Smith v. Atlantic Properties, Inc.

Massachusetts Appeals Court · 1981 · Corporations

CorporationsClose corporationsFiduciary dutiesDividend policyMinority veto controlclose corporation80% voting provisionminority veto

Facts

Atlantic was a close corporation formed by four equal shareholders, each holding twenty-five shares, and its articles and by-laws required an 80% vote for corporate action, giving each shareholder a veto. Dr. Wolfson consistently refused to approve dividends because he preferred repairs and possible improvements, while the other shareholders favored dividends; yet he did not present a specific, definitive plan for repairs and improvements that would satisfy tax authorities as reasonable business needs. Atlantic accumulated substantial earnings, and the Internal Revenue Service assessed accumulated earnings penalty taxes for multiple years, with substantial taxes, interest, and legal expenses resulting. The trial judge found that Wolfson's refusal to approve dividends stemmed more from dislike of the other shareholders and tax-avoidance concerns than from any genuine plan to improve the property.

Issue

Whether, in a close corporation with an 80% voting provision that gives a 25% shareholder veto power, that minority shareholder breaches fiduciary duties by refusing to approve dividends and thereby causing accumulated earnings tax penalties to the corporation. Also, whether the trial court's prospective dividend order and denial of the plaintiffs' counsel fees were proper.

Rule

In a close corporation, a shareholder who has controlling power over a particular issue by virtue of a supermajority voting provision is subject to fiduciary obligations of utmost good faith and loyalty and may not exercise that power unreasonably or in a manner clearly inconsistent with the corporate interest. Judicial intervention should weigh the business interests asserted by the controlling side and the rival side under the Wilkes approach, and a shareholder who recklessly creates serious and unjustified risks of corporate loss through misuse of such control may be charged with the resulting out-of-pocket losses to the corporation.

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Harbor Foundry, Inc., a close corporation in Providence, has four equal shareholders. Its charter requires 80% shareholder approval for any dividend, and Nina Patel has repeatedly blocked dividends for three years even after the company received warnings from tax counsel that its retained earnings were likely to trigger accumulated earnings penalties; she has offered only general remarks about someday modernizing the warehouse.

If the corporation later pays accumulated earnings taxes, interest, and tax-litigation fees largely because no adequate dividends were declared, what is the strongest argument that Nina is liable to the corporation?

Explanation. The majority opinion treated a minority shareholder with supermajority-based veto power as an ad hoc controlling interest on the disputed issue. In a close corporation, that shareholder must exercise the power with utmost good faith and loyalty. If, after warnings, the shareholder unreasonably withholds dividends without a convincing, definitive business plan and thereby recklessly creates serious and unjustified risks of tax penalties, the shareholder may be charged with the corporation's out-of-pocket losses, including related tax-case fees. The rule is not strict liability, and the supermajority provision itself is not invalid.