Do Shareholders Of Closely Held Corporations Owe Each Other A Fiduciary Duty Of Loyalty Including A Duty Not To Compete?
It is firmly established under California law that controlling shareholders of closely held corporations owe minority shareholders a fiduciary duty not to compete against their own corporations.1 Less clear, however, is whether equal and minority shareholders of closely held California corporations owe their fellow shareholders the same fiduciary duty.
Although federal and unpublished cases indicate a judicial trend against imposing any fiduciary duties on equal and minority shareholders in closely held corporations2, the California Supreme Court has yet to squarely address the issue, and the relevant case law which does exist is inconsistent and inconclusive.
For example, in Fox v. Abrams,3 the court held that “attorneys practicing together in a law corporation owe each other fiduciary duties very similar to those owed by law partners …”4 Arguably, this holding supports the proposition that all shareholders of closely held corporations owe each other fiduciary duties because it makes no distinction between controlling and equal/minority shareholders. However, the specific issue of whether equal and minority shareholders of closely held corporations have the same fiduciary duties as do controlling shareholders was not presented to the court, so it neither considered nor ruled on that issue. Further, the court appears to have been influenced by the nature of the corporation at issue rather than the fact it was closely held,5 a possible basis for limiting its holding to professional corporations.6
Contrary to the holding in Fox, the court in Persson v. Smart Inventions, Inc. held that two equal shareholders, former partners who had incorporated their partnership, no longer owed each other the same fiduciary duties they did while partners.8 As the court explained, “… shareholders in a duly formed corporation … do not become de facto partners, and thereby acquire fiduciary duties to each other …”9 Standing alone, this holding supports the proposition that equal shareholders of closely held corporations do not owe each other any fiduciary duties. But the court immediately clarified its holding, stating: “They have the rights and obligations of shareholders, not partners …”10 Of course, this begs the question of what exactly are the “rights and obligations” of equal shareholders in closely held corporations? That question was not answered in Persson.
Not only is California law muddy on whether equal and minority shareholders of closely held corporations owe their fellow shareholders a fiduciary duty not to compete against their own corporations, there are other factors to be considered when assessing the risk of potential liability for such competitive conduct.
For example, most equal and many minority shareholders also serve as officers, directors and/or employees, and in those capacities clearly do owe their closely held corporation and its shareholders a fiduciary duty not to compete.11 Or, might a court conclude, based on the individual facts before it that the equal or minority shareholders voluntarily assumed a confidential relationship with other shareholders giving rise to a fiduciary duty not to compete.12 And then there are also legal theories other than breach of fiduciary duty under which liability may be imposed on a shareholder who used client/customer lists, funds or other corporate assets in connection with a competing enterprise (e.g., misappropriation of trade secrets, fraud, interference with contract/prospective economic advantage, etc.).
The bottom line is that any equal or minority shareholder of a closely held California corporation who is thinking about launching a competing business or otherwise engaging in a competing enterprise should first seek the advice of an attorney who specializes in shareholder rights.
Robert M. Heller has extensive experience in business litigation with an emphasis on shareholder disputes. He has been admitted to practice law in both California and New York. He can be reached at (310) 286-1515, or by email: heller@hellerlaw.com.
____________________________
1 See e.g., Jones v. H.F. Ahmanson & Co., 1 Cal.3d 93, 108-09 (1969); Remillard Brick Co. v. Remillard-Dandini Co., 109 Cal.App.2d 405, 420-421 (1952).
2 See e.g., Shum v. Intel Corp., 2008 WL 4414722 at *5 (N.D. Cal., 2008) (“Under California law, equal shareholders in a [closely held] corporation do not owe one another a fiduciary duty merely by virtue of that relationship. This is the case even if the equal shareholders also serve as directors and officers of the corporation.”); Miles, Inc. v. Scripps Clinic and Research Foundation, 810 F. Supp. 1091, 1099 (S.D. Cal. 1993) (a federal court held that equal shareholders of a closely held California corporation do not owe each other fiduciary duties). While they may have persuasive value, federal decisions applying California law are not binding on California courts. Moreover, unpublished decisions, even those issued by California courts, may not be cited or relied on by California courts or litigants.
3 163 Cal.App.3d 610, 617 (1985).
4 By statute, California partners owe each other a long list of significant fiduciary duties. Cal. Corp. Code §16404; see also, Tri-Growth Centre City, Ltd. V. Silldorf, Burdman, Duignan & Eisenberg, 216 Cal.App.3d 1139, 1150 (1989) (under California law, “a partner is bound to act in the highest good faith to his copartner …”).
5 Ibid. at 616-617.
6 For example, unlike the shareholders of other closely held corporations, the conduct of attorneys and other professionals are governed by ethical rules unique to their professions, regardless of whether they elect to practice together in a professional corporation or as a partnership.
7 125 Cal.App.4th 1141, 1156-1159 (2005).
8 Id. at 1159.
9 Id.
10 Id.
11 See e.g., Xum Speegle, Inc. v. Fields, 216 Cal.App.2d 546, 554 (1963).
12 See Persson, supra, 125 Cal.App.4th at 1159-62 (discussing the essential elements of a confidential relationship giving rise to a fiduciary duty).