Liability of Shareholders

Terms:

Entire Fairness
In situations where board members or management have engaged in conflicted (interested) transactions, it is not uncommon for the court to judge the nature of the transaction through a standard known as “entire fairness”. In such a case, the court is evaluating whether the transaction was fair to the company and shareholders at the time that the transaction was commenced and if it continued to be fair right through the current moment. If, at any point, the court determines that there were dealings that privileged the directors or if the directors acted in a way that advantaged them unfairly, then the court is likely to hold the director liable.

Implied Knowledge
Previously in your legal studies, you may have encountered situations where a court, in trying to determine whether or not a party had “actual knowledge” of an illegal circumstance, is willing to “imply” such knowledge merely from the factors surrounding the situation. In the case of shareholder liability, it is not entirely uncommon for the court to imply knowledge of certain illegal acts to major shareholders who are in a position to (and have shown the proclivity to) assert major influence over the firm.

Overview to Shareholder Liability

You may be asking why we are studying shareholder liability when we already covered the basic tenet that shareholders in a corporation are immune from liability. As with any statement in the law, however, the statement that corporate shareholders are immune from liability has its qualifications. This section provides a brief overview to those instances that may subject a shareholder to liability for corporate obligations.

You will note that this section is divided into liability of the shareholders in the “closed” (or “close”) corporation and in the “open” corporation. While the type of ownership ultimately does not matter for the rules regarding shareholder liability, courts are apt to view each type of company differently, based on its ownership base. As we have already seen, the closer the shareholders are to the company, in terms of day to day management, the more likely they are to be able to exercise control over its operations. Thus, a court dealing with a liability issue in the context of a close corporation is more likely to hold shareholders liable for corporate debts, as there is a much greater chance that they were either involved in or knew of the transaction at issue.

Liability in the Close Corporation

In a closely held corporation, shareholders need to be particularly aware of the actions taken by their directors, which may impute liability to the shareholder. In general, shareholders in a close corporation owe each other a duty of loyalty and good faith. Liability for company acts can occur in a variety of ways. The following lists some of the instances when a shareholder need pay particularly close attention.

1. Employment
Courts are extremely protective of employees of small, close corporations. The reason for this is that employees in such a position may have placed a great deal of time and effort into a career that can quickly be lost due to poor management or the actions of a shareholder with less than the best intentions. Given this, it should not be surprising that in the event of corporate dissolution, a court may hold corporate officers, directors and/or shareholders personally liable for the back wages of the company’s employees. See Dumas v. InfoSafe Corp., 320 S.C. 188 (S.C. Ct. of App. 1995). Because there is no immediate way for a shareholder to protect herself from such liability, it does behoove the shareholder to keep close tabs to insure that management is paying the full wage to its employees.

EXAMPLE: Small Co, a closely held company, had gotten behind on its back wages when the company was forced into insolvency by its creditors. Because of the massive debt load of the firm, the company was unable to raise sufficient funds in bankruptcy to pay off the full amount of the employees’ back wages. As such, the court chose to hold the company’s ten largest shareholders personally liable for the full amount of the wages.

In addition, note that many states further take steps to protect employees of insolvent corporations. In Delaware, for example, employees automatically receive liens on corporate assets to secure the payment of their salaries. See 8 Del. C. § 300.

2. Fraud or Insider Transactions

A paramount concern of the courts is protecting employees, creditors, and innocent shareholders from the potential damage that can be inflicted by a large shareholder taking advantage of her position. As such, shareholders who hold large stakes in close corporations may be liable for the full value of damage inflicted on the company as a result of a transaction between the shareholder and the company.

When transacting business with their company, large shareholders need to conform to the standard of “entire fairness” in their dealings. Entire fairness is as strict a standard as it sounds. Its general interpretation by the courts is that any transaction between a large shareholder and his close corporation must be fair – both before AND after the transaction is conducted – and that fairness needs to extend to the company, other shareholders, creditors, and employees. Any hint of fraud or unfair dealings will often lead the court to a finding against the shareholder.

Liability in the Open Corporation

In the large, public company context, liability is much less frequently a concern of the shareholders than in the context of the close corporation. However, there are several instances where shareholders need to be concerned. Shareholders owe no fiduciary duty to the corporation or other shareholders, except in the cases of 1) unpaid stock, 2) a pierced corporate veil, and 3) lack of a de facto corporation when the shareholder knew of problems in a legal incorporation. In addition to this list, shareholders are liable for the following:

1. Dividends and Distributions
A shareholder who knowingly receives an illegal distribution will be liable for the full amount of that distribution in payment back to the corporation. See John A. Roebling's Sons Co. v. Mode, 17 Del. 515 (Del. Superior Court 1899). Essentially, an illegal distribution is any payment – of property, cash, etc. – to a shareholder, which has the effect of rendering the company insolvent. See 8 Del. C. §§ 173, 174. From a legal standpoint, insolvency means that the company, after paying the dividend, is no longer able to pay its debts as they come due. The result, from such a position, is that the company is likely to seek bankruptcy protection or dissolve outright within a short time.

Note as to the above that the standard is one of “knowledge” on the part of the shareholder. Thus, a shareholder who did not know that the dividend would render the company insolvent will not be liable to pay back the dividend. Even if there is no actual knowledge on the part of the offending shareholder, however, a court can “impute” knowledge where the shareholder should have known that the dividend would render the company insolvent. Thus, if the shareholder held a substantial stake in the company and had regular access to the corporation’s financial information, it is possible that the court would hold her responsible as if she knew that the distribution was illegal even though she did not actually know so.

EXAMPLE: Turbulent, Inc. was having a rocky year with its finances. The company was expecting payment for the completion of a large contract. However, the customer had yet to pay for the work. At the same time, however, several major preferred shareholders were threatening that if the company did not pay a dividend, they would sell their interests, an action that could have the effect of lowering the company’s market value. The company decided to pay a dividend to these preferred shareholders. After the dividend was paid, several common shareholders noted that the company was legally insolvent as it had ceased paying its creditors for the past three months in order to pay the dividend. The shareholders brought suit. In the court proceedings, it was determined that the preferred shareholders had access to the company’s financial information. Thus, they should have known that the dividend distribution would render the company insolvent. As such, the court held the preferred holders liable to repay the full amount of the dividend.

2. “Watered” Stock
A final instance of shareholder liability is what is known as the case of a “watered” stock issuance. When a shareholder purchases stock from a company, or receives it in return for services rendered, the money or services paid must equate to the full value of the stock as fixed by the board (par or a value placed on the services). If the amount tendered for the stock is less than the fixed price, the difference in value is known as “water” and is a personal liability as to the shareholder. See 8 Del. C. § 152.

EXAMPLE: Mick had intended, and subscribed to purchase several thousand shares of stock for X Co. at an upcoming issuance of a new class of preferred securities. At the time when the company called for the money, however, Mick was in desperate financial straits and had very limited liquidity. He offered to transfer to the company a piece of property that he owned. The company agreed, accepted the property, and transferred the stock to Mick. Subsequently, the company had the property valued and determined that it was worth significantly less than the value of the stock it had issued Mick. When Mick refused to pay, the company sued and Mick was held liable for the “water” – the difference in value between the property and the par value of the stock he was issued.