s findings reflect a state of affairs in which the defendants were the only ones receiving any financial benefit from the corporation. The Appeals Court determined that the findings were warranted, and the defendants have not sought further appellate review with respect to liability. Thus, the only question before us is whether, on this record, the plaintiff was entitled to the remedy of a forced buyout of her shares by the majority. We conclude that she was not so entitled.
Curiously, there is no mention of the Wilkes three prong test, although later Massachusetts cases continue to apply that test, so it clearly survives Brodie.
This leaves me with two questions:
- Why are Marie Brodie's expectations relevant at all? She was not the original investor whose expectations might have been known to the defendants. Shouldn’t it be Walter’s expectations as to how his widow would be treated after his death that are the relevant ones? And how in the world do you divine that state of mind? Is it reasonable to suppose that he expected his widow to serve on the board, for example, if she had no relevant business experience?
- Does conduct that defeats an investors reasonable expectations constitute an illegal freezeout? Or can the majority frustrate reasonable expectations if they have a legitimate business purpose for doing so? My impression from a quick scan of the Massachusetts cases is that the answer to the latter question is "yes." In other words, you first ask whether the majority shareholders' conduct frustrated the minority shareholder's reasonable expectations on the sorts of issues identified by the court as constituting freezeouts. You than ask whether the majority had a legitimate business purpose for doing so. And so on with the rest of the Wilkes test.
With respect to the latter set of questions, I'm pretty confident that I've read the Massachusetts cases correctly. But I would welcome correction (or confirmation, for that matter) from any Massachusetts law expects in the reading audience.
BTW, in prior editions of the KRB teacher's manual, we claimed that the Louis E. Wolfson who figures so prominently in Smith v. Atlantic Properties was the Louis E. Wolfson of Abe Fortas and securities law infamy. It turns out that our Wolfson was a prominent Massachusetts medical doctor. It seems appropriate to clear his name, but it also makes me sad. Somehow the case just became much less interesting.
