Protecting Minority Shareholders in Alaska Close Corporations

• Publication year: 2007

§ 24 Alaska L. Rev. 45. PROTECTING MINORITY SHAREHOLDERS IN ALASKA CLOSE CORPORATIONS

Alaska Law Review
Volume 24
Cited: 24 Alaska L. Rev. 45

PROTECTING MINORITY SHAREHOLDERS IN ALASKA CLOSE CORPORATIONS

KEITH ROGERS ^[*]

I. INTRODUCTION

II. THE NATURE OF CLOSE CORPORATIONS

A. Special Considerations of Close Corporations

B. Sources of Relief for Minority Shareholders in Close Corporations

III. FACTUAL BACKGROUND OF THE COPPOCK CASES

A. The First Alaska Supreme Court Case

B. The Second Alaska Supreme Court Case

IV. ANALYSIS OF THE COURT'S OPINIONS IN ALASKA PLASTICS AND STEFANO

V. THE ALASKA STATUTORY APPROACH

VI. WHAT TEST SHOULD ALASKA ADOPT?

A. The Flaw in the Delaware Approach.

B. The Limitations of the Reasonable Expectations Test.

C. A Proposal for Alaska

VII. APPLICATION OF THE ABOVE PRINCIPLES TO THE COPPOCK CASES

VIII. CONCLUSION

FOOTNOTES

The lack of case law in Alaska concerning close corporations, combined with recent supreme court decisions and statutory changes, has made for a confusing state of the law with respect to close corporations. This Comment outlines the nature of close corporations and the particular issues that they face, and it discusses the recent Alaska Supreme Court decisions in the Coppock cases. The Comment then offers a suggestion for how Alaska should proceed in changing and clarifying the state of close corporation law.

I. INTRODUCTION

Alaska is one of the youngest and least populous states in the Union. It should therefore come as no surprise that Alaska case law on close corporations is exceedingly thin. In fact, a case involving the protection of minority shareholders in close corporations did not come before the Alaska Supreme Court until 1980. ^[1] Perhaps also because of the state's small size, Alaska's statutes do not exhaustively cover topics relevant to minority shareholders. Thus, in Alaska Plastics v. Coppock ^[2] and Stefano v. Coppock, ^[3] the supreme court had a great deal of freedom to formulate Alaska law on the subject. Unfortunately, the court's opinions in these cases, combined with recent statutory changes, leave one feeling confused about the current state of the law in Alaska. This Comment critically examines these cases and statutes [*pg 46] and proposes a new framework within which Alaska should consider the rights of minority shareholders in close corporations.

II. THE NATURE OF CLOSE CORPORATIONS

Close corporations differ from public corporations in a number of important respects. Although there is no formal definition of a close corporation, close corporations are typified by a small number of shareholders, the absence of a market for the company's stock, and substantial participation in the business of the corporation by shareholders. ^[4]

A. Special Considerations of Close Corporations

1. Relative Position of Minority Shareholders.

Close corporations present unique opportunities for the holders of a majority of the stock to burden the minority. In public corporations, shareholders typically receive a return on their investment through capital gains upon the sale of their stock or through the payment of dividends. In close corporations, however, there is by definition no ready public market for the sale of shares. ^[5] Also, shareholders in close corporations typically receive a return on their investment primarily through salaries as opposed to dividends. ^[6] Consequently, a shareholder in a close corporation who is not employed by the corporation often has no way to earn a return on her investment. ^[7] The majority shareholders can take advantage of this situation by offering to purchase the minority's shares for an unfairly low price. ^[8] In the absence of legal remedies, the minority shareholder might have no choice but to accept the unfair offer. ^[9]

2. Restrictions on the Transfer of Shares.

Unlike shareholders in public corporations, shareholders in close corporations usually know and plan to work with all the other shareholders in the corporation. ^[10] An investment in a close corporation can be thought of as part of a "package deal" in that an individual invests only in [*pg 47] contemplation of working with certain specific people in operating the business of the close corporation. ^[11] Consequently, shareholders in close corporations may wish to restrict the ability of a fellow shareholder to transfer her shares to a third party. Restrictions on the transfer of shares, often placed in the charter or by-laws, are a key part of close corporation planning. ^[12] Although a basic principle of property law is that restrictions on the alienability of property are disfavored, several forms of restrictions on the transfer of shares are allowed. ^[13] For example, a "right of first refusal" gives the corporation the right to purchase shares at the same price offered by any third party. ^[14] Also, a "consent restraint" dictates that shares cannot be sold unless the corporation (in the form of fellow shareholders) gives its approval. ^[15]

3. Shareholders Agreements.

A special problem of a close corporation is that it is frequently rational for the majority shareholders to "freeze out" a minority shareholder by using their voting power to deny the minority a return on her investment. Although a freeze-out may take many forms, the end result is the same regardless of the form taken: the majority rids itself of an unwanted minority shareholder. In addition to relying on the fiduciary duties owed by the majority to the minority, a minority shareholder can protect herself by entering into a shareholders agreement at the onset of the corporation. ^[16] These agreements can be placed in the charter or by-laws. ^[17]

One example of a shareholders agreement is a voting agreement, in which a shareholder agrees to vote her shares a specific way. ^[18] Voting agreements can cover a variety of areas, including management policy, deadlock, and dissolution. ^[19] A buyout agreement is another way for a minority shareholder to [*pg 48] protect herself. ^[20] It grants the shareholder the right to have her shares bought at a price determined by a method previously agreed to upon the happening of a specified event, such as the shareholder's departure from the employ of the corporation. ^[21] Alternatively, a charter provision might grant a shareholder veto power over all key decisions, ^[22] or an agreement may be made to compel dividends to be paid at specified intervals. ^[23]

B. Sources of Relief for Minority Shareholders in Close Corporations

1. The "Equal Opportunity" Principle.

Most courts hold that majority shareholders owe the minority a fiduciary duty. ^[24] In many states, these fiduciary duties are enhanced in the close corporation context. ^[25] This duty has been expressed as a duty of the "highest degree of honesty and good faith." ^[26] Some courts have even gone so far as to hold that shareholders in close corporations owe each other the same fiduciary duty as partners in a partnership. ^[27]

The Massachusetts case of Donahue v. Rodd Electrotype Co. ^[28] laid out a special rule concerning the fiduciary duty owed by a controlling shareholder in a close corporation to the minority. ^[29] In Donahue, the directors of a close corporation caused the company to purchase the shares of a director who was also the firm's largest shareholder. ^[30] A minority shareholder sued to rescind the purchase. ^[31] The court noted that while close corporations and partnerships share many similarities, the use of the corporate form [*pg 49] gives directors of close corporations an opportunity to disadvantage the minority by, for example, refusing to declare dividends. ^[32] While a partner can dissolve the partnership at any time, a minority shareholder of a close corporation has no market in which to sell her shares and can only achieve dissolution of the corporation by complying with the strict terms of a state's dissolution statute. ^[33] The result is that a minority shareholder is often forced to deal with the majority on the majority's terms. ^[34] Because of this "inherent danger" to minority interests in a close corporation, the court held that shareholders in a close corporation owe each other the same fiduciary duty as partners, a duty of "the utmost good faith and loyalty." ^[35] The court contrasted this with the less stringent duty that applies to corporations generally. ^[36] As part of this enhanced fiduciary duty, the court held that "the controlling group [in a close corporation] may not . . . utilize its control of the corporation to obtain special advantages and disproportionate benefit from its share ownership." ^[37] Applying this rule to the facts of the case, the court held that a controlling shareholder who causes the corporation to purchase his stock has violated his fiduciary duties unless the corporation offers to purchase the minority's shares on the same terms. ^[38] According to the court, there were two forms of appropriate relief for the plaintiffs in Donahue: (1) a remission of the money the defendant director received in exchange for the shares, and (2) an order that the corporation purchase the plaintiff's shares on the same terms as those offered the defendant. ^[39]

Another Massachusetts case, Wilkes v. Springside Nursing Home, ^[40] was decided a year after Donahue and tilted the scales [*pg 50] back in favor of the majority...