The Ohio State Bar Association regularly publishes court decisions from courts throughout the State of Ohio. It is not uncommon for one or more of these decisions in a given week to address allegations regarding the breach of what are termed fiduciary duties. This type of duty is created by contract or by law and requires good faith, honesty and loyalty to the party to whom the duty is owed. A full examination of fiduciary duties would cut across numerous areas of law as this type of duty is fairly common and arises in many situations. For this reason, court opinions addressing fiduciary duty obligations in varied settings are regularly issued.
In the area of business law, fiduciary duties arise between shareholders in privately held corporations. It is very easy to become a shareholder, but it can come with significant obligations. These obligations are not always understood by shareholders who control the operations of privately held corporations. It is well worth the effort to have an understanding of the fiduciary duties you may owe to your fellow shareholders if you are owners of a closely held corporation. The law can provide mechanisms to clarify the fiduciary duties you may owe as well as to address resolving fiduciary duty conflicts should they arise.
Entities and Associations
The Ohio Revised Code (the “ORC”) provides authority for the creation of a variety of entities and associations of individuals through which business or other legitimate organized activity may be conducted. Without listing all available options, the ORC provides for entities as partnerships, for-profit corporations, non-profit corporations, limited liability companies, charitable organizations, community improvement corporations, title companies, limited partnerships, and other associations described in various chapters of the ORC.1
Closely Held Corporations
Of the entities identified in the ORC, one entity frequently used to conduct business is the for-profit corporation. In general, a corporation is owned by its shareholders, who vote their shares for its directors, who then appoint corporate officers. A corporation can grow in volume of business and number of its shareholders and may ultimately have its shares of stock traded on a public securities exchange: a stock market. Conversely, a corporation may be owned by a smaller number of shareholders, may not be registered, and therefore have no readily available market for the sale of its shares of stock. This type of corporation is termed a “close corporation” or a “closely held corporation.” Other general features of these corporations include the involvement of shareholders in the management of the corporation and a general close working relationship between the shareholders.
Ohio courts have addressed duties and obligations owed by the shareholders of a close corporation due to the unique characteristics of these corporations. Without a readily available stock market mechanism for the sale or purchase shares of stock, the minority or non-controlling shareholders of a closely held corporation are at a distinct disadvantage to the majority or controlling shareholders.
Courts have determined that close corporation majority or controlling shareholder(s) (jointly referred to as the “majority”) owe to the minority shareholder(s) what is termed a fiduciary duty: a duty of utmost good faith and loyalty in their business dealings. Minority shareholders enjoy the right to expect compliance with this duty by the majority or controlling shareholders.
The controlling shareholders do not have to be the owners of the greatest number of shares, but they must be exercising a dominant, controlling force in the corporation.
Due to the similarities between partnerships and close corporations, this fiduciary duty has been expressly described by courts as a “heightened fiduciary duty.” Like partnerships, close corporations are generally owned by a small number of people dependent upon each other to succeed. The Ohio Supreme Court clarified and expounded on this fiduciary duty in its opinion in Crosby v. Beam, 47 Ohio St. 3d 105 (1989). This heightened fiduciary duty is analogous to the duty partners owe to one another. Subsequent case law has addressed a variety of scenarios in which the fiduciary duty can be breached.
This heightened fiduciary duty can be breached when majority or controlling shareholders use their control to gain their own advantage to the detriment of the minority shareholder(s). The minority shareholders are entitled to an equal opportunity obtain to certain benefits from the corporation. Without a legitimate business purpose, engaging in activity detrimental to the minority may be actionable. Oppressing the minority or impairing their rights can bring about damage claims brought by the minority against the majority or controlling shareholders.
The heightened fiduciary duty owed to minority shareholders also includes the obligation of the majority or controlling shareholders to disclose to the minority information regarding the status of the corporation and regarding important issues affecting the finances and operation of the close corporation. When cases are filed alleging the breach of fiduciary duties are filed in court, the disruption to the corporation, its operations, finances and the lives of the shareholders is significant.
Close Corporation Agreement
ORC § 1701.591 entitled Close Corporation Agreement provides a mechanism for shareholders of a close corporation to agree in advance on issues related to the internal management and business operations of their corporation and the relations between and among themselves as shareholders. This type of agreement can clarify duties and obligations and can thereby help avoid conflicts in the future which might otherwise arise. These agreements can even provide for expedited ways of resolving disputes over issues on which the directors or parties managing a corporation might be deadlocked. A deadlock between directors or voting shareholders can under certain circumstances provide a basis for the filing of a petition for judicial dissolution of the corporation. (See, ORC § 1701.91) This is obviously a serious problem for a corporation.
If a close corporation agreement is entered into, this fact must be noted on each share certificate. The notification must be conspicuous. Any purchaser or transferee of such a share certificate is conclusively presumed to have taken the shares of stock represented by the certificate with notice of the close corporation agreement.
These agreements are specifically tailored to the close corporation circumstances and there are numerous provisions in the close corporation statute from which options for shareholders can be derived. The terms of such an agreement can encompass access to corporate information, the ability to permit director delegation, the right to dissolve the corporation under certain circumstances, the obligation to vote shares in a particular way, terms and conditions of officer employment, issues related to the payment of dividends, limitations on the corporation issuing or selling shares, and others. (See, ORC § 1701.591 (C)). The statute also provides for limitations on the scope of a close corporation agreement.
In the event that the close corporation becomes a publicly traded corporation, any close corporation becomes invalid. Additionally, there are requirements for filings and notations withing the corporations records regarding close corporation agreements. Proper guidance through these procedures is always important.
Individuals considering associating for business purposes through the formation of a close corporation should seek the advice of knowledgeable attorneys to explore the benefits of this business form as well as operational and shareholder relationship issues going forward.
1 See Ohio Revised Code Chapters 1701-1785, which provide for procedures and practices related to types of organizations and associations. The associates identified in these chapters can be for-profit or not for-profit.