A.W. Chesterton Co. v. Chesterton
1997 U.S. App. LEXIS 28460, 128 F.3d 1, 80 A.F.T.R.2d (RIA) 7280 (1997)
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Rule of Law:
In a closely held corporation, a minority shareholder owes a fiduciary duty of utmost good faith and loyalty to the corporation and other shareholders, and breaches that duty by acting out of self-interest to knowingly cause substantial financial harm to the corporation, such as by terminating its advantageous tax status.
Facts:
- A.W. Chesterton Company is a closely held corporation primarily owned by descendants of its founder.
- Arthur W. Chesterton ('Chesterton') is the founder's grandson and the company's largest shareholder with 27.06% of the stock.
- In 1975, the company's Articles of Organization established a right of first refusal for stock transfers to non-family members.
- In 1985, with Chesterton's active support and the unanimous consent of all shareholders, the company elected to become a Subchapter S corporation to gain significant tax advantages.
- To maintain Subchapter S status, a corporation cannot have another corporation as a shareholder, a fact understood by all shareholders at the time of the election.
- Dissatisfied with the company's performance, Chesterton sought to sell his shares but was unable to find a buyer for his minority stake.
- Chesterton then devised a plan to transfer a portion of his shares to two shell corporations wholly owned by him.
- This proposed transfer would automatically terminate the company's Subchapter S status, resulting in significant financial loss for the company and all its shareholders.
Procedural Posture:
- The A.W. Chesterton Company and its shareholders sued Arthur W. Chesterton in the U.S. District Court for the District of Massachusetts, seeking to enjoin his proposed stock transfer.
- The parties stipulated to dismiss all claims except for the breach of fiduciary duty claim, with the plaintiffs seeking only equitable relief (an injunction).
- Chesterton filed a counterclaim seeking monetary relief under Massachusetts corporate law.
- After a bench trial, the district court ruled that the proposed transfer would violate Chesterton's fiduciary duty and granted a permanent injunction.
- The district court also denied Chesterton's counterclaim.
- Chesterton, as the appellant, appealed the injunction and the denial of his counterclaim to the U.S. Court of Appeals for the First Circuit.
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Issue:
Does a minority shareholder in a closely held corporation breach his fiduciary duty by proposing to transfer stock to corporate entities he controls, when that transfer would terminate the corporation's advantageous Subchapter S tax status, even if the transfer complies with the corporation's articles of organization?
Opinions:
Majority - Lynch, Circuit Judge
Yes, a minority shareholder in a closely held corporation breaches his fiduciary duty by taking such an action. Under Massachusetts law established in Donahue v. Rodd Electrotype Co., shareholders in a close corporation owe each other a strict fiduciary duty of 'utmost good faith and loyalty,' akin to that of partners. This duty is not limited to the majority; a minority shareholder whose actions can control a specific corporate outcome, like the company's tax status, is held to the same high standard. Chesterton's proposed transfer was a self-interested act that would cause substantial, direct financial harm to the corporation and fellow shareholders by destroying its valuable S-corp status. The action served no legitimate business purpose for the corporation. Complying with the procedural requirements of the Articles of Organization's right-of-first-refusal clause does not excuse a breach of the higher, independent fiduciary duty imposed by law.
Analysis:
This decision reinforces and clarifies the application of the stringent Donahue fiduciary duty to minority shareholders in Massachusetts closely held corporations. It establishes that a shareholder's actions are judged not just by their compliance with corporate bylaws, but by their adherence to a higher duty of loyalty. The case sets a precedent that knowingly destroying a corporation's advantageous tax status for personal benefit, without a legitimate corporate purpose, constitutes a breach of this duty. This holding limits a disgruntled minority shareholder's ability to use their stock ownership as leverage to harm the corporation, even when their actions are not explicitly prohibited by corporate documents.
