All corporations experience development cycles that are affected not only by their market area and the prevailing economic climate, but also by the personalities of the directors, officers and shareholders. This is especially true for closely-held corporations and, in particular, for family businesses. In the family business setting, the level of formality is often dictated by what stage of development the business has reached. As a family business develops, so will pressures that strain the family structure which provided a level of cohesion for the business. These pressures can arise from a variety of stimuli. A growing market share may require changes to meet new demands. These new demands may suggest a need for new expertise and, possibly, non-family managers. Perhaps a member of the family has reached an age where he or she is ready to undertake management responsibilities; or conversely, perhaps the founding member of the business is approaching retirement. All of these positive changes will put pressures on the existing structure of the family business. Negative changes can likewise lead to strain on this structure. To manage these pressures, the professional advisor must offer planning mechanisms that will assist the family to govern effectively in these times of transition. This paper will outline the tools available to family businesses which can assist it in times of transition and stress. The author argues that family businesses should be allowed maximum flexibility in arranging the equity and management relationship of its participants and the corporate governance structure in order to channel family relationships in the most constructive direction.
THE EXISTING CONTEXT OF FIDUCIARY DUTIES.
Duty of Care and Duty of Loyalty
1. Two fiduciary duties are generally applied in the corporate setting. Corporate leadership is expected to use due care in managing the assets entrusted to them (duty of care) and to manage the assets for the good of the business and not for their own personal benefit (duty of loyalty).
2. Generally, the business decisions of directors will not be challenged by the court if the decisions are independent, informed, rational, and taken in good faith.
3. Many commentators have argued that this deference -- the business judgment rule -- should not be applicable in the context of the closely-held corporation because shareholders have a less fluid economic remedy if they become dissatisfied with their investment and because of the inherent interest a director/officer/shareholder has in closely held corporate actions. As there is greater potential that majority shareholders will "oppress" minority shareholders in a close corporation, commentators believe that the courts should look more closely at the decisions of close corporations. See Moni Murdock and Charles Murdock, "A Legal Perspective on Shareholder Relationships in Family Businesses: The Scope of Fiduciary Duties," Family Business Review (vol. IV, no.3, 1991); Ralph Peeples, "The Use and Misuse of the Business Judgment Rule in the Close Corporation," 60 Notre Dame Law Review 456 (1985).
Substitutes for Traditional Fiduciary Duties in Closely-Held Corporations.
A number of standards have been suggested to replace the business judgment rule in the small business context.
1. Intrinsic Fairness. In instances where a corporate director or officer has an "interest" in a corporate action as a shareholder, some commentators suggest that, rather than looking at the process by which a decision was reached, the consequences of the corporate decision itself for minority shareholders should be examined. This standard does not begin with the presumption of fairness and the burden of justifying the complained of conduct is thereby shifted to the defendants.
2. Partnership Standard. This standard essentially views the closely held corporation as a partnership and imposes a heightened level of fiduciary duty. Consequently, majority or controlling shareholders in a close corporation must satisfy a standard of "trust, confidence, and absolute loyalty" in their conduct of the corporation affairs. Donahue v. Dodd Electrotype Company of New England, 328 N.E.2d 505, 512 (Mass. 1975).
3. Less Harmful Means. The Donahue standard was curtailed slightly in Wilkes v. Springside Nursing Home, Inc., 353 N.E.2d 657 (1976). This case holds that close corporate action can be sustained if there is a reasonable business rationale for the majority's actions and the plaintiffs can not establish that there was an alternative action less harmful to minority interests. See Peeples at 498.
4. Reasonable Expectations. New York has applied a "reasonable expectations" standard by which the court considers the previously articulated expectations of the parties to determine if oppression has occurred. For example, a minority shareholder may invest in a close corporation with the expectation that his economic return will be in the form of employment with the corporation. Despite the courts usual deference to employment decisions, if all other shareholders are receiving employment and this particular termination appears suspect, under the reasonable expectation standard, the court will scrutinize a decision to terminate this employment because it conflicts with the minority shareholder's reasonable expectation. See In re Kemp & Beatley, Inc., 473 N.E.2d 1173 (N.Y. 1984).
Criticism of the Heightened Standard in the Family Business Setting.
1. Some commentators have suggested that the application of a heightened fiduciary standard to the close corporation often results in the court writing rather than enforcing the bargain among the parties. (See Frank H. Easterbrook and Daniel R. Fischel, The Economic Structure of Corporate Law at 245, (Harvard University Press, 1991)).
2. Instead, these commentators would have the court ask what the parties themselves would have contracted for if the transaction costs made such bargaining possible. Easterbrook and Fischel at 250.
3. To answer the above question, courts will likely be influenced by the contractual relationship the parties did create as evidenced by the corporation's governing documents.
4. Therefore, like the reasonable expectation standard, this approach puts a heavy emphasis on the express agreements between the parties and the content of organizational documents.
5. In planning for the governance of family businesses, the legal advisor should advocate the full use of the corporate tools discussed below in order to paint a picture detailed enough to assist any judicial review of corporate actions.
TRADITIONAL CORPORATE TOOLS IN THE FAMILY BUSINESS SETTING
The following is an abbreviated review of the various tools available to the family business to structure their corporate governance. The professional advisor can utilize these tools in various ways to manage the inevitable pressures that occur as the family business develops.
The following materials provided helpful reference for this section: Joseph J. Norton, "Adjustment and Protection of Shareholder Interests in the Closely-Held Corporation in Texas," 39 Southern Methodist Law Journal 781 (1985); Robert C. Clark, Corporate Law (Little, Brown & Co., 1986); and William H. Painter, Business Planning: Problems and Materials (2d ed., West Publishing, 1984).
Depending on the stage in which the professional advisor intervenes, he or she may have an opportunity to influence the basic documents of the corporation. With shareholder approval these documents can also be changed to reflect the evolving needs of the corporation.
1. Preincorporation Agreements. When dealing with an ongoing concern, it is unlikely that the advisor will have the luxury to sit down with the participants of the family business to memorialize their expectations of the business and its governance structure. Yet, given the opportunity the exercise of documenting such expectations can be invaluable when drafting post-incorporation documents structuring various aspects of corporate relationships.
2. Articles of Incorporation. This is the basic corporate document that will, along with the bylaws, constitute the fundamental contract among shareholders. Each jurisdiction dictates the basic content of the articles of incorporation. The articles typically include at least the following:
a. the corporate name;
b. the duration of the corporation (e.g. perpetual);c. the nature of the business and its purposes;
d. the number of shares and their par value;
e. the designation of classes of shares and their attendant rights, preferences, and limitations;
f. provisions on preemptive rights, if desired; and
g. the name and address of the corporate agent.
The following may also be included in the articles of incorporation, if desired:
a. the minimum capitalization requirements;
b the size and composition of the initial board of directors;
c. a statement regarding the corporation's status as a closed corporation; and
d. provisions regarding the management of the business and the conduct of its affairs.
The classes of shares, their rights and limitations, the terms of directors and the process of succession are all components of corporate governance that can be arranged to effectuate the expectations of the participants as to equity and managerial control.
3. Bylaws. While the articles of incorporation set forth an external corporate structure, the bylaws define internal arrangements. The decision as to whether internal management arrangements are included in the articles of incorporation or in the bylaws will be determined to some extent by how easy, or difficult, the participants want it to be to alter these initial arrangements.
Participants in a family business bring different contributions to the corporation in terms of capital, experience and expertise. The relative rights assigned to corporate shares and the distribution of those shares will allow the corporation to allocate the profit, risk, ownership, and management control of the business in a way that best meets the expectations of all concerned.
1. Common stock. Common stock represents the basic equity instrument in the corporation. The rights and privileges attached to the common stock are determined by the participants as reflected in their basic corporation documents, as well as by the statutory and case law of the applicable jurisdiction. The flexibility which the law allows to disproportionately allocate voting power among different classes of common stock allow participants in a family business an ability to grant certain shareholders the power to elect directors and to influence other important corporate decisions.
2. Preferred Stock. A class of preferred stock can be created to give certain shareholders an interest in the family business that differs from those holding common stock -- an interest that may or may not have voting rights. For example, a class of preferred stock may carry a fixed dividend which takes precedence over the payment of dividends on the common stock and can have a priority claim in the liquidation of assets upon dissolution. The terms of preferred stock can be very flexible and, beyond the issues of voting and dividends, participants will want to consider whether the stock is voluntarily or mandatorily redeemable by the corporation, and whether it is convertible to common stock.
3. Other Rights of Ownership. Shareholders of a family business may well want to give family members who are not actively involved with the corporation the opportunity to share in the equity of the business. One way this can be achieved is through the grant of options, rights, or warrants. These instruments are not stock (although they are usually considered securities for purposes of state and federal law), but instead are contractual rights to purchase stock in the future on terms set forth in the particular instrument. The author has found that these instruments afford tremendous opportunity for "sharing the wealth" among family members on such terms, in such amount, and at such times as the parties may desire.
Tools for Controlling Ownership.
In addition to creating different classes of stock, other tools are available to the family corporation that can structure the ownership, voting power, and control rights of certain shareholders.
1. Stock Classification. Corporate statutes allow for tremendous flexibility in allocating corporate power by the issuance of different classes of stock as long as the relative rights, preferences, and limitations of the various classes are set forth in the articles of incorporation.
a. Through the classification of shares, the owners of a family business can separate voting control from equity ownership.
(1) For example, the founder of a family enterprise may choose to grant voting stock to children active in the business and non-voting stock (which may have an equal claim on the equity of the corporation) to children who are not active in the business.
b. Note: If the business has elected to be taxed under Subchapter S of the Internal Revenue Code, the corporation's legal advisor will want to be sure that any differences between classes of common stock do not jeopardize this tax election.
2. Restrictions on Dilutive Issuances of Stock. The initial capitalization of the corporation and stock classification will allocate ownership interests to participating shareholders. The power to issue more shares, however, can quickly alter this allocation and the relative power of participants.
a. It is therefore not unusual if the ability of a corporation to issue additional stock (the issuance of which can dilute equity percentages or control rights of certain shareholders) is restricted through provisions which would allow additional stock to be issued only if a specified super-majority of the corporation's stockholders consent.
b. Another option is to provide for preemptive fights, a mechanism which allows existing shareholders to maintain their relative
position by subscribing for a pro-rata portion of any new stock being issued. A shareholder's priority fight to purchase newly
issued stock can be an important mechanism for maintaining the careful balance of ownership interests.
c. Jurisdictions differ as to whether they allow for preemptive fights through common law or by statute, and some restrictions on this fight may apply.
d. If preemptive rights are to be relied on to protect minority interests, certain inherent limitations must be considered.
(1) Preemptive rights will allow a shareholder to maintain her relative position only if the shareholder has the resources to exercise her rights to purchase the new shares.
(2) Some preemptive rights schemes can frustrate the ability of a corporation to raise additional capital on favorable terms.
3. Stock Transfer Restriction.
a. The ability to keep shares within the family or within a specified group of individuals is of great importance to the family business.
b. While the basic rule of free alienability governs stock transfers in the public corporation, exceptions have been allowed in the closely held corporation as long as the restrictions on transfer are reasonable.
c. Restrictions that have been found reasonable include:
(1) right of first refusal provisions;
(2) Reasonable consent restraints (shareholder must get the consent of other shareholders, which must not be unreasonably withheld, before transferring the shares); and
(3) reasonable purpose restrictions (particularly relevant to the family business, some states have allowed reasonable restrictions intended to keep shares of a family business within the family unit).
d. Most jurisdictions also require that any transfer restriction be noted conspicuously on the front of the stock certificate evidencing affected shares.
e. In addition to giving the shareholders control over transfers of the ownership of their corporation, stock transfer restrictions can operate as a "buy-sell" arrangement that can provide needed liquidity to a shareholder in the event of disability, death, or divorce.
4. Shareholder Pooling Agreements.
a. Most jurisdictions will allow shareholders to agree to vote their shares together to achieve a certain goal, like control of the corporation.
b. Generally, pooling arrangements take the form of a contract among shareholders and, therefore, requires adequate consideration.
c. State corporation statutes should be reviewed for any formalities necessary to the creation of a valid shareholder pooling agreement.
(1) Care should be taken not to inadvertently create a voting trust (discussed below) which generally are governed by distinct statutory requirements.
d. It is especially important that the agreement of the participants be well delineated as to how and when their votes will be jointly cast.
(1) These agreements should incorporate dispute resolution methods to resolve disagreements if and when they occur.
e. In order to ensure specific performance from a court of law, the agreement should expressly provide for this remedy.
5. Irrevocable Proxies.
a. This device is often used in conjunction with shareholder pooling agreements and creates an agency relationship so that one person is authorized to vote the stock of another.
b. This is necessary when the shareholder pooling agreement provides for arbitration and the arbitrator is given the right to vote the stock of one of the disagreeing shareholders. If the jurisdiction's statute does not provide a mechanism to ensure the proxies' irrevocability, then traditional agency law suggests the proxy must be "coupled with an interest." See W. Painter, Corporate and Tax Aspects of Closely Held Corporations, Sec. 3.4 (2d ed. 1981).
c. If another shareholder is to act as proxy, the "right of first refusal" provision in a stock transfer restriction agreement may provide such an interest. If the proxy holder is an outsider, however, it is unclear that pooling agreements allowing the arbitrator to vote the share will hold up as an irrevocable proxy.
6. Voting Trusts.
a. With a voting trust shareholders retain beneficial ownership of their shares but transfer record title to one or more trustees who have the exclusive right to vote the shares.
b. The trustees vote the shares according to the terms of a voting trust agreement. Oftentimes the trust confers complete discretion of the trustee, who may be a fellow shareholder.
(1) Most jurisdictions require that the trust be filed in the corporation's registered office and be open to the inspection of shareholders and beneficiaries of the voting trust.
c. Many statutes permitting voting trusts limit the initial duration of a trust to ten years (as do many statutes regulating shareholder pooling agreements) but permit their renewal for another ten years.
d. While generally a shareholder transfers all voting rights to the trustee, the exercise of certain enumerated voting rights by the trustee may sometimes be subject to the prior consent of the beneficial owner. In the family context, it is often wise to do reserve certain rights to the shareholder.
(1) These retained rights often pertain to voting on issues basic to the corporate structure such as amendments to the articles or bylaws, or votes that provide for a reduction of capital, a sale of assets, and for dissolution.
(2) A voting trust may, alternatively limit the trustees ability to vote on such basic issues without the consent of a
specified percentage of those holding beneficial ownership of the shares.
e. In the context of a family business, one major advantage of the voting trust is that it removes some voting decisions from the immediate fray of the familial relationships among shareholders. Therefore, disagreements that do arise among family members are less likely to adversely affect the corporation's ability to conduct its business by reducing the likelihood of deadlock insofar as the voting trustee usually votes all shares in the same way.
f. As with the shareholder pool, the need to strictly comply with the requirements of governing statutes and to be explicit in the drafting of these agreements cannot be overemphasized.
7. Cumulative Voting.
a. This is a tool that might be used by a family business to ensure those holding a minority of shares will always be represented on the board of directors.
b. Under a typical cumulative voting scheme, each shareholder gets votes equal to the number of shares he or she owns multiplied by the number of director slots being filled. The shareholder is then able to cast all resulting votes toward any one or more directors. By allowing shareholders to concentrate all their resulting votes for a single candidate, the likelihood of such candidate being elected is greatly enhanced.
c. Cumulative voting is allowed in most all jurisdictions (Massachusetts does not recognize cumulative voting, See M.G.L. ch. 156B sec. 41), and some jurisdictions require it.
d. Note that the effectiveness of this tool can be blunted in situations where there is a small board of directors, by instituting classified boards with staggered terms, by going around the board of directors through the use of executive committees, and by amending the articles of incorporation or bylaws.
Tools for Controlling Management.
1. Supermajority Provisions.
a. To ensure minority shareholders have a voice in the management of the business, shareholders can alter the vote percentage or quorum needed for the election of a director or the passage of a particular provision.
b. This tool, like cumulative voting, has been criticized as being an essentially negative power and that the resulting dissension may outweigh the benefit to the minority shareholder.
(1) These concerns are especially poignant in the context of the family business. If the expectations of family members have been articulated, and better yet, documented through the articles of incorporation, bylaws and supplemental shareholder agreements, introducing the possibility for minority control may serve only to undermine these expectations and exacerbate rather than calm the pressures of a changing business.
c. Perhaps because of these concerns, some courts have been unwilling to enforce some supermajority provisions drafted for close corporations.
(1) In Gearing v. Kelly, 182 N.E.2d 391 (N.Y.1962), the court refused to enforce a quorum requirement that allowed one director to block board action filling a vacancy on the board simply by not showing up.
2. Shareholder Agreements.
a. Shareholder agreements can be especially important for the family business as they can cover a broader array of decisions made by directors than can devices tied to the voting of shares.
b. Issues affecting management, employment, and salary, for example, may well be of much greater interest to the family
business participant whose most direct economic benefit often derives from employment within the business.
c. When applied in the public corporation setting, such agreements have been resisted because they violate a basic tenet of corporate structure: centralized management and the primacy of director control over day-to-day matters.
d. In the family business setting this concern loses its punch and, in fact, some states have amended their corporate statutes to allow businesses to provide in their articles that management will be carried out by the shareholders. See e.g., Del. Gen. Corp. Law, sec. 351.
(1) The New York approach is to allow restrictions on the director's exercise of power through shareholder
agreements if there is the unanimous consent of all shareholders, such power is given in the certificate of incorporation, and if notice is given to subsequent shareholders. New York Business Corp. Law, sec.620(b).
e. Shareholder agreements have been criticized by many as unrealistic and unhelpful to minority shareholders because they lack sufficient bargaining power to ensure that such an agreement adequately defends their positions. See Peeples, "The Use and Misuse of the Business Judgment Rule in the Close Corporation," 60 Notre Dame L.Rev. 456, 491 (1985).
f. This tension will be present in all contractual settings. Nevertheless, the process of articulating the relationship within a
context where familial as well as judicial notions of good faith are imposed is more than useful.
3. Employment Agreements.
a. Closely related to shareholder agreements in the family business setting, are employment contracts.
b. In the family business it is likely that stock transfer restrictions will greatly restrict the sale of a participants' stock. In such a case, the receipt of a salary is often a participant's only tangible economic benefit from the ongoing business.
c. Therefore, employment agreements can be used to provide a measure of security against hastily made decisions to deny or terminate a family member's employment.
(1) If employment agreements are utilized, the remedy for any breach may be limited to monetary damages. Nevertheless, as has been the theme of this paper, such an agreement will make explicit the parties' expectations and at least make directors hesitate before cutting a family member off from the business.
d. If an employment agreement is utilized in a family business involving specialized expertise, it will be important to consider using covenants not to compete.
(1) These provisions will provide incentives for the individual employee to make the arrangement work by limiting his or her immediate options outside of the corporation.
(2) States vary widely on what kind of restrictions are allowed in covenants not to compete and some states do not recognize them at all. Generally, in those states that do recognize these covenants, they will be allowed if their duration and geographical reach are not longer or greater than reasonably necessary to protect the company's legitimate interests.
e. There are alternative tools that can be utilized to provide some employment security.
(1) For example, the bylaws or articles of incorporation can require a vote of a designated percentage of directors or of outstanding shares before an employee is discharged or a salary reduced.
As other papers and discussions will be focusing directly on resolving disputes in the family business context, the discussion here will be brief. It is important to emphasize, however, that planning for the resolution of disputes within the corporation's basic documents as well as in the supplemental governance agreements is an integral part of comprehensive business planning for the family business.
1. Buy-sell Agreement.
a. One mechanism to break a deadlock among shareholders is to obligate a dissenting shareholder to sell and obligate the corporation to buy the dissenter's stock upon the occurrence of specified events (e.g. if dissension or deadlock continues for a set period of time).
b. Such agreements should set forth a fair valuation or formula for reaching such valuation in order to adequately compensate the selling shareholder and to avoid further disputes.
(1) Alternatively, valuation issues can be addressed by contractually agreed to appraisal provisions.
(2) Note that buy-sell agreements will favor those shareholders with available cash.
c. Note further that since provisions allowing the buy-out of dissenting shareholders may be abused by majority shareholders in order to freeze out minority holders, other dispute resolution tools (e.g. arbitration) should be incorporated into these agreements.
2. Stand-by Trust, Irrevocable Proxy, or Special Stock.
a. A standby trust operates in a similar way as the voting trust (discussed above) but it is triggered only after the happening of a specified event (e.g. shareholder deadlock).
b. In creating a standby trust the formalities for setting up a voting trust must be followed as specified by the applicable jurisdiction.
c. As with the voting trust, care must be taken to provide the standby trustee with specific instructions as to how the shares should be voted given the particular circumstances.
d. An alternative to the standby trust is the irrevocable proxy (discussed above) granted to a mutually acceptable neutral third party which can be invoked in the event of deadlock.
e. A related tool that shifts control to a third party in times of deadlock is the creation of a special class of stock.
(1) This stock, issued to a neutral party, might have voting rights and the power to call a special shareholders' meeting under designated circumstances.
(2) This power would last only as long as deadlock remains.
(3) Generally, stock of this class would have a negligible claim of the corporation's equity.
3. Voluntary Dissolution.
a. This mechanism allows a dissenting shareholder to force the sale or liquidation of the corporation either at will or at the occurrence of a specified event.
b. While drastic, this tool allows closely-held corporations to act more like partnerships and thus provides a remedy for deadlock.
(1) To mitigate the potential effects of this provision, the terms may provide for a delay in implementing dissolution once called for or to supplement the provision with a buy-sell option.
c. A corporation's flexibility to utilize voluntary dissolution provisions will be dictated by the applicable corporations statute. It is likely that closely-held corporations will be able to take advantage of tool if it is included in the articles of incorporation.
a. Arbitration provides a predetermined procedure by which disputing parties take their grievance to a neutral party for settlement.
b. Like shareholders' agreements, arbitration has struggled for legitimacy in the corporate context because of the established principles of director control.
c. Now a majority of states allow and even promote the use of arbitration
(1) Variation remains, however, in the extent to which statutory enabling provisions adequately provide for enforcement of arbitration results if challenged.
d. Advantages include:
(1) efficiency and relative low cost;
(2) privacy; and
(3) flexibility of remedy.
e. Disadvantages include:
(1) the tension in underlying shareholder relationships may remain after an arbitrator's decision; and, therefore,
(2) litigation may still result.
1. Neil C. Churchill and Virginia L. Lewis, "The Five Stages of Small
Business Growth," Harvard Business Review at 30 (May-June, 1983).
2. Louis B. Barnes and Simon A. Hershon, "Transferring Power in the
Family Business," Harvard Business Review at 105 (July-August 1976).
3. S. Kumar Jain, "Look to Outsiders to Strengthen Small Business Boards,"
Harvard Business Review at 162 (July-August 1980).
4. Harold W. Fox, "Quasi-boards: Useful Small Business Confidants,"
Harvard Business Review at 158 (January-February 1982).
1. Moni Murdock and Charles Murdock, "A Legal Perspective on
Shareholder Relationships in Family Businesses: The Scope of Fiduciary
Duties," Family Business Review at 287 (vol. IV, no.3, Fall 1991).
2. Brent Nicholson, "The Fiduciary Duty of Close Corporation Shareholders:
A Call for Legislation," 30 American Business Law Journal 513 (1991).