McLaughlin v. Schenck
2009 UT 64, 2009 WL 3151201, 220 P.3d 146 (2009)
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Rule of Law:
Shareholders in a closely held corporation owe each other a heightened fiduciary duty of utmost good faith, similar to that owed between partners. A breach of this duty occurs when a majority shareholder's action thwarts a minority shareholder's reasonable expectations of benefits from their ownership interest, which are assessed based on the connection between their investment and their role in the company.
Facts:
- In 1992, Greg Schenck, president of Cookietree, Inc., a closely held corporation, recruited Samuel McLaughlin as an employee.
- McLaughlin's employment agreement designated him an at-will employee and gave him the option to acquire company stock, which he did over time.
- All shareholders, including McLaughlin, were bound by a Shareholder Agreement requiring a selling shareholder to first offer their shares to the corporation, and then to the other shareholders, before selling elsewhere.
- In 1999, Anna Schenck sold a large block of shares to her son, Greg Schenck, making him the majority shareholder. This transfer violated the Shareholder Agreement as the right of first refusal was not offered to the corporation or other shareholders.
- McLaughlin's relationship with Greg Schenck deteriorated after McLaughlin expressed interest in buying the company and asserted his right of first refusal concerning the 1999 stock transfer.
- On August 17, 2004, Greg Schenck terminated McLaughlin's employment without cause.
- After his termination, McLaughlin continued to receive dividends from his stock holdings in Cookietree.
- In May 2005, Cookietree's board of directors and shareholders holding nearly 90% of the shares (including Greg Schenck) signed waivers to retroactively ratify the 1999 stock transfer from Anna Schenck to Greg Schenck.
Procedural Posture:
- Samuel McLaughlin filed three lawsuits against Cookietree, Inc. and Greg Schenck in Utah district court for breach of contract and breach of fiduciary duty.
- The cases were consolidated, and the district court referred McLaughlin's employment contract claims to arbitration.
- An arbitrator awarded McLaughlin damages on a severance pay claim but dismissed other contract claims.
- Cookietree and Schenck moved for summary judgment on the remaining fiduciary duty claims in district court.
- The district court granted the defendants' motion for summary judgment, dismissing all of McLaughlin's pending claims.
- The district court then denied McLaughlin's subsequent motion to amend his complaint.
- McLaughlin (appellant) appealed the district court's final order to the Utah Supreme Court, with Schenck and Cookietree as appellees.
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Issue:
Does a majority shareholder in a closely held corporation breach the fiduciary duty of utmost good faith by terminating a minority shareholder's at-will employment, where the minority shareholder's investment was not inextricably tied to that employment?
Opinions:
Majority - Chief Justice Durham
No. While shareholders in a closely held corporation owe each other a duty of utmost good faith similar to that of partners, this duty is not breached by terminating an at-will employee-shareholder when their reasonable expectations of ownership are not thwarted because their investment was separate from their employment. The court adopted the 'Massachusetts rule,' holding that the unique nature of close corporations—lacking a ready market for shares and having overlapping ownership and management—requires a heightened, partnership-like duty of utmost good faith between shareholders. However, a breach of this duty occurs only when a shareholder's reasonable expectations of their investment are frustrated. Here, McLaughlin's expectations were not thwarted because he was not a founding member, his stock purchases were not required for employment, he received a competitive salary separate from his investment dividends, and he continued to receive those dividends after being fired. Therefore, the termination primarily affected his interests as an employee, not his investment interests as a shareholder. The court also held that the waivers ratifying the stock sale were tainted by a conflict of interest and remanded for a determination of whether they were fair to the corporation.
Analysis:
This decision formally adopts the 'Massachusetts rule' in Utah, establishing that shareholders in closely held corporations owe each other a heightened, partnership-like fiduciary duty of utmost good faith. The significance lies in the court's simultaneous adoption of the 'reasonable expectations' test to define the limits of this duty, preventing it from creating a de facto guarantee of employment for any shareholder-employee. The ruling provides a remedy for oppressed minority shareholders whose investment interests are harmed but distinguishes such harm from the loss of employment, thereby balancing shareholder protection with the corporation's need for managerial discretion. This framework will guide future disputes in Utah's close corporations by focusing the legal inquiry on the link between a shareholder's investment and the specific benefit they claim was denied.
