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14:11. Dissension in the close corporation, 3 Treatise on the Law of Corporations ...

3 Treatise on the Law of Corporations 14:11 (3d) Treatise on the Law of Corporations Database updated January 2011 James D. Cox and Thomas Lee Hazen Chapter 14. Closely Held Entities 14:11. Dissension in the close corporation Dissension among the owners of a close corporation has a heavy impact on the enterprise. 1 Because of the participants' intimately close working relationship, in most close corporations, once dissatisfaction or distrust has developed, intracorporate friction is likely to continue to grow. 2 Dissatisfied shareholders of a publicly held corporation have a ready market for their shares, whereas an interest in a closely held corporation does not have a readily available market, at least if the interest is not a controlling one. The marketability of a minority interest in a close corporation is further narrowed if the corporation is racked by dissension. Even if a buyer can be found for a minority interest, the price may be sharply discounted. 3 Furthermore, the existence of transfer restrictions may enable an antagonistic associate to thwart an unhappy shareholder's sale of close corporation shares. Dissension and the inability of unhappy shareholders to get out sometimes results in serious and continuing strife among the shareholders and managers 4 and may result in extensive litigation and serious harm to the corporation and the shareholders. 5 Deadlocks among the shareholders and in the directorates of closely held corporations may occur because of the way voting shares and positions on the board are distributed. 6 Shares are sometimes divided equally among two or more shareholders or groups of shareholders. 7 And it is not unusual for a close corporation to have an even number of directors; thus a deadlock of directors is likely to occur. Further, in an effort to protect themselves against the power generally vested in shareholders and directors to determine corporate policy by simple majority vote, minority shareholders often bargain for and obtain either a veto over corporate policies and decisions or condition their approval upon a greater than majority vote. 8 Such a veto power increases the risk of corporate paralysis. 9 As one Virginia court eloquently stated, A recalcitrant shareholder may embalm his corporation and hold it helpless in a state of suspended animation. 10 Despite the frequency of dissension and deadlock in close corporations, in some states neither legislatures nor courts have provided satisfactory solutions. Therefore, during the organization of a close corporation, counsel must anticipate such problems and may need to provide special contractual arrangements to resolve them. These arrangements usually are set up in the corporation's charter or bylaws or in a shareholders' agreement. They typically take one or more of the following forms: (a) provisions for the buyout of the interests of aggrieved shareholders, (b) the creation of special dissolution rights and procedures, or (c) undertakings to arbitrate disputes. 11 Further possibilities to consider to avoid locking unhappy shareholders into a corporation for an indefinite period of time are: (d) limiting the life of the corporation rather than giving it perpetual existence, (e) setting up a voting trust that gives trustees the power to vote for dissolution, and, where legal, (f) issuing stock that is convertible into notes or debentures. 1
See generally F. Hodge O'Neal & Robert B. Thompson, O'Neal and Thompson's Oppression of Minority Shareholders and LLC Members (rev. 2d ed. 2009); William H. Painter, Corporate and Tax Aspects of Closely Held Corporations, ch. 7 (2d ed. 1981 &

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14:11. Dissension in the close corporation, 3 Treatise on the Law of Corporations ... Supp. 1985); Harold D. Field, Jr., Resolving Shareholder Disputes and Breaking Deadlocks in the Close Corporation, 58 Minn. L. Rev. 985 (1974).

For the underlying causes of disputes among the owners of close corporations, see 1 O'Neal & Thompson, Minority Shareholders, supra note 1, ch. 2. The New Jersey Supreme Court has addressed the issue of whether to apply a marketability discount when a court orders a shareholder to sell his or her stock, concluding that the court must take into account what is fair and equitable. More specifically, a marketability discount cannot be used by the controlling or oppressing shareholders to benefit themselves to the detriment of the minority or oppressed shareholders. Lawson Mardon Wheaton, Inc. v. Smith, 734 A.2d 738, 752 (N.J. 1999); Balsamides v. Protameen Chems., Inc., 734 A.2d 721, 738 (N.J. 1999). In Lawson the court declined to apply a marketability discount, since no extraordinary circumstances existed. However, in Balsamides, a case in which the oppressing shareholder was ordered to sell his shares to the oppressed shareholder, the court found that a 35 percent marketability discount was appropriate. Otherwise, the remaining (oppressed) shareholder would be forced to absorb the full reduction for lack of marketability if he sold the company at a future date. Balsamides v. Protameen Chems., Inc., 734 A.2d 721, 735736 (N.J. 1999). The court noted that an oppressing shareholder who has instigated the problems should not benefit at the expense of the oppressed, and that ordering a buyout at an undiscounted price under these circumstances would penalize the oppressed shareholder. Id. at 738. Accord Advanced Communication Design, Inc. v. Follett, 601 N.W.2d 707, 711 (Minn. Ct. App. 1999) (citing Lawson and Balsamides and holding that marketability discount could not be applied to minority shareholder's shares when sale resulted in buyer becoming sole owner of corporation). For a general discussion of marketability discounts in valuing closely held businesses, see Mukesh Bajaj, David J. Denis, Stephen P. Ferris & Atulya Sarin, Fair Value and Marketability Discounts, 27 J. Corp. L. 89 (2001). See, e.g., Hall v. John S. Isaacs & Sons Farms, Inc., 163 A.2d 288 (Del. 1960). See Carlos L. Israels, The Sacred Cow of Corporate Existence: Problems of Deadlock and Dissolution, 19 U. Chi. L. Rev. 778, 781 (1952); Note, 1972 Duke L.J. 653; Comment, 58 Neb. L. Rev. 791 (1979). See, e.g., In re Radom & Neidorff, Inc., 119 N.E.2d 563 (N.Y. 1954); In re Weiss, 301 N.Y.S.2d 839 (App. Div. 1969); In re Surchin, 286 N.Y.S.2d 580 (Sup. Ct. 1967); Stott Realty Co. v. Orloff, 247 N.W. 698 (Mich. 1933); Nashville Packet Co. v. Neville, 235 S.W. 64 (Tenn. 1921). See also Callier v. Callier, 491 N.E.2d 505 (Ill. App. Ct. 1986) (dissension among shareholders found to adversely affect business although corporation still making profits). Cf. Roach v. Bynum, 403 So.2d 187 (Ala. 1981), later appeal ex parte, 414 So.2d 80 (Ala. 1982), later appeal, 437 So.2d 69 (Ala. 1983) (no deadlock among shareholders found where bylaw requiring 70 percent vote could be repealed or amended by shareholders); Rowland v. Rowland, 633 P.2d 599 (Idaho 1981) (although dissension among shareholders exists, court will not dissolve corporation unless ability to carry on business affected). See 14:12 for a discussion of dissolution-on-deadlock statutes. A deadlocked corporation is one that, because of decision or indecision of the shareholders, cannot perform its corporate powers. However, a minority shareholder's mere disagreement with management's decision or dislike of another shareholder does not create a deadlock. Woodward v. Andersen, 627 N.W.2d 742, 751752 (Neb. 2001).

See, e.g., Black v. Graham, 464 S.E.2d 814, 815 (Ga. 1996) (having shown deadlock it was not necessary to further establish any related misconduct); Bendetson v. Killarney, Inc., 913 A.2d 756 (N.H. 2006) (same); Callicoat v. Callicoat, 657 N.E.2d 874, 875 (Ohio Com. Pl. 1994) (same). Roach v. Bynum, 403 So.2d 187, 192 (Ala. 1981). See also Mordka v. Mordka Enter., 693 P.2d 953 (Ariz. Ct. App. 1984) (resolution requiring unanimous vote of the three shareholders in effect gave each shareholder veto power); Industrial Distribution Group, Inc. v. Waite, 485 S.E.2d 792 (Ga. 1997) (super quorum requirement gave rise to deadlock); Sutter v. Sutter Ranching Corp., 14 P.3d 58 (Ok. 2000) (fundamental transactions conditioned on seventy-five percent approval). See generally 2 O'Neal & Thompson, Minority Shareholders, supra note 1, 9.08. Veto arrangements are popular. In most jurisdictions, a valid way of setting up effective veto arrangements is available. See, e.g., Zion v. Kurtz, 405 N.E.2d 681 (N.Y. 1980). The possibility of ultimate corporate paralysis has not been sufficient to cause veto

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14:11. Dissension in the close corporation, 3 Treatise on the Law of Corporations ... arrangements to be legally prohibited. As was said by the Court of Appeals of New York in Sterling Indus. v. Ball Bearing Pen Corp., 84 N.E.2d 790, 793 (N.Y. 1949): Had the Legislature intended to eliminate the problem of deadlock it could have done so by the simple expedient of requiring an odd number of directors. Instead, apparently realizing the desire for equal control in some closely held corporations, it has continued to permit the election of a board of directors with an even number of directors.

10 11

Kaplan v. Block, 31 S.E.2d 893, 896897 (Va. 1944). See 14:14. Arbitration is a useful device but too broad a delegation may run afoul of traditional management norms. Courts, however, frequently enforce arbitration clauses in close corporation deadlock situations. Ginsberg v. Coating Prods., Inc., 210 A.2d 667 (Conn. 1965) (valuation of shares for repurchase agreement); Blum Folding Paper Box Co. v. Friedlander, 261 N.E.2d 382 (N.Y. 1970) (justness of discharge of employee shareholder); In re Vogel, 224 N.E.2d 738 (N.Y. 1967), aff'g 268 N.Y.S.2d 237 (App. Div. 1966) (corporate exercise of option to purchase certain property). See generally Martin Domke, The Law and Practice of Commercial Arbitration (rev. ed. 1984); 2 1 F. Hodge O'Neal & Robert B. Thompson, O'Neal and Thompson's Close Corporations and LLCs: Law and Practice ch. 9 (rev. 3d ed. 2009). See also Field, supra note 1; John A. C. Hetherington, Special Characteristics, Problems, and Needs of the Close Corporation, 1969 U. Ill. L.F. 1, 1025; Cheryl Jean Few, The Custodian Remedy for Deadlocks in Close Corporations, 13 U.C. Davis L. Rev. 498 (1980). Compare In re Validation Review Associates, Inc., 646 N.Y.S.2d 149, (N.Y. App. Div. 1996) (a provision in a shareholder agreement that waives statutory and common law right to petition for dissolution is void as against public policy) with R & R Capital, LLC v. Buck & Doe Run Valley Farms LLC, 2008 WL 3846318 (Del. Ch. 2008) (LLC act encourages private ordering so that members can waive their reight to seek dissolution and winding up). An arbitration provision in a shareholder agreement will be enforceable only as to claims arising out of that agreement. See, e.g., Havens v. Attar, 1997 WL 55957, 22 Del. J. Corp. L. 1230 (Del. Ch. 1997) (claims involving taking of corporate opportunity did not arise out of shareholder agreement even though agreement helped define the company's lines of business).

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2011 Thomson Reuters. No claim to original U.S. Government Works.

2011 Thomson Reuters. No claim to original U.S. Government Works.