Opinion ID: 2533533
Heading Depth: 3
Heading Rank: 1

Heading: The Fiduciary Duty of Shareholders in Closely Held Corporations Is Similar to the Duty of Partners in a Partnership

Text: ¶ 16 Under the revised business code, directors and officers are required to carry out their corporate duties in good faith, with prudent care, and in the best interest of the corporation. Utah Code Ann. § 16-10a-840 (2005). These corporate duties have been interpreted to coincide with the common law understanding that officers and directors owe these duties to the corporation and shareholders collectively, not individually. Aurora Credit Servs., 970 P.2d at 1280 (indicating that actions for breach of a fiduciary duty generally belong to the corporation). In this case, however, McLaughlin urges us to apply a different standardthe partnership standard. In contrast to the general standard for corporate duties, the statutory partnership standard of care has been interpreted to require the utmost good faith between individual partners. Ong, Int'l (U.S.A.), Inc. v. 11th Ave. Corp., 850 P.2d 447, 453-54 (Utah 1993) (Normally partners `occupy a fiduciary relationship and must deal with each other in the utmost good faith.' (quoting Burke v. Farrell, 656 P.2d 1015, 1017 (Utah 1982))); Nelson v. Matsch, 38 Utah 122, 110 P. 865, 868 (1910) ([P]artners stand in a fiduciary relation to each other, and that[]is the duty of each partner to observe the utmost good faith towards his copartners in all dealings and transactions that come within the scope of the partnership business.); Utah Code Ann. § 48-1-18 (2007). ¶ 17 Whether to modify the fiduciary duty standard in closely held corporations is an issue of first impression for this court. Numerous other states have considered the question, and; we look to their analyses and to the Corporation Act's language and structure to guide our determination. See Arndt v. First Interstate Bank of Utah, N.A., 1999 UT 91, ¶ 17, 991 P.2d 584 (indicating that in the absence of Utah precedent, the court looks to Utah statutes and case law from other jurisdictions for guidance). ¶ 18 McLaughlin urges us to follow the partnership-like duty standard originally articulated by Massachusetts courts and subsequently adopted by several other states. Beginning with Donahue v. Rodd Electrotype Co. of New England, 367 Mass. 578, 328 N.E.2d 505 (1975), Massachusetts changed the landscape of duties owed by shareholders in close corporations. Relying on (1) the resemblance between close corporations and partnerships, (2) the need for trust and confidence in such companies, and (3) the inherent risk of loss due to shareholders' inability to recoup their investments, the Massachusetts court imposed on close corporation shareholders the same duties owed by partners utmost good faith and loyalty to all shareholders of the corporation. Id. at 515. Compared to the fiduciary duty owed by directors and stockholders of public corporations, the court found this duty to be more rigorous than the somewhat less stringent corporate duty of good faith and inherent fairness. Id. at 515-16. The Donahue court explained, stockholders in close corporations must discharge their management and stockholder responsibilities in conformity with this strict good faith standard. They may not act out of avarice, expediency or self-interest in derogation of their duty of loyalty to the other stockholders and to the corporation. Id. at 515. The Massachusetts courts have repeatedly upheld and applied this standard. See O'Brien v. Pearson, 449 Mass. 377, 868 N.E.2d 118, 124 (2007); Zimmerman v. Bogoff, 402 Mass. 650, 524 N.E.2d 849, 853 (1988); Wilkes v. Springside Nursing Home, Inc., 370 Mass. 842, 353 N.E.2d 657, 663 (1976). The Donahue standard has also been adopted by other jurisdictions. Hollis v. Hill, 232 F.3d 460, 468 (5th Cir.2000) (noting that Donahue's recognition of special rules of fiduciary duty applicable to close corporations has gained widespread acceptance.); Orchard v. Covelli, 590 F.Supp. 1548, 1559 (W.D.Pa.1984). (The duty of utmost good faith and loyalty in the context of closely[] held corporations has been recognized by a number of courts confronting similar fact situations.). ¶ 19 The defendants, however, urge this court to follow the minority position, which has been adopted by Delaware and Texas. The minority position narrowly construes the duties of shareholders in a closely held corporation and differentiates between a person's status as employee and shareholder. In Riblet Products Corp. v. Nagy, for example, the Delaware Supreme Court noted that Delaware had not adopted Massachusetts' approach to fiduciary duties, but instead imposed identical duties on shareholders of closely held corporations and public corporations. 683 A.2d 37, 39 n. 2 (Del.1996); accord Hoggett v. Brown, 971 S.W.2d 472, 488 (Tex.App.1997) ([A] co-shareholder in a closely held corporation does not as a matter of law owe a fiduciary duty to his co-shareholder.). Additionally, the Delaware Supreme Court distinguished between the plaintiff's rights as a stockholder and his contractual rights as an employee. Riblet Prods. Corp., 683 A.2d at 40. While the court noted the Riblet plaintiff had not alleged that his termination amounted to a wrongful freeze-out of his stock interest, in subsequent cases where the plaintiff has made such allegations, other courts following Delaware's approach have determined that any injury caused by a termination decision would only be an injury to an individual's employment interests and not to his interests as a stockholder. Berman v. Physical Med. Assocs., Ltd., 225 F.3d 429, 433 (4th Cir. 2000). At least one court has described this approach as being more predictable because it treats all corporations the same way. Bagdon v. Bridgestone/Firestone, Inc., 916 F.2d 379, 383-84 (7th Cir.1990) (comparing Ohio's Donahue fiduciary duty standard for close corporations to Delaware's traditional standard). The Delaware approach thus stands in sharp contrast to the fiduciary duty standard followed by the majority of states. ¶ 20 Presented with two divergent approaches, we must assess which approach best suits Utah's corporate law scheme. Our Corporation Act does not provide explicit guidance, as it does not directly address close corporations or duties between shareholders. However, considering the Act as a whole and its specific provisions together, such as the duties imposed on directors and the dissolution remedy explicitly outlined, Utah Code Ann. §§ 16-10a-840, -1430(b), we believe it is apparent that the legislature intended to protect shareholders from oppression and misconduct by those in control. To construe the Act's provisions to require the same fiduciary duties for publicly held and closely held corporate shareholders would not adequately protect close corporation shareholders. This is because the Model Business Code, on which the Utah Corporation Act was based, was developed largely in the context of publicly held corporations and the common law surrounding their governance. See Model Bus. Corp. Act Ann. Introduction (2009) ([T]he Model Act does not generally distinguish between publicly held and privately held corporations. Additionally, the Model Act was amended in 1990 and 2006 to provide greater certainty and more flexibility to non-public corporations.); See also F. Hodge O'Neal, Robert B. Thompson, & Blake Thompson, O'Neal & Thompson's Close Corporations and LLCs: Law and Practice § 9:21 (3d ed. 2004) (Courts recognize that the usual default rules of corporate law affect close corporations differently from large publicly held corporations. . . .). Close corporations differ, however, in significant ways, and when these differences result in undesired outcomes, we have interpreted the Corporation Act in a way that achieves the intent and goal of the Act as a whole. This is a trend followed by many courts. See Melrose v. Capitol City Motor Lodge, Inc., 705 N.E.2d 985, 990 (Ind.1998) (Courts have traditionally interpreted fiduciary duties differently for closely[]held corporations as opposed to publicly held corporations for which most of the statutory norms were established.). ¶ 21 As discussed in Angel Investors and Aurora, the form of closely held corporations subjects shareholders to distinct challenges in protecting their investment. These core characteristics, and other common elements, lead to what has been referred to as the close corporation trap. James M. Van Vliet, Jr. & Mark D. Snider, The Evolving Fiduciary Duty Solution for Shareholders Caught in a Closely Held Corporation Trap, 18 N. Ill. U.L.Rev. 239, 242 (1998); see also F. Hodge O'Neil, Robert B. Thompson, & Blake Thompson, O'Neal and Thompson's Close Corporations and LLCs: Law and Practice § 9:2 (3d ed. 2004) (noting that a close corporation shareholder does not have a partner's power to dissolve the enterprise and get out and similarly does not have the exit option of selling her shares in a securities market available to shareholders of publicly held corporations). Shareholders in close corporations lack a ready market for their shares. This means that closely held corporation shareholders have no liquidity in their shares, see Donahue, 328 N.E.2d at 515 (No outsider would knowingly assume the position of the disadvantaged minority.), and have no avenue for price discovery other than the costly process of acquiring an independent valuation for the company. Without an available market in which to sell their interest in a company, minority shareholders who disagree with the direction or governance of the close corporation must rely on contractual or statutory remedies, which are often nonexistent, impractical, or inadequate. Id. This, in effect, leaves the shareholder with no remedy for the abuses and oppression that may result due to the small number of shareholders, the frequency of familial and other personal relationships, and the likelihood that majority shareholders control the board in close corporations. Though the Act provides for dissolution, this is often a drastic remedy that may not serve the interest of the complaining shareholder and certainly not the corporation of which he is a part owner. ¶ 22 Without a market remedy, shareholders in close corporations are easily subjected to freeze outs, squeeze outs, and other forms of oppression, which the Corporation Act aims to prevent. Thus, the Massachusetts approach of recognizing broader fiduciary duties in closely held corporations better achieves the goals of the Act by stemming shareholder oppression and is the appropriate standard for evaluating fiduciary relationships among shareholders in a closely held corporation. Our adoption of the Massachusetts standard is a logical extension of our existing case law regarding close corporations, which acknowledges the unique nature of such corporations and seeks to protect their shareholders by interpreting the Corporation Act with different corporate circumstances in mind. By adopting this broader fiduciary obligation for close corporation shareholders, alternative remedies exist for oppressed shareholders, [4] such as an equitable claim for dissolution or a claim for breach of fiduciary duty. ¶ 23 Having concluded that shareholders in closely held corporations owe their coshareholders fiduciary obligations, we now consider whether the Defendants breached these duties in this case.