Massachusetts Law Review

Over thirty years ago, the Supreme Judicial Court (“SJC”) issued its landmark ruling in Donahue v. Rodd Electrotype Co. of New England, Inc.,[1] in which it established standards for the governance of closely held corporations in Massachusetts and held that each shareholder in a closely held corporation owes a fiduciary duty to the other shareholders.[2]  In the years since the Donahue decision, and in conformance with that landmark ruling, the Massachusetts courts have analyzed an array of issues involving the management and control of closely held corporations.

This article first will review the Donahue ruling itself.  It then will discuss significant developments in the Donahue doctrine, including:  (a) the tension between running the corporation and protecting the interests of minority shareholders; (b) employment issues when a shareholder also is an employee; (c) the improper use of corporate opportunities; (d) the applicability of Donahue to non-Massachusetts corporations; (e) applying the Donahue rules to limited liability companies and limited liability partnerships; (f) drafting around the Donahue requirements; and (g) special issues for disputes involving professional services firms.  Third, the article will provide an overview of available remedies, both by resort to the courts and through negotiation.  Lastly, the article will note trends in the case law after Donahue and suggestions for further refinements in the balance between the needs of entities and the rights of individual shareholders.

Euphemia Donahue was the widow of Joseph Donahue, who had been employed by Rodd Electrotype Company of New England, Inc., starting out as a “‘finisher’ of electrotype plates” and rising to “the positions of plant superintendent (1946) and corporate vice-president (1955)” although he “never participated in the ‘management’ aspect of the business.”[3]  Over time, Mr. Donahue bought stock in the company and by 1955, was the owner of twenty percent of the company’s stock, with Harry Rodd owning the remaining eighty percent.[4]  During the ensuing years, Mr. Rodd gave some of his stock to his children and, in 1970, the corporation purchased the remaining stock that he owned.[5]  Mrs. Donahue learned of this purchase in 1971 and demanded that the company buy her stock on the same terms; the company refused, and a lawsuit was filed later that year.[6]  The superior court ruled in favor of the company and its officers and directors and, in a brief opinion, the Appeals Court affirmed.[7]  The SJC reversed the two lower courts, ruling that the company, Mr. Rodd, and its other individual officers and directors breached their fiduciary duties to Mrs. Donahue by not allowing her the opportunity to have the corporation buy her stock on the same terms that had been given to Mr. Rodd.[8] 

The court then used this rather narrow internal dispute to provide a broad framework for the governance of “close corporations” in Massachusetts, dealing with the basics (formation, allocation of power, employment, stock purchase and sale) and then how operations, management and compensation can change over time.[9]  First, the court defined the term “close corporation,” ruling that a corporation will be considered closely held when there are “(1) a small number of shareholders; (2) no ready market for the corporate stock; and (3) substantial majority stockholder participation in the management, direction and operation of the corporation.”[10]

Then came the heart of what would become the Donahue doctrine.  Noting that “the close corporation bears striking resemblance to a partnership,” the court held that “[j]ust as in a partnership, the relationship among the stockholders must be one of trust, confidence, and absolute loyalty…” and the same standard applies to both large and small closely held entities.[11]  Building on the concepts of trust and fairness, the court recognized that while there were many advantages for using the corporate form, “it also supplies an opportunity for the majority stockholders to oppress or disadvantage minority stockholders.”[12]  In such cases, the oppressed minority shareholder has few remedies since “[h]e cannot easily reclaim his capital, cannot readily sell his stock and cannot force a dissolution.”[13]  Thus, the court ruled, shareholders owe one another a strict fiduciary duty.[14]  Shareholders must act with “utmost good faith and loyalty.”[15]  “Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.”[16]  Furthermore, the court ruled that these rules applied not just to majority stockholders but to “all stockholders in close corporations.”[17]  In doing so, the court applied well-settled trust and partnership law to corporations which traditionally had been governed, for the most part, by statutory and contract law.

Having established the standards to be applied to shareholders in closely held corporations, the court then addressed the issues of equal opportunities for all shareholders.[18]  Thus, if a shareholder who is a member of the group controlling the corporation has had his stock repurchased, the other shareholders must be given the same opportunity to have the same percentage of their shares repurchased at the same price.[19]  An effort by a shareholder to “issue stock in order to expand his holdings or to dilute holdings of other stockholders” is a similar breach of duty.[20]  Based on these rules, the court concluded that either Mr. Rodd had to return the money he had received (with interest) to the company, or Mrs. Donahue had the right to sell her stock to the company at the same price that Mr. Rodd had received (without interest).[21]

II.         Significant Developments in the Donahue Doctrine

A.        Legitimate Business Interest and Other Basic Rules

In its first decision after issuing its broad pronouncements in Donahue, the SJC recognized that problems might be caused in the legitimate governance of closely held corporations by the “untempered application” of the Donahue standards.[22]  Thus began a series of appellate decisions over the next thirty years that have attempted to balance the rights of minority shareholders against the needs of controlling shareholders to run their businesses.[23]

In Wilkes v. Springside Nursing Home, Inc.,[24] four men, including the plaintiff Wilkes, bought a building and began operating it as a nursing home through a corporation that they

formed.[25]  Each of the four served as a director of the corporation, undertook responsibility for certain tasks associated with running the business, and eventually began to withdrawing money regularly from the business.[26]  After a number of years, disagreements arose between Wilkes and one of the other shareholders.[27]  As a result, at directors and shareholders’ meetings in 1967, Wilkes was forced “out of active participation in the management and operation of the corporation” and the company “cut off all corporate payments to him.”[28]  Wilkes then filed suit for breach of fiduciary duty.[29]  The court ruled that the exclusion of Wilkes constituted a corporate “freeze out” and recognized that termination of employment can effectively prevent a minority shareholder from getting any return on his investment.[30]

While recognizing the power that majority shareholders had, however, the court also expressed concern that the Donahue standards, applied literally, might be too stringent and inhibit legitimate management of the entity.[31]  Thus, the court set some limits on the application of the Donahue doctrine and rules as to who bears the burden of proof concerning an alleged Donahue violation.  In each case involving a challenge by a minority shareholder, the court must first ask “whether the controlling group can demonstrate a legitimate business purpose for its action.”[32]  If the majority meets this initial test, then the burden shifts to the minority shareholder to show “that the same legitimate objective could have been achieved through an alternative course of action less harmful to the majority’s interest.”[33]  The courts “must weigh the legitimate business purpose, if any, against the practicability of a less harmful alternative.[34]  Here, there was no legitimate business purpose for the corporation’s action and, therefore, Wilkes was entitled to relief.[35] 

In cases following Donahue and Wilkes, the appellate courts have charted a basic series of rules concerning such issues as burden of proof, the duty of disclosure, problems that ensue when shareholders take on multiple roles in a corporation, and the principle that these rules apply to all shareholders of the entity.  These rules generally follow logically from the basic premise that shareholders in a closely held corporation owe an enhanced duty of fairness to one another.

Thus, in breach of fiduciary duty cases, the burden of proof is on the alleged wrongdoers, at least in the first instance, to justify their actions.  A corporate insider whose transaction with the corporation is challenged “has the task of showing that the deal was not in breach of his fiduciary obligations toward directors, stockholders, and corporation.”[36]  The director or shareholder must “prove that his or her actions were intrinsically fair, and did not result in harm to the corporation or partnership.”[37]  Likewise, the burden is on the party whose action is challenged to show that its action had a legitimate business purpose.[38] 

The corporate insider is bound to make “full contemporaneous disclosure” of a transaction to the other directors and shareholders so they can review and approve it in order for the transaction to withstand a later challenge that it violated a duty owed to the other shareholders or to the corporation itself.[39]  In O’Brien v. Pearson,[40] for example, the court ruled that a breach of fiduciary duty had occurred when the defendants unilaterally decided to change the enterprise’s objective without consulting the minority shareholder.[41]  Self-dealing by a fiduciary may not be ratified by a corporation without full disclosure.[42]  Moreover, the deference (more so in Delaware than in Massachusetts) given to corporate actions under the business judgment rule, namely that actions will not be subject to judicial scrutiny if they are an exercise of legitimate business judgment, “does not apply if the plaintiff can show self-dealing.”[43]  For example, “[s]etting one’s own level of compensation, without corporate approval, is a form of self-dealing.”[44]  As such, it will be subjected to close scrutiny by the court.”[45]  Even silence alone can constitute a breach of a fiduciary duty.[46]  Thus, a shareholder’s failure to disclose to his fellow shareholders the amount of rent payments he was receiving was a breach of his fiduciary duty.[47] 

Fiduciaries must be particularly careful when they assume multiple roles, such as when serving as “trustees of a trust [as well as] stockholders, directors, and officers of a close corporation involved in transactions in which they st[and] on both sides and in which they ha[ve] a self-interest.”[48]  As the Appeals Court observed, “[w]earing more than one hat --here, at least three-- requires a fiduciary to be very nimble as well as most prudent.  While the fiduciaries may purport to wear one hat at a particular moment, in truth all hats are worn together at all times.”[49] 

These rules apply to all shareholders, not just minority owners.[50]  Even though a fifty percent shareholder, for example, can pursue the remedy of dissolution, he also can avail himself of the Donahue protections.[51]  Thus, in Smith v. Atlantic Properties, Inc.,[52] the court applied Donahue to a minority shareholder who, through provisions in the entity’s articles of organization and bylaws, was able to veto certain corporation actions (in this case by voting against declaring a dividend which resulted in an adverse tax consequence to the entity).[53] 

At the same time that the courts have outlined the basic rules for shareholders to follow, they also have recognized that not every situation that may harm a shareholder constitutes a violation of the Donahue - Wilkes standards.  For example, in a case involving the recapitalization of a publicly held company that had the attributes of a closely held corporation, the recapitalization passed scrutiny because the minority shareholders failed to show that legitimate business purpose could have been reached with “less drastic alternatives....”[54]  In Goode v. Ryan,[55] the court refused to order a corporation to repurchase a deceased shareholder’s stock.[56]  There was nothing in the corporate documents or any agreement among the shareholders that required repurchase nor was the refusal to buy back the shares part of a freeze-out; “the plaintiff’s predicament… [was] merely one of the risks of ownership of stock in a close corporation.”[57]  Thus, unlike Donahue, the corporation was not benefiting one shareholder while refusing to do the same for another.  The entity was simply exercising its legitimate right not to undertake an activity that is was not obligated to do.  In this regard, no Wilkes situation was presented because there was no harm to a minority interest.  Rather, the court simply refused to create an affirmative right that the parties had not chosen to create.[58]

Moreover, while a minority shareholder owed Donahue duties to the majority, the majority can legitimately “take its own interest into account” in deciding how to act.[59]  Thus, “self-interest may be a proper motive for a stockholder’s actions, so long as that interest does not result in acts in derogation of the stockholder’s fiduciary duty.”[60]  This right of “‘selfish ownership’” extends “at least in part, to minority stockholders, although their interests are somewhat different in character.”[61]  So a minority shareholder’s decision to vote against a merger was legitimate where it had not been given requested financial information and it had a reasonable suspicion that the proposed transaction “was based on unrealistic assumptions….”[62]  Voting for the merger was not “a reasonable and practicable alternative….”[63]

In In re Mi-Lor Corp.,[64] the United States Court of Appeals for the First Circuit faced the question whether a release signed “by a close corporation and its directors and shareholders” barred a later claim of unjust enrichment.[65]  In Mi-Lor Corp., all of the directors and shareholders of a closely held corporation, and the entity itself, entered into a global settlement agreement among themselves that included mutual releases.[66]  Later, when the entity filed for bankruptcy, the creditor trustees brought claims on behalf of the entity against certain shareholders.[67]  The court held that “where there is unanimous and fully informed shareholder approval in a close corporation,” even if all of them were “interested,” that was sufficient to uphold a release and no further showing of fairness was necessary.[68]  The court further ruled, “that Massachusetts would place the burden of showing the enforceability of a release on the corporate fiduciary who relies on that release to extinguish any recovery for the underlying breach.”[69]

Often in a closely held corporation, the minority shareholder is an employee and the effort to harm him is to deprive him of employment.[70]  In Merola v. Exergen,[71] the court was confronted with the problem of how to balance the competing principles of duties to fellow shareholders with the general right to terminate an at-will employee with or without cause.[72]  Steven Merola, an employee who was not a founder of the company, purchased shares of stock in his employer, a closely held corporation, when the company allowed its employees to make such stock purchases.[73]  When Merola was terminated, he sued the company and its president and majority stockholder, Francesco Pompei, alleging that there was no legitimate business purpose for his termination and, therefore, it was a breach of fiduciary duty to fire him.[74]  The SJC ruled that:

[a]lthough there was no legitimate business purpose for the termination of the plaintiff, neither was the termination for the financial gain of Pompei or contrary to established public policy.  Not every discharge of an at-will employee of a close corporation who happens to own stock in the corporation gives rise to a successful breach of fiduciary duty claim.[75] 

Important factors in Merola were that (a) the employee got a fair price for his stock; (b) the employee did not help to form the company; (c) there was no expectation by any other employee-stockholders of continued employment with the company; (d) the value of the stock increased while the employee was employed; and (e) buying stock in the company was not a condition of employment.[76]  Furthermore, termination of employment pursuant to the terms of an employment contract is permissible and therefore, does not give rise to a Donahue inquiry.[77] 

In other cases, the courts also have balanced the issue of the rights of employers to freely terminate their employees (subject to certain limited exceptions) in at-will employment situations with the fiduciary duties owed to those same employees in their capacities as shareholders.  For example, termination of an employee for participating in a shareholder derivative suit does not constitute a violation of public policy.[78]  But when a company terminated a shareholder-employee, thereby depriving him of a lifetime employment situation, triggering a stock redemption, and, by removing him from the company, denied him information relevant to the diversion of corporate assets, and, the day after the termination, had its employees sign a “confidentiality agreement” “whose only apparent purpose was to prevent these employees from disclosing to” the discharged employee what was going on at the company, the court entered a preliminary injunction ordering the employee reinstated to his position.[79]  It should be noted that an employee-shareholder who is wrongfully terminated cannot just sit back and wait for her rights to be vindicated; she still has an obligation to attempt to mitigate her damages.[80] 

The balance that must be struck between recognizing the rights of management to run the entity and protecting the minority shareholder from losing perhaps the only tangible benefit of stock ownership – her job -- is difficult to achieve.  In Wilkes and then in Merola, the court seems to have struck the appropriate balance, enhanced but not absolute protection for the shareholder who helps found or fund the company and diminished rights for the shareholder who receives stock incident to employment.

The rules concerning diversion of a corporate opportunity flow naturally from the general principles enunciated in Donahue, Wilkes, and their progeny.  A shareholder (like a corporate officer or director) breaches “his fiduciary duty by acquiring or diverting a corporate business opportunity for his personal profit….”[81]  Before diverting a corporate opportunity for his own use, a shareholder must fully disclose that opportunity to the corporation.[82]  As with other allegations of shareholder wrongdoing, full disclosure is the critical issue.[83]  In order to avoid later challenges, it is better to make the disclosure in writing and even better to get written consent for the action. Whether there has been a breach of duty in diverting an opportunity depends on the particular facts of the situation.[84]  But it is a defense to a claim of usurping a corporate opportunity that the corporation would be unable to avail itself of that opportunity.[85]  Thus, in Energy Resources Corp. v. Porter,[86] the Appeals Court held that in a “refusal to deal” defense, that is, the argument that there was no corporate opportunity if someone was refusing to transact business with the company, the refusal must be disclosed to the company along with a fair statement of the reason for the refusal.[87]  Only with full disclosure can a claim of diversion of a corporate opportunity be avoided.[88]  “The nondisclosure of a corporate opportunity is, in itself, unfair to a corporation and a breach of a fiduciary duty.”[89]  A director who usurps or diverts a corporate opportunity “is personally liable even where the profits or benefits accrue to a third party, whether or not it is under the control of the director.”[90] 

While the Donahue standard applied to the Massachusetts corporations, until the 1990s it was not clear how it applied to “foreign” corporations.  This was a particularly important issue because Delaware is often the choice of forum for corporate lawyers looking to create a new

entity.  In Demoulas v. Demoulas Super Markets, Inc.,[91] the corporation had been formed in Delaware but then merged into a new Massachusetts corporation.[92]  The SJC held that only one state’s laws should apply (even though some of the wrongdoing occurred while the entity was a Delaware corporation) and so it applied Massachusetts law.[93]  Four years later, in Harrison v. Netcentric Corp.,[94] the court shifted course, rejecting any suggestion that it would adopt a functional approach to determining which state’s law applied, and holding that “the State of incorporation dictates the choice of law regarding the internal affairs of a corporation.”[95]  In reaching this conclusion, the court noted that “[t]o avoid the imposition of ‘conflicting demands,’ ‘only one State should have the authority to regulate a corporation’s internal affairs….’”[96]  The court reconciled its ruling in Demoulas by noting that the “case was an exceptional one, as it concerned a company that has changed its State of incorporation as well as conduct that spanned both periods….”[97]  Interestingly, the breach of fiduciary duty claim involved the company buying back the stock under a stock restriction agreement, which agreement provided that it would be governed by Massachusetts law.  Yet, the court ruled that this choice of law provision did “not mean that the plaintiff’s breach of fiduciary duty claim must also be governed by the law of this State.”[98] 

The difference between Massachusetts and Delaware law is quite significant since Delaware does not follow Donahue and has adopted different standards which are less favorable to minority shareholders.  In Clemmer v. Cullinane,[99] however, the Appeals Court indicated that all may not be lost even if Delaware law governs.  Applying the lenient Massachusetts Rule of Civil Procedure 12(b) (6) standard, the Clemmer court ruled that Delaware law “did not preclude a cause of action for minority shareholder freeze-out in close corporations.”[100]  If the entity in question is a Delaware corporation, then careful analysis of Delaware law will be necessary.

There are a number of reasons why a corporation may chose to incorporate in Delaware rather than Massachusetts, such as the settled body of Delaware corporate law.  Nevertheless, there seems to be some element of unfairness in allowing an entity that, except for its state of incorporation, is based entirely in Massachusetts to be able to deprive its minority shareholders of the protections of Donahue.  While, as discussed below, a well-crafted shareholders’ agreement can limit this inequity (and by the same token modify the Donahue duties for a Massachusetts entity), the fairer rule would be to look at least in some instances not just to the entity’s forum state but also to its principal place of business. 

Since Donahue was decided in 1975, the legislature has authorized two new types of legal entities:  limited liability partnerships and limited liability companies.[101]  Although no Massachusetts appellate case has squarely addressed the issue, it appears that the Donahue principles will be equally applicable to these new types of entities.  In Billings v. GTFM, LLC,[102] for example, the court applied the rules relating to derivative actions brought by shareholders to members of a limited liability company.[103]  In so ruling, the court applied the word “member” in Rule 23.1 of the Massachusetts Rules of Civil Procedure to include members of limited liability companies even though the text of Rule 23.1 refers to “member” as a part of an “unincorporated association….”[104] 

The extension of Donahue and its progeny to these new entities seems logical.  The Donahue principles are derived from general partnership law, so requiring members of limited liability partnerships to continue to abide by these duties while enjoying the primary benefit of a limited liability partnership, the ability to engage in business with others with at least some shield from personal liability, is reasonable.  Likewise, since limited liability companies are designed to be a more flexible form of the corporate legal entity, it also is fair to require members of limited liability companies that share the attributes of closely held corporations to follow the Donahue rules. 

F.         Shareholder and Other Agreements

Agreements among shareholders are enforceable.[105]  An agreement to purchase stock, for example, even if the price is less than market value, is enforceable if the agreement was entered into by all shareholders in advance.[106]  “The validity of such agreements will be upheld absent any fraud, overreaching, undue influence, duress or mistake at the time the deceased entered into the agreement.…”[107]  Thus, “[q]uestions of good faith and loyalty do not arise when all the stockholders in advance enter into an agreement concerning termination of employment and for the purchase of stock of a withdrawing or deceased stockholder.”[108]  The crucial issue then is the circumstances and the disclosures at the time the agreement was negotiated, not what may subsequently appear fair in hindsight.  The requirements of Donahue will have been met if the parties knew what they were doing at the time they entered into the agreement.  What seems fair later on does not come into play.[109]  

Blank v. Chelmsford Ob-Gyn, P.C.,[110] is particularly instructive.  There, the court ruled on a motion to dismiss that where three individual shareholders had established a corporation and prepared and signed written employment agreements allowing the company to terminate employment on six-months notice (which, in turn, triggered a shareholder’s stock buy back agreement), the termination was valid and not a breach of fiduciary duty.[111] 

Absent such an agreement, one would have expected the court to readily conclude that there had been a Donahue violation.  Indeed, termination of employment of a founder without cause is a classic example of a freeze out.  Yet, the existence of the employment agreement negated any potential Donahue breach.  Certainly, a shareholder-employee in a closely held entity will need to be very careful about such agreements lest he essentially sign away the protections otherwise owed to him under Donahue standards. 

While a discussion of the intricacies of drafting shareholder agreements (including tax ramifications which may be of critical importance) is beyond the scope of this article, some general comments are appropriate.  Shareholder agreements should include, if possible, provisions on to how to deal with death, disability, and termination of employment (whether for cause, voluntary termination, or by retirement).  They also should include, where appropriate, protections for minority shareholders (such as imposing obligations for super-majority votes for certain events) while not unduly limiting the ability of the majority to run the enterprise.  Counsel plays an important role in the creation of such agreements, although care must be taken to make it clear who the attorney does (and does not) represent, to advise individual shareholders to seek independent counsel where appropriate, and to obtain informed consent regarding potential conflicts of interest.  While even a well-crafted shareholders’ agreement will not stop the errant shareholder from usurping a corporate opportunity or wrongfully terminating a founding shareholder’s employment, it will, in many instances, help avoid disputes in the first instance or provide guidance for their resolution when they do arise.  There are also other contractual means to deal with the Donahue standards, including employment agreements and provisions in the articles of organization or bylaws.

G.        Special Issues for Professional Services Firms

            Disputes among shareholders of a professional firm present additional issues.  While the Donahue standards certainly apply, they must be balanced with and, indeed, may at times be outweighed by the ethical rules governing the conduct of these professionals.  So, for example, in the case of attorneys, the general prohibition against taking a corporate opportunity is balanced against the ethical concept that an attorney’s client has the right to choose her own counsel.[112]  A joint letter from both the firm and the departing attorney is the proper way to proceed.[113]  Whether similar considerations affect other professional corporations has not been addressed at the appellate level in Massachusetts.[114]  Counsel representing professionals in shareholder disputes in closely held businesses must consult not only the general duties set forth in this article but also the applicable professional codes of ethics as well as any statutes that may affect that particular type of professional.

III.       Remedies

A.        Statutes of limitations

In seeking legal recourse for an alleged wrongdoing, one of the first questions to ask is:  is it timely?[115]  In cases involving shareholders in a closely held corporation, the issue can be particularly difficult because the wrongdoing may have been going on for a long time and there may be a mix of contract and tort claims.  Generally, the statute of limitations for tort claims is three years.[116]  The general statute of limitations for breach of contract claims is six years (although for contracts under seal it is extended to twenty years).[117]  Thus, a claim for breach of fiduciary duty is governed by the three-year statute of limitations.[118]

But determining the applicable statute of limitations is only the beginning of the analysis.  In Demoulas, the court had to grapple with alleged wrongdoing that had occurred over many years.[119]  Recognizing that a shareholder’s derivative action was a tort claim subject to the three-year statue of limitations, the court had to consider whether actions that had occurred outside of the three year window nevertheless could be maintained by virtue of General Laws chapter 260, section 12, the so-called “fraudulent concealment” exception to the statute of limitations.[120]  Relying on trust law concerning claims of breach of fiduciary duty by a trustee, the court held that the statute begins to run when a trustee “repudiates the trust and the beneficiary has actual knowledge of that repudiation.”[121]  The SJC ruled:

[w]hen a defendant fraudulently conceals a cause of action from the knowledge of the plaintiff, the statute of limitations is tolled under . . . §12, for the period prior to the plaintiff’s discovery of the course of action.  Where a fiduciary relationship exists, the failure adequately to disclose the facts that would give rise to knowledge of a cause of action constitutes fraudulent conduct and is the equivalent to fraudulent concealment for purposes of applying §12.[122]

Applying “[a]n actual knowledge standard,” the court held that “a plaintiff need only show that the facts on which the cause of action is based were not disclosed to him by the fiduciary.”[123]  It rejected the “reasonable diligence standard” used in most tort cases involving “the so-called discovery rule.”[124]  Furthermore, the court ruled that in a derivative action, the statute of limitations does not begin to run “until knowledge is gained by those who have the power and responsibility to act on the corporation’s behalf and who are not themselves involved in the wrongdoing that is the basis for the cause of action.”[125]  Thus, using the “adverse domination doctrine,” “the statute of limitations is tolled while a private plaintiff continues under the domination of the wrongdoer.[126]

Nearly a decade after deciding Demoulas, the SJC, in Aiello v. Aiello,[127] set some bright-line rules regarding the so-called “doctrine of adverse domination,” namely whether the domination of a board of directors by interested directors tolls the statute of limitations.[128]  In Aiello, the plaintiff was a director and a shareholder of the corporation.[129]  Thus, once she had actual knowledge of the wrongdoing, she could not avail herself of the adverse domination doctrine to further toll the statute.[130]  As the court ruled:

we now adopt the “doctrine of adverse domination” as a form of equitable tolling in the Commonwealth.  We also conclude that the complete domination test - - and not the disinterested majority test - - was appropriately chosen and applied by the judge in the circumstances of these cases.  Under the former test, the statute of limitations is not tolled by reason of adverse domination unless the plaintiff can show the absence of any corporate director or shareholder who had actual knowledge of the alleged wrongdoing and the ability (and motivation) to sue the wrongdoers on behalf of the corporation or induce such a suit.[131]

Before the issue of adverse domination is considered, however, plaintiff must have actual knowledge of the claim.[132]  Only when an aggrieved shareholder has actual knowledge of the wrongdoing does the statute of limitations start to run (unless it is tolled by the “adverse domination” rule).[133] 

There are two reasons for the “adverse domination” rule:  (a) it is not fair to have the statute of limitations bar a claim where the alleged wrongdoers will not let the corporation act and; (b) knowledge by wrongdoers of the claim should not be imputed to the corporation.[134]  Under the Aiello court’s “complete domination” test, “only where a plaintiff can show that the culpable directors (or officers) completely or exclusively controlled the corporation” will the adverse domination doctrine apply.[135]  In so ruling, the court rejected the “disinterested majority” test, which holds that, as long as a board of directors is controlled by wrongdoers (i.e., they are in the majority), the statute of limitations is tolled.[136]

Statutes of limitations can be claim or even case dispositive in shareholder disputes.  Yet, determining when the statute started to run may involve considerable discovery.  The vigilant plaintiff’s counsel will need to carefully consider when a claim arose and, if some claims are barred, whether others will survive.  Counsel for the defendant will need to plead the statute as an affirmative defense, if appropriate, and then engage in careful discovery to build support for the defense.

One choice that a shareholder must make before bringing a case is whether the action is direct or derivative -- an action in his or her personal capacity or on behalf of the corporation -- or some combination of the two.  The choice is significant since there are special rules for bringing derivative actions and the available remedies differ.  In a direct action, the shareholder brings, and pays for, the suit in her individual capacity against other individual shareholders.  In a derivative action, in contrast, the shareholder sues on behalf of the corporation and may seek reimbursement of her legal fees from the corporation.

To bring a derivative action, one must follow the requirements of the Massachusetts Business Corporation statute (the “Business Corporation Act”),[137] which went into effect in 2004, as well as Rule 23.1 of the Massachusetts Rules of Civil Procedure, which provides that:

the complaint shall be verified by oath and shall allege that the plaintiff was a shareholder or member at the time of the transaction of which he complains or that his share or membership thereafter devolved on him by operation of law from one who was a stockholder or member at such time.[138]

Although an analysis of the specific requirements of the statute and Rule 23.1 is beyond the scope of this article, it is important to note that the statute has an explicit procedure for making demand on the corporation before an action is brought and careful attention must be paid to the requirements of the statute, including those that pertain to the review by independent directors or shareholder or independent persons and their ability to determine that such an action should not proceed.[139] 

In regard to remedies, in direct actions, damages are awarded to the wronged shareholder, while in derivative actions they belong to the corporation.  The difference may be quite significant.  For example, if a minority shareholder who owns 25 percent of a company’s stock claims that an owner of 75 percent of the company’s stock paid himself an excessive salary (a typical derivative claim), the money goes back to the corporation, not to the minority shareholder.  If the funds are then distributed to the shareholders, the minority shareholder’s proportionate share is only one-quarter of the recovery.  Another significant difference is in regard to attorneys’ fees.  While a plaintiff in a derivative action can recover them, a plaintiff in an individual action probably cannot.[140]  The rationale for the differing rules is that a derivative action is really brought for the benefit of the corporation.  In addition, the difference in the two rules mitigates the fact that a plaintiff in a derivative action may only have a limited personal benefit for her actions.[141]

Donahue and some of its early progeny did not do much to distinguish between direct and derivative claims, preferring to simply right a wrong.[142]  Beginning with Bessette v. Bessette,[143] however, the Massachusetts appellate courts began to draw sharp lines between the two types of actions.  In Bessette, minority shareholders sued the individual majority shareholder, claiming that she had received “an excessive salary and payments on notes for which the corporation received no consideration.”[144]  The action was brought as an individual claim rather than a derivative action because the corporation had filed for bankruptcy and the bankruptcy trustee had not brought a claim on behalf of the corporation.[145]  The court distinguished Donahue, ruling that a direct action under Donahue could be brought only if “it would be difficult for the plaintiff... to establish breach of a fiduciary duty owed to the corporation...”[146]  Since the only breach was of the duty owed to the entity, the direct action failed.[147] 

In subsequent cases, the courts have attempted to refine the lines between direct and derivative actions.  For example, the refusal of the majority of shareholders to offer equal opportunity for a stock repurchase to a minority shareholder is an individual claim.[148]  Individual claims also arise when there is an attempt to freeze out a minority shareholder through efforts to wrongfully withhold money due, deny employment in the corporation, or remove him as an officer or director.[149] 

Certain claims may only be brought by minority shareholders as derivative actions; that is, actions brought for the benefit of the corporation.[150]  Claims that a majority shareholder received an excessive distribution and salary are corporate claims and therefore need to be brought in a derivative action.[151]  Claims that funds were improperly diverted from the corporation are corporate claims.[152]  The prudent plaintiff will plead, if appropriate, both direct and derivative claims and follow the procedural requirements for both.[153] 

Of particular importance in a derivative action is the issue of standing.  In Billings v. GTFM, LLC,[154] the court allowed some creative lawyering to deprive a plaintiff of the ability to assert a derivative claim.  Mr. Billings, a member of a limited liability company, brought a derivative action against the company.[155]  After the suit was filed, the company sold its assets and liabilities to another entity and then dissolved the company.[156]  Although as a member of a limited liability company, Billings had the right to maintain a derivative action, the court ruled that he lost that right once the entity was dissolved.[157]  The court held that only if there is “some misconduct such as fraud” will the member be able to continue to maintain his claim.[158]  The company had sold its assets to a new entity, which was owned by most of the members of the limited liability company.[159]  The court concluded that this transaction was proper “in order to solve a business problem, the need to remove Billings from the management and ownership of their venture”.[160]  The court stated that the trial “judge found that this was a rational business decision, taken in good faith based on legitimate concerns about Billing’s performance.”[161]  Since Billings did not argue that the transaction was fraudulent, he could not argue fraud on appeal.[162]  In addition, not only did the court rule that Billings had lost standing but it also allowed claims against him that had been assigned to the new company to continue to go forward.[163]

The Billings ruling, while understandable in a pure legal sense, seems at odds with the general Donahue-Wilkes principles of fairness.  In many of these types of cases there is a perceived need on the part of the majority to remove a dissenting shareholder from the business.  It is the abuse of that right that Donahue, Wilkes, and their progeny were designed to prevent.  Now, under Billings, there is a vehicle available to majority shareholders to reach a result that might not otherwise seem to pass muster.

C.        Rights to Information

Often in closely held corporations, it is a lack of information that (a) can prevent a shareholder from knowing his rights or (b) in and of itself can be a breach of fiduciary duty.[164]  Relief for some of these problems can be found in the Business Corporation Act.[165] 

For example, a shareholder is entitled to a list of all shareholders in advance of a shareholders’ meeting.[166]  There also are procedures for shareholders meetings that may be relevant. [167]  In addition, the statute provides for a shareholder’s right to inspect various records of the corporation, including certain financial records.[168]   Both counsel for a minority shareholder and counsel for the company need to carefully consult the statute to determine what is legitimately subject to inspection and what may be properly withheld.[169]

D.        Damages, Equitable Relief, and Attorneys’ Fees

Generally, many of the claims arising out of shareholder disputes in closely held corporations are equitable, leaving the courts free to craft appropriate relief.[170]  A court has considerable discretion in fashioning remedies.[171]  For example, an award of damages may not be necessary if a lesser remedy is appropriate.[172]

In a derivative action, it is proper for those who profited from wrongdoing to have to repay the corporation those profits less what they invested personally in the new entities and less taxes that had been paid.[173]  Thus, in one appellate case, the remedy was to have the money be repaid by the wrongdoing shareholders to the entity and then a dividend issued to all shareholders (after consideration of the rights of creditors and claims by the Internal Revenue Service).[174]  In another case, the Appeals Court remanded for a further hearing in the superior court after which, if appropriate, it permitted the court to order the corporation to issue a dividend.[175] 

Interest also is an important consideration.  In Demoulas, for example, an award of interest on cash distributions that had been made “was well within [the judge’s] power to frame the relief so as to avoid unjust enrichment.”[176] 

In certain instances, injunctive relief may be warranted.  Thus, in Cain v. Cain,[177] the court enjoined the wrongdoing shareholder from engaging in improper competitive activity.[178]

Two recent cases have focused on the remedies available to an aggrieved shareholder and, in both decisions, the SJC has imposed limits on the relief that may be awarded.  In Brodie v. Jordan,[179] the SJC was faced with the question of whether a court could order a defendant to buy back “the plaintiff’s shares in the corporation at a price equal to her share of the corporation’s net assets, as valuated by a court-appointed expert, plus prejudgment interest” in the absence of any contract providing for such relief.[180]  The court ruled that such a remedy was improper.[181] 

Mary Brodie was the widow of Walter Brodie, a founder of Malden Centerless Grinding Co., Inc., a company that ran “a small machine shop….”[182]  After Mr. Brodie ceased being involved in the company’s regular operations, he and the other shareholders had disagreements and he asked to be bought out; the others refused.[183]  In the ensuing years after Mr. Brodie’s death, the other shareholders refused to provide Mrs. Brodie (as his heir) with relevant information about the company.[184] 

Relying on theory of “reasonable expectations,” the court ruled that while the Donahue duties to Mrs. Brodie had been breached, the remedy of a “forced buy-out” was improper.[185]  “The proper remedy for a freeze-out is to restore [the minority shareholder] as nearly as possible to the position [s]he would have been in had there been no wrongdoing.”[186]  “The remedy should neither grant the minority a windfall nor excessively penalize the majority.”[187]  While “[c]ourts have broad equitable powers to fashion remedies for breaches of fiduciary duty in a close corporation, . . . and their choice of a remedy is reviewed for abuse of discretion,” that right is not unfettered.[188]  Thus, a court’s order that a closely held business buy out a minority shareholder, in the absence of anything requiring such a buy-out in the corporation’s articles of organization, bylaws or in a shareholders’ agreement, was not a permissible remedy.[189]  The court’s ruling underscores the tension between balancing fairness and avoiding the imposition of judicially  created remedies.  In this case, the court took the more hands-off approach.

Following Brodie, in O’Brien v. Pearson,[190] the court confronted the question of the appropriate monetary “remedy for the freeze-out of a minority shareholder…”[191]  The court cited to the rule set forth in Brodie: “the appropriate remedy, ‘should, to the extent possible, restore to the minority shareholder those benefits which [he] reasonably expected, but has not received because of the fiduciary breach.’  Such a remedy seeks to place the injured party in the same position as he would have been but for the breach.”[192]  Unfortunately for the O’Brien plaintiff, the court held that his theory of lost profits was too speculative and that the only reasonable expectation that he had “would be involvement in the information sharing and decision-making….”[193]  While the court remanded for a determination of damages, its ruling appears to make it difficult for the plaintiff to recover anything.  Thus, while he achieved victory insofar as the court ruled that a fiduciary duty had been breached, the result may be hollow if there are no damages.

These two cases, while reaffirming the rules of Donahue, represent an obstacle for minority shareholders.  After all, it is not enough to pursue a case simply to prove wrongdoing.  To make it viable, there also must be a meaningful recovery.  The Brodie and O’Brien plaintiffs may have “won,” but at what price and for what result?

Attorneys’ fees are not considered damages in a breach of fiduciary case.[194]  However, an award of attorneys’ fees as a separate element of recovery is appropriate for a successful shareholder in derivative actions.[195]  Under the Business Corporations Act, not only may a successful shareholder recover her attorney’s fees in a derivative action but the corporation can recover its attorneys’ fees from a plaintiff if the court “finds that the proceeding was commenced or maintained without reasonable cause or for an improper purpose.”[196]  Under the statute, the plaintiff may recover her attorneys’ fees if the court “finds that the proceeding has resulted in a substantial benefit to the corporation.”[197]  An award of attorneys’ fees appears to be discretionary given the use of the word “may” in the statute.[198]

The pre-Act cases may provide guidance as to when an award of attorneys’ fees is appropriate.  Whether a defendant in a derivative action acted in good faith or bad faith is a factor a trial court may consider, “a finding of the defendant’s bad faith is not essential to a lawful award of counsel fees in such an action.”[199]  “The most important, but not dispositive, factor... is whether the plaintiffs have benefited the corporation in some way by the result obtained in the lawsuit.”[200]  Thus, where plaintiffs did not get any money for the corporation but “created... the opportunity to save corporate funds by identifying corporate misconduct” (even though the corporation chose “not to accept the benefits of the litigation”), an award of attorneys’ fees was appropriate.[201]  Furthermore, since the defendants’ counsel fees had been paid by the corporation, it was equitable for the plaintiffs also to have their fees paid by the corporation.[202]  The court specifically avoided the question of “whether intangible corporate benefits, such as raising the standards of fiduciary relationships (corporate therapeutics), could ever justify an award of attorneys’ fees in a stockholders’ derivative action.”[203]  Such fees are at the discretion of the court and it was not error for a court to decide not to award fees.[204]  But attorneys’ fees probably are not recoverable at all in individual actions.[205]

E.         Dissolution of the entity

In certain extreme instances, dissolution of the entity may be appropriate.[206]  Under the corporate dissolution statute, an action to dissolve a corporation may be brought in the superior court by any shareholder owning forty percent or more of the shares of an entity if:

upon a petition filed by the shareholders holding not less than 40 percent of the total combined voting power of all the shares of the corporation’s stock outstanding and entitled to vote on the question of dissolution, if it is established that:

      (i) the directors are deadlocked in the management of the corporate affairs, the shareholders are unable to break the deadlock, and irreparable injury to the corporation is threatened or being suffered; or

(ii) the shareholders are deadlocked in voting power and have failed, for a period that includes at least 2 consecutive annual meeting dates, to elect successors to directors whose terms have expired, or would have expired upon the election of their successors, and irreparable injury to the corporation is threatened or being suffered….[207] 

Although there has been little case law on dissolution of a closely held entity under the new statute, it has been the subject of at least one superior court opinion.[208]  In that case, the court permitted the dissolution of a small entity with two fifty percent shareholders (with a grace period for the parties to attempt to reach a settlement) but noted that: 

Comment 2 to c. 156D, sec. 14.30, cautions that “involuntary dissolution should be available as a mechanism for resolving internal corporate disputes only in the case of true deadlock, and even then only when continuation of the deadlock will impose real and serious harm, and . . . significantly broader availability of this remedy in such circumstances invites gamesmanship in the negotiation of internal corporate disputes and makes the dissolution remedy available in circumstances in which nothing so extreme is required, or in the end, normally consummated.”  Significantly, the Comment goes on to say: “The ‘irreparable injury’ requirements of both clauses of sec. 14.30(2) are more strongly worded than the ‘best interests of the shareholders’ requirement of BCL sec. 99, reflecting the strength of the belief that the availability (or potential availability) of dissolution to a disgruntled shareholder is rarely desirable, normally has material adverse effects on other constituencies (such as employees and vendors), and normally leads in the end to a buyout and not dissolution even after dissolution is entered.”[209]

While dissolution is an appropriate remedy in certain circumstances, it will not be granted lightly, particularly if other constituencies may be adversely affected.

In any shareholders’ dispute, one of the starting points is the Business Corporation Act and the corporate documents and agreements: articles of organization, bylaws, employment agreements, shareholder agreements and corporate votes.  As the courts have repeatedly held (and the Act now provides), these agreements are enforceable and can alter the fiduciary duties that might otherwise be owed.  Even if these documents do not precisely address all of the issues at stake, they can be used as a guide to help counsel negotiate appropriate resolutions.[210]

Shareholder disputes in a closely held business can be described as the business equivalent of a divorce.  Family law practitioners can recount the tales of soon-to-be ex-spouses spending considerable energy and legal fees fighting over an item of little value.  In the business dispute, the fights can lead to the destruction of the business itself.

Counsel involved in these cases can and should exercise creativity in helping parties resolve these cases.  The appropriate resolution will vary depending on the type of business.  For example, a professional services business such as a law or accounting firm will be relatively easy to divide between or among shareholders since the firms’ primary assets are clients or cases, both of which are very mobile.  In such cases, the best agreements will allow the shareholders to work out a mechanism for retaining clients (subject to appropriate ethics rules), sharing or dividing staff, and dividing computers, furniture and other similar assets.  Other types of businesses, such as companies that manufacture or sell a product, may be difficult if not impossible to divide.  There, the best solution may be to facilitate a buy-out of a shareholder or to sell the entire business.  Regardless of the form of resolution, whether a division of assets, a buyout or a sale, no one benefits (except perhaps the shareholder whose only goal is revenge or destruction) on the value of the business diminishing.

If the parties cannot agree, even with the assistance of counsel and other professional advisors, regarding how to proceed, then other forms of alternative dispute resolution, such as mediation, neutral valuators, arbitration or limited discovery are particularly appropriate.  Of course, it will take the guidance of skilled counsel to help clients reach such results.  

Donahue is alive and well in the 21st century in Massachusetts and it should be.  Its fundamental holdings still form the basis for how owners of closely held businesses must deal with one another.  But its teachings are not unfettered - not every action that hurts a minority shareholder is unfair or oppressive.  Nor are the remedies that a court may impose without limit.  Still, the courts have broad latitude in fashioning just results.  The Business Corporation Act also will be important as case law develops that interprets its provisions.  Nevertheless, basic fairness remains the standard.  Indeed, many shareholder disputes are inherently fact-intensive and the equities associated with each case often drive the result.

Lawyers for closely held businesses and their shareholders, particularly those who advise them in their formation and ongoing operations, have a critical role to play in this regard.  They must have a full understanding of the facts of each case as well as a knowledge of the Donahue body of law in order to represent their clients effectively.  Many of the disputes that have ended up in the courts since Donahue could have been avoided, or their outcomes changed, with good advice.  Of course, that presupposes that corporations and their shareholders consult with their attorneys when they form their businesses and then before they act, a course of conduct that unfortunately is often absent.  Still, the prudent attorney can steer his or her client through the thicket of Donahue law with carefully crafted agreements, having clients make full disclosure, and creative efforts to resolve disputes when they do arise.