Lawyers Journal

Taking exception: The universal demand requirement and close corporations

INTRODUCTION

The current law governing corporations, Massachusetts General Laws Chapter 156D, significantly altered the longstanding prerequisites to filing a derivative suit by instituting a "universal demand" requirement and eliminating the longstanding futility exception.

While this change appears to have been intended to protect the interests of the corporation, it does not serve that goal in cases involving so-called "close corporations." By subjecting aggrieved minority shareholders in close corporations to the demand requirement and lengthy waiting period, Chapter 156D presents a significant risk that these shareholders will lose the opportunity to obtain meaningful relief.

The concerns that underlie the universal demand requirement are not as compelling in cases involving close corporations, and those concerns are likely to be outweighed by the harm that will befall shareholders and the corporation where the universal demand requirement is enforced. The Legislature should amend Chapter 156D to permit an exception to the universal demand requirement for close corporations where a demand would be futile.

CHARACTERISTICS OF CLOSE CORPORATIONS

A closely-held or "close" corporation is one that has (1) a small number of stockholders, (2) no ready market for corporate stock and (3) substantial stockholder participation.1 Although such an entity bears the corporate form and is treated as a corporation in all meaningful respects, a close corporation is distinguished from a traditional corporation.

"[T]he close corporation bears striking resemblance to a partnership. Commentators and courts have noted that the close corporation is often little more than an 'incorporated' or 'chartered' partnership."2 "In essence … the enterprise remains one in which ownership is limited to the original parties or transferees of their stock to whom the other stockholders have agreed, in which ownership and management are in the same hands, and in which the owners are quite dependent on one another for the success of the enterprise."3 More than 90 percent of businesses are closely-held.4

One of the distinguishing features of a close corporation is the vulnerability of the minority shareholder. Unlike a passive shareholder who realizes a return on his or her investment through dividends or capital gains, the minority shareholder in a close corporation often relies upon the corporation for a substantial portion of his or her regular income, through profit distributions, salary or both.

Because there is no ready market for shares, a minority shareholder in a close corporation cannot readily liquidate his or her shares, and any significant or persistent losses are certain to have proportionately deleterious effects on the shareholder. As a result of the precarious nature of ownership in these corporations, for example, that courts act to protect shareholders in close corporations from freeze outs, including by providing an exception to the employment at-will doctrine.5

Similarly, in cases where an oppressed shareholder is not able to exercise control or receive financial rewards of ownership, courts provide relief because the nature of the wrongdoing is such that it denies "the minority's reasonable expectations of benefit."6

THE UNIVERSAL DEMAND REQUIREMENT UNDER CHAPTER 156D

Chapter 156D was enacted on July 1, 2004.7 The statute was drafted by the Task Force on the Revision of the Massachusetts Business Corporation Law, and was based on the American Bar Association's Model Business Corporation Act.8 Chapter 156D replaced and modified many provisions of Chapter 156B. Among the changes to existing law is the procedure applicable to derivative proceedings.

Under Chapter 156D, a derivative proceeding may not be commenced until a written demand has been made and the prescribed waiting period has expired.9 The applicable waiting period is 90 days, unless the demand has been submitted to shareholder vote, where the period is 120 days.10

The derivative claimant may proceed with a claim once he or she is notified of the corporation's rejection, and there is also an exception to the waiting period where "irreparable injury to the corporation would result by waiting" for the period to expire.11

The "demand-required" rule is intended to provide the corporation "the opportunity to take over" the derivative claim and to "allow the directors the chance to occupy their normal status as conductors of the corporation's affairs."12

Recent decisions have recognized the absolute nature of the demand requirement under Chapter 156D, and the SJC has unequivocally stated that any derivative claim that is commenced after the rejection of a demand will be dismissed where "the shareholders or an appropriate group 'has determined in good faith after conducting a reasonable inquiry … that the maintenance of the derivative proceeding is not in the best interests of the corporation.'"13

The rules governing derivative claims under Chapter 156D implicitly make a number of structural and operational assumptions about the nature of corporate ownership and governance. These assumptions are at odds with the structure and operation of many close corporations in practice, in that they tilt the balance away from the rights and expectations of shareholders toward protecting the corporation from bad-faith or wasteful derivative suits. As a result, Chapter 156D significantly complicates the litigation of derivative claims involving close corporations and, perversely, may place these entities at greater peril.

The procedures and prerequisites to filing a derivative claim under Chapter 156D assume that the board of directors is distinct from the shareholders. It is also implicit that there are at least some disinterested shareholders who are able to conduct an inquiry into the allegations. The relatively lengthy timeframe reflects an understanding that a board or the shareholders will be dispersed, and that it will take time for them to coordinate and deliberate on the matter.

The current system also assumes that there is not likely to be any immediate or substantial risk to shareholders caused by delay. The overarching goal of this universal demand requirement is to protect the corporation from needlessly wasting resources on litigation. It reflects the position that the board of directors is able to dispassionately consider the aggrieved party's claim and, if warranted, provide a remedy. Indeed, the only exception to the demand requirement occurs where "irreparable harm" is threatened to the corporation itself.

These assumptions are directly at odds with how most close corporations are composed and governed. Many of the procedures outlined in Chapter 156D are not practical within small close corporations, which may have no directors or officers other than the shareholders themselves. It is highly possible that there will be no shareholders or directors who are disinterested in a potential derivative claim, and because the outcome of such a claim promises to have a sizeable and direct impact on their finances, all shareholders in a close corporation will have a stake in its outcome.

Furthermore, given the small number of shareholders and the likelihood that they are in frequent contact (if not close geographic proximity), there is no practical need for the extended timeframes provided to deliberate under Chapter 156D. These timeframes are also problematic, given the vulnerability of the aggrieved minority shareholder. Because he or she likely relies upon the corporation for his or her livelihood, the longer the waiting period, the greater the risk that the shareholder will suffer an irretrievable loss.

THE FUTILITY EXCEPTION IN PRACTICE

Under prior law, an exception to the demand requirement existed where "a majority of directors are alleged to have participated in wrongdoing, or are otherwise interested."14

As the SJC explained in Harhen v. Brown, a director or officer is "interested" where, among other things, he or she is a party to the conduct, has a relationship with a party to the conduct that would reasonably be expected to affect his or her judgment, or has a "material pecuniary interest" in the conduct.15 In these circumstances, the aggrieved shareholder was excused from making a demand due to futility.

The futility exception came into play frequently in close corporation derivative suits.16 In close corporations, there is a greater likelihood that directors, shareholders and officers will be interested in the conduct at issue. If they are not alleged to be participants in the conduct, they will almost certainly have a significant pecuniary interest in the conduct, given the relationship between the corporation's finances and their own.

The futility exception was an important tool for aggrieved shareholders because it provided a means to initiate suit and seek relief without having to wait for the inevitable rejection or lack of response. Because aggrieved shareholders were able to bypass the demand requirement, they could "stop the bleeding" and protect the corporate assets (and their own) before it was too late. In a close corporation, where shareholders are few and depend heavily on the corporation for their livelihood, any wrongful act that impacts the corporate funds has a proportionate and direct impact on other shareholders.

REVIVING THE FUTILITY EXCEPTION


While current law eliminates the futility exception, it does provide an exception to the 90- or 120-day waiting period where "irreparable injury" to the corporation would result. Indeed, the drafters of Chapter 156D explicitly recognized the need for the application of the irreparable-injury exception to be applied under certain circumstances.

Comment 3 to Section 7.42 stated that "[i]n applying the irreparable injury exception to the 90 or 120-day waiting period, the standard to be applied is intended to be the same as that governing the entry of a preliminary injunction. Other factors may also be considered such as the possible expiration of the statute of limitations …" 17

However, this exception is of little benefit for an aggrieved shareholder in a close corporation, and invoking it comes at a significant risk. Under Chapter 156D, the Superior Court may dissolve a corporation upon a petition filed by shareholders holding at least 40 percent of the total voting shares where there is deadlock, the shareholders are unable to break the deadlock, and "irreparable injury to the corporation is threatened or being suffered."18

Therefore, by alleging that irreparable injury would result from waiting for the demand response period to expire, a shareholder raises the specter of dissolving the corporation at a time when his or her actual aim may very well be to save the corporation.

Furthermore, because the primary determining factor provided by the statute is injury to the corporation, rather than the integrity of the directors' decision-making process, courts may reject derivative claims by shareholders where, despite the magnitude of the harm to an injured minority shareholder, the corporation nonetheless shows signs of solvency. The current system, therefore, requires the formality of a demand and, at minimum, a 90-day waiting period, even in cases where wrongful conduct is ongoing and a demand is obviously futile.

The Legislature should amend Chapter 156D to permit a futility exception for pre-suit demands in cases involving close corporations. While there is a benefit generally to providing the corporation itself an opportunity to review and, if appropriate, take over a claim - as well as limiting unscrupulous or unmeritorious shareholders' ability to launch a corporation into litigation - these concerns are outweighed by the rights and interests of minority shareholders in close corporations.

These individuals are often vulnerable, highly dependent on the corporation for their own well-being, and have rights that, without ready access to the courts, may not be able to be enforced in a timely or effective manner.

Reinstating the futility exception for this class of corporations would recognize the fact that close corporations are not structured, and often do not operate, as other corporations do. The availability of a futility exception would permit aggrieved minority shareholders to obtain meaningful relief, enforce the bargain that shareholders in close corporations make with one another, and keep these corporations viable in circumstances where delay would likely only cause greater harm.

Many thanks to David E. Belfort, Eric R. LeBlanc and Raymond Ausrotas for their valuable input and editing.


1See Donahue v. Rodd Electrotype Co. of New England, Inc., 367 Mass. 578, 586 (1975).
2Id.
3Id. at 587.
4JANE MALONIS, ENCYCLOPEDIA OF BUSINESS (Jane Malonis ed., 2d ed. 1999)
5See Wilkes v. Springside Nursing Home, Inc., 370 Mass. 842 (1976).
6Brodie v. Jordan, 447 Mass. 866, 870 (2006).
7See MASS. GEN. LAWS c. 156D (2011); Halebian v. Berv, 457 Mass. 620, 624 (2010).
8Halebian, 457 Mass. at 625.
9See MASS. GEN. LAWS c. 156D § 7.42.
10Id.
11Id.
12See MASS. GEN. LAWS c. 156D § 7.42 (Comment 4), citing Lewis v. Graves, 701 F.2d 245, 247-248 (2d Cir. 1983).
13Halebian, 457 Mass. at 626, citing MASS. GEN. LAWS c. 156D § 7.44(a).
14Harhen v. Brown, 431 Mass. 838, 844 (2000).
15See id. at 843 n.5 (adopting definition from 1 ALI PRINCIPLES OF CORPORATE GOVERNANCE: ANALYSIS AND RECOMMENDATIONS §§ 1.15 and 1.23 (1994)).
16See, e.g., Aiello v. Aiello, 447 Mass. 388, 396 n.18 (2006) citing Harhen, 431 Mass. at 842-44.
17MASS. GEN. LAWS c. 156D § 7.42 (Comment 3).
18MASS. GEN. LAWS c. 156D § 14.30(2)(i).

Michael L. Mason is an associate at Bennett & Belfort PC, where he practices in business and employment litigation.

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