By: Richard Gauthier

A recent decision by the Massachusetts federal district court held that Massachusetts corporate law relating to fiduciary duty does not apply to Delaware corporations doing business in Massachusetts.  As most privately held tech-based companies started in Massachusetts are typically formed in Delaware and qualified here as a foreign corporation, this decision, while not surprising, provided comfort and clarity on this important issue.

Paul Nahass, a shareholder and former director and officer of FlexLite Corporation, sued a group of FlexLite shareholders, for terminating him as an officer and director of FlexLite.  Nahass alleged the termination violated their fiduciary duty to Nahass as a minority shareholder in a close corporation and FlexLite’s corporate bylaws.  Nahass argued that because FlexLite was a close corporation, under the famous Massachusetts Donohue v. Rodd decision, the other shareholders owed him a fiduciary duty that he claimed was breached.

The Court rejected this argument.  Pursuant to the Massachusetts “internal affairs” doctrine, the law of the state of incorporation applies to disputes over the internal workings of a corporation, including allegations that majority shareholders breached a fiduciary duty to shareholders. Because FlexLite is a Delaware corporation, The Court held that Massachusetts law does not apply.

The Court then went on to clarify that, unlike Massachusetts, under Delaware law shareholders in a close corporation do not have a fiduciary duty to each other.  Instead, Delaware courts have expressly rejected the Massachusetts Supreme Judicial Court’s reasoning.  The Court noted that some Delaware courts have held that “majority stockholders have fiduciary duties to minority stockholders as stockholders …” in certain circumstances, which were not alleged in this case.[1]

The Court also upheld Nahass’ removal from the FlexLite board that was effected by a written consent of stockholders.  While he claimed the corporate bylaws entitled him to a stockholder vote, the Court rejected this argument based on the provisions in the DGCL and the corporate bylaws that permitted action by written consent.

Tags: board of directors, corporate bylaws, fiduciary duty, FlexLite, foreign corporation, freeze-out, internal affairs doctrine, majority stockholders, minority stockholders, squeeze-out, startup

Since the 1974 landmark decision in Donohue v. Rodd, Massachusetts courts have held that majority stockholders in close corporations owe minority stockholders a fiduciary duty akin to that owed in a partnership. This type of duty has been relied up to protect minority shareholders from squeeze-out or freeze-out scenarios. It has also been used as an offensive tactic to argue for implied rights of shareholders that are not expressly provided in the corporate documents, such as the articles of organization, bylaws or shareholder agreements.

In Merriam, et. al. v. Demoulas Supermarkets, Inc., the Supreme Judicial Court refused to extend the duties provided under Donohue v. Rodd to restrict stock transfers that were not expressly restricted under the Corporation’s governing documents.

While a fiduciary duty may exist, the Court encouraged shareholders of close corporations to enter into a shareholder agreement or specify in the corporate bylaws “rights, protections, and procedures that define the scope of their fiduciary duty in foreseeable situations.” The Court held that good faith compliance with the specific terms will not implicate that fiduciary duty. “A claim for breach of fiduciary duty may arise only where the agreement does not entirely govern the shareholder’s actions.”

In this case the plaintiffs attempted to use the concept of fiduciary duty in a creative way to prevent the transfer of stock because the corporation was an S corporation and the transfer could blow the S election. After reviewing the shareholder agreement and bylaws, the Court held that the challenged actions fell within the scope of those agreements – which did not restrict such a transfer – and that the fiduciary duty was not implicated in this case.

The court also rejected the argument that the fiduciary duty could be used to create an implied right of first offer or co-sale rights on a transfer to a third party. Transfer restrictions are to be construed narrowly in Massachusetts, and the Court reasoned that had the parties intended to create such rights and restrictions, they would have stated so expressly in their shareholder agreement.

Certainly, this decision does not present any major news to most corporate practitioners. While it is nice to know that shareholder agreements are still given weight in Massachusetts, the key takeaway is the importance of having such an agreement in the first place. Close corporations, particularly those with employee shareholders, should be strongly encouraged to enter into detailed shareholder agreements to provide for situations dealing with transfers, rights of first refusal, preemptive rights and potential divorce and dissolution. Majority stockholders may feel some reluctance to spend money and time on such a document, when the protection is often for their fellow stockholders. However, as shown by this decision, not having such an agreement will subject everyone to the vague principles of applicable fiduciary duties, which could have wide-ranging and negative implications.

If you have any questions about this topic, please feel free to email us.

Tags: acquisition, articles of organization, bylaws, change of ownership, close corporations, corporate law, donohue v. rodd, et. al. v. Demoulas Supermarkets, fiduciary duty, freeze-out, good faith, implied right, Inc., M&A, majority stockholders, massachusetts supreme judicial court, Merriam, minority stockholders, partnership, S-corporation, shareholder agreements, squeeze-out, stock transfers