Jump to Navigation | Jump to Content
American Bar Association

Commercial & Business Litigation

Minority Shareholder Threats to Subchapter S Elections

By Paula M. Bagger – February 5, 2014


Family businesses organized as closely held corporations often qualify for “S corporation” status under federal tax law. Corporations that make a subchapter S election, see 26 U.S.C. §§1361–1379, are taxed like partnerships:  There is no income tax at the entity level, and all income and loss “passes through” to the shareholders.  S corporation status is generally viewed as desirable because shareholders avoid so-called “double taxation,” which occurs when corporate earnings are taxed first as income to the corporation and then as dividends to the shareholders.  Not any small corporation may make a subchapter S election, however.  In order to qualify as an S corporation—and retain this status—a corporation may have no more than 100 shareholders, all of whom must be natural persons or trusts and none of whom can be nonresident aliens.  Id. § 1362(d). 


Absent restrictions in the Articles of Incorporation or a shareholders’ agreement, any shareholder in an S corporation is in a position to cause an involuntary termination of the corporation’s subchapter S status. A shareholder need only transfer his or her stock to a corporation, nonresident alien, or other non-qualifying person or entity. Amid the multitude of ways in which the majority shareholders of a closely held corporation may oppress the minority, the need for every shareholder to refrain from disqualifying transfers creates a rare instance in which a minority shareholder is in a position to hold the majority hostage, as he or she has the means at his or her disposal to cause significant damage to the corporation and its shareholders. 


How a state’s law views this situation depends to some degree on how the state’s law addresses the broader question of what duties shareholders in closely held corporations owe one another.  At one end of the spectrum, shareholders in closely held Massachusetts corporations owe each other a duty of the utmost good faith and loyalty—the same fiduciary duty owed by partners.  See Donahue v. Rodd Electrotype Co., 328 N.E.2d 505 (Mass. 1975).  While Massachusetts’s enhanced fiduciary duties are intended to protect minority shareholders from oppression at the hands of the majority, this duty runs from minority shareholders to the majority as well. 


Delaware stakes out the other end of the spectrum, specifically rejecting the idea that shareholders owe each other any common-law fiduciary duties; a minority stockholder looking to protect himself or herself must bargain for contractual protections. See Nixon v. Blackwell, 626 A.2d 1366, 1376 (Del. 1993). In between, various jurisdictions have fashioned common-law rules that impose more specifically tailored obligations on shareholders to consider the interests of their fellow shareholders in particular circumstances. See, e.g., In re Kemp & Beatley, Inc., 473 N.E.2d 1173 (N.Y. 1984) (protecting a minority shareholder’s “reasonable expectations” of participation in management or continued employment).    


The question of whether an individual shareholder should be allowed to exercise a basic shareholder’s right in a way that would terminate a corporation’s subchapter S status casts competing policies in high relief—particularly in family businesses, where shareholders have not necessarily “chosen” to invest or had an opportunity to negotiate the terms of their investment and where shared understandings reached in happier days are not always adequately reflected in corporate governance documents or shareholder agreements.  On the one hand, a minority shareholder is in a poor position to protect himself or herself via contract and presumably has already agreed to at least some limits on his or her ability to transfer stock.  If these do not prohibit the transfer, why should the common law pile on additional restrictions?  On the other hand, minority shareholders presumably agreed to elect subchapter S status.  Should they be given carte blanche to blackmail the majority, in a manner unlikely to have been contemplated at that time, simply because they have less to lose?


Two decisions from the 1990s lay out the “fiduciary duty” versus “contract right” approaches to this problem.  In A.W. Chesterton Co., Inc. v. Chesterton, 128 F.3d 1 (1st Cir. 1997), the U.S. Court of Appeals for the First Circuit was asked to predict how Massachusetts would apply the fiduciary duties outlined in Donahue when a closely held corporation sued to enjoin a minority shareholder’s sale of shares to shell corporations that he owned.  The First Circuit focused on the duty that the minority shareholder owed to the majority and affirmed the district court’s decision to enjoin the sale:


If Chesterton were to effect his proposed transfer, the Company and its shareholders would lose the substantial financial benefits they have derived from the Company’s Subchapter S status. Chesterton, disgruntled with overall Company performance and in pursuit of his own self-interest, has threatened to destroy these substantial benefits.  No claim is before us as to whether the Company and its other shareholders have acted fairly toward Chesterton over the years; we decide only that the district court did not abuse its discretion in holding that he did not act fairly towards them.


128 F.3d at 6. 


The opposite result was obtained on almost identical facts in Hunt v. Data Management Resources, 985 P.2d 730 (Kan. Ct. App. 1999). A minority shareholder offered to sell her shares back to the corporation for $50,000, and the corporation declined to buy. Her husband then formed a corporation, which offered $25,000 for the shares. The minority shareholder gave the corporation its option to repurchase at that price and then sold the shares to her husband’s corporation.  The Kansas Court of Appeals ruled that the sale did not violate any fiduciary duties because shareholders in Kansas corporations (following Delaware) do not owe fiduciary duties to either the corporation or their fellow shareholders.  It was simply a question of contract, and the court parsed the repurchase provision, which applied when a bona fide third-party offer for corporate stock had been made. It ruled that the offer made by the husband’s corporation qualified as a “bona fide offer” because the dollar amount was sufficient, and no other criteria were relevant—“not the identity of the third party purchaser or the motive of the seller. Absent a transfer restriction in the articles, how Hunt and/or her husband financed the transaction is simply not relevant.”  985 P.2d at 733. 


A similar result was obtained in Merner v. Merner, 129 F. App’x 342 (9th Cir. 2005), where the U.S. Court of Appeals for the Ninth Circuit was asked to predict how the California Supreme Court would rule in a declaratory judgment action brought by majority shareholders of a close corporation to enjoin the minority shareholder from selling his shares to a third-party corporation.  The Ninth Circuit decided that California would not adopt a Massachusetts-like common-law fiduciary duty of loyalty running between the shareholders of a close corporation.  Like the Kansas court, it ruled that this was a contract dispute and the minority shareholder had not breached any contractual obligation.  Unless limited by contract, “a shareholder has the right to transfer or hypothecate his shares. . . .  ‘A shareholder without a shareholder’s rights is at best an anomaly and at worst a shadowy figure in corporate limbo who would be . . . largely defenseless against neglect or overreaching by management.’”  Id. at 334 (quoting Stephenson v. Drever, 947 P.2d 1301, 1307 (Cal. 1997)). 


More recently, a pair of decisions have sought a more nuanced approach, eschewing categorical decisions either that it is “unfair” to allow a minority shareholder to destroy an S election or that such an action is immune to challenge if not prohibited by the articles or shareholder agreements.  In Sery v. Federal Business Centers, Inc., 616 F. Supp. 2d 496 (D.N.J. 2008), the U.S. District Court for the District of New Jersey reached a result that recognized both the dangers of imposing extra-contractual obligations on minority shareholders and the dangers of coercive conduct by the minority. 


First, it noted that the New Jersey Supreme Court had not yet indicated whether it would follow Massachusetts’s Donahue rule, although at least one intermediate appellate court had recognized fiduciary obligations running among the shareholders of closely held corporations.  It expressed doubt that New Jersey’s highest court would conclude that a shareholder of a close corporation had breached breach his or her fiduciary duty any time it participated in a stock transfer that destroyed the company’s subchapter S status, “regardless of whether the sale was executed in good faith for a reasonable business purpose,” while also expressing discomfort at leaving the entire question to contract, so that “any fiduciary duties that may normally apply are completely abrogated by provisions of the [New Jersey Business Corporations Act].”  Id. at 502.   Ultimately, it decided that the common-law fiduciary duties of good faith and loyalty might “complement the statutory provisions governing restrictions on the transferability of S corporation stock”: 


[T]he Court is satisfied that the New Jersey Supreme Court would hold that the fiduciary duties of good faith and loyalty restrict the sale or transfer of S corporation stock to the extent that these duties bar a shareholder from entering into a bad faith or sham transaction which destroys the corporation’s Subchapter S status for the primary purpose of injuring fellow shareholders. However, where the shareholder sells or transfers their S corporation shares in good faith in an economically reasonable manner, even if that entails a sale to an unqualified entity, this Court is satisfied that the New Jersey Supreme Court would uphold the sale.


Id.   


Most recently, in March 2013, the Massachusetts Supreme Judicial Court decided Merriam v. Demoulas Super Markets, Inc., 985 N.E.2d 388 (2013), the latest decision born of an epic family dispute over a grocery chain that has been in the Massachusetts courts for almost 20 years. In Merriam, the plaintiff minority shareholders sought a declaratory judgment that they had complied with all contractual restrictions on transfer in the corporate articles and were now free to sell their stock in the defendant S Corporation however they wished.  The Supreme Judicial Court seized the opportunity to reject the First Circuit’s reasoning in the A.W. Chesterton decision, ruling that the existence of contractual arrangements governing disposition of stock in the corporation (in Merriam, these were the Articles of Incorporation) meant that the only duties in connection with transfers of stock were contractual:  “[W]here the parties have defined in a contract the scope of their rights and duties in a particular area, good faith action in compliance with that agreement will not implicate a fiduciary duty.”  985 N.E.2d at 394.  Conduct violating the implied covenant of good faith and fair dealing (an implied term in every Massachusetts contract) would, however, breach not only the contract but also the shareholders’ fiduciary duties.


The plaintiff minority shareholders had complied with an elaborate procedure dictated by the Articles of Incorporation for the disposition of their shares. Particularly insofar as the majority had forgone an opportunity to repurchase the minority’s shares at a price set by an independent appraisal, the Supreme Judicial Court would not allow the majority to call upon fiduciary principles to enjoin the sale and save the corporation’s subchapter S status. 


Merriam, therefore, achieved through application of the implied covenant of good faith and fair dealing a result not dissimilar to what Sery had achieved through the imposition of a limited fiduciary duty.  But what conduct would be considered a violation of the implied covenant of good faith and fair dealing (in Massachusetts) or a breach of fiduciary duty (in New Jersey), allowing the majority to enjoin a sale?    


The Supreme Judicial Court contrasted the case before it, where the plaintiff sellers had followed a set of procedures that included obtaining an independent valuation of the shares and then found a willing third-party buyer, with A.W. Chesterton, where a minority shareholder of an S corporation, unable to sell his shares either on the open market or to the corporation, had “proposed to transfer his shares to his shell corporation, which would not have increased their marketability or otherwise advanced his interests but would have terminated [the] corporation’s tax status.”  985 N.E.2d at 395 n.15.  The sole purpose of the Chesterton seller’s threatened action was to coerce the majority, using this singular bit of power the tax code had given it, to force a repurchase of his shares for which he had failed to bargain.  In Sery, the minority, which had pledged its stock to fund shareholder oppression litigation against the majority, claimed that it needed to sell the stock to pay its legal bills, while the majority claimed that its true goal was leverage in the underlying litigation, as evidenced by alleged bad-faith threats to “go nuclear.” The district court decided that the claim was not ripe, “with only hypothetical facts at the court’s disposal,” but its discussion indicated that it considered the terms of the sale and the purpose for such a sale “key facts upon which the Court will base its decision.”  616 F. Supp. 2d at 503.  


If an S corporation does not have effective contractual restrictions in place to limit a minority shareholder’s ability to sell his or her shares to a non-qualifying individual or entity, a minority shareholder is in a position to justify such a sale on the grounds that he or she is exercising a basic right as a shareholder to convey his or her shares. Whether the corporation will be able to stop the minority shareholder will depend on the state law applied. In jurisdictions that look only to the express terms on which shares are held, the minority has a powerful weapon, although it may be that jurisdictions that reject the idea that shareholders owe fiduciary duties may be more receptive to the  Supreme Judicial Court’s rationale in Merriam and provide protections against undue coercion through contractual duties of good faith and fair dealing. In jurisdictions that apply protections against coercion by the minority—via either an implied covenant of good faith and fair dealing or a fiduciary duty—the result will likely depend on whether the sale is deemed a legitimate exercise of the shareholder’s self-interest. Is the shareholder selling to a third party? As the court noted in Merriam, selling one’s stock to a corporation of one’s own serves no purpose other than destroying the corporation’s favorable tax status. The same can likely be said when a minority shareholder sells only a small fraction of its shares to a non-qualifying individual or entity. What is the purpose of the sale? A sympathetic explanation of the need to sell, such as the corporation’s failure to distribute dividends sufficient to cover taxes due on the corporation’s undistributed profit, may help support the shareholder’s decision to sell. The inquiry will be fact-intensive, with the goal of mediating between competing legitimate concerns of the majority and the minority and identifying bad-faith activity by both.


Keywords: litigation, commercial, business, corporations, S corporation, good faith, fiduciary duty, shareholder oppression


Paula M. Bagger is a partner with Cooke Clancy & Gruenthal LLP in Boston, Massachusetts and an editor with the ABA Section of Litigation's Commercial & Business Litigation Committee.


 
Copyright © 2017, American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association, the Section of Litigation, this committee, or the employer(s) of the author(s).