Close Corporations

• Pages: 565-602
• Author: Stephen M. Bainbridge

565

Chapter 14

CLOSE CORPORATIONS

§ 14.1 Exit Versus Voice

A “close corporation is one in which the stock is held in a few

hands, or in a few families, and wherein it is not at all, or only rarely,

dealt in by buying or selling.”

1

The firm’s size thus is not

determinative, although most close corporations tend to be small,

local businesses. Instead, the hallmarks of the closely held

corporation are the small number of shareholders and, most

important, the absence of a secondary market in which its stock is

traded.

This definition emphasizes a critical difference between the

public and close corporation; namely, the absence of a market out. If

shareholders of a public corporation are unhappy with the firm’s

management, they can easily exit via the stock market.

Consequently, they can simply sell out and put the unhappy

experience behind them. Shareholders of a close corporation, in

contrast, have no access to a secondary trading market for their

shares and, as a result, may find it very difficult to locate a buyer for

their shares. Where exit is precluded, dissatisfied constituencies of

an organization must resort to voice; that is, because they cannot

escape from the unsatisfactory situation, they must seek to change it

through internal governance mechanisms.

2

Unlike a large public corporation, where collective action

problems preclude shareholders from bargaining with one another,

the small group of investors in a close corporation permits them to

bargain at comparatively low cost. Investors would be foolish to agree

to invest in the business, but leave planning the details about the

firm until the future. Instead, they should settle the critical questions

in advance—before they’ve invested money in the business.

The small number of shareholders typical of close corporations

also vitiates the efficiency rationale for separating ownership and

control. To the contrary, shareholders of close corporations are far

less likely to be passive investors than is the case with respect to

public corporations. (These are exceptions, of course, as many close

corporations have “silent partners.”) A desire for active involvement

follows directly from the lack of a market out. If the shareholders

1

Galler v. Galler, 203 N.E.2d 577, 583 (Ill.1964). See also G & N Aircraft, Inc.

v. Boehm, 743 N.E.2d 227, 236 n. 2 (Ind.2001) (“A minimum requirement is a lack of

a public market for the shares, and most would require a small number of shareholders

as well.”).

2

See generally Albert O. Hirschman, Exit, Voice, and Loyalty (1970).

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CLOSE CORPORATIONS

Ch. 14

cannot protect themselves by selling out, they are wise to want an

effective voice in how the firm is operated.

Earning a return on one’s investment provides yet another

reason for shareholders to be actively involved in running the close

corporation. Most close corporations do not pay significant dividends.

Instead, for tax reasons, the shareholders’ principal return on their

investment comes in the form of salary and bonuses. Dividends are

not deductible by the firm, so they are subject to double taxation, once

at the firm level and again when received by the shareholder. In

contrast, reasonable salary and bonuses are deductible by the firm,

so they are taxed only once (at the shareholder/employee level).

Because of these tax consequences and the resulting practice of not

paying dividends, a denial of employment to a minority shareholder

may deny that shareholder a fair return on his investment.

Finally, unlike the public corporation context, it is often

practical for the shareholders to be actively involved in running the

store. In many closely held corporations, all shareholders are

employees and/or directors of the firm, which means that they are in

a much better position to monitor the firm’s performance and the

performance of other firm employees than their public corporation

counterparts.

The difficulty, of course, is that the corporation statutes fail to

take this into account. Recall that shareholders have no meaningful

management rights. Instead, once they have elected the directors,

the firm is run by the board of directors. As we have just seen,

however, this approach makes very little sense in the context of a

small firm where the managers, directors, and shareholders are

likely to be one and the same.

There are a wide variety of techniques by which close

corporation shareholders can be given effective control over firm

management. Most entail some degree of private ordering. Will

courts enforce private contracts that derogate from the statutory

allocation of powers and rights? If private ordering fails, what ex post

extra-contractual rights do allegedly injured shareholders possess?

A number of states have adopted special statutes for close

corporations, commonly modeled on the ABA’s Model Close

Corporation Supplement. Promoters of a close corporation may opt

into coverage by such statutes through an express designation of

such status in the articles of incorporation. The regulatory regime for

statutory close corporations is substantially more liberal in a variety

of ways than is mainstream corporate law.

Nevertheless, these statutes are little used. Courts frequently

grant comparable benefits to non-statutory close corporations,

§ 14.2

PRIVATE ORDERING IN CLOSE CORPORATIONS

567

moreover. In Ramos v. Estrada,

3

for example, defendants noted that

California’s close corporation statute authorizes vote pooling

agreements but the general corporation statute was silent.

Defendants inferred that vote pooling agreements were invalid in

close corporations that had not opted into the special statute. The

court rejected that argument, upholding vote pooling agreements as

valid even in non-statutory close corporations. Accordingly, separate

treatment of those statutes is omitted in this text.

§ 14.2 Private Ordering in Close Corporations

A. Private Ordering of Voting Rights

Whether a corporation is public or close, the most important

thing shareholders do as shareholders is the election of directors.

Shareholder voting on such matters as dissolution, mergers, and the

like runs a reasonably close second. In the close corporation, with its

limited number of shareholders, voting can prove problematic in a

variety of ways. If shareholders are evenly divided on some issue,

deadlock may ensue.

4

More likely, a majority faction may use its

voting power to oppress the minority. The majority might, for

example, decline to elect minority representatives to the board of

directors. The law provides two contractual solutions to this problem:

the voting trust and the vote pooling agreement.

1. Voting Trusts

A voting trust is an agreement among shareholders under which

all of the shares owned by the parties are transferred to a trustee,

who becomes the nominal, record owner of the shares. The trustee

votes the shares in accordance with the provisions of the trust

agreement, if any, and is responsible for distributing any dividends

to the beneficial owners of the shares.

At common law, voting trusts originally were suspect. Early

courts believed that the power to vote stock was an essential incident

of owning shares and that separating voting rights from ownership

3

10 Cal.Rptr.2d 833 (Cal.App.1992). See also Zion v. Kurtz, 428 N.Y.S.2d 199

(1980) (similar holding under Delaware law).

4

A creative solution to the deadlock problem was validated in Lehrman v.

Cohen, 222 A.2d 800 (Del.1966). The Lehrman and Cohen families were equal partners

in a grocery store corporation. The corporation had three classes of stock. One class

was owned solely by the Lehrman family and gave them the right to elect two directors.

A second class was owned solely by the Cohen family and gave them the right to elect

two directors. A third class with very limited economic rights but also the right to elect

one director was issued to the corporation’s legal counsel, who thus functioned as a

tiebreaker between the two families. The Delaware Supreme Court held that the third

class was a valid class of stock and that the agreement did not constitute an illegal

voting trust.