• 17 August 2009

“Voice” in the Close Corporation

Benjamin Means - University of South Carolina School of Law

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In a recent article published by the Georgetown Law Journal, I criticize the inflexibility of existing law concerning claims of minority shareholder oppression in close corporations.  A more satisfactory approach, I contend, would encourage courts to vary their level of scrutiny, requiring detailed justification from controlling shareholders when the minority lacks the ability to advocate for its own interests.  Thus, rather than apply a one-size-fits-all approach, courts would use minority shareholder voice as an important proxy for possible oppression.  This short editorial summarizes the principal argument and responds to three noteworthy objections.


I.

Minority shareholders typically play an active role in closely held corporations, but, if serious differences arise, majority shareholders have the power to call the shots, including whether to employ minority shareholders and whether to declare dividends.  Absent additional bargained-for rights, minority shareholders may find themselves unemployed and frozen out of any return on their investment.  Unlike shareholders in public corporations, minority shareholders cannot protect themselves by selling their stock and exiting the corporation.  There is no public market for close corporation stock, by definition, and who would be willing to buy a minority interest in a business after the shareholders have had a falling out?

In order to salvage their investment, minority shareholders may seek judicial intervention.  However, because claims of minority shareholder oppression involve the standard features of a close corporation—majority control and locked investment—courts face a dilemma.  If they revise central terms of the relationship after the fact to avoid perceived unfairness to minority shareholders, courts diminish the viability of the close corporation as a distinct form of business organization.  For that reason, some courts refuse to recognize any doctrine of shareholder oppression, observing that corporate law permits minority shareholders to bargain for desired protections before investing.1 In a majority of jurisdictions, though, courts either borrow the heightened fiduciary obligations of partnership law, holding controlling shareholders to a higher standard than would be required under corporate law, or provide relief to the extent a minority shareholder’s “reasonable expectations” have not been met.2

Taken at face value, each of these standard approaches is flawed—either too quick to dismiss the specific challenges faced by the minority in a close corporation or else too willing to impose vague obligations on the majority.  But there is also a procedural aspect to the evaluation of claims of oppression.  Often, controlling shareholders can assert a plausible business justification for conduct that disadvantages the minority and the underlying facts will be hard to ascertain.

In close cases, as a practical matter, the outcome may depend more on the level of scrutiny applied by the court in deciding whether the minority’s claim of oppression has merit than on any divergence in the substantive standard for oppression.  Thus, whether the core obligations of controlling shareholders are understood primarily in contractual or fiduciary terms, it independently matters how hard the court will look to see if the obligations have been met.  Unless a court places some burden on the majority to substantiate its proffered justification, the minority shareholders will almost certainly lose.


II.

Despite its importance, the procedural dimension of minority shareholder litigation has received little notice.3 The level of scrutiny instead seems to correlate with the substantive standard in a particular jurisdiction, reflecting either a relatively permissive or strict attitude toward the majority’s right to enjoy the benefits of control.  The procedural and substantive questions can be disaggregated, however.  I argue that courts should embrace this flexibility and should use minority “voice” to set the appropriate level of scrutiny.

Flexible judicial scrutiny based on voice would improve existing approaches to shareholder oppression, allocating pleading or production burdens to the party best able to meet them.  If the minority lacks a voice in the business—in other words, a meaningful opportunity to review information relevant to important corporate governance decisions and to participate in the decisionmaking process—courts should apply enhanced scrutiny, accepting general pleadings and requiring controlling shareholders to establish a legitimate business purpose for challenged conduct. When adjudicating claims of shareholder oppression in close corporations with substantial minority participation—paradigmatically, representation on the board of directors—courts should apply more relaxed scrutiny, giving substantial deference to the majority’s business judgment absent evidence of self-dealing or bad faith.4

Although it might seem odd to focus on voice when the more pressing issue for minority shareholders, in the event of a freeze out, is lack of exit, the two problems are connected.  The foundation of my argument is Albert Hirschman’s classic insight that exit and voice are interrelated mechanisms and that economic and political responses to a firm’s decline may be complementary.5 For example, regular customers at a restaurant may complain of bad service, if they think that will help; if service does not improve, they can shift from voice to exit and take their business elsewhere.  Given the restrictions on exit in a close corporation, minority shareholders must rely on voice to protect their interests when potential conflicts arise.  The proposed voice-based framework would offer close corporations an incentive to include substantial minority input in corporate governance decision making, and it would guide judicial analysis when litigation cannot be avoided.


III.

In the article, I identify three major objections to the proposed voice-based framework.  First, why not attack the problem of oppression directly by creating an enhanced right of exit for minority shareholders? Second, and related, why worry about minority shareholder voice when, at the end of the day, the majority still has the power to make the decisions? Third, since shareholders have the ability to bargain for desired protections, or to choose a different form of business organization, why give minority shareholders a voice option they did not bargain for?

Admittedly, an automatic right of exit would seem to simplify matters by eliminating the need for complex liability determinations.  Professors Matheson and Maler, for example, have proposed a statutory right of exit akin to a no-fault divorce.6 My principal concern is that creating a right of exit would undermine the significance of the close corporation form and the shareholders’ interest in having a locked investment.  If corporate law rules can be circumvented without even a showing of fault, the distinction between a partnership and a close corporation will be lost.  To the extent choice of form has value, the loss of a meaningful choice is a cost to consider.

It also seems unclear whether an automatic exit right would actually reduce the cost of litigation.  Given the lack of an established market for shares, creating liquidity for close corporations involves considerable valuation difficulties.  Under existing doctrine, there must be a showing of harm before any remedy is available, which limits litigation and focuses those lawsuits that do go forward on liability issues that courts are better suited to address.  Even if no-fault exit promises some efficiency benefits, those savings may not amount to much because litigating valuation will also be expensive.

Moreover, minority shareholders could gain too much power in the governance of the close corporation.  While some boost in exit could enhance voice by backing it with a credible threat, the possibility of shareholder litigation may already serve that function.  If the threat of exit becomes too strong, given the need for locked investment, then minority shareholder demands may overwhelm sensible decision making.  (For similar reasons, the problem of oppression cannot be solved via mandatory voice-enhancing mechanisms like veto power or super-majority voting because those mechanisms, too, would shift power to the minority, creating a risk of deadlock or the extraction of rents to avoid holdout problems.)

However, my modest insistence that minority shareholder voice is important to the health of close corporations and should guide the intensity of judicial scrutiny leaves me open to a different kind of objection—that voice, as I define it, has no practical value.  Allowing a minority shareholder to have her say and then outvoting her is, for all practical purposes, the same thing as just outvoting her.  The problem with the objection is that it conflates voice with voting.

Although majority shareholders ultimately decide all contested questions, voice is a political mechanism and need not be synonymous with control.  A person’s ability to participate and to be heard on issues important to a shared enterprise, whether family, business organization, or nation-state, does not turn on the final tally of votes.  Voice is not as crude a mechanism as exit; its value lies in its nuance, as a means of shaping the goals of a close corporation to better accommodate the interests of all shareholders.  Corporate decisions based on transparent, open discussion will more often serve the interests of all shareholders and the minority will more likely accept the results of an inclusive, deliberative process as fair.

Finally, some scholars may object that voice-based scrutiny would disregard the choice of business form made by the parties, altering the bargain they thought they had.  The objection is misplaced.  The proposed framework does not change substantive doctrine or impose a new fiduciary obligation; rather, to the extent controlling shareholders are already prohibited from appropriating the value of the minority’s investment, I contend that courts should place the burden on the party best able to meet it.  A more flexible, voice-centered model of judicial scrutiny would better serve the interests of minority shareholders and the close corporations to which they belong.

Even if the proposal could be understood to restrict the ability of parties to customize control arrangements, because minority voice determines the level of judicial review, the choice-of-form objection would remain unconvincing.  One of the distinguishing features of corporate law is the mandatory fiduciary duty of loyalty owed by controlling shareholders to the corporation—directly or by dint of their control of the board of directors.  If investors want to sharply limit fiduciary duties, perhaps in favor of enhanced, contractual exit rights, the choice-of-form theory indicates that they should pick a partnership or limited liability company form more amenable to contractual modification.dingbat

Acknowledgments:

Copyright © 2009 Georgetown Law Journal.

Benjamin Means is Assistant Professor of Law at University of South Carolina School of Law.

This Editorial is based on the following full-length Article:  Benjamin Means, A Voice-Based Framework for Evaluating Claims of Minority Shareholder Oppression in the Close Corporation, 97 GEO. L.J. 1207 (2009).

  1. See, e.g., Nixon v. Blackwell, 626 A.2d 1366, 1380 (Del. 1993) (“It would do violence to normal corporate practice . . . to fashion an ad hoc ruling which would result in a court-imposed stockholder buy-out for which the parties had not contracted.”).
  2. See, e.g., Donahue v. Rodd Electrotype Co. of New Eng., 328 N.E.2d 505, 598 (Mass. 1975) (fiduciary duty approach); In re Kemp & Beatley, Inc., 473 N.E.2d 1173 (N.Y. 1984) (reasonable expectations approach).
  3. Cf. Robert B. Thompson, Mapping Judicial Review: Sinclair v. Levien, in THE ICONIC CASES IN CORPORATE LAW 79, 79 (Jonathan R. Macey ed., 2008) (“The intensity of judicial review of corporate decisions is the central issue of corporate law.”).
  4. Of course, minority shareholders who choose to reject an active role in the business should not then be heard to complain about lack of voice.
  5. See generally ALBERT O. HIRSCHMAN, EXIT, VOICE, AND LOYALTY: RESPONSES TO DECLINE IN FIRMS, ORGANIZATIONS AND STATES 4-5 (1970) (identifying economic pressure (“exit”) and political influence (“voice”) as the two primary mechanisms available to a firm’s members or customers to protect their interests).
  6. John H. Matheson & R. Kevin Maler, A Simple Statutory Solution to Minority Oppression in the Closely Held Business, 91 MINN. L. REV. 657 (2007).

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