Enhanced or Modified Fiduciary Duties in Closed Corporations

While controlling shareholders in public companies may attempt to act opportunistically or obtain a disproportionate share of financial benefits from the corporation, the opportunity for and occurrence of such predatory behavior is compounded in close corporations. One reason is that most public corporations do not have a controlling shareholder while close corporations often have either a single controlling shareholder or a control group of a small number of shareholders, while many close corporations do. A second reason is that opportunistic behavior in public corporations may be constrained by the market, whereas close corporations lack this market, and therefore lack this monitor.

There are two schools of thought on the fiduciary duties owed in a close corporation. The majority rule is that that officers, directors, and all shareholders in close corporations are fiduciaries and, in that capacity, owe each other enhanced fiduciary duties, akin to those owed within partnerships. The minority rule is that only officers, directors, and controlling shareholders acting in their corporate capacities owe any fiduciary duties, and even then only to the corporation primarily. Several states, including Illinois, have adopted hybrid positions that adopt elements of both the majority and minority rules.

Under the minority rule, the fiduciary duties owed are the regular fiduciary duties of care and loyalty. These duties govern the fiduciary’s conduct with regard to the corporation. The interest of the corporation is paramount to those of the fiduciary and shareholders. Under the minority rule, shareholders have no obligations or duties to each other. Under the majority rule, in contrast, all shareholders owe an enhanced duty to act in strict good faith toward each other. As one federal court summarizing Illinois law put it, these enhanced fiduciary duties require a shareholder to “deal with the utmost good faith, fairly, honestly, and openly with their fellow stockholders.”

Over the past decades, there has been a trend in judicial decisions and statutes towards recognizing enhanced fiduciary duties in close corporations, where shareholder dissension arises most frequently. These enhanced duties can affect the relief available to minority shareholders who are oppressed.

The seminal case on enhanced fiduciary duties in close corporations comes from the Massachusetts Supreme Judicial Court’s 1975 decision in Donahue v. Rodd Electrotype Company, Incorporated. After noting the difficulty that a minority shareholder will have in challenging dividend and employment policies under traditional fiduciary obligations, the court went on to hold that “stockholders in the close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another.” In explaining the nature and scope of this duty, the Donahue court described this enhanced duty as one of “utmost good faith and loyalty” that demanded “not honesty alone, but the punctilio of an honor the most sensitive,” in dealings with other shareholders. The court went on to contrast this heightened or enhanced duty owed in close corporations to “the somewhat less stringent standard of fiduciary duty” owed in public corporations.

The court then applied this enhanced duty to require a corporation which repurchased the shares of the majority shareholder to extend a similar opportunity to the minority shareholders in a family-owned business.

More than a decade before Donahue, the Illinois Supreme Court, in Galler v. Galler, 32 Ill. 2d 16 (1964), predicted the Donahue holding when it identified what it considered to be a “definite, albeit inarticulate trend toward eventual judicial treatment of the close corporation as sui generis.” Since Galler, Illinois has adopted a middle ground wherein it has found that enhanced fiduciary duties are owed to shareholders in a close corporation but has limited the application of this rule to only certain shareholders, namely controlling shareholders. Taking it one step further, the Illinois legislature in 2005 added a new section to the Illinois Business Corporation Act of 1983, found at 805 ILCS 5/7.90, allowing shareholders to waive certain rights in exchange for a release of fiduciary obligations to the corporation or other shareholders based merely on status as a shareholder.

The Seventh Circuit has explained the rationale for finding these enhanced fiduciary duties between shareholders of a close corporation exist:

Shareholders in close corporations have often invested “a substantial percentage” of their assets in the corporation … and their position in the corporation may provide them with their only source of income. Minority shareholders are vulnerable to “freeze-outs” or “squeeze-outs,” where the majority, for personal rather than legitimate business reasons, deprives the minority shareholder of his office, employment, and salary…. Moreover, because no active market exists for the corporation’s stock (and prospective purchasers may be wary of buying into a small enterprise where dissension has already occurred), the minority stockholder most likely will not be able to sell his shares for any sum approaching their fair value.

Unlike courts in Illinois and many other states, Delaware courts have been unwilling to impose fiduciary duties on shareholders of closely held corporations. In explaining its decision to reject the majority rule, the Delaware Supreme Court stated:

A stockholder who bargains for stock in a closely-held corporation and who pays for those shares … can make a business judgment whether to buy into such a minority position, and if so, on what terms…. Moreover, in addition to [certain statutory protections in Delaware Corporate Law], a stockholder intending to buy into a minority position in a Delaware corporation may enter into definitive stockholder agreements, and such agreements may provide for elaborate earnings tests, buy-out provisions, voting trusts, or other voting agreements…. The tools of good corporate practice are designed to give a purchasing minority stockholder the opportunity to bargain for protection before parting with consideration. It would do violence to normal corporate practice and our corporation law to fashion an ad hoc ruling which would result in a court-imposed stockholder buy-out for which the parties had not contracted.

The tools of good corporate practice are designed to give a purchasing minority stockholder the opportunity to bargain for protection before parting with consideration. It would do violence to normal corporate practice and our corporation law to fashion an ad hoc ruling which would result in a court-imposed stockholder buy-out for which the parties had not contracted.

Our Chicago breach of fiduciary duty and business litigation attorneys have defended and prosecuted minority oppression, business divorce, stolen corporate opportunity and breach of fiduciary duty lawsuits for more than three decades.

Lubin Austermuehle’s Wheaton, Naperville, and Oak Brook litigation attorneys have more than thirty-five years of experience helping business clients unravel the complexities of Illinois and out-of-state business laws. Our Chicago business divorce litigation lawyers represent individuals, family businesses and enterprises of all sizes in a variety of legal disputes, including disputes among partners and shareholders as well as lawsuits between businesses and consumer rights, auto fraud, and wage claim individual and class action cases. In every case, our goal is to resolve disputes as quickly and successfully as possible, helping business clients protect their investments and get back to business as usual. From offices near Aurora and Elgin, we serve clients throughout Illinois and the Midwest. If you’re facing a business or class-action lawsuit, or the possibility of one, and you’d like to discuss how the experienced Illinois breach of fiduciary duty attorneys at Lubin Austermuehle can help, we would like to hear from you. To set up a consultation with one of our Chicago class action attorneys and Chicago business trial lawyers, please call us toll-free at 630-333-0333 or contact us online.