3.4.3.3.3 Case development

The most famous case in the fiduciary duty area in a close corporation is Donahue v. Rodd Electrotype Co.,2 which pioneered in developing an effective claim for minority shareholders by way of the concept "enhanced fiduciary duty".

Donahue and Rodd were shareholders of Rodd Electrotype Co. They owned respectively 20% (50 shares) and 80% (200 shares) of the corporation's shares. Harry Rodd was general manager and treasurer of the company. Later, Rodd's two sons, Charles and Frederick, joined the corporation and took high positions. Charles Rodd was later elected president and general manager of the corporation. Each of the two sons received 39 shares from their father, Harry Rodd. In 1970, owing to health problems, Harry Rodd retired, and his sons, voting in their capacity as board members, made the corporation purchase part of Rodd's shares at $800 per share. When Donahue died, his shares were passed on to his wife and his son. When the widow heard that the corporation had bought back Rodd's shares, she proposed to the corporation to have her shares purchased on the same terms. But her offer was refused. So she initiated a suit, alleging that by refusing to accord her the equal opportunity to have her shares repurchased by the corporation, the Rodds were in violation of the fiduciary duty owed by the majority to the minority. The defendants replied that the corporation had the power to purchase its stock according to Massachusetts law, and there was no right to equal opportunity in corporate stock purchase for the corporate treasury.

The Massachusetts Supreme Judicial court favoured Donahue by advancing that: "the purchase of Harry Rodd's shares by the corporation is a breach of the duty which the controlling stock holders, the Rodds, owed to ...the plaintiff and her son." In the ruling, two forms of relief were proposed by the court. Either Rodd returned the interests to the corporation or the corporation purchased all of the plaintiff's shares on the same terras.

In its analysis, the court first defined the concept of a close corporation. It was deemed as a corporation typified by: "1) a small number of stockholders, 2) no ready market for the corporate stock, and 3) substantial majority stockholder participation in the direction of management and operations of the corporation." Then an analogy was drawn between a close corporation and a partnership. A standard of fiduciary duties between partners in a partnership was extended to stockholders in a close corporation. The Supreme Court of Massachusetts thus reasoned:

Normally, onder Massachusetts law, a corporation has the power to purchase its own shares. In the context of a close corporation, however, the court applied the concept of enhanced fiduciary duties set forth above: there was a breach of fiduciary duties when the controlling shareholders were offered the chance to have their shares bought back and the minorities were not. Therefore, the Supreme Court held that "in any case in which controlling shareholders in a close corporation have exercised their power over the corporation to deny minority equal opportunity in stock purchases, the minority shall be entitled to appropriate relief." 4

The notion of the strict duty put forth by the Mass. Court is welcomed by many states in the US.5 It also invites suspicion, however, because the strict duty entails the risk of dampening the majority's investment enthusiasm, as too much protection for the minority afforded by this interpretation would impede the efficient and effective management desired by the majority.6 Notwithstanding the above concerns, this court interpretation has meritoriously provided more assurance for the minority shareholders and has alleviated their plight in a close company.

Later, there was another important case concerning fiduciary duty in Massachusetts in which the court refined the Donahue decision and tried to strike a balance between the majority's fiduciary duties and minority shareholder protection. It stated "when minority stockholders in a close corporation bring suit against the majority alleging a breach of the strict good faith duty owed to them by the majority, we must carefully analyze the action taken by the controlling stockholders in the individual case."8 On this ground, the court suggested a two-step method. First, the action of the majority shareholders have to be tested against the legitimate business purpose. If the test is passed, the plaintiff, in order to obtain relief, can attempt to prove in the second step that there is a less harmful way to achieve the desired business result.

Wikes, Quinn, Riche and Pikkin set up a nursing home and it was a success. After a long illness, Pikkin sold his shares to Conner, who was later elected as director of the corporation. In 1965 the stockholders decided to sell a portion of the corporate property to Quinn who, in addition to being a stockholder in Springside, also held a stake in another corporation which was considering operating a rest home on the property. Wikes was successful in persuading other stockholders of Springside to charge a higher selling price for the property than Quinn had expected. Quinn apparently held a grudge about this and collaborated with other shareholders to squeeze Wikes out. At the annual meeting, Wikes was not re-elected as a director, and was told that he was no longer wanted by the corporation nor by his associates.

The court declared that Quinn, Riche and Conner had breached their fiduciary duty owed to Wikes on the ground that Wikes had been expelled from the business not because of his "misconduct or neglect of duties, but because of the personal desire of the defendant to prevent him from continuing to receive money from the corporation."9 The Donahue decision recognized a strict obligation on the part of majority shareholders in a close corporation, namely, to deal with the minority with "the utmost good faith and loyalty".10 The standard applied in Donahue also appeared to be workable here as "the distinction between the majority action in Donahue and in this case is more one of form than of substance."11 In both case, the majority discriminated against the interests of the minority in a legal but not equitable manner. Their behaviour did not accord with the `utmost good faith and loyalty'. Nevertheless, the court in Wikes was concerned that:

With that, the Massachusetts court acknowledged the need for a certain discretion on the part of the majority in conducting business.13 And it confirmed the fact that "the controlling group in a close corporate must have some room to manoeuvre in establishing the business policy of the corporation".14 The court thus devised a two-step balancing test. Firstly, the court allowed the majority to rely on the legitimate business purpose to justify their actions.15 After an alleged purpose had been advanced, the court had to decide whether a legitimate business purpose had been demonstrated.16 As mentioned above, courts were reluctant to interfere in the interaal business operations because they deemed such operations to be subject to majority control. Given that the plight of the minority shareholders in a close company was manifest, courts felt the need to step forward to make sure that a business purpose put forth by the majority was legitimate. In this case, the majority did not advance any business purpose for their action. They failed the first step of the test, so the second step which required the minority shareholders to show that the desired goals could have been achieved by a less harmful action was unnecessary.