SJC issues key interpretive decision in employee-shareholder context
- In closely held corporations, Massachusetts has long afforded minority shareholders the protection of a fiduciary duty owed to them by the other shareholders that is more extensive than other states, such as Delaware, for example. While courts will allow shareholders to provide otherwise in written agreements, Selmark holds that if the shareholder agreements are not specifically on point, the fiduciary duty standard will apply.
- Going the other way, Selmark holds that the solicitation of customers by a former employee shareholder (who is then still a shareholder) is also breach of such shareholder’s fiduciary duty to his fellow shareholders, even where the employment was terminated by the corporation and was considered a “freeze out” under corporate law. While this holding certainly could give companies more leverage in separation discussions with former employee shareholders, the potential uncertainty created over the scope of such a non-solicitation duty that was not reduced to writing could present significant challenges to practitioners on both sides of the matter.
Because of the potential uncertainly to fiduciary duty claims added by this decision, parties on both sides would be well advised to address the issue of fiduciary duty head-on in their agreements, and to define as specifically as possible the scope of any limitations to that duty. While this point is not addressed by the Court, both employers and employees may also consider the advantages (and disadvantages) of using holding companies and special purpose entities to separate the legal identity of the employee from that of the shareholder.
In addition, potential buyers and sellers of Massachusetts corporations should take note of this case in the planning of their transaction.
If you have any questions about this topic, please feel free to email us.
They say that bad facts often make bad law. If that is true, then this case certainly does not disappoint. The case ultimately arises from a sudden (and apparently unwarranted) termination of employment of a shareholder employee, Ehrlich, who had been a long term valued employee of Selmark and its affiliate Marathon. Ehrlich originally was employed by Marathon and had informally been promised equity in the company by its founder. As part of Marathon founder’s planned retirement and succession plan a number of years later, Erhlick entered into a series of agreements with the sole stockholder of Selmark (Elofson) involving the gradual sale of Marathon to Ehrlich and Selmark. These agreements comprised a stock purchase agreement, an employment agreement, a conversion agreement and a stock (shareholders) agreement.
The purchase agreement provided for the gradual acquisition of Marathon stock by the two purchasers through monthly payments pursuant to promissory notes. Upon full payment, Selmark would own 51% and Ehrlich 49%. Under the terms of the purchase agreement, Marathon bore primary responsibility for the monthly payments and Ehrlich and Selmark were each separate co-guarantors.
The employment agreement between Ehrlich and Marathon provided for a term of employment through 2002, with extension possible on the written agreement of the parties. Per its terms, Ehrlich became the vice-president of Marathon and potentially a director, and could only be terminated for cause. If the agreement was not extended, at the conclusion of the initial contract term, it would terminate and Ehrlich would be required to resign as an officer and director of Marathon.
Pursuant to a separate conversion agreement, Ehrlich had the option, once he and Selmark fully paid off the purchase of Marathon, to convert what would his then 49% interest in Marathon into a 12.5% interest in Selmark (and then Selmark would own 100% of Marathon). This agreement also required that, upon conversion, Selmark offer Ehrlich an employment agreement that would provide “for compensation, bonuses, expense payments, and benefits consistent with his percentage ownership of [Selmark].” Independent of employment, upon conversion, Ehrlich was to become an officer of Selmark and member of its board of directors.
Under a separate “stock agreement”, if Ehrlich paid off his purchased stock and exercised his conversion option, Ehrlich’s rights as a minority stockholder of Selmark would be governed by that agreement. This agreement provided both parties with the opportunity to end their business relationship through the sale of Ehrlich’s stock, which included a cross-purchase put and call rights for the parties.
After these agreements were executed, Marathon and Selmark remained separate entities, but presented themselves as “Selmark” to the outside world. Ehrlich identified himself as a VP of Selmark even, while technically he was an employee and vice-president of Marathon. Ehrlich’s employment agreement expired by its terms in 2002, but Ehrlich remained an employee of Marathon and retained his position as vice-president. In 2003, Ehrlich began to report directly to Selmark’s management and received no complaints about his job performance.
In the summer of 2007, Ehrlich provided notice to Elofson that he intended to accelerate his final payments on his 49% share of Marathon stock by December 2007. According to the Court, Elofson then decided that he did not want Erhlich as a business partner and in October 2007 informed Ehrlich that his employment with Marathon was terminated and offered for Selmark to purchase Ehrlich’s 49% interest in Marathon for the same price he would have received had he converted his Marathon shares into Selmark stock and then Selmark had exercised its call rights pursuant to the stock agreement. To assuage him to sell his shares, Elofson also told Ehrlich that Marathon did not have the cash-flow to support the continuing payments under the Notes, and that Ehrlich would have to meet the shortfall if he did not sell his shares to Elofson.
In November 2007, Ehrlich took a job with a competing manufacturer’s representative company and afterwards solicited some of Marathon’s customers. After his termination, Ehrlich received a small severance, but did not cash in his Marathon stock under the terms offered in the termination letter and remained a minority shareholder of Marathon.
Following his termination, Ehrlich did not believe that Marathon had insufficient funds to make its remaining payments under the notes. Taking matters somewhat into his own hands, he suspended payments to Marathon which appears to have only complicated the parties disputed because of the default issues that arose. While it appears that Ehrlich did eventually pay off his portion of the Notes and attempted to cure the default, the ambiguity over whether he perfected his conversion rights and his shareholder rights under the stock agreement added additional complexity to the dispute.
In 2008, Selmark and Marathon sued Ehrlich for breach of fiduciary duty for his solicitation of Marathon customers, and Ehrlich responded with thirteen counterclaims against counterclaims, also including fiduciary duty claims. At trial, the jury ruled in favor of the plaintiffs on their fiduciary duty claim, and in favor of Ehrlich (with respect to Selmark and Elofson) on his breach of contract, fiduciary duty and 93A counterclaims, netting a significant verdict in his favor. (The trial judge also later doubled the 93A damages and awarded attorney’s fees. ) The parties then appealed.
Discussion
While many aspects of this decision are worth a careful reading in its original, unabridged version, the most interesting parts of this case for me relate to its holdings on the fiduciary duty issue.
1. Fiduciary Duty owed to Ehrlich as an Employee Shareholder. The jury found that Selmark and Elofson breached their fiduciary duties to Ehrlich in relation to the termination of his employment by Marathon. Citing the long standing precedent in Massachusetts protecting minority stockholders in closely held corporations, the SJC held that a “freeze-out” can occur “when a minority shareholder is deprived of employment”.
Although the Court acknowledged that fiduciary duties of good faith and loyalty may be inapplicable where the parties have negotiated a series of agreements intended to govern the terms of their relationship, the challenged conduct must be clearly contemplated by the terms of the written agreements. The presence of a contract “will not always supplant a shareholder’s fiduciary duty, ” and when the contract does not entirely govern the other shareholders’ or directors’ challenged actions, a claim for breach of fiduciary duty may still lie. To supplant the otherwise applicable fiduciary duties of parties in a close corporation, the terms of a contract must clearly and expressly indicate a departure from those obligations.
In this case, while the parties had entered into multiple, complex written agreements, the Court still held that none of these agreements covered the duties at issue. The Court reasoned that none of the agreements contained terms that addressed Ehrlich’s employment rights upon expiration of his Marathon employment agreement and before conversion of his Marathon stock. Finding that fiduciary duty did apply, the Court affirmed the trial court’s findings in favor of Ehrlich on these issues. Among its reasoning, the Court noted that Elofson could have sought less harmful alternatives before resorting to termination, and cited precedent that a fellow shareholder employee is owed “real substance and communication, including efforts to resolve supposed complaints by less drastic measures than termination.”
2. Fiduciary Duty owed by Ehrlich. At trial, Marathon and Selmark argued that Ehrlich violated his fiduciary duties of good faith and loyalty to Marathon when he solicited Marathon’s customers for his new employer. The jury agreed, and awarded them $240,000 in damages. On appeal, Ehrlich contended that, because he was fired by Elofson and essentially “frozen out” of Marathon, he had the right to compete with Marathon without committing a breach of his fiduciary duties to the company.
Ruling in favor of the employer in this case, the Court cited long-standing precedent under Massachusetts law that shareholders in close corporations owe fiduciary duties not only to one another, but to the corporation as well. (See, e.g., Chambers v. Gold Medal Bakery, Inc., 464 Mass. 383, 394 (2013); Donahue v. Rodd Electrotype Co. of New England, Inc., 367 Mass. at 593.)
At issue here was whether those fiduciary duties to the corporation continue once a shareholder has been “frozen out,” or wrongfully terminated, by that corporation. Declining to follow precedent from the Supreme Court of Wyoming that held that a freeze out does extinguish such a duty, the Court held that the fiduciary duty does, in fact, survive a freeze out. The Court saw what Ehrlich proposed as a “drastic step” and reasoned that “allowing a party who has suffered harm within a close corporation to seek retribution by disregarding its own duties has no basis in our laws and would undermine fundamental and long-standing fiduciary principles that are essential to corporate governance.”
Because the Court did not address what would be the scope and extent of such a duty, parties are still advised to address all such issues in a written non-solicitation agreement, which can define more precisely the specifics such as the term, geographic scope and other similar issues.
