Shareholder oppression & dividend policy in the close corporation

Shareholder oppression & dividend policy in the close corporation

Moll, Douglas K

I. Introduction

The receipt of a dividend is perhaps the most basic method by which a shareholder earns a return on her investment in a corporation.1 Because of the dividend’s importance, scholars have long focused their attention on the fundamental question of when judicial intervention into a company’s dividend policy is warranted.2 Significantly, however, this academic focus has concentrated almost exclusively on the publicly-held corporation. In that context, a number of authorities have argued that there is little need for the judiciary to involve itself in compelling the payment of dividends, primarily for two reasons.

First, if a public corporation retains profits rather than declaring dividends, “the price of the firm’s shares will rise accordingly.”3 A shareholder desiring a current return can always create a “homemade” dividend by selling some stock and capturing the appreciated value.4 Second, if corporate management pursues a dividend policy that is contrary to shareholder interests, dissatisfied investors will sell their holdings. Widespread selling will decrease a company’s stock price and will expose management to the threat of removal. Commentators have argued, therefore, that senior managers’ self-interest in retaining their valuable employment positions will independently restrain poor dividend decisions without the need for judicial oversight.5

It is somewhat obvious that these two rationales are premised on the existence of a well-functioning market. A market is necessary to convert stock into homemade dividends, and a market is necessary to put “dissatisfaction” pressure on management. Both rationales protect public corporation investors from suboptimal dividend decisions, and both suggest that there is little need for judicial interference in public corporation dividend policy.

In the close corporation setting, however, these market-based rationales are wholly inapplicable. A close corporation, by definition, lacks a market for its stock.6 As a consequence, a close corporation minority investor7 can rarely capture the appreciation in the value of its shares, as willing purchasers are typically scarce or nonexistent.8 Moreover, the majority shareholder’s control over dividend policy is free of market constraints. When close corporation dividend policy is at issue, therefore, a “hands-off ‘ attitude by the judiciary makes considerably less sense. Although other scholars have previously made this observation,9 the academic discussion has not proceeded substantially beyond the observation itself. It is important, therefore, to return to the fundamental question and to consider it in the close corporation setting-that is, when is judicial intervention into a close corporation’s dividend policy warranted?

To some extent, a consideration of this question has been aided by the development of the shareholder oppression doctrine. The doctrine of shareholder oppression attempts to safeguard the close corporation minority investor from the improper exercise of majority control.10 By identifying and protecting the “reasonable expectations” of close corporation shareholders, including the reasonable expectation of dividends, the oppression doctrine combats majority shareholder efforts to exclude a minority investor from the company’s financial and participatory benefits.11 Although the doctrine usefully acknowledges that close corporation shareholders can have reasonable expectations of dividends, the doctrine provides no guidance on whether an asserted expectation is “reasonable,” and thus enforceable, in the particular circumstances before a court. 12 One could argue, therefore, that the shareholder oppression doctrine has simply rephrased the fundamental question. Asking whether judicial intervention into a close corporation’s dividend policy is warranted, in other words, is functionally equivalent to asking whether a shareholder’s expectation of dividends is reasonable under the circumstances.13

This Article squarely addresses the issue of close corporation dividend policy and the question of when judicial intervention is warranted. More specifically, this Article analyzes close corporation dividend disputes through the lens of the shareholder oppression doctrine. By examining when a shareholder’s expectation of dividends is reasonable and enforceable, this Article moves beyond the mere observation that close corporations require greater judicial scrutiny. Indeed, this Article discusses the basic types of dividend disputes that arise in close corporations and provides guidance to courts for resolving such disputes.

To put this Article in context, one should understand that the vast majority of corporations in this country are close corporations.14 Family-owned businesses (which close corporations often are) “represent ninety-five percent of all United States businesses and are responsible for nearly fifty percent of the jobs in the United States.”15 Moreover, the number of new business incorporations in this country has reached peak levels.16 As a consequence, the issues discussed in this Article affect an enormous number of companies as well as individuals.

Part II of this Article provides needed background information by discussing the nature of the close corporation, the development of the shareholder oppression doctrine, and the effect of a denial of dividends on close corporation shareholders. Part III contends that courts should evaluate close corporation dividend disputes under the oppression doctrine’s reasonable expectations standard, rather than under the traditional, majority-deference approach. Because there is no market for close corporation stock, and because the dividend decisions of majority shareholders are often tainted by conflicts of interest, this part argues that a judicial framework based on deference to the majority is unworkable in the close corporation setting. The shareholder oppression doctrine, however, is premised on the notion that the majority’s dividend decisions-decisions that might otherwise be innocuous in public corporations-can be devastating to minority investors in close corporations. The doctrine recognizes, in other words, that majority deference is inappropriate in the close corporation context. This Part concludes, therefore, that the reasonable expectations standard is a superior approach for evaluating close corporation dividend controversies.

Parts IV and V explore the basic types of close corporation dividend disputes and seek to develop a principled framework for resolving them. Part IV involves de facto dividend claims-that is, claims that the majority shareholder is receiving a disproportionate share of the company’s profits, often in the form of salary and other employment-related benefits. Although de facto dividend disputes may result from the fault of the majority, the fault of the minority, or from no fault at all, this Part utilizes a hypothetical bargaining model to conclude that the disproportionate receipt of company profits should always be viewed as oppressive and worthy of judicial intervention. Moreover, this Part reveals that the judicial relief provided in many de facto dividend controversies is often incomplete.

Part V focuses on disputes over dividend suppression when de facto dividends are not involved. Put differently, even when a majority shareholder does not receive a disproportionate amount of the company’s profits through salary or otherwise, a minority shareholder may, at some point, reasonably expect dividends-particularly when a business has been profitable for some period of time but has not yet distributed those profits to shareholders. This Part borrows from the field of financial economics in arguing that an expectation of dividends should be deemed reasonable when the majority attempts to reinvest the company’s profits in projects that provide below “cost of capital” returns-that is, projects with expected rates of return that are insufficient given their levels of risk. As this Part explains, a majority shareholder will have an incentive to make below cost of capital investments whenever those investments provide employment benefits to the majority that more than offset the insufficient financial return. Such investments, however, disadvantage minority shareholders who, for either voluntary or involuntary reasons, do not work for the company. By again utilizing a hypothetical bargaining model, this part advocates an approach that no court presently follows: whenever the majority seeks to make below cost of capital investments, oppression liability should arise.

II. The Doctrine of Shareholder Oppression

A. The Nature of the Close Corporation

A close corporation is a business organization that typically has a small number of stockholders, the absence of a market for the corporation’s stock, and substantial shareholder participation in the management of the corporation.17 In the traditional public corporation, the shareholder is normally a detached investor who neither contributes labor to the corporation nor takes part in management responsibilities.18 In contrast, within a close corporation, “a more intimate and intense relationship exists between capital and labor.”19 Close corporation shareholders “usually expect employment and a meaningful role in management, as well as a return on the money paid for [their] shares.”20 Moreover, family or other personal relationships often link close corporation investors, resulting in a familiarity between the participants.21

Conventional corporate law norms of majority rule and centralized control can lead to serious problems for the close corporation minority shareholder.22 Traditionally, most corporate power is centralized in the hands of a board of directors.23 In a close corporation, the board is ordinarily controlled “by the shareholder or shareholders holding a majority of the voting power.”24 Through this control of the board, the majority shareholder has the ability to take actions that harm the minority shareholder’s interests.25 Such actions are often referred to as “freeze-out” or “squeeze-out” techniques26 that “oppress”27 the close corporation minority shareholder. Common freeze-out techniques include the refusal to declare dividends, the termination of a minority shareholder’s employment, the removal of a minority shareholder from a position of management, and the siphoning off of corporate earnings through high compensation to the majority shareholder.28 Quite often, these tactics are used in combination. For example, the close corporation investor generally looks to salary more than dividends for a share of the business returns because the “[e]arnings of a close corporation often are distributed in major part in salaries, bonuses and retirement benefits.”29 When actual dividends are not paid, therefore, a minority shareholder who is discharged from employment and removed from the board of directors is effectively denied any return on his investment as well as any input into the management of the business.30 Once the minority shareholder is faced with this “indefinite future with no return on the capital he or she contributed to the enterprise,”31 the majority often proposes to purchase the shares of the minority shareholder at an unfairly low price.32

In the public corporation, the minority shareholder can escape these abuses of power by simply selling its shares on the market. By definition, however, there is no ready market for the stock of a close corporation.33 Thus, when dividend suppression or some other action results in the unfair treatment of a close corporation shareholder, the shareholder “cannot escape the unfairness simply by selling out at a fair price.”34

B. The Cause of Action for Oppression

Over the years, state legislatures and courts have developed two significant avenues of relief for the “oppressed” close corporation shareholder. First, many state legislatures have amended their corporate dissolution statutes to include “oppression” by the controlling shareholder as a ground for involuntary dissolution of the corporation.35 Moreover, when oppressive conduct has occurred, actual dissolution is not the only remedy at the court’s disposal. Both state statutes and judicial precedents have authorized alternative remedies that are less drastic than dissolution.36 As the alternative forms of relief have broadened over the years, orders of actual dissolution have become less frequent.37 The most prevalent alternative remedy today is a buyout of the oppressed investor’s holdings.38 Thus, oppression has evolved from a statutory ground for involuntary dissolution to a statutory ground for a wide variety of relief.39

Second, particularly in states without an oppression-triggered dissolution statute, some courts have imposed an enhanced fiduciary duty between close corporation shareholders and have allowed an oppressed shareholder to bring a direct cause of action for breach of this duty.40 In the seminal decision of Donahue v. Rodd Electrotype Co.,41 the Massachusetts Supreme Judicial Court adopted such a standard:

[W]e hold that stockholders in the close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another. In our previous decisions, we have defined the standard of duty owed by partners to one another as the “utmost good faith and loyalty.” Stockholders in close corporations must discharge their management and stockholder responsibilities in conformity with this strict good faith standard. They may not act out of avarice, expediency or selfinterest in derogation of their duty of loyalty to the other stockholders and to the corporation.42

Following the lead of the Donahue court, several courts outside of Massachusetts have also imposed an enhanced fiduciary duty running from shareholder to shareholder in a close corporation.43

The development of the statutory cause of action and the enhanced fiduciary duty “reflect the same underlying concerns for the position of minority shareholders, particularly in close corporations after harmony no longer reigns.”44 Because of the similarities between the two remedial schemes, it has been suggested that “it makes sense to think of them as two manifestations of a minority shareholder’s cause of action for oppression.”45 In the close corporation context, therefore, it is sensible to view the parallel development of the statutory cause of action and the enhanced fiduciary duty action as two sides of the same coin-that is, the shareholder’s cause of action for oppression.

C. Measuring Oppression Through “Reasonable Expectations”

The development of a shareholder’s cause of action for oppression requires courts to determine when “oppressive” conduct has occurred. In wrestling with this issue, the courts have developed three principal approaches to defining oppression. First, “some courts define oppression as ‘burdensome, harsh and wrongful conduct… a visible departure from the standards of fair dealing and a violation of fair play on which every shareholder who entrusts his money to a corporation is entitled to rely.'”46 Second, some courts link oppression to breach of an enhanced fiduciary duty owed from one close corporation shareholder to another.47 Third, a number of courts tie oppression to the frustration of the reasonable expectations of the shareholders.48 Of these three approaches, the reasonable expectations standard garners the most approval, and courts have increasingly used it to determine whether oppressive conduct has taken place.49 The highest courts in several states have adopted the reasonable expectations approach50 and commentators have generally been in favor of the reasonable expectations standard.51

The New York decision of In re Kemp & Beatley, Inc.52 has been particularly influential in giving some context to the reasonable expectations framework. In Kemp, the Court of Appeals stated that “oppressive actions . . . refer to conduct that substantially defeats the ‘reasonable expectations’ held by minority shareholders in committing their capital to the particular enterprise.”53 As the court continued:

A court considering a petition alleging oppressive conduct must investigate what the majority shareholders knew, or should have known, to be the petitioner’s expectations in entering the particular enterprise. Majority conduct should not be deemed oppressive simply because the petitioner’s subjective hopes and desires in joining the venture are not fulfilled. Disappointment alone should not necessarily be equated with oppression.

Rather, oppression should be deemed to arise only when the majority conduct substantially defeats expectations that, objectively viewed, were both reasonable under the circumstances and were central to the petitioner’s decision to join the venture.

A shareholder who reasonably expected that ownership in the corporation would entitle him or her to a job, a share of corporate earnings, a place in corporate management, or some other form of security, would be oppressed in a very real sense when others in the corporation seek to defeat those expectations and there exists no effective means of salvaging the investment.54

It is important to understand the distinction between “general” reasonable expectations and “specific” reasonable expectations. At bottom, the shareholder oppression doctrine protects close corporation stockholders with a set of special judicial rules that go beyond the protections that public corporation law provides.55 An important corollary to this proposition, however, is that close corporation shareholders do not lose any of the protections that general corporate law provides-that is, at a minimum, they receive the baseline public corporation protections. In a public corporation, of course, the mere status of “shareholder” entitles one to a proportionate stake in the company’s earnings as well as to various other rights.56 One can assert, therefore, that every shareholder-whether in a public corporation or a close corporation-reasonably expects that her position as a stockholder entitles her to a proportionate share of the company’s profits.57 Whenever this “general” reasonable expectation is frustrated in a close corporation, oppression liability should arise.

A proportionate share of the company’s earnings, however, is only one component of the typical close corporation shareholder’s investment. Unlike in a public corporation, the investment return in a close corporation often includes employment and management benefits as well.58 “Specific” reasonable expectations refer to these “extra” components of the close corporation shareholder’s investment return-extra to the extent that they are in addition to the stockholder’s entitlement to a proportionate share of the company’s earnings. Unlike a status-triggered general reasonable expectation, a specific reasonable expectation is not held by every close corporation participant who can be characterized as a “shareholder.” To the contrary, a specific reasonable expectation is personal in nature,59 as it requires proof that a close corporation majority shareholder and a particular minority shareholder reached a mutual understanding about a certain entitlement (for example, employment, management) the minority is to receive in return for its investment in the business.60 By safeguarding specific reasonable expectations of employment, management, or other entitlement, the oppression doctrine is offering special protection to close corporation shareholders-“special” to the extent that public corporation shareholders do not receive similar protection.61

D. Oppression and the Denial of Dividends

In a public corporation, one could argue that dividend decisions do not significantly affect the value of an investor’s stockholdings. After all, economic theory suggests that any decision to retain earnings within the company rather than to pay dividends will have a positive effect on the overall value of the firm-an effect which translates into an increase in the value of the company’s shares.62 Assuming that retained funds are reinvested at the firm’s cost of capital,63 the theory suggests that a minority shareholder of a public corporation is largely indifferent as to whether dividends are declared or not (ignoring taxes and transaction costs).64 If a dividend of one dollar per share is paid, a minority shareholder is enriched by one dollar per share. If that same amount is instead retained in the company, the company’s value increases by one dollar per share and, correspondingly, the value of the minority’s stock increases by one dollar per share.65 By selling the stock, the minority can capture that increase in value. The minority’s wealth, in other words, increases by one dollar per share regardless of whether a payout or reinvestment decision is made, as the dollar takes the form of either a cash dividend or of stock appreciation.66

In the close corporation, of course, this theory of “dividend irrelevance”67 is harder to accept, as there is no liquid market that allows for the realization of capital appreciation.68 When funds are retained and reinvested in the company rather than paid out as dividends, the minority has little ability to capture the increased value of its shares, as “[t]he holder of a minority interest in a close corporation may not be able to find anyone willing to purchase that interest at any serious price.”69 For the minority shareholder to receive a return on investment, therefore, dividends are needed, as capital appreciation is difficult (if not impossible) to realize.70

Where all of the shareholders are salaried employees of the close corporation, the payment of actual dividends is less important. The salary and other employment-related compensation provides the expected return.71 Where the majority shareholder is employed by the company and the minority investor is not, however, dividends become critical, as they provide the minority shareholder with its only source of return.72 Not surprisingly, the wrongful suppression of dividends is a common ground upon which the courts grant oppression relief.73

III. Evaluating Dividend Policy in the Close Corporation

Before a discussion of the basic types of close corporation dividend disputes can occur, one must consider the appropriate framework for evaluating the propriety of a majority’s dividend decision. The inquiry is complicated, primarily for two reasons. First, despite the widespread acceptance of the reasonable expectations approach, a good deal of pre-oppression case law exists that defers to the majority’s business judgment on dividend decisions. Second, even assuming that the reasonable expectations standard applies, it is often unclear whether a frustrated expectation of dividends is reasonable in the circumstances.

A. The Traditional Approach to Compelling Dividends

Courts have generally viewed the declaration of dividends as “discretionary and within the business judgment of the board of directors.”74 Without an abuse of discretion, a court typically will decline to substitute its own judgment and will avoid ordering a distribution of dividends.75 Historically, such an abuse of discretion was found “only if there [was] evidence of fraud or bad faith or a clear case of unreasonableness.”76 Significantly, the burden to demonstrate such abuses was placed on the complaining shareholder,77 and that “onerous” burden was rarely met.78 Indeed, the business judgment rule79 was (and still is) often employed by courts to insulate the majority’s dividend decision from any meaningful judicial review.80

This traditional, majority-centered approach to close corporation dividend disputes is out of step with modern understandings about the nature of close corporations and the expectations of investors who commit their capital to such ventures. The traditional view’s reliance on the business judgment rule is an uneasy fit in the close corporation context, and its minimal inquiry into the propriety of the majority’s decision is inconsistent with the thrust of the shareholder oppression doctrine. For both of these reasons, courts should reject the traditional view in favor of the reasonable expectations approach as the standard for evaluating dividend decisions in close corporations.

B. The Need to Reject the Traditional Approach

1. The Uneasy Fit of the Business Judgment Rule

The business judgment rule is a corporate law principle that insulates a manager from liability so long as its decision was made “on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company.”81 Under the business judgment rule, courts review the majority’s substantive business decision with a minimal level of scrutiny.82

a. The Absence of a Market for Close Corporation Shares

In dividend disputes in public corporations, business judgment rule deference is arguably appropriate. A well-functioning market can discipline a majority shareholder for its “poor” dividend decisions because dissatisfied minority investors can sell. Significant selling will decrease the company’s stock price83 and, at some level, will expose company management to the dangers of displacement through proxy fights or takeovers.84 Because senior managers generally value their positions, this threat of displacement will curb dividend decisions that fail to maximize shareholder value.85 When a well-functioning market exists, therefore it provides an effective restraint on the majority’s dividend decisions and there is a correspondingly diminished need for additional judicial review.86

In close corporations, however, the constraints provided by the market are absent.87 Without meaningful judicial review, there is insufficient oversight of the controlling group’s dividend decisions. In the close corporation context, therefore, the judicial deference embodied in the business judgment rule makes less sense:

With the large corporation, the business judgment rule can be used to prevent the courts from second-guessing corporate managers. Their review is not necessary because other more effective schemes regularly protect the shareholders. But with the close corporation the same thing is not true. For instance, in a large corporation, the failure to pay dividends sufficient to satisfy the shareholders will reflect itself in a lowered stock price and the danger of a proxy fight or a takeover. Thus there is no incentive for management to follow such a policy, and it is quite logical to remove substantially all discretion from the courts on the matter of forcing dividends from large corporations. In the small corporation, on the other hand, the dividend policy will most frequently reflect the personal and perhaps peculiar financial needs of the controlling shareholders. There will be no market to reflect dissatisfaction with this policy. Furthermore, a failure to pay dividends may be used by the controlling group in small corporations to force minority shareholders to sell their shares at a bargain price. Here it can be seen that it makes considerably less sense to adopt a judicial hands-off attitude.88

Because the market-based rationale for the business judgment rule is absent in the close corporation context, close corporation dividend decisions call for more judicial scrutiny than the conventional business judgment rule deference.

b. The Presence of a Conflict of Interest

It is a fundamental principle of corporate law that a decision does not receive the protection of the business judgment rule if the decisionmaker is “tainted” by a conflict of interest in the transaction.89 When a close corporation majority shareholder makes a decision to forego dividends, it is important to recognize that a conflict of interest is often present. That conflict stems from the majority’s desire to preserve and enhance its own employment position within the company.90 Indeed, for many (if not most) close corporation investors, the desire for employment is the principal enticement motivating their decision to commit capital to a venture.91 Compared to similar employment in other contexts, a close corporation job is frequently associated with a higher salary,92 a prestigious management position,93 and intangible benefits stemming from working for oneself.94 Because of the value of close corporation employment, the majority’s decision to forego dividends may be dictated by the majority’s personal desire to preserve and enhance its own employment capital, rather than by an interest in maximizing shareholder value. For example, the majority shareholder may retain profits and forego dividends in order to fuel company growth, as growth often has the effect of increasing the majority’s employment compensation.95 Even if this conflict is not as direct as the law typically requires for rebutting the business judgment rule,96 its presence casts at least some doubt on the wisdom of giving great deference to the majority and of avoiding a deeper review of the majority’s decision.97

2. The Thrust of the Shareholder Oppression Doctrine

The shareholder oppression doctrine is premised on the notion that majority shareholder decisions in close corporations can disadvantage minority shareholders in ways that would not be possible in a public corporation context. The doctrine recognizes that matters traditionally entrusted to majority business discretion-for example, employment, management, and dividend decisions-can be manipulated to effectuate a minority shareholder freeze-out.98 More specifically, one of the lessons conveyed by the shareholder oppression doctrine is that the majority’s control over the firm’s dividend policy can be devastating to a minority investor in a close corporation.99

Because employment discharges, management removals, and dividend denials can severely harm the value of a close corporation shareholder’s investment,100 the oppression doctrine calls for legitimate scrutiny of a majority’s decision to take one or more of such actions. The doctrine conveys, in other words, that such decisions require a more probing judicial review than the conventional business judgment rule allows.101 Thus, the thrust of the shareholder oppression doctrine is at odds with a judicial approach that gives great deference to the majority’s actions. Because the traditional right to compel dividends operates with such a “majority-deference” view,102 that law is a poor choice for close corporation disputes. In contrast, by inquiring into whether the majority’s actions have frustrated the minority’s investment expectations, the reasonable expectations approach requires more than a mere surface inquiry into the majority’s conduct. As such, it is a more appropriate standard.103 In jurisdictions that have adopted the shareholder oppression doctrine, it should be deemed that such adoption has, in the close corporation context, displaced the case law representing the traditional approach.104

3. Summary

Because the reasonable expectations standard avoids reliance on the business judgment rule, it is a more appropriate standard for a close corporation context where the discipline of a market is absent and where the majority is tainted by self-interest. Similarly, because the reasonable expectations approach involves a deeper inquiry into the majority’s employment, management, and dividend decisions, the approach is consistent with the underlying premises of the shareholder oppression doctrine. For these reasons, courts should view the shareholder oppression doctrine as having superseded the traditional approach to compelling dividends.

C. The Limits of the Reasonable Expectations Standard

As previously discussed, close corporation shareholders, at a minimum, possess a general expectation that their status as “stockholders” entitles them to a proportionate share of the company’s profits.105 Because close corporations lack a market that reflects capital appreciation, the investor usually receives its share of the profits through dividends (either as “true” declarations or as “de facto” distributions through, typically, employment compensation).106 In a sense, therefore, one can view the general expectation of sharing proportionately in the company’s profits as a general expectation of dividends.

The mere fact that a general expectation of dividends is possessed, however, does not mean that a minority shareholder can demand its proportionate share of the profits-that is, can demand a dividend-at any time. The oppression doctrine only enforces “reasonable” expectations and, depending on the particular circumstances before the court, a demand for dividends may not be reasonable. For example, where the majority chooses not to declare a dividend in an effort to retain profits for company expansion, or for an investment opportunity, or for any other legitimate business purpose, premising oppression liability on the frustration of the minority’s general expectation may be inappropriate.107 In such circumstances, a minority’s general expectation of dividends is arguably unreasonable, and the majority’s “frustration” of that unreasonable expectation should not give rise to oppression liability.108 Simply put, the minority’s interest in dividends has to be balanced against the majority’s legitimate right to make business decisions for the company.109 Although it is fair to say that all close corporation shareholders possess a general expectation of profit participation, a court cannot give effect to that expectation-that is, a court cannot deem that expectation to be reasonable-in all circumstances.

Obviously, if explicit evidence exists indicating that the majority and minority shareholders agreed to defer dividends in particular circumstances,110 a court should rely on that evidence in assessing the reasonableness of a minority investor’s assertion that the majority’s conduct has frustrated its general expectation.111 For example, if the evidence indicated that all of the investors reached an understanding that the corporation would not pay dividends during a period of corporate growth, that evidence should, in most instances, lead a court to reject a claim of oppression liability during that period, at least a claim that is based upon an alleged frustrated general expectation,112

Unfortunately, in most close corporation disputes, such explicit understandings or agreements are absent.113 A court has only the outer parameters of the general expectation to go on-the basic notion that all shareholders reasonably expect that they are entitled to participation in the company’s profits. In many respects, it is analogous to a court attempting to interpret a skeletal agreement between the shareholders. It is clear that the majority and minority participants have reached an understanding that all stockholders are entitled to a proportionate share of the company’s profits,114 but it is unclear when a particular shareholder can demand distribution of its share through dividends.115

One way to resolve these uncertainties is to ask hypothetically what the shareholders would have agreed to had they contemplated the particular circumstances at issue.116 That is, what understandings would the shareholders likely have reached if, at the outset of the venture, they had bargained over the possibility of the majority refusing to declare dividends for business reasons, personal reasons, or for no reasons at all?117 Put differently, to convince the objectively reasonable investor to commit a substantial part of his savings to a close corporation,118 what understandings would the shareholders likely have to reach regarding the distribution of dividends?

This Article contends that the understandings resulting from these hypothetical bargains should be accepted as valid and accurate statements about the rationale of shareholders that invest in close corporations. More precisely, this Article asserts that the understandings should be accepted as the presumptive terms of the dividend “deal” that typical close corporation shareholders strike. In the absence of evidence indicating that the parties actually reached a consensus contrary to these understandings,119 the majority’s violation of the hypothetical understandings should give rise to oppression liability. As this Article discusses the basic types of dividend disputes in close corporations, this hypothetical bargaining model will be employed to provide guidance for resolving the disputes.

IV. The Problem of De Facto Dividends

Perhaps the clearest case for judicial intervention into a close corporation’s dividend policy involves the majority shareholder’s receipt of “de facto” dividends to the exclusion of the minority shareholder. A dividend is merely a distribution of corporate profit to shareholders.120 As mentioned, a close corporation often chooses vehicles other than traditional dividend declarations to distribute its profits to investors. For example, salary and other employment-related compensation are typically used as mechanisms for distributing close corporation profit because the company can deduct reasonable employee compensation, but not reasonable dividend payments, from its taxable income.121 A “de facto” dividend, therefore, is simply a distribution of corporate profit to shareholders that a company disguises, often for tax reasons, as some other form of compensation or perquisite.122

Because close corporations often distribute their business returns in the form of de facto dividends, declarations of “true” dividends are rare.123 So long as all of the investors are receiving their proportionate share of the de facto dividends, this absence of true dividends is generally unobjectionable as a corporate matter. In such circumstances, the investors are receiving their proportionate share of the company’s profits and, consequently, their general reasonable expectations are met. When the majority receives de facto dividends but excludes the minority from them, however, the absence of true dividends becomes problematic. Without true or de facto dividends, the minority has been effectively excluded from its proportionate share of the company’s profits. Such situations likely frustrate the minority’s general reasonable expectation and warrant judicial intervention.124

In de facto dividend cases, however, some important distinctions could be drawn. In many of the published oppression decisions that address the issue, the minority’s exclusion from de facto dividends results from “majority fault”-that is, the majority shareholder takes some sort of unjustified action, such as a wrongful termination of the minority’s employment, that creates the exclusion.125 In such cases, the equities favor the aggrieved minority shareholder and the need for judicial intervention seems clear. Significantly, however, the minority’s exclusion from de facto dividends can also result from “minority fault”-that is, the minority’s misconduct or incompetence can prompt a justified majority action, such as the termination of the minority’s employment.126 The judiciary has rarely confronted these cases, and the propriety of judicial intervention is less clear. Finally, some disputes involve a “no fault” exclusion from de facto dividends, such as when a minority shareholder has been passive since the inception of the venture.127 Each of these scenarios will be discussed in turn.

A. Exclusion from De Facto Dividends: Majority Fault

As mentioned, many of the published oppression decisions involve a classic freeze-out where the majority shareholder unjustifiably terminates the minority shareholder’s employment.128 As a result, the minority is no longer entitled to salary and other employment-related compensation. The majority, however, will typically maintain its employment with the company and will continue to receive a salary and bonuses.129 When a company is paying de facto dividends through employment rather than declaring true dividends, this state of affairs is obviously detrimental to the minority. The amounts received as salary and bonuses constitute not only compensation for the value of the actual labor services performed for the company, but also a distribution of profit to the shareholder.130 By terminating the minority’s employment and maintaining its own job, therefore, the majority has created a situation where it continues to receive a return on its investment while the minority shareholder does not.131 It is the functional equivalent of the majority shareholder choosing to declare a dividend only for itself. Such a non-uniform declaration is impermissible under general corporate law principles.132

Moreover, from a hypothetical bargaining standpoint, the investors surely would not have agreed to an arrangement where the majority, solely at its whim and without any valid reason, could exclude a minority shareholder from distributions of profit that other shareholders (including the majority) are continuing to receive.133 Such an arrangement would give the majority the unfettered right to freeze a minority investor out of the company’s business returns for so long as the majority desires. Given the absence of bargaining power disparities at the inception of a close corporation venture,134 it seems likely that minority investors would have refused to invest in the company if the majority had insisted on such unfettered discretion. Put differently, to induce minority investors to commit capital to the venture, the majority shareholder would likely have to agree that it would not pay dividends (“true” or “de facto”) in a disproportionate manner.

In majority fault disputes, therefore, judicial intervention into a close corporation’s dividend policy is clearly warranted. By and large, the courts have agreed, presumably because frustration of the minority’s general reasonable expectation is so clear where the majority wrongfully excludes the minority from de facto dividends but continues to receive those dividends itself.135

B. Exclusion from De Facto Dividends: Minority Fault

Where the minority’s own misconduct or incompetence has led to its exclusion from de facto dividends, more difficult questions arise. On the one hand, although a termination of the minority’s employment or a removal of the minority from management is likely justifiable when the majority can establish the minority’s misconduct or incompetence,136 unfairness to the minority may still arise if the actions result in the minority ceasing to receive its share of the company profits. After all, while misconduct or incompetence directly relates to one’s ability to serve as an effective manager or employee, such “unfitness” has nothing to do with one’s right to a financial return on a previously-made investment in the business.137 Under such a view, a company that distributed profits solely as salary might have to declare “true” dividends in order to provide a return to a shareholder who was terminated, even justifiably, from its employment position.138 On the other hand, the shareholders may have had legitimate business reasons for structuring the company as one that distributed profits via de facto dividends rather than true dividends.139 Should the company have to change that profit-distribution scheme-that is, declare true dividends-simply because of a blameworthy shareholder whose own actions caused the original de facto dividend scheme to become inequitable?

If explicit agreements or understandings between the shareholders speak to this problem, they should clearly govern the situation. As mentioned, however, explicit agreements or understandings are absent in most close corporations and, as a consequence, one can only make hypothetical inquiries.140 That is, what understandings would the shareholders likely have reached if, at the outset of the venture, they had contemplated the possibility of a justifiable exclusion from the company’s method of distributing profits?

Unless very special circumstances are present, it is hard to imagine close corporation shareholders agreeing that a complete freeze-out is permissible under any set of facts. After all, when the majority justifiably terminates a minority shareholder from employment and consequently cuts the minority shareholder out of the company’s earnings distribution scheme, the net effect is the same as a malicious freeze-out. The majority denies the minority its proportionate share of the business returns for an indefinite period of time, and there is no market available for the minority to exit the situation.141 Most likely, an understanding that the majority could render a shareholder’s investment worthless for an indeterminate period of time is not one that close corporation shareholders would reach, even if the minority shareholder’s misconduct or incompetence precipitated the situation.142

Perhaps another way of articulating the same idea is to assert that close corporation shareholders would likely reach an understanding that the punishment needs to fit the crime. As mentioned, while misconduct or incompetence may be grounds for the forfeiture of a specific reasonable expectation of employment or management,143 such notions of unfitness are unrelated to the general reasonable expectation of sharing in the business returns.144 It is the making of the financial investment itself-not any notion of satisfactory performance in an employment or management position-that gives rise to the general expectation of sharing proportionately in the company’s profits.145 Simply put, misconduct or incompetence in an active participation role (employment, management) should forfeit the shareholder’s right to that active participation in the company. Allowing that same conduct to forfeit the shareholder’s right to passive participation in the company (profitsharing), however, goes too far.146 Either a buyout of the shareholder’s interests should occur, or a court should force the company to declare true dividends.147 Although the company may be compelled to change its profit-distribution mechanism as a result of the minority shareholder’s fault (that is, from “de facto” to “true” dividends), such a forced change is one that the shareholders would likely have agreed to had they discussed the alternative of a wholesale exclusion from the profits of the company.148 It bears repeating that the company can avoid this change in structure if it (or the majority shareholder) is willing to buy out the minority’s holdings at “fair value.”149

Gimpel v. Holstein150 is a rare precedent that confronts the issue of a minority shareholder’s exclusion from a company’s profit-distribution scheme as a result of the minority’s own fault.151 In Gimpel, the close corporation at issue had declared no true dividends since its inception.152 Instead, the corporation distributed profits to the shareholders via de facto dividends, as there was a “policy of distributing profits in the form of salaries, benefits and perquisites, without declaring dividends.”153 According to the court, this de facto dividend policy “was basic to the financial structure of the business,”154 and for years it was carried out “apparently by consent of all shareholders, but in any event without objection from anybody.”155

Robert Gimpel, a minority shareholder in the company, was terminated from his employment position as a result of his embezzlement of $85,000 from the business.156 The company continued to adhere to its policy of not declaring dividends, and Robert eventually sued. He alleged, in relevant part, that the “profits of the corporation are distributed to the majority interests in the form of salaries, benefits and perquisites, with no dividends being declared,” and that, as a result of his termination, he “derives no benefit whatsoever from his ownership interest.”157

The Gimpel court recognized that Robert’s misconduct justified his termination from company employment.158 Significantly, however, the court realized that Robert’s general reasonable expectation still deserved protection:

[T]he court is nonetheless constrained to recognize that Robert cannot be forever compelled to remain an outcast…. While his past misdeeds provided sufficient justification for the majority’s acts to date, there is a limit to what he can be forced to bear, and that limit has been reached. The other shareholders need not allow him to return to employment with the corporation, but they must by some means allow him to share in the profits.159

The court concluded that the company “must either alter the corporate financial structure so as to commence payment of dividends, or else make a reasonable offer to buy out Robert’s interest.”160

Gimpel is a noteworthy opinion to the extent that the court explicitly acknowledged the competing concerns of the terminated shareholder’s general reasonable expectation and the company’s pre-existing de facto dividend scheme. Even though the shareholder’s own misconduct caused his exclusion from this pre-existing scheme, the court recognized that such fault could not justify the wholesale defeat of his general reasonable expectation of sharing proportionately in the venture’s profits.161 In short, the Gimpel analysis properly captures the notion that a minority shareholder’s misconduct or incompetence can serve to “forfeit” the minority’s specific expectation of an employment or management position, but that such minority fault should not permanently alter the minority’s basic rights as a shareholder of the company. If a court nonetheless believes that minority fault should have some effect, it could account for such fault in ways that are less harsh than a complete denial of relief.162

C. Exclusion from De Facto Dividends: No Fault

Even if no majority or minority “fault” is involved, de facto dividends are still problematic when the minority investor is not receiving its proportionate share. Typically, a “no fault” exclusion from de facto dividends arises when a minority shareholder has quit or retired from its former employment position with the company,163 although it could also arise when a minority shareholder has been passive since the inception of the venture.164 Where a majority shareholder receives de facto dividends but fails to pay the minority investor its proportionate share, the majority is paying a dividend only to itself. As mentioned, such a non-uniform declaration is impermissible under general corporate law principles.165 Passive minority shareholders-investors who depend solely on dividends for their investment return-would not have assented to such an arrangement. Simply put, if such a disproportionate dividend is oppressive where the minority has acted with misconduct or incompetence,166 it is certainly oppressive where the minority’s actions are free of such fault.167

D. Remedying an Exclusion from De Facto Dividends

When a shareholder is excluded from de facto dividends, the shareholder effectively misses profit distributions that it is entitled to receive. Proper judicial relief should, therefore, provide compensation for these missed distributions and prohibit such exclusions in the future. For example, a court’s award should encompass (1) a damages award equal to the past de facto dividends that the excluded shareholder did not receive (plus interest),168 and (2) an order that future dividends (true or de facto) shall be paid to the excluded shareholder in the same proportional amount that other shareholders receive.

Significantly, this remedial structure should not change even if a court awards a buyout of the minority’s holdings. A buyout of the minority will remove the aggrieved shareholder from the company. Thus, it is certainly true that the need for a court order of future dividends to the excluded minority shareholder is obviated. A buyout award, however, does not provide the aggrieved minority shareholder with compensation for the past de facto dividends that it failed to receive. Although a proper company valuation for buyout purposes adds the de facto dividend amounts back into the corporation’s income,169 that adjustment is because the valuation is typically based upon the company’s earnings.170 In other words, de facto dividends are profits that have not been recorded as such on the company’s books, typically for tax reasons.171 Before performing a valuation that is based on the amount of profits that a company generates, the company’s books must be adjusted to account for these mischaracterized profits (that is, the de facto dividends must be added back into earnings).172

It is critical to recognize, however, that this is truly a “paper” adjustment to the company’s stated profit figures. That is, the shareholders who received their proportionate share of the de facto dividends do not actually return those sums.173 Thus, this well-accepted valuation adjustment does not provide the minority shareholder with compensation for the value of the de facto dividends that it missed; instead, it simply restates the company’s earnings to insure the accuracy of an earnings-based company valuation.174

Perhaps another way to see this point is to imagine that the majority has excluded the minority shareholder from true dividend payments that the other shareholders have received. A buyout award would not require any adjustment to the company’s stated earnings figures because sums distributed as true dividends are profits of the company that have already been recorded as profits on the company’s books. If the buyout was of a shareholder who had received the dividend payments, the shareholder would keep those sums and would receive its proportionate share of the company’s earnings-based value. The minority shareholder excluded from the dividend payments should receive no less-that is, it should receive its portion of the prior dividend payments and its share of the company’s value. Nothing changes when de facto dividends are involved other than a bookkeeping adjustment to correct the stated profit figures so that a profit-driven valuation is accurate.175 Thus, the mere award of a buyout in the context of an exclusion from de facto dividends is incomplete. A court’s relief should encompass (1) a damages award equal to the past de facto dividends that the excluded shareholder did not receive (plus interest),176 and (2) a buyout via a company valuation that adds the de facto dividend amounts back into income to reflect the company’s real earning power.177 Unfortunately, many courts have failed to recognize the need to award both of the relevant components.178

V. The Problem of Dividend Suppression: Forcing Distributions in the Absence of De Facto Dividends

At some level, disputes involving de facto dividends are relatively easy to resolve. After all, these disputes typically involve a majority shareholder who takes a disproportionate amount of the company’s profit. Such conduct, simply put, is clearly unlawful, and one can characterize it as unlawful in a number of different ways-for example, fraud on the minority investors, bad faith to the minority investors, an illegal dividend to the majority, or plain and simple theft by the majority. Where de facto dividends are not involved, however, dividend disputes are much more complicated. For example, where a company has earned profits for a period of time without distributing them to anyone, when, if ever, should a minority shareholder be able to force a dividend? Put differently, if all shareholders are treated equally-that is, if no one receives a disproportionate amount of the company’s profits-is it ever reasonable for the minority shareholder to expect a dividend?179

A. The Cost of Capital Inquiry

Modern economic theory provides a conceptual answer to this question. A company’s board of directors should reinvest profits in a new project (and therefore forego dividends) only when the expected returns from the project equal or exceed the firm’s cost of capital.180 That is, a company should pursue an investment only if the investment’s return justifies its risk. Otherwise, “shareholders are unfairly compensated for the risk of the investments and are better off receiving dividends and choosing their own investment vehicles.”181 The theory suggests, therefore, that even a profitable investment (an investment with a positive rate of return) should not be pursued unless the expected return is high enough to compensate for the risk.182

A simple example helps to convey this point. Suppose that a person wishes to invest $100 and is considering two investment options. The money could be invested in relatively safe U.S. government securities,183 or the money could be invested in a company that sells widgits (Widgits, Inc.). Assume that the government securities are expected to pay a five percent return, Widgits, Inc. is expected to pay a ten percent return, and that all transaction costs are ignored. Even though the expected return from investing in Widgits, Inc. is twice as much as the expected return from investing in government securities, the investment may still be unwise. Indeed, an investment in Widgits, Inc. presumably carries more risk, as the company is exposed to the general risks of competition and business failure.184 A rational investor would commit capital to Widgits, Inc. only if the investor believed that the expected five percent additional return sufficiently compensated it for the greater risk of such an investment.185

When a rational shareholder commits capital to a company, therefore, the investment is premised on the notion that the expected returns from the company will, when factoring in the risk of the company’s business, equal or exceed the expected returns from other investment possibilities when their risks are considered. More succinctly, when investing in a company, the rational shareholder believes that the risk-adjusted expected returns from the company will equal or exceed the risk-adjusted expected returns from other possible investments. A particular company’s “cost of capital” is a reflection of this idea-it signifies the minimum return on financial capital that shareholders demand for the risk of investing in that company’s line of business.186 Put differently, it is the return that shareholders could get themselves, on a riskadjusted basis, by investing elsewhere.187 In our example, if Widgits, Inc. had a cost of capital of ten percent, and if it was approximately twice as risky as an investment in government securities, the ten percent cost of capital signifies that shareholders could get a similar risk-adjusted return on their financial capital by investing elsewhere, namely in “safer” government securities paying a rate of return of five percent.188

Conceptually, therefore, there is an answer to the question of whether it is reasonable for a shareholder to expect dividends in the absence of de facto distributions. When the expected returns from possible investments fall short of the company’s cost of capital, the majority should declare dividends rather than retain profits, as the shareholders are better off making their own investment choices.189 Conversely, when the expected returns from investment projects equal or exceed the company’s cost of capital, the majority should retain profits to commit to those projects rather than pay dividends.190 By doing so, shareholders are earning more on their financial capital than they could in their own investment vehicles.191

Articulated from a hypothetical bargaining perspective, these are the understandings that the shareholders would likely have reached if they had discussed when, in the absence of de facto distributions, actual dividends should be declared.192 Simply put, when the company can reinvest its profits at a risk-adjusted rate greater than the shareholders could earn elsewhere, the majority and minority shareholders would probably concede that reinvestment is superior to dividends, particularly because these circumstances should translate to more valuable dividends down the road.193 If a majority shareholder insisted on greater flexibility in making dividend decisions than these understandings would provide, it is fair to assert that a reasonable minority shareholder would have refused to invest in the company.194

B. Corruption of the Cost of Capital Inquiry: Conflicts of Interest Between the Majority and Minority

In the abstract, one would assume that the interests of both the majority and minority shareholders are served by investing only in projects with an expected return that exceeds the firm’s cost of capital. If the return on investment for both the majority and the minority depends solely on the corporation’s expected returns-that is, if return on financial capital is the investors’ only concern-the shareholders’ incentives are aligned. If expected returns from the company’s new projects exceed the firm’s cost of capital, it is in the majority and minority’s mutual interest to reinvest in the company. If such expected returns fall short of the company’s cost of capital, it is in their mutual interest to declare a dividend so that they can more profitably invest their money elsewhere.195 Simply put, where the shareholders’ incentives are aligned, there is little need for a rigorous judicial inquiry. The majority’s selfinterest can be relied upon to protect the minority’s interests as well.196

The problem, however, is that return on investment in the typical close corporation is not solely based on the corporation’s expected returns. Instead, return on investment in a close corporation is usually a combination of return on financial capital and return on human capital.197 Close corporation employment, in other words, is valuable,198 and it is often the largest component of the shareholder’s overall return on investment.199 As a consequence, it is often rational for a majority shareholder to care more about increasing the return on its human capital than increasing the return on its financial capital. Put differently, because the lion’s share of the majority’s investment return likely derives from the benefits of employment,200 the majority will have an incentive to act in ways that preserve and enhance those benefits. At times, however, those actions are not ones that the majority would take if return on financial capital were the only concern, as the actions often take the form of below cost of capital investments.201 Of course, when a passive minority shareholder is present (either a true passive shareholder or a formerly active shareholder whose employment with the company has ended), return on financial capital is the only concern.202 Thus, for passive shareholders whose return on investment does not include an employment component, below cost of capital investments are problematic. When the majority works for the company and the minority does not, therefore, the interests of the shareholders skew. An understanding of this divergence is necessary to appreciate the utility of the cost of capital inquiry.

1. The Desire for Growth

Reasonable compensation for an employment position in a business is, at some level, related to the size of the company.203 In general, as a company grows larger, both the upper and lower limits of a reasonable salary for a particular position increase.204 Intuitively, the president of a company with $100 million in annual sales can earn more than the president of a comparable company with $ 10 million in annual sales without exceeding the constraint of “reasonable” compensation.

Given this relationship between company size and managerial compensation, it may be in a majority shareholder’s interest to grow the firmnot because growth is necessarily profit-maximizing for shareholders, but because growth increases the perquisites and prestige associated with management positions.205 Indeed, the increased return on employment capital provided by growth can outweigh any relative losses that result from investing at less than the company’s cost of capital.

For example, imagine a close corporation that operates a restaurant. The majority shareholder works full-time for the business as the chief executive officer and draws a $50,000 salary. (Assume that this salary does not include any de facto dividends-i.e., it is reasonable in light of the value of the labor services that the majority performs for the company).206 Assume further that the majority could earn only $40,000 in comparable employment outside of the close corporation.207 The corporation is considering whether to distribute $100,000 in surplus as a dividend, or whether to invest that $100,000 in expansion of the existing restaurant (for example, larger seating area, larger kitchen). Expansion is projected to pay a return of $ 12,000 a year, and it is not expected to increase the number of hours worked by the majority to any significant degree. The corporation’s cost of capital is 15%. For the moment, assume that expansion will not affect the majority’s salary.

On these facts, the rational majority shareholder would choose to pay a dividend rather than to expand. On the assumption that the shareholders can earn the cost of capital themselves in other investment vehicles, the shareholders require at least a $ 15,000 return on a $ 100,000 investment. With expected returns of only $12,000, or 12% a year, the expansion project falls short by $3,000, or 3% a year. Foregoing expansion in favor of a dividend is in the interest of all shareholders-majority and minority-who care solely about their return on financial capital.

Now assume that expansion will allow the majority to increase its salary from $50,000 to $55,000. This increase includes no de facto dividends and is still considered reasonable compensation in light of the additional revenues and earnings generated from the expansion. Outside of the close corporation, assume that the majority could still earn only $40,000 in comparable employment, as chief executive officer positions are simply not available at other similar companies.208 Thus, without expansion, close corporation employment is paying the majority shareholder $10,000 more than the shareholder could earn outside of the company ($50,000-540,000). With expansion, the employment “spread” increases, as the majority is earning $15,000 more than it could earn outside of the company ($55,000-$40,000). Overall, expansion has increased the return on the majority’s employment capital by $5,000-i.e., the majority’s close corporation position now commands a $15,000 “market premium” rather than a $10,000 “market premium.”209

Given this additional information, notice how the majority’s incentives change. Expansion now provides the majority shareholder with a $5,000 gain on its employment capital that more than offsets the $3,000 loss on its financial capital. On these numbers, a rational majority shareholder would choose expansion, even though expansion is still a poor investment choice from the standpoint of return on financial capital.210 Stated more broadly, the majority will prefer expansion because its total return on investment (the aggregate of the return on its employment capital and the return on its financial capital)211 increases as a result. Of course, passive minority shareholders will prefer dividends because expansion produces no gain on their employment capital (by definition) and generates an inferior return on their financial capital. Where such divergence between the majority and minority interests is present, the potential for conflicts over dividend policy is apparent.212

2. The Desire for Surplus

Aside from the desire for growth, a close corporation majority shareholder also has a desire for surplus which may cause it to forego dividends in favor of below cost of capital investments. This desire for surplus stems from two related incentives. First, the majority shareholder has a general incentive to insure that the company maintains sufficient resources to pay its employment compensation in future years.213 Second, a majority shareholder has a specific incentive to increase its salary to the upper limit of its reasonable compensation range.214 Because of the value of close corporation employment,215 in other words, a rational majority shareholder will desire a sizable company surplus to insure that the employment position and its perquisites are maintained, if not enhanced. Given this context, the majority will be wary of dividends.216

At some level, this conservative dividend policy is appropriate. It is perfectly proper for the majority shareholder to care about the future viability of the enterprise and the enterprise’s ability to meet its obligations. Moreover, the majority’s own economic interests should, in theory, prevent it from following an overly conservative dividend policy. After all, the majority has an economic incentive to maximize its total return on investment-return on its employment capital as well as its financial capital.217 Where the company has no above cost of capital investment opportunities, this maximization is theoretically accomplished at the point where (1) the company has retained just enough funds to pay the majority’s present and future employment compensation (and other fixed company obligations); and (2) the company has distributed the remaining funds as dividends such that the majority can invest its share in other vehicles paying at least the cost of capital. At this optimal point, the majority is maximizing its return on employment capital as well as its return on financial capital. That is, just enough funds are left in the company to accomplish the majority’s compensation goals (and to pay fixed obligations), while the company distributes all other available funds so that the shareholders can earn cost of capital returns.

In actuality, however, there is good reason to believe that the typical majority shareholder will be overly conservative in its desire for surplus and its reluctance to pay dividends. Although in theory the above-described optimal point for retention and distribution may exist, in actuality such a point is difficult (if not impossible) to identify with any degree of accuracy. Simply put, the future is uncertain and, as a consequence, it is unclear how much surplus is required to insure that the majority’s compensation goals are met. If the majority’s return on employment capital were comparable to its return on financial capital, perhaps the effect of this uncertainty could be ignored. Because the return on employment capital is usually the far larger component of the majority’s overall investment return,218 however, it is fair to assert that this uncertainty will cause the majority to err on the side of conservatism, most likely to an excessive degree.219 Like the desire for growth, therefore, the desire for surplus is apt to push the majority away from dividends and towards the only profitable investment opportunities that the company has, even if those opportunities provide a below cost of capital return.220

C. The Need for the Judiciary to Make the Cost of Capital Inquiry

As a result of these conflicts of interest, one cannot trust the close corporation majority shareholder to ask the right question when deciding whether to pay dividends. Rather than asking whether the financial return from a contemplated project exceeds the company’s cost of capital, the majority is often asking whether the financial and employment return from the project exceeds the company’s cost of capital.221

In some contexts, however, even this distrust might not call for judicial review. In the public corporation, for example, managers have similar desires to preserve and enhance their employment capital-desires that push them towards growth and below cost of capital investments.222 These desires, however, are constrained by the market and the effect that the market price can have on the continuance of a managerial position. Systemic below cost of capital investments, in other words, fail to maximize shareholder value and ultimately translate into a lower stock price for the company.223 As mentioned, a decreased stock price gives rise to investor pressure for managerial replacements, and it makes the company more attractive as a takeover target (again threatening managerial positions).224 In a public corporation, therefore, a manager’s self-interest in keeping its position may lead to some abuse of dividend policy, but not to excessive abuse.225 Even though public corporation management may not ask the right question in making a dividend decision, the presence of market constraints lessens the need for judicial scrutiny.226

Even in close corporations, distrust of the majority may not call for judicial review. As mentioned, where the company employs all of the shareholders, the majority’s selfish interests may wind up protecting the minority’s interests as well.227 The majority will only decide to retain earnings for investment purposes if the total return on the investment (return on financial capital and return on the majority’s human capital) exceeds the firm’s cost of capital. So long as the investment affects the human capital of the majority and the minority by approximately the same amount, this calculus also serves the minority’s interests.228 If the majority decides to retain and invest rather than to pay dividends, the minority will presumably have no problem with the decision, even if the investment’s expected financial returns fall below the company’s cost of capital.229 When the interests of the majority and minority are aligned, in other words, the need for judicial scrutiny is less pressing.

In most close corporation dividend disputes, however, the majority shareholder is employed by the company while the minority shareholder is not.230 Interests diverge in these situations, as the minority receives no benefit from majority decisions that favor employment capital. It is here where the inability to trust the majority to ask the right cost of capital question is problematic, as there are no market or other constraints to curb excessive majority abuses.231 In the typical close corporation dividend dispute, therefore, a rigorous judicial review is needed.232

Obviously, this review must go beyond the superficial inquiry that is often associated with the business judgment rule.233 If the majority puts forth a legitimate business purpose for retention of funds (for example, need for expansion), most courts end the inquiry.234 It is these business purposes, however, that the courts must scrutinize to insure that their financial returns justify their risks. The courts, in other words, should resolve close corporation dividend disputes by making the cost of capital inquiry. Even when the majority proffers a business purpose for retention, a court should inquire into whether the expected financial returns from retention exceed the company’s cost of capital.235 If the returns fall short, the majority’s decision to retain and invest violates the understandings that the shareholders likely would have reached if they had discussed the issue. As a consequence, a court should deem the general reasonable expectation frustrated, and oppression liability should arise.236

D. The Role of Time in the Cost of Capital Inquiry

In applying the cost of capital inquiry to close corporation dividend disputes, the length of time that a business has been operating will often be relevant. With high growth companies, for example, dividends are rarely paid in the early years of the business.237 In such companies, this emphasis on reinvestment of earnings is often consistent with the cost of capital inquiry, as attractive investment opportunities are generally more prevalent in the beginning stages of a company’s life cycle, particularly where competitors have not yet entered the market.238 Moreover, in the early years of a company’s development, retention of some earnings is prudent until a sufficient surplus is built up to handle contingencies. As long as surplus-building typically involves the reinvestment of company profits in vehicles with less risk than projects within the company’s line of business (for example, placing company funds into a money market account), such activity can also satisfy the cost of capital inquiry.239 In the early years of a business, therefore, the absence of dividends may not run afoul of the cost of capital framework. This lack of dividends is consistent with the expectations of many shareholders at this stage in a company’s existence, as reasonable investors understand (or certainly should understand) that reinvestment of profits is necessary to help establish the business.240

With the passage of time, however, the continuance of a no-dividend or low-dividend policy becomes increasingly more suspect. In a competitive business environment, high current rates of growth “can rarely be sustained indefinitely.”241 Indeed, in the later stages of a company’s development, above cost of capital investment opportunities tend to be few and far between.242 For many companies, therefore, these later stages are the time period when the cost of capital inquiry would indicate that dividends are appropriate.243

Obviously, not every company is a growth company, and even growth businesses differ significantly. Depending on the particular firm, therefore, the cost of capital inquiry may indicate that dividends are proper at an earlier or later date than the above generalizations would suggest. Nevertheless, in conducting a cost of capital inquiry into a firm’s dividend policy, the length of time that a business has been operating will often be a relevant consideration. As a general matter, it is fair to state that it becomes increasingly more difficult to justify the retention of profits and the absence of dividends as a company matures.

E. The Ability of the Judiciary to Make the Cost of Capital Inquiry

As this Article has explained, there are two general inquiries that courts need to make in close corporation dividend disputes. First, where a plaintiff alleges the payment of de facto dividends, a court needs to inquire into whether the majority shareholder has taken profits while excluding a minority investor from its proportional share.244 Second, where de facto dividends are not present but a shareholder still challenges a corporation’s dividend policy, a court needs to inquire into whether the majority is making below cost of capital investments.245

Even if one accepts that these are the two relevant inquiries, the judicial administrability of such inquiries is still in question. It is often stated that the judiciary lacks institutional competence to review a corporation’s dividend decisions, as such decisions are shaped by factors that are peculiarly within the knowledge and experience of a company’s management.246 In disputes involving de facto dividends, this argument carries very little weight. Taking profits while excluding other investors from their share of those profits is plain and simple theft-self-dealing of the first order-that courts look for in both close and public corporation disputes (not to mention in a host of other noncorporate contexts).247 Spotting and rectifying theft is arguably a core function of courts in general, and it makes little sense to treat dividend disputes differently.

Where de facto dividends are not involved, however, the judicial incompetence argument has more force. Given that dividend decisions involve projections about the future affairs of a company, one could argue that courts have no superior information or judgment to second-guess the decisions of company insiders.248 Of course, where a market is involved to discipline overly conservative dividend policies, this argument for a “hands-off” judiciary is easier to accept. In the close corporation, a hands-off approach by the judiciary effectively grants the majority an unreviewable discretion, even though that authority can be used to the detriment of minority investors.249 Before accepting a judicial “punt” in disputes where de facto dividends are not involved, therefore, it is important to examine whether cost of capital inquiries are truly different from other financial issues that courts routinely handle in valuation and other “fair price” disputes.250

In the typical dividend lawsuit, the majority shareholder claims that dividends are inappropriate because the company’s excess funds are to be used for a particular project that the majority favors.251 For a court to assess whether the expected returns from that project exceed the company’s cost of capital, it needs information on both of these variables. That is, the court must determine the company’s cost of capital, and the court must assess the expected returns from the project. By no means are these inquiries simple, but it is fair to assert that they are routinely made in other valuation disputes. For example, cost of capital calculations are performed as a standard step in many valuations of closely-held businesses, whether for buyout or other purposes.252 Granted, the court usually does not have the expertise to perform the cost of capital calculations itself; instead, the court relies on, and assesses the merits of, the calculations of the parties’ expert witnesses.253 This reliance on expert testimony for knowledge that is beyond the ken of the average judge or juror is, of course, commonplace in litigation in general.254 In valuation disputes specifically, expert reports are ubiquitous.255 Determining a company’s cost of capital, therefore, is no more beyond the competence of the judiciary than any other valuation issue that requires an assessment of expert opinion.

Assessing the expected return from a particular project is complicated by the fact that it is a future-oriented analysis. As a consequence, assessments of expected return are simply guesses-educated guesses to be sure, but still guesses-about the likely success or failure of a project.256 Nevertheless, as part of their capital budgeting strategy, companies routinely make such calculations before embarking on a project,257 and the concept of valuation itself is often viewed as a function of expected investment returns.258 Indeed, one valuation technique that is well-accepted in financial and legal circles is the discounted cash flow (DCF) model.259 In operation, the DCF analysis is premised on discounting a stream of estimated future cash flows from an investment back to the present at an appropriate “discount” rate (or cost of capital).260 A positive net present value (the present value of the investment’s expected cash flows minus the cost of the investment) indicates that the investment has a rate of return that exceeds the discount rate.261

The DCF model is simply a subcategory of the broader discounted economic income method of valuation where some measurement of economic income anticipated from an investment (for example, cash flow, net income) is discounted back to present value at an appropriate rate.262 The cost of capital inquiry suggested by this Article is a subcategory of this broader method as well, as the projected income from an investment is discounted back to present value at the company’s cost of capital. If the net present value is positive, it indicates that the investment has a rate of return that exceeds the company’s cost of capital.263 To the extent that courts accept the DCF analysis as a legitimate valuation method, therefore, they have accepted the premise of the cost of capital inquiry as well. That is, the valuation of a stream of projected cash flows (the DCF model) is functionally identical to the valuation of a stream of projected investment returns (the cost of capital inquiry).264 If courts are sufficiently competent to assess valuations based on projections of future cash flow, they would seem to be sufficiently competent to assess valuations based on expected investment returns.265

Despite the similarities between the DCF and cost of capital frameworks, it is important to note that courts typically use the DCF model to value companies rather than to value particular projects.266 Such an inquiry into a company’s value may pose lesser administrative difficulties for courts than a cost of capital inquiry into a specific investment. Within any one particular company, for example, dividend disputes may occur on an ongoing basis. Each time the majority decides to retain funds for a particular project, there maybe a question as to whether that project’s expected returns exceed the firm’s cost of capital. A court may find itself assessing future streams of income on multiple projects-a task that may be more difficult and ongoing than a one-time assessment of a firm’s future stream of income in a company valuation.267 Nevertheless, given the importance of dividends to a close corporation minority shareholder and the great potential for majority abuse,268 such inquiries are necessary to protect the minority’s rights. If a majority shareholder is found to have frustrated the minority’s general expectation by investing in a below cost of capital project, a court fearful of recurring litigation between the parties over subsequent projects could simply order a fair value buyout of the complaining minority investor.269

Moreover, when a court is engaged in the task of valuing a company, it can avoid the DCF approach if the future cash flows for that particular company are too speculative to rely upon. If necessary, courts can turn to other valuation methods that focus more on a company’s historical data than on its projected numbers.270 At times, in other words, future numbers are too hard to predict, and courts cannot rely on future-oriented valuation methods to any credible degree.271 In such circumstances, it may not be possible to evaluate a dividend dispute with a cost of capital inquiry that relies solely on projections of investment returns.272 Where the returns from a project are too speculative for a court to evaluate, however, a majority shareholder would seem to have little justification for wanting to invest in that project. In fact, given the conflicts of interest that a majority shareholder often faces in making dividend decisions,273 the majority shareholder should have the burden of proof to demonstrate that the future returns from a proposed investment exceed the cost of capital. If the majority cannot meet that burden because the project’s future returns are too speculative, the majority should not be able to retain funds for investment m that project.274

VI. Conclusion

It is far from startling to observe that close corporations and public corporations are different. What is significant, however, is the recognition that these differences matter, particularly when dividend policy is at issue. Without a well-developed market, a close corporation shareholder has no ability to manufacture “homemade” dividends through sales of stock at an appreciated value. Moreover, without a market, perhaps the most critical constraint on self-interested managerial behavior is absent. In the close corporation context, therefore, the majority shareholder’s dividend decisions should not escape legitimate judicial scrutiny. Instead of reflexively applying the deferential business judgment rule, courts should employ the oppression doctrine’s more searching reasonable expectations framework.

A meaningful inquiry into close corporation dividend policy, however, requires more than merely recognizing that the reasonable expectations standard is a superior analytical framework. Indeed, this Article has pushed further by developing standards for determining when a close corporation’s dividend policy warrants judicial intervention. With respect to disputes involving de facto dividends, a minority shareholder’s expectation of dividends should be considered reasonable, and thus enforceable, whenever the majority shareholder receives a disproportionate amount of the company’s profits. Regardless of whether such disputes arise from the fault of the majority, the fault of the minority, or from no fault at all, such a position mirrors the understandings that the shareholders themselves likely would have reached had they contemplated the possibility of an exclusion from de facto dividends.

In dividend controversies where de facto distributions are not at issue, basic principles of financial economics provide a useful standard for when judicial intervention is appropriate. When the majority shareholder seeks to reinvest company profits in a project expected to pay a below cost of capital return, the majority is committing the company’s funds to a project whose return is inadequate to compensate for its risk. From the standpoint of return on financial capital, such a below cost of capital investment is disadvantageous to all shareholders-majority and minority alike. As this Article has discussed, however, the majority shareholder’s desire to maximize its return on financial capital will frequently fail to curb this behavior, as below cost of capital investments can provide employment benefits to the majority-and often only to the majority-that more than offset the insufficient financial return.

To combat this majority incentive to make sub-optimal investment choices, judicial intervention is necessary. As a consequence, this Article has argued that judicial compulsion of a dividend is warranted when the majority seeks to retain profits for reinvestment in below cost of capital projects. A minority shareholder has a reasonable expectation of dividends, in other words, when the projected financial returns from the majority’s investment choices are inadequate to compensate for the risks of those choices. Once again, this is the understanding that all of the shareholders likely would have reached if they had bargained over the possibility of the majority refusing to declare dividends for reinvestment purposes.

In short, the close corporation is different, and it is those differences that make dividends critical to minority investors in such organizations. As a result, dividend policy in close corporations cannot be free from scrutiny. By attempting to channel that scrutiny into a principled framework, this Article takes a needed step in the right direction.

Douglas K. Moll*

* Associate Professor of Law, University of Houston Law Center. B.S. 1991, University of Virginia; J.D. 1994, Harvard Law School. The author wishes to thank Adam Goldberg, Stefanie Moll, Zelda Moll, Michael Muskat, and Robert Ragazzo for their helpful comments.

Copyright Washington & Lee University, School of Law Summer 2003

Provided by ProQuest Information and Learning Company. All rights Reserved