What is a closely-held business and what is the big deal?

There is much discussion about the rights of shareholders or members of a “closely held” (or close) corporation or LLC, particularly for shareholder oppression issues. This is because in many states, shareholders (or members in an LLC) of closely held businesses have fiduciary duties to one another derived from the common law, where the relationship of shareholders is considered comparable to that of partners in a partnership.

Partners in a partnership have long had a duty to act with the highest standards of integrity and good faith in their dealings with one another. Basically, partners are required to be open, truthful and reasonable with one another. This duty opens the door to a variety of potential claims for shareholders who are treated unfairly, but does not typically apply among shareholders or members of a business that is not closely held.

A closely held business has three characteristics that make it analogous to a partnership: (1) there is no ready market for selling the shares; (2) the shareholders actively participate in the business; and (3) there are a small number of shareholders (or members).

The most obvious concept here is that a publicly traded company is not a closely held business. Shareholders of publicly-traded business do not typically know and interact with one another. Since the shares are publicly-traded, a disgruntled shareholder may simply sell their stock at the going price. By contrast, shareholders in a closely held business are often stuck in the investment indefinitely, even if they are dissatisfied.

The second characteristic is important as well in that when controlling shareholders participate in management of the business, there is a risk that they engage in unfair management practices such as increasing their individual pay rates at the expense of shareholder distributions or freezing minority shareholders out of management.

As to the characteristic of “a small number of shareholders,” this component has yet to be determined, but it is likely that the number of shareholders is not as significant as the other factors.

Whether a company is closely held is important for determining the best legal course of action for an oppressed shareholder. In many cases, an oppressed shareholder in a closely held business can assert a direct action against oppressive shareholders seeking damages, injunctive relief or a court-ordered buyout. Without a direct right of action, the shareholder often must proceed as a “derivative” claimant. This means that their claims are stated on behalf of the company itself, rather than the oppressed shareholder individually, and there are procedural hurdles and limitations that make it harder for a disgruntled shareholder to directly benefit from bringing a derivative case.

Timothy Peters is happy to provide a free initial consultation for shareholders or LLC members who are dealing with oppression issues. Such a consultation is typically necessary to determine what, if any, remedies are available.