Opinion
No. 88-1516
Submitted October 11, 1989 —
Decided December 20, 1989.
Corporations — "Close corporation," defined — Controlling shareholders in close corporation breach their fiduciary duty to minority shareholders, when — Claims of breach of fiduciary duty not subject to provisions of Civ. R. 23.1, when.
O.Jur 3d Business Relationships §§ 502.5, 743, 745.
1. Typically, a close corporation is a corporation with a few shareholders and whose corporate shares are not generally traded on a securities market.
2. Where majority or controlling shareholders in a close corporation breach their heightened fiduciary duty to minority shareholders by utilizing their majority control of the corporation to their own advantage, without providing minority shareholders with an equal opportunity to benefit, such breach, absent any legitimate business purpose, is actionable.
3. Claims of breach of fiduciary duty alleged by minority shareholders against shareholders who control a majority of shares in a close corporation, and use their control to deprive minority shareholders of the benefits of their investment, may be brought as individual or direct actions and are not subject to the provisions of Civ. R. 23.1.
APPEAL from the Court of Appeals for Lucas County, No. L-87-198.
On October 23, 1986, appellees, Howard F. (Dean) Crosby ("Crosby") and Christian Caring Center, The Church of Holy Light ("Church"), filed an amended complaint in the Court of Common Pleas of Lucas County. The record indicates that Seascape Building Company, Inc. ("Seascape") was, between April 30, 1977 and January 29, 1985, an Ohio corporation; that Crosby was a 26.214 percent shareholder in Seascape from April 30, 1977 until September 14, 1984; that in September 1984, Crosby transferred his shares of stock to the Church; that the Church held the shares in Seascape until January 29, 1985 when Seascape was voluntarily dissolved; and that upon dissolution, all corporate assets were transferred to the Crosby Properties Liquidating Trust ("the Trust") and each shareholder of Seascape stock became a beneficiary of the Trust in percentages identical to his interest in Seascape.
Appellees brought this action against appellants, Kenneth and Sally Beam and Gary and Sue Graves, who were the controlling shareholders, officers and directors of Seascape. Appellees alleged that appellants improperly expended corporate funds in that appellants: paid themselves unreasonable salaries (Count 1); caused Seascape to pay their personal expenses (Count 2); used Seascape's property for personal enterprise (Count 3); caused Seascape to purchase life insurance for their benefit (Count 4); and took improper, low-interest loans from Seascape, thereby depriving the corporation of interest income (Count 5). Count 6 alleged that the Church received less in Trust payments than the amount to which it was entitled. Appellees' final count, Count 7, alleged that all the foregoing acts of corporate wrongdoing were carried out pursuant to a conspiracy between the appellants. Appellees also claimed to have been deprived of $215,600 in distributions from the Trust and to have incurred more than $50,000 in attorney fees. Jointly, appellees sought $275,000 in compensatory damages and $200,000 in punitive damages.
Appellants filed a Civ. R. 12(B)(6) motion to dismiss the complaint for failure to state a claim. Appellants argued that appellees' action could only be brought as a Civ. R. 23.1 shareholder's derivative action. Appellants contended that appellees did not have standing to bring a shareholder's derivative action because Crosby did not own Seascape stock when this action was commenced and the Church could not assert claims which occurred prior to its acquisition of Seascape stock.
On May 13, 1987, the trial court granted the appellants' motion to dismiss Counts 1 through 5 and Count 7 of appellees' amended complaint. The trial court found that the claims of the appellees affected the corporation itself and that the shareholders were affected only in a general way. Hence, the appellees should have instituted a shareholder's derivative action since the appellees lacked standing to proceed individually. The trial court also noted that one shareholder, Toledo Trust, was not a party to the action and agreed with appellants that Crosby lacked standing to pursue a shareholder's derivative action since Crosby did not own any stock when the action was commenced and the Church could not assert any claims prior to obtaining the stock on September 14, 1984.
Furthermore, the trial court found no merit in the appellees' argument that they should be permitted to proceed individually against the appellants for breach of fiduciary duty owed by majority shareholders to minority shareholders. The trial court found that the alleged acts of appellants did not destroy the appellees' investment for the appellants' benefit. Also, the trial court found that appellants' alleged acts did not produce special damages peculiar to the appellees.
On July 8, 1988, the court of appeals, in reversing the common pleas court, held that the appellees were asserting their claims personally, so compliance with Civ. R. 23.1 was not required. The court of appeals found that appellees' complaint stated a cause of action and the trial court had improperly dismissed appellees' complaint.
The cause is now before this court pursuant to the allowance of a motion to certify the record.
David R. Pheils, Jr. Associates and David R. Pheils, Jr., for appellees.
Cooper, Straub, Walinski Cramer, Keith A. Wilkowski and John L. Straub, for appellants.
Murray Murray Co., L.P.A., Dennis S. Murray, Sr. and Kirk J. Delli Bovi, urging affirmance for amicus curiae, Terrence P. Morris.
Vorys, Sater, Seymour Pease, Michael J. Canter and John J. Kulewicz, urging reversal for amici curiae, Dale W. Van Voorhis, Gasper C. Lococo and Funtime, Inc.
The issue before us is whether the appellees' cause of action may be maintained as an individual action or whether dismissal was proper because the suit was not instituted as a Civ. R. 23.1 shareholder's derivative suit.
A shareholder's derivative action is brought by a shareholder in the name of the corporation to enforce a corporate claim. Such a suit is an exception to the usual rule that a corporation's board of directors manages or supervises the management of a corporation. A derivative action allows a shareholder to circumvent a board's refusal to bring a suit on a claim. On the other hand, if the complaining shareholder is injured in a way that is separate and distinct from an injury to the corporation, then the complaining shareholder has a direct action. 2 O'Neal Thompson, O'Neal's Close Corporations (3 Ed. 1987) 119-121, Section 8.11.
Civ. R. 23.1 states that:
"In a derivative action brought by one or more legal or equitable owners of shares to enforce a right of a corporation, the corporation having failed to enforce a right which may properly be asserted by it, the complaint shall be verified and shall allege that the plaintiff was a shareholder at the time of the transaction of which he complains or that his share thereafter devolved on him by operation of law. The complaint shall also allege with particularity the efforts, if any, made by the plaintiff to obtain the action he desires from the directors and, if necessary, from the shareholders and the reasons for his failure to obtain the action or for not making the effort. The derivative action may not be maintained if it appears that the plaintiff does not fairly and adequately represent the interest of the shareholders similarly situated in enforcing the right of the corporation. The action shall not be dismissed or compromised without the approval of the court, and notice of the proposed dismissal or compromise shall be given to shareholders in such manner as the court directs."
Appellants contend that this case should have been brought as a derivative action because appellees' amended complaint alleges only that the appellants-majority shareholders misappropriated corporate funds. This misappropriation directly affected the corporation, appellants contend, and only indirectly harmed the appellees-minority shareholders. Thus, the appellants argue that the appellees could not maintain this cause as a direct action.
I Close Corporation
Typically, a close corporation is a corporation with a few shareholders and whose corporate shares are not generally traded on a securities market. 1 O'Neal Thompson, O'Neal's Close Corporations (3 Ed. 1986) 2-3, Section 1.02. See, also, R.C. 1701.591.
Close corporations bear a striking resemblance to a partnership. In essence, the ownership of a close corporation is limited to a small number of people who are dependent on each other for the enterprise to succeed. Just like a partnership, the relationship between the shareholders must be one of trust, confidence and loyalty if the close corporation is to thrive. While a close corporation provides the same benefits as do other corporations, such as limited liability and perpetuity, the close corporation structure also gives majority or controlling shareholders opportunities to oppress minority shareholders. For example, the majority or controlling shareholders may refuse to declare dividends, may grant majority shareholders-officers exorbitant salaries and bonuses, or pay high rent for property leased from the majority shareholders. Donahue v. Rodd Electrotype Co. of New England, Inc. (1975), 367 Mass. 578, 588-589, 328 N.E.2d 505, 513.
Whether this device is a freeze-out as stated in Donahue, supra, at 588-589, 328 N.E.2d at 513, or a partial squeeze-out as identified in 1 O'Neal Thompson, O'Neal's Oppression of Minority Shareholders (2 Ed. 1985) 1-2, Section 1:01, is not before us in this case.
Minority shareholders in a close corporation, denied any share of the profits by the majority shareholder's action, will either suffer a loss or try to find a buyer for their stock. This situation is contrasted with an oppressed minority shareholder in a large publicly owned corporation who can more easily sell his shares in such a corporation. Generally, there is no ready or available market for the stock of a minority shareholder in a close corporation. This presents a plight for a minority shareholder in a close corporation who can become trapped in a disadvantageous situation from which he cannot be easily extricated. Donahue, supra, at 591-592, 328 N.E.2d at 515.
II Majority Shareholders' Fiduciary Duty in a Close Corporation
Generally, majority shareholders have a fiduciary duty to minority shareholders. Jones v. H.F. Admanson Co. (1969), 1 Cal.3d 93, 81 Cal.Rptr. 592, 460 P.2d 464. Courts in sister states and Ohio appellate courts have found a heightened fiduciary duty between majority and minority shareholders in a close corporation. This duty is similar to the duty that partners owe one another in a partnership because of the fundamental resemblance between the close corporation and a partnership. Donahue, supra, at 593, 328 N.E.2d at 515, found the standard of a duty to be of the "`utmost good faith and loyalty.'"
Cases in sister states include Tillis v. United Parts, Inc. (Fla.App. 1981), 395 So.2d 618; Alaska Plastics, Inc. v. Coppock (Alaska 1980), 621 P.2d 270; Horizon House-Microwave, Inc. v. Bazzy (1985), 21 Mass. App. 190, 486 N.E.2d 70; and Donahue v. Rodd Electrotype Co. of New England, Inc. (1975), 367 Mass. 578, 328 N.E.2d 505.
See, generally, the following Ohio appellate court cases: Estate of Schroer v. Stamco Supply, Inc. (1984), 19 Ohio App.3d 34, 19 OBR 100, 482 N.E.2d 975; North v. Wick (1957), 104 Ohio App. 332, 5 O.O. 2d 19, 144 N.E.2d 132; and Soulas v. Troy Donut Univ., Inc. (1983), 9 Ohio App.3d 339, 9 OBR 607, 460 N.E.2d 310.
Federal courts, applying what they found to be Ohio law, assumed the existence of a fiduciary duty between shareholders of a close corporation and particularly between majority and minority shareholders. In United States v. Byrum (1972), 408 U.S. 125, 137, the court stated in a case involving several Ohio close corporations that "[a] majority shareholder has a fiduciary duty not to misuse his power by promoting his personal interests at the expense of corporate interests."
Further, Byrum, supra, at 137-138, fn. 11, stated that:
"Such a fiduciary relationship would exist in almost every, if not every, State. Ohio, from which this case arises, is no exception: `[I]f the majority undertakes, either directly or indirectly, through the directors, to conduct, manage, or direct the corporation's affairs, they must do so in good faith, and with an eye single to the best interests of the corporation. It is clear that the interests of the majority are not always identical with the interests of all the shareholders. The obligation of the majority or of the dominant group of shareholders acting for, or through, the corporation is fiduciary in nature. A court of equity will grant appropriate relief where the majority or dominant group of shareholders act in their own interest or in the interest of others so as to oppress the minority or commit fraud upon their rights.' * * *" (Citation omitted.)
Majority or controlling shareholders breach such fiduciary duty to minority shareholders when control of the close corporation is utilized to prevent the minority from having an equal opportunity in the corporation. Donahue, supra, at 598, 328 N.E.2d at 518, and Tillis v. United Parts, Inc. (Fla.App. 1981), 395 So.2d 618. Control of the stock in a close corporation cannot be used to give the majority benefits which are not shared by the minority. Alaska Plastics, Inc. v. Coppock (Alaska 1980), 621 P.2d 270. As an example, in Wilkes v. Springside Nursing Home, Inc. (1976), 370 Mass. 842, 353 N.E.2d 657, majority shareholders breached their fiduciary duty to the minority by removing a minority shareholder from the payroll of a close corporation, which had never paid a dividend, and there was no legitimate business purpose for the removal.
Given the foregoing, if we require a minority shareholder in a close corporation, who alleges that the majority shareholders breached their fiduciary duty to him, to institute an action pursuant to Civ. R. 23.1, then any recovery would accrue to the corporation and remain under the control of the very parties who are defendants in the litigation. Thus, a derivative remedy is not an effective remedy because the wrongdoers would be the principal beneficiaries of the recovery. See, generally, 2 O'Neal's Close Corporations, supra, at 120-123, Section 8.11.
Where majority or controlling shareholders in a close corporation breach their heightened fiduciary duty to minority shareholders by utilizing their majority control of the corporation to their own advantage, without providing minority shareholders with an equal opportunity to benefit, such breach, absent a legitimate business purpose, is actionable. Where such a breach occurs, the minority shareholder is individually harmed. When such harm can be construed to be individual in nature, then a suit by a minority shareholder against the offending majority or controlling shareholders may proceed as a direct action. This was just the situation in Steelman v. Mallory (1986), 110 Idaho 510, 716 P.2d 1282, where the court held that a breach by majority shareholders-directors of their fiduciary duty to a minority shareholder was actionable directly, as opposed to requiring a shareholder's derivative action.
Accordingly, we hold that claims of a breach of fiduciary duty alleged by minority shareholders against shareholders who control a majority of shares in a close corporation, and use their control to deprive minority shareholders of the benefits of their investment, may be brought as individual or direct actions and are not subject to the provisions of Civ. R. 23.1.
III Plaintiffs-Appellees' Capacity to Sue
We must now determine if the complaint before us states an injury to the appellees upon an individual claim as distinguished from an injury which directly affects the corporation and only indirectly affects appellees. See Adair v. Wozniak (1986), 23 Ohio St.3d 174, 23 OBR 339, 492 N.E.2d 426.
Civ. R. 8(F) states that "[a]ll pleadings shall be so construed as to do substantial justice." The rule "* * * emphasizes the fact that pleadings shall be construed liberally * * *." Staff Notes to Civ. R. 8(F).
The complaint before us, in essence, alleges that the majority shareholders acted both separately and collectively to exclude the appellees from the corporation's profit. Seascape, the corporation, possessed characteristics consistent with an Ohio close corporation.
Arguably, Counts 1 through 5 of plaintiffs-appellees' amended complaint sound in the nature of claims that should be redressed through a derivative action and, therefore, appellees would be required to proceed in accordance with Civ. R. 23.1. Conversely, under a liberal construction, the matters pled in Counts 1 through 5 and clearly that matter pled in Count 7 can easily be construed as pleading claims that are not wholly derivative in nature. In effect, the claims are direct or individual claims for a breach of the fiduciary duty owed by the majority shareholders to the minority shareholders in close corporations. Liberally construing the pleadings, we find that appellees properly brought this action as a direct action rather than as a shareholder's derivative action.
Since we have decided that it was proper for appellees to bring this case as an individual action, it is not necessary to address the standing of appellees to institute a Civ. R. 23.1 suit. Furthermore, it is unnecessary to decide, as urged by appellees, whether there is an exception to the standing requirements of Civ. R. 23.1, which exception would allow a former minority shareholder, who parted with his shares unaware of misappropriations by the corporate directors, to recover the amount by which the misappropriations had reduced the value of his prior shareholdings. See Watson v. Button (C.A.9, 1956), 235 F.2d 235.
For the above-mentioned reasons, the trial court erred when it dismissed this action for failure to state a claim. Appellees' complaint alleges a breach of fiduciary duty which may be brought as a direct action. Accordingly, the judgment of the court of appeals is affirmed.
Judgment affirmed.
MOYER, C.J., SWEENEY, HOLMES, H. BROWN and BROGAN, JJ., concur.
WRIGHT, J., concurs in part and dissents in part.
JAMES A. BROGAN, J., of the Second Appellate District, sitting for RESNICK, J.
I heartily agree with the majority's discussion of the effects of stock ownership in a close corporation, as compared to equity ownership in a corporation with a large number of stockholders where the stock is publicly traded. Ofttimes the relationship between the shareholders in a close corporation is premised upon mutual confidence and trust. Ownership in a close corporation does indeed expose a minority stockholder to oppression by the majority. The trend of the law in this country is represented by Donahue v. Rodd Electrotype Co. of New England, Inc. (1975), 367 Mass. 578, 328 N.E.2d 505. In that case the Massachusetts Supreme Court held that majority stockholders in a close corporation should be held to a strict standard of fiduciary duty when minority stockholders were, in effect, "frozen out" through exorbitant salaries, self-dealing and the like, and their ability to receive reasonable dividends was obviously undermined. There certainly is no ready market for the stock of a minority shareholder in a close corporation. The modern trend in the law has been to provide relief to a minority stockholder in a close corporation who is forced into an unfair situation from which he cannot extricate himself. Donahue, supra, at 591-592, 328 N.E.2d at 514-515.
Accordingly, I accept the concept that in situations such as we may have here, we should impose upon majority shareholders a heightened fiduciary duty to minority shareholders in a close corporation and sanction a direct action against the alleged wrongdoers. Construing the pleadings in this case in the most liberal fashion, I believe Count 7 of plaintiff's complaint may state a cause of action for what amounts to a freeze-out. However, I am not prepared to accept the third paragraph of the syllabus announced by the majority outside the context of the facts alleged in this case. I am concerned that applying the third paragraph of the syllabus to a situation where there is no potential of demonstrating a freeze-out will amount to repeal of Civ. R. 23.1 as it relates to all actions by disgruntled minority shareholders in close corporations. To my mind this would be both unwise and outside our authority to, in effect, amend the Civil Rules in this manner. Thus, I would limit the syllabus law in this case to situations where the plaintiff can demonstrate an effort to "freeze him out" as a stockholder or where he is directly affected through loss of dividends, company employment or the like. Thus, I can concur only in paragraphs one and two of the syllabus in this case and in the judgment announced by the majority.