Privately Held Corporations, Quirky Question # 140

Quirky Question # 140:

We have a small closely held company. Our owners are family members and a few close friends. Happily, our company has been increasingly successful. Unhappily, one of our executives does not seem capable of growing with the company. We have made a difficult decision to get rid of this at will employee. When we advised him of this decision, he said that because he felt he had been treated unfairly for some time, he had spoken with a lawyer. He also told us that he is not truly an “at will” employee and that we owe him higher duties. He claims we have breached the covenant of good faith and fair dealing. What is he talking about?

Dorsey’s Analysis:

There are a number of additional pieces of information we would need from you to be able to provide you a comprehensive response to your question.  But, even without this data, we hope that we can point you in the right direction. There are some aspects about the fact pattern you described that cause concern, and that likely will cause you some concern, as you will see from the observations below.

Before turning to the critical questions, let’s make some general observations that nevertheless could be outcome determinative. First, as you likely know, there is not a federal law concerning the management of closely held corporations. Closely held companies are creatures of state law, and state laws on these issues are not uniform. Your first order of business, therefore, is to review (or have your attorney review) your state’s laws regarding closely held corporations. The degree of protection afforded your employee and the substantive and procedural rights he enjoys may be influenced significantly by these statutes and the judicial decisions interpreting these statutes. Second, even though there may be a relevant state statutory scheme, you also should explore your state’s common law to ascertain what rights are afforded your employee. As you likely know, some state statutory schemes supplant completely (or “preempt”) common law. But, in the area of closely held corporations, the preemption analysis may not apply at all or may apply only in part. Third, you did not mention in your question whether, at the time of its inception, your company established By-Laws, a Shareholder Agreement, or other fundamental corporate documents regarding the structure and governance of your company. If so, these documents could bear significantly on the rights of your majority and minority shareholders, including minority shareholders who are employees. Fourth, it is not clear from the information you provided whether your employee has a contract and whether that contract included any representations regarding duration of employment, or circumstances under which a discharge might be warranted. Fifth, your question does not really explain why you and others within your company have reached the conclusion that he is not capable of “growing with the company.” Has he engaged in misfeasance or some other wrongful conduct? Has he engaged in any conduct that clearly would justify a discharge “for cause”? Sixth, what types of feedback have you provided this employee regarding the performance deficiencies that you now have concluded warrant his termination? Keep in mind that procedural failings (e.g., no notice of his performance problems, no opportunity to rectify those problems, tolerance of the same type of problems in others, etc.) often can affect the analysis of the substantive correctness of your decision.

To recap these preliminary points: a) examine your state law on closely held corporations and the decisions interpreting your state’s statutory scheme; b) examine your state’s common law decisions that bear upon the rights of majority and minority shareholders, particularly those minority shareholders who also are employees; c) review your company’s origination documents, particularly those regarding the structure and governance of the company and any agreement describing shareholders’ rights; d) evaluate whether your executive has any contract (whether in writing or oral, including quasi-contractual arrangements) that would affect his employment rights; e) consider carefully the individual circumstances relating to this employee, focusing on why you have concluded that his performance no longer is adequate for your company; and f) assess whether you have provided adequate procedural (and substantive) guarantees for this employee.

With those preliminary observations in mind, let’s evaluate a few of the general principles that may affect your situation. In general, your employee is correct – by virtue of the fact that he is an executive in a closely held corporation, courts will hold your company to a higher standard than they would for an executive in a publicly traded company. In New York, for example, the Court of Appeals noted that the Legislature “has shown a special solicitude towards the rights of minority shareholders . . ..” In re Kemp & Beatley, Inc., 473 N.E.2d 1173, 1177 (N.Y. 1984). The courts in New York and elsewhere have emphasized the differences between shareholders in publicly traded companies and closely held companies. Owners of closely held corporations are held to the highest standards of fiduciary duty – honesty, loyalty, candor, and trust. Owners of closely held companies, and the duties they owe each other, have been compared to the relationships and duties owed among partners. Indeed, some courts have characterized closely held companies as “chartered partnerships.”

Courts also have noted that employees in closely held companies have different expectations than those in publicly traded companies. For example, in the Kemp & Beatley case cited above, the court observed, “”It is widely understood that, in addition to supplying capital to a contemplated or ongoing enterprise and expecting a fair and equal return, parties comprising the ownership of close corporation may expect to be actively involved in its management and operation.” Id. at 1178.

Quoting O’Neal, a leading commentator on closely held companies, the Court of Appeals, stated further,

“‘Unlike the typical shareholder in a publicly held corporation, who may be simply an investor or a speculator and cares nothing for the responsibilities of management, the shareholder in a close corporation is a co-owner of the business and wants the privileges and powers that go with ownership. His participation in that particular corporation is often his principal source of income. As a matter of fact, providing employment for himself may have been the principal reason why he participated in organizing the corporation. He may or may not anticipate an ultimate profit from the sale of his interest, but he normally draws very little from the corporation as dividends. In his capacity as an officer or employee of the corporation, he looks to his salary for the principal return on his capital investment, because earnings of a close corporation, as is well known, are distributed in major part in salaries, bonuses and retirement benefits.’” Id. (citation omitted).

As this analysis illustrates, courts and commentators view closely held companies differently than their publicly held counterparts. Moreover, employee shareholders are given special deference in terms of their treatment by the majority shareholders.

As noted above, states have their own independent statutes governing closely held companies. Many of those statutes discuss “oppression” of minority shareholders. Few of these statutes, however, define the word “oppression.” The question, therefore, is whether a minority shareholder/employee can argue that he has been “oppressed” if discharged. The NY courts have answered this question affirmatively. “A shareholder who reasonably expected that ownership in the corporation would entitle him or her to a job, a share of corporate earnings, a place in corporate management, or some other form of security, would be oppressed in a very real sense when others in the corporation seek to defeat those expectations and there exists no effective means of salvaging the investment.” 473 N.E.2d. at 1179.

The court held that assessing whether conduct was oppressive should be based on the complaining shareholders’ “reasonable expectations.” Id. The court stressed, “oppression should be deemed to arise only when the majority conduct substantially defeats expectations that, objectively viewed, were both reasonable under the circumstances and were central to the petitioner’s decision to join the venture.” Id.

Several key themes are evident from the many New York cases addressing these issues. First, oppression is judged in large part on the minority shareholder’s “reasonable expectations.” Second, the standard is objective, not subjective. Third, the expectations are not confined to the issue of dividends or valuation – expectations also may relate to an ongoing role in management, continued employment, and/or other facets of corporate involvement. Fourth, it is not enough for a minority shareholder merely to express “disappointment” with the majority’s decisions. (Again, as the Kemp court observed, “Majority conduct should not be deemed oppressive simply because the petitioner’s subjective hopes and desires in joining the venture are not fulfilled. Disappointment alone should not be equated with oppression.”)

As reflected in your question, you consider your employee to be employed “at will.” In general, absent a contract of employment defining the duration of employment and/or the grounds for discharge, a company’s employees are employed “at will.” This means that an employee may be discharged at any time, for any (legal) reason, or no reason at all, with or without notice. With few exceptions, this basic tenet of employment law has little to no applicability for a minority shareholder of a closely held corporation who also is an employee. As described above, both state legislatures and state courts have demonstrated “special solicitude” for the rights of the minority shareholder. This solicitude applies equally to the minority shareholder in his/her status as an employee.

This does not mean, however, that a minority shareholder/employee can never be terminated. Although the playing field is tilted decidedly in the employee’s direction, there are at least two alternative analyses that can justify a closely held company’s decision to terminate an employee shareholder. First, the courts have looked to the legitimate interests of the controlling, or majority, shareholders and their need to manage the company effectively. Second, the courts have assessed the terminations of shareholder/employees from the “good cause” perspective.

Even those courts that impose partner-like fiduciary obligations (good faith, candor, loyalty, etc.) on the majority shareholders have recognized that majority shareholders must have some flexibility to manage and run the company. These courts have concluded that the otherwise high standards of fiduciary duty cannot be used to stymie the legitimate actions sought by the majority shareholders, even if those actions have some adverse consequences for the minority shareholders. As explained by the Supreme Court of Massachusetts, “we are concerned that the untempered application of the strict good faith standard . . . will result in the imposition of limitations on the legitimate action by the controlling group in a close corporation which will unduly hamper its effectiveness in managing the corporation in the best interest of all concerned.” Wilkes v. Springside Nursing Home, Inc., 353 N.E.2d 657, 663 (Mass. 1976). The court identified several areas where the majority shareholders needed to maintain both control and flexibility: declaring or withholding dividends; deciding whether to merge or consolidate; establishing the salaries of corporate officers; dismissing directors without cause; and hiring and firing corporate employees.

The Wilkes court went on to establish a two-part analysis to evaluate actions taken by the majority shareholders that would benefit the corporation but arguably disadvantage the minority shareholders. First, the courts should examine “whether the controlling group can demonstrate a legitimate business purpose for its action.” Id. Second, the courts must “weigh the legitimate business purpose, if any, against the practicability of a less harmful alternative.” Id.

The question then becomes whether there is a less harmful alternative to discharging your executive. Perhaps you could provide him a chance to demonstrate that he too can grow with the company. Or perhaps you could provide him a “last chance” warning to demonstrate that he can meet your company’s legitimate performance expectations. Alternatively, another less harsh option would be to alter his position, possibly with a commensurate reduction of his salary. These alternatives are not risk free, especially for someone who, as he advised you, already has retained counsel.

The alternative analytical model that some courts have utilized is to require that the discharges of minority shareholder/employees meet a “good cause” standard. The notion simply is that there must be some circumstances under which a non-performing minority shareholder/employee can be discharged. For example, if an employee engaged in workplace violence, the company must be free to discharge him even if he is a minority shareholder. Conversely, however, if the employee merely engaged in periodic absenteeism or demonstrated performance deficiencies in some other non-material way, it is doubtful that good cause could be established.

The bottom line is that your employee does have rights that do not exist for most employees. Your majority shareholders owe the minority shareholder/employee significant fiduciary duties. Moreover, as the discussion above illustrates, these duties take your executive out of the “at will” context.

In addition, as long as your employee remains employed, he will have additional rights that should be honored scrupulously by your company. You should assume that your company’s future conduct will be scrutinized closely by your executive employee, his lawyer, and ultimately, the court. As difficult as it is to manage a current employee who is suing or threatening suit, as long as he is employed, you owe him significant obligations.  [We did not ask whether your executive falls in the category of “family” that you referenced above, or whether he merely is a “close friend.” If the former, the potential tensions could be exacerbated further.]

It is beyond the scope of this discussion to delineate all of the statutory and common law rights that may be available to your company. But you should familiarize yourself with the statutory requirements that may be imposed on your company with regard to this employee. Your failure to do so could enhance his argument that he is being treated unfairly by the company.

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