All corporations experience development cycles that
are affected not only by their market area and the prevailing economic
climate, but also by the personalities of the directors, officers and
shareholders. This is especially true for closely-held corporations
and, in particular, for family businesses. In the family business
setting, the level of formality is often dictated by what stage of
development the business has reached. As a family business develops, so
will pressures that strain the family structure which provided a level
of cohesion for the business. These pressures can arise from a
variety of stimuli. A growing market share may require changes to meet
new demands. These new demands may suggest a need for new expertise
and, possibly, non-family managers. Perhaps a member of the family has
reached an age where he or she is ready to undertake management
responsibilities; or conversely, perhaps the founding member of the
business is approaching retirement. All of these positive changes will
put pressures on the existing structure of the family business.
Negative changes can likewise lead to strain on this structure. To
manage these pressures, the professional advisor must offer planning
mechanisms that will assist the family to govern effectively in these
times of transition. This paper will outline the tools available to
family businesses which can assist it in times of transition and
stress. The author argues that family businesses should be allowed
maximum flexibility in arranging the equity and management
relationship of its participants and the corporate governance
structure in order to channel family relationships in the most
THE EXISTING CONTEXT OF FIDUCIARY DUTIES.
Duty of Care and Duty of Loyalty
1. Two fiduciary duties are generally applied in the
corporate setting. Corporate leadership is expected to use due care in
managing the assets entrusted to them (duty of care) and to manage
the assets for the good of the business and not for their own personal
benefit (duty of loyalty).
2. Generally, the business decisions of directors will
not be challenged by the court if the decisions are independent,
informed, rational, and taken in good faith.
3. Many commentators have argued that this deference
-- the business judgment rule -- should not be applicable in the
context of the closely-held corporation because shareholders have a
less fluid economic remedy if they become dissatisfied with their
investment and because of the inherent interest a
director/officer/shareholder has in closely held corporate actions. As
there is greater potential that majority shareholders will "oppress"
minority shareholders in a close corporation, commentators believe
that the courts should look more closely at the decisions of close
corporations. See Moni Murdock and Charles Murdock, "A Legal
Perspective on Shareholder Relationships in Family Businesses: The
Scope of Fiduciary Duties," Family Business Review (vol. IV, no.3,
1991); Ralph Peeples, "The Use and Misuse of the Business Judgment Rule
in the Close Corporation," 60 Notre Dame Law Review 456 (1985).
Substitutes for Traditional Fiduciary Duties in Closely-Held Corporations.
A number of standards have been suggested to replace the business judgment rule in the small business context.
1. Intrinsic Fairness. In instances where a corporate
director or officer has an "interest" in a corporate action as a
shareholder, some commentators suggest that, rather than looking at
the process by which a decision was reached, the consequences of the
corporate decision itself for minority shareholders should be
examined. This standard does not begin with the presumption of fairness
and the burden of justifying the complained of conduct is thereby
shifted to the defendants.
2. Partnership Standard. This standard essentially
views the closely held corporation as a partnership and imposes a
heightened level of fiduciary duty. Consequently, majority or
controlling shareholders in a close corporation must satisfy a
standard of "trust, confidence, and absolute loyalty" in their conduct
of the corporation affairs. Donahue v. Dodd Electrotype Company of New
England, 328 N.E.2d 505, 512 (Mass. 1975).
3. Less Harmful Means. The Donahue standard was
curtailed slightly in Wilkes v. Springside Nursing Home, Inc., 353
N.E.2d 657 (1976). This case holds that close corporate action can be
sustained if there is a reasonable business rationale for the
majority's actions and the plaintiffs can not establish that there was
an alternative action less harmful to minority interests. See Peeples
4. Reasonable Expectations. New York has applied a
"reasonable expectations" standard by which the court considers the
previously articulated expectations of the parties to determine if
oppression has occurred. For example, a minority shareholder may
invest in a close corporation with the expectation that his economic
return will be in the form of employment with the corporation. Despite
the courts usual deference to employment decisions, if all other
shareholders are receiving employment and this particular termination
appears suspect, under the reasonable expectation standard, the court
will scrutinize a decision to
terminate this employment because it conflicts with the minority
shareholder's reasonable expectation. See In re Kemp & Beatley,
Inc., 473 N.E.2d 1173 (N.Y. 1984).
Criticism of the Heightened Standard in the Family Business Setting.
1. Some commentators have suggested that the
application of a heightened fiduciary standard to the close
corporation often results in the court writing rather than enforcing
the bargain among the parties. (See Frank H. Easterbrook and Daniel R.
Fischel, The Economic Structure of Corporate Law at 245, (Harvard
University Press, 1991)).
2. Instead, these commentators would have the court
ask what the parties themselves would have contracted for if the
transaction costs made such bargaining possible. Easterbrook and
Fischel at 250.
3. To answer the above question, courts will likely be
influenced by the contractual relationship the parties did create as
evidenced by the corporation's governing documents.
4. Therefore, like the reasonable expectation
standard, this approach puts a heavy emphasis on the express
agreements between the parties and the content of organizational
5. In planning for the governance of family
businesses, the legal advisor should advocate the full use of the
corporate tools discussed below in order to paint a picture detailed
enough to assist any judicial review of corporate actions.
TRADITIONAL CORPORATE TOOLS IN THE FAMILY BUSINESS SETTING
The following is an abbreviated review of the various
tools available to the family business to structure their corporate
governance. The professional advisor can utilize these tools in
various ways to manage the inevitable pressures that occur as the
family business develops.
The following materials provided helpful reference for
this section: Joseph J. Norton, "Adjustment and Protection of
Shareholder Interests in the Closely-Held Corporation in Texas," 39
Southern Methodist Law Journal 781 (1985); Robert C. Clark, Corporate
Law (Little, Brown & Co., 1986); and William H. Painter, Business
Planning: Problems and Materials (2d ed., West Publishing, 1984).
Depending on the stage in which the professional
advisor intervenes, he or she may have an opportunity to influence the
basic documents of the corporation. With shareholder approval these
documents can also be changed to reflect the evolving needs of the
1. Preincorporation Agreements. When dealing with an
ongoing concern, it is unlikely that the advisor will have the luxury
to sit down with the participants of the family business to
memorialize their expectations of the business and its governance
structure. Yet, given the opportunity the exercise of documenting such
expectations can be invaluable when drafting post-incorporation
documents structuring various aspects of corporate relationships.
2. Articles of Incorporation. This is the basic
corporate document that will, along with the bylaws, constitute the
fundamental contract among shareholders. Each jurisdiction dictates
the basic content of the articles of incorporation. The articles
typically include at least the following:
a. the corporate name;
b. the duration of the corporation (e.g. perpetual);c. the nature of the business and its purposes;
d. the number of shares and their par value;
e. the designation of classes of shares and their attendant rights, preferences, and limitations;
f. provisions on preemptive rights, if desired; and
g. the name and address of the corporate agent.
The following may also be included in the articles of incorporation, if desired:
a. the minimum capitalization requirements;
b the size and composition of the initial board of directors;
c. a statement regarding the corporation's status as a closed corporation; and
d. provisions regarding the management of the business and the conduct of its affairs.
The classes of shares, their rights and
limitations, the terms of directors and the process of succession are
all components of corporate governance that can be arranged to
effectuate the expectations of the participants as to equity and
3. Bylaws. While the articles of
incorporation set forth an external corporate structure, the bylaws
define internal arrangements. The decision as to whether internal
management arrangements are included in the articles of incorporation or
in the bylaws will be determined to some extent by how easy, or
difficult, the participants want it to be to alter these initial
Participants in a family business bring
different contributions to the corporation in terms of capital,
experience and expertise. The relative rights assigned to corporate
shares and the distribution of those shares will allow the corporation
to allocate the profit, risk, ownership, and management control of
the business in a way that best meets the expectations of all
1. Common stock. Common stock represents
the basic equity instrument in the corporation. The rights and
privileges attached to the common stock are determined by the
participants as reflected in their basic corporation documents, as well
as by the statutory and case law of the applicable jurisdiction. The
flexibility which the law allows to disproportionately allocate voting
power among different classes of common stock allow participants in a
family business an ability to grant certain shareholders the power to
elect directors and to influence other important corporate decisions.
2. Preferred Stock. A class of preferred
stock can be created to give certain shareholders an interest in the
family business that differs from those holding common stock -- an
interest that may or may not have voting rights. For example, a class
of preferred stock may carry a fixed dividend which takes precedence
over the payment of dividends on the common stock and can have a
priority claim in the liquidation of assets upon dissolution. The
terms of preferred stock can be very flexible and, beyond the issues
of voting and dividends, participants will want to consider whether
the stock is voluntarily or mandatorily redeemable by the corporation,
and whether it is convertible to common stock.
3. Other Rights of Ownership.
Shareholders of a family business may well want to give family members
who are not actively involved with the corporation the opportunity to
share in the equity of the business. One way this can be achieved is
through the grant of options, rights, or warrants. These instruments are
not stock (although they are usually considered securities for
purposes of state and federal law), but instead are contractual rights
to purchase stock in the future on terms set forth in the
particular instrument. The author has found that these instruments
afford tremendous opportunity for "sharing the wealth" among family
members on such terms, in such amount, and at such times as the parties
Tools for Controlling Ownership.
In addition to creating different classes
of stock, other tools are available to the family corporation that
can structure the ownership, voting power, and control rights of
1. Stock Classification. Corporate
statutes allow for tremendous flexibility in allocating corporate
power by the issuance of different classes of stock as long as the
relative rights, preferences, and limitations of the various classes are
set forth in the articles of incorporation.
a. Through the classification of shares, the owners of a family business can separate voting control from equity ownership.
(1) For example, the founder of a family
enterprise may choose to grant voting stock to children active in the
business and non-voting stock (which may have an equal claim on the
equity of the corporation) to children who are not active in the
b. Note: If the business has elected to be taxed
under Subchapter S of the Internal Revenue Code, the corporation's
legal advisor will want to be sure that any differences between
classes of common stock do not jeopardize this tax election.
2. Restrictions on Dilutive Issuances of
Stock. The initial capitalization of the corporation and stock
classification will allocate ownership interests to participating
shareholders. The power to issue more shares, however, can quickly
alter this allocation and the relative power of participants.
a. It is therefore not unusual if the ability of a
corporation to issue additional stock (the issuance of which can
dilute equity percentages or control rights of certain shareholders)
is restricted through provisions which would allow additional stock to
be issued only if a specified super-majority of the corporation's
b. Another option is to provide for preemptive
fights, a mechanism which allows existing shareholders to maintain
position by subscribing for a pro-rata portion of any new stock
being issued. A shareholder's priority fight to purchase newly
issued stock can be an important mechanism for maintaining the careful balance of ownership interests.
c. Jurisdictions differ as to whether they allow for
preemptive fights through common law or by statute, and some
restrictions on this fight may apply.
d. If preemptive rights are to be relied on to protect minority interests, certain inherent limitations must be considered.
(1) Preemptive rights will allow a shareholder to
maintain her relative position only if the shareholder has the
resources to exercise her rights to purchase the new shares.
(2) Some preemptive rights schemes can frustrate
the ability of a corporation to raise additional capital on favorable
3. Stock Transfer Restriction.
a. The ability to keep shares within the family or
within a specified group of individuals is of great importance to the
b. While the basic rule of free alienability governs
stock transfers in the public corporation, exceptions have been
allowed in the closely held corporation as long as the restrictions on
transfer are reasonable.
c. Restrictions that have been found reasonable include:
(1) right of first refusal provisions;
(2) Reasonable consent restraints (shareholder
must get the consent of other shareholders, which must not be
unreasonably withheld, before transferring the shares); and
(3) reasonable purpose restrictions (particularly
relevant to the family business, some states have allowed reasonable
restrictions intended to keep shares of a family business within the
d. Most jurisdictions also require that any transfer
restriction be noted conspicuously on the front of the stock
certificate evidencing affected shares.
e. In addition to giving the shareholders control
over transfers of the ownership of their corporation, stock transfer
restrictions can operate as a "buy-sell" arrangement that can provide
needed liquidity to a shareholder in the event of disability, death,
4. Shareholder Pooling Agreements.
a. Most jurisdictions will allow shareholders to
agree to vote their shares together to achieve a certain goal, like
control of the corporation.
b. Generally, pooling arrangements take the form of a
contract among shareholders and, therefore, requires adequate
c. State corporation statutes should be reviewed for
any formalities necessary to the creation of a valid shareholder
(1) Care should be taken not to inadvertently
create a voting trust (discussed below) which generally are governed
by distinct statutory requirements.
d. It is especially important that the agreement of
the participants be well delineated as to how and when their votes
will be jointly cast.
(1) These agreements should incorporate dispute resolution methods to resolve disagreements if and when they occur.
e. In order to ensure specific performance from a court of law, the agreement should expressly provide for this remedy.
5. Irrevocable Proxies.
a. This device is often used in conjunction with
shareholder pooling agreements and creates an agency relationship so
that one person is authorized to vote the stock of another.
b. This is necessary when the shareholder pooling
agreement provides for arbitration and the arbitrator is given the
right to vote the stock of one of the disagreeing shareholders. If the
jurisdiction's statute does not provide a mechanism to ensure the
proxies' irrevocability, then traditional agency law suggests the
proxy must be "coupled with an interest." See W. Painter, Corporate and
Tax Aspects of Closely Held Corporations, Sec. 3.4 (2d ed. 1981).
c. If another shareholder is to act as proxy, the
"right of first refusal" provision in a stock transfer restriction
agreement may provide such an interest. If the proxy holder is an
outsider, however, it is unclear that pooling agreements allowing the
arbitrator to vote the share will hold up as an irrevocable proxy.
6. Voting Trusts.
a. With a voting trust shareholders retain
beneficial ownership of their shares but transfer record title to one
or more trustees who have the exclusive right to vote the shares.
b. The trustees vote the shares according to the
terms of a voting trust agreement. Oftentimes the trust confers
complete discretion of the trustee, who may be a fellow shareholder.
(1) Most jurisdictions require that the trust be
filed in the corporation's registered office and be open to the
inspection of shareholders and beneficiaries of the voting trust.
c. Many statutes permitting voting trusts limit the
initial duration of a trust to ten years (as do many statutes
regulating shareholder pooling agreements) but permit their renewal
for another ten years.
d. While generally a shareholder transfers all
voting rights to the trustee, the exercise of certain enumerated
voting rights by the trustee may sometimes be subject to the prior
consent of the beneficial owner. In the family context, it is often
wise to do reserve certain rights to the shareholder.
(1) These retained rights often pertain to voting
on issues basic to the corporate structure such as amendments to the
articles or bylaws, or votes that provide for a reduction of capital, a
sale of assets, and for dissolution.
(2) A voting trust may, alternatively limit the trustees ability to vote on such basic issues without the consent of a
specified percentage of those holding beneficial ownership of the shares.
e. In the context of a family business, one major
advantage of the voting trust is that it removes some voting decisions
from the immediate fray of the familial relationships among
shareholders. Therefore, disagreements that do arise among family
members are less likely to adversely affect the corporation's ability to
conduct its business by reducing the likelihood of deadlock insofar
as the voting trustee usually votes all shares in the same way.
f. As with the shareholder pool, the need to
strictly comply with the requirements of governing statutes and to be
explicit in the drafting of these agreements cannot be overemphasized.
7. Cumulative Voting.
a. This is a tool that might be used by a family
business to ensure those holding a minority of shares will always be
represented on the board of directors.
b. Under a typical cumulative voting scheme, each
shareholder gets votes equal to the number of shares he or she owns
multiplied by the number of director slots being filled. The
shareholder is then able to cast all resulting votes toward any one or
more directors. By allowing shareholders to concentrate all their
resulting votes for a single candidate, the likelihood of such
candidate being elected is greatly enhanced.
c. Cumulative voting is allowed in most all
jurisdictions (Massachusetts does not recognize cumulative voting, See
M.G.L. ch. 156B sec. 41), and some jurisdictions require it.
d. Note that the effectiveness of this tool can be
blunted in situations where there is a small board of directors, by
instituting classified boards with staggered terms, by going around
the board of directors through the use of executive committees, and by
amending the articles of incorporation or bylaws.
Tools for Controlling Management.
1. Supermajority Provisions.
a. To ensure minority shareholders have a voice in
the management of the business, shareholders can alter the vote
percentage or quorum needed for the election of a director or the
passage of a particular provision.
b. This tool, like cumulative voting, has been
criticized as being an essentially negative power and that the
resulting dissension may outweigh the benefit to the minority
(1) These concerns are especially poignant in the
context of the family business. If the expectations of family members
have been articulated, and better yet, documented through the articles
of incorporation, bylaws and supplemental shareholder agreements,
introducing the possibility for minority control may serve only to
undermine these expectations and exacerbate rather than calm the
pressures of a changing business.
c. Perhaps because of these concerns, some courts
have been unwilling to enforce some supermajority provisions drafted
for close corporations.
(1) In Gearing v. Kelly, 182 N.E.2d 391
(N.Y.1962), the court refused to enforce a quorum requirement that
allowed one director to block board action filling a vacancy on the
board simply by not showing up.
2. Shareholder Agreements.
a. Shareholder agreements can be especially
important for the family business as they can cover a broader array of
decisions made by directors than can devices tied to the voting of
b. Issues affecting management, employment, and salary, for example, may well be of much greater interest to the family
business participant whose most direct economic benefit often derives from employment within the business.
c. When applied in the public corporation setting,
such agreements have been resisted because they violate a basic tenet
of corporate structure: centralized management and the primacy of
director control over day-to-day matters.
d. In the family business setting this concern loses
its punch and, in fact, some states have amended their corporate
statutes to allow businesses to provide in their articles that
management will be carried out by the shareholders. See e.g., Del.
Gen. Corp. Law, sec. 351.
(1) The New York approach is to allow restrictions on the director's exercise of power through shareholder
agreements if there is the unanimous consent of all
shareholders, such power is given in the certificate of incorporation,
and if notice is given to subsequent shareholders. New York Business
Corp. Law, sec.620(b).
e. Shareholder agreements have been criticized by
many as unrealistic and unhelpful to minority shareholders because
they lack sufficient bargaining power to ensure that such an agreement
adequately defends their positions. See Peeples, "The Use and Misuse
of the Business Judgment Rule in the Close Corporation," 60 Notre Dame
L.Rev. 456, 491 (1985).
f. This tension will be present in all contractual
settings. Nevertheless, the process of articulating the relationship
context where familial as well as judicial notions of good faith are imposed is more than useful.
3. Employment Agreements.
a. Closely related to shareholder agreements in the family business setting, are employment contracts.
b. In the family business it is likely that stock
transfer restrictions will greatly restrict the sale of a
participants' stock. In such a case, the receipt of a salary is often a
participant's only tangible economic benefit from the ongoing
c. Therefore, employment agreements can be used to
provide a measure of security against hastily made decisions to deny
or terminate a family member's employment.
(1) If employment agreements are utilized, the
remedy for any breach may be limited to monetary damages.
Nevertheless, as has been the theme of this paper, such an agreement
will make explicit the parties' expectations and at least make
directors hesitate before cutting a family member off from the
d. If an employment agreement is utilized in a
family business involving specialized expertise, it will be important
to consider using covenants not to compete.
(1) These provisions will provide incentives for
the individual employee to make the arrangement work by limiting his
or her immediate options outside of the corporation.
(2) States vary widely on what kind of
restrictions are allowed in covenants not to compete and some states
do not recognize them at all. Generally, in those states that do
recognize these covenants, they will be allowed if their duration and
geographical reach are not longer or greater than reasonably necessary
to protect the company's legitimate interests.
e. There are alternative tools that can be utilized to provide some employment security.
(1) For example, the bylaws or articles of
incorporation can require a vote of a designated percentage of
directors or of outstanding shares before an employee is discharged or
a salary reduced.
As other papers and discussions will be
focusing directly on resolving disputes in the family business
context, the discussion here will be brief. It is important to
emphasize, however, that planning for the resolution of disputes within
the corporation's basic documents as well as in the supplemental
governance agreements is an integral part of comprehensive business
planning for the family business.
1. Buy-sell Agreement.
a. One mechanism to break a deadlock among
shareholders is to obligate a dissenting shareholder to sell and
obligate the corporation to buy the dissenter's stock upon the
occurrence of specified events (e.g. if dissension or deadlock
continues for a set period of time).
b. Such agreements should set forth a fair valuation
or formula for reaching such valuation in order to adequately
compensate the selling shareholder and to avoid further disputes.
(1) Alternatively, valuation issues can be addressed by contractually agreed to appraisal provisions.
(2) Note that buy-sell agreements will favor those shareholders with available cash.
c. Note further that since provisions allowing the
buy-out of dissenting shareholders may be abused by majority
shareholders in order to freeze out minority holders, other dispute
resolution tools (e.g. arbitration) should be incorporated into these
2. Stand-by Trust, Irrevocable Proxy, or Special Stock.
a. A standby trust operates in a similar way as the
voting trust (discussed above) but it is triggered only after the
happening of a specified event (e.g. shareholder deadlock).
b. In creating a standby trust the formalities for
setting up a voting trust must be followed as specified by the
c. As with the voting trust, care must be taken to
provide the standby trustee with specific instructions as to how the
shares should be voted given the particular circumstances.
d. An alternative to the standby trust is the
irrevocable proxy (discussed above) granted to a mutually acceptable
neutral third party which can be invoked in the event of deadlock.
e. A related tool that shifts control to a third party in times of deadlock is the creation of a special class of stock.
(1) This stock, issued to a neutral party, might
have voting rights and the power to call a special shareholders'
meeting under designated circumstances.
(2) This power would last only as long as deadlock remains.
(3) Generally, stock of this class would have a negligible claim of the corporation's equity.
3. Voluntary Dissolution.
a. This mechanism allows a dissenting shareholder to
force the sale or liquidation of the corporation either at will or at
the occurrence of a specified event.
b. While drastic, this tool allows closely-held
corporations to act more like partnerships and thus provides a remedy
(1) To mitigate the potential effects of this
provision, the terms may provide for a delay in implementing
dissolution once called for or to supplement the provision with a
c. A corporation's flexibility to utilize voluntary
dissolution provisions will be dictated by the applicable corporations
statute. It is likely that closely-held corporations will be able to
take advantage of tool if it is included in the articles of
a. Arbitration provides a predetermined procedure by
which disputing parties take their grievance to a neutral party for
b. Like shareholders' agreements, arbitration has
struggled for legitimacy in the corporate context because of the
established principles of director control.
c. Now a majority of states allow and even promote the use of arbitration
(1) Variation remains, however, in the extent to
which statutory enabling provisions adequately provide for enforcement
of arbitration results if challenged.
d. Advantages include:
(1) efficiency and relative low cost;
(2) privacy; and
(3) flexibility of remedy.
e. Disadvantages include:
(1) the tension in underlying shareholder relationships may remain after an arbitrator's decision; and, therefore,
(2) litigation may still result.
1. Neil C. Churchill and Virginia L. Lewis, "The Five Stages of Small
Business Growth," Harvard Business Review at 30 (May-June, 1983).
2. Louis B. Barnes and Simon A. Hershon, "Transferring Power in the
Family Business," Harvard Business Review at 105 (July-August 1976).
3. S. Kumar Jain, "Look to Outsiders to Strengthen Small Business Boards,"
Harvard Business Review at 162 (July-August 1980).
4. Harold W. Fox, "Quasi-boards: Useful Small Business Confidants,"
Harvard Business Review at 158 (January-February 1982).
1. Moni Murdock and Charles Murdock, "A Legal Perspective on
Shareholder Relationships in Family Businesses: The Scope of Fiduciary
Duties," Family Business Review at 287 (vol. IV, no.3, Fall 1991).
2. Brent Nicholson, "The Fiduciary Duty of Close Corporation Shareholders:
A Call for Legislation," 30 American Business Law Journal 513 (1991).