Duties Owed to Other Shareholders When Dissolving the Corporation

Under California law, all officers, directors, and majority shareholders owe fiduciary duties to minority shareholders and to other members of the corporation. Among the most common claims of breach of fiduciary duty are:

• Self-dealing
• Diversion of business opportunities.

Most often, such behavior will result in the offender being held liable in a court of equity and law for violation of fiduciary duties. This is particularly true where the offender sets up a competing corporation and begins running the new business in competition with the previous business.

However, there is an exception to this general rule when the minority shareholders or other members of the corporation are acting in such a manner as to prevent the corporation from achieving its business purpose. Under those extreme circumstances, a majority shareholder can act to preserve his or her investment by creating a new corporation and, essentially, beginning a new business.

Note that well-drafted and custom-drafted corporation bylaws can help avoid some of the problems discussed in this article. Seeking a skilled and talented business attorney for legal advice when you form your company is the wisest business practice.

Shareholder Duties When Dissolving the Corporation: Legal Principles

Cal. Corp. Code § 1900 (a) authorizes a corporation to voluntarily wind up and dissolve “by the vote of shareholders holding shares representing 50 percent or more of the voting power.” But, when dissolving a corporation, a shareholder owes the other shareholders the duty to act in good faith. Thus, majority shareholders cannot dissolve a corporation as a means of defrauding the other shareholders or of “freezing them” out of profits or as a mechanism for buying the assets of the dissolved corporation at a low price.

In reviewing the question of “good faith,” courts will look at all the circumstances INCLUDING the behavior of the minority shareholders. If the minority shareholders have acted in ways that have prevented the corporation from functioning, such facts are to be considered with respect to whether dissolution was made in good faith. Moreover, the majority shareholders are allowed to exercise the power of dissolution to protect their investment in the corporation and, by itself, acting to protect one’s investment is not bad faith.

Shareholder Duties When Dissolving the Corporation: Case Law Example

The leading California case is In re Security Finance Co., 49 Cal. 2d 370 (Cal. Supreme Court 1957). In that case, one 50% shareholder, a certain Mr. Rouda, brought his expertise to the corporation, which included making personal loans and buying conditional sales contracts. The other 50% shareholder (a pair of brothers) brought capital and financing to the corporation.

The bylaws of the corporation limited the shareholders’ ability to transfer their shares or take other major actions without the unanimous vote of all shareholders. At the beginning, the corporation put Rouda under contract to, among other things, devote 100% of his time to the company. Rouda was very successful in growing the business, but he wanted an increase in his salary or dividends from the corporation. Alternatively, Rouda wanted to be allowed to spend some of his time making money with other endeavors. The other shareholders refused to agree unless Rouda paid $100,000. Rouda refused to pay the money and, since 100% shareholder agreement was needed, Rouda was unable to receive a fair return on his investment. Rouda then issued an ultimatum that he would dissolve the corporation unless the other shareholders agreed to buy his shares, sell their shares, or sell the entire corporation. The other shareholders refused. Then Rouda dissolved the corporation and sought judicial supervision for winding up the corporation’s business.

When the case reached the California Supreme Court, the court held that Rouda had acted in good faith in dissolving the corporation. The court noted these facts:

• Corporation was at an impasse
• Alternatives had been explored and were denied
• Rouda’s purpose in dissolving the corporation was to protect his investment
• Rouda did not secure any advantage over the other shareholders
• No rights of third parties were compromised

Under those circumstances, there was no breach of his duties by Rouda in dissolving the corporation.

Importance of Corporation Bylaws

The Security Finance case is a good example of why custom-drafted corporation bylaws are very important. There are plenty of off-the-shelf “standard” bylaws on the market, but using those can put you and your other shareholders at risk of litigating issues that should be resolved at the beginning of your business with the help of good legal counsel. As just a couple of examples, your custom-drafted bylaws can provide for voting rights that reflect the expected needs of the business. Requiring 100% agreement for everything may be too restrictive — maybe for a limited number of things, but not everything. Further, if the shares are split 50-50, tie-breaking mechanisms can be written into the bylaws. In addition, the bylaws can strengthen shareholder fiduciary duties, such as requiring that consent to salary increases not be unreasonably withheld; or weaken fiduciary duties, such as making it clear that dissolution is not bad faith if an impasse has been reached among the shareholders.

Contact San Diego Corporate Law

For further information, please contact Michael Leonard, Esq. of San Diego Corporate Law. Mr. Leonard has the experience to help you form your San Diego corporation, can draft your bylaws to the specific and unique needs of your corporation and can assist with any other business-related legal matter. Contact Mr. Leonard by email or by calling (858) 483-9200.

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