Fiduciary Duties in Massachusetts and Delaware Closely Held Corporations

by Nicholas Nesgos and Benjamin Greene

Legal Analysis

Introduction

Where a company chooses to incorporate directly affects the fiduciary duties imposed upon its leadership and shareholders. Under the internal affairs doctrine, the law of the state in which a company is incorporated applies to disputes over the company’s internal workings, regardless of where the company is actually based or where the alleged conduct occurred.[1] Consequently, the distinctions between Massachusetts and Delaware corporate law take on particular importance in the context of closely held corporations and LLCs, where each state’s case law and statutes uniquely impact the imposition of fiduciary duties and the extent to which such duties can be contractually waived. Understanding these differences is essential to making informed decisions on business formation and litigation strategy.

Fiduciary Duties In Closely Held Corporations

In both Massachusetts and Delaware, a corporate fiduciary, such as a director, generally owes a duty of care and a duty of loyalty, both of which impose a responsibility to act in the best interests of the corporation and/or its shareholders. Specifically, the duty of care requires a fiduciary to act in an informed and reasonable manner, and the duty of loyalty requires a fiduciary to act in good faith with the primary intent of furthering the best interests of the company. In the context of closely held corporations, including LLCs, Massachusetts and Delaware take divergent approaches as to whether shareholders may owe each other additional or enhanced fiduciary duties.

In Donahue v. Rodd Electrotype Co. of New England, the Massachusetts Supreme Judicial Court held that a “close corporation” is typically one in which there is “(1) a small number of stockholders; (2) no ready market for the corporate stock; and (3) substantial majority stockholder participation in the management, direction and operations of the corporation.”[2] The Donahue Court then held that “[s]tockholders in close corporations must discharge their management and stockholder responsibilities” under a standard of utmost good faith and loyalty.[3] 

Therefore, a controlling group of shareholders in a close corporation “may not, consistent with its strict duty to the minority, utilize its control of the corporation to obtain special advantages and disproportionate benefit from its share ownership.”[4] Even if the majority shareholders demonstrate a legitimate business purpose for their actions, minority shareholders may still maintain a claim if they can establish that the same business purpose could have been achieved in an alternative manner less harmful to the minority.[5] Importantly, minority shareholders in Massachusetts close corporations also owe fiduciary duties and may not intentionally engage in corporate conduct to their own personal advantage that is detrimental to the corporation and its other shareholders.[6] 

In Massachusetts, where a minority shareholder has a reasonable expectation of continued employment within a closely held company, the termination of such minority shareholder’s employment  may be considered a “freeze-out” and, as such, be a breach of the majority shareholders’ fiduciary duties.[7] In this regard, the remedy for a breach of a majority shareholder against the minority shareholder is, to the extent possible, to “restore to the minority shareholder those benefits which she reasonably expected, but has not received because of the fiduciary breach.”[8] Massachusetts courts have the ability to award monetary damages, as well as impose a wide range of equitable remedies, such as reinstating corporate officers, forcing the distribution of dividends or even amending corporate operating agreements.[9]   

In contrast, a closely held Delaware company must be specifically incorporated as a “close corporation.” Even when incorporated as such, shareholders generally will not  owe each other fiduciary duties unless the articles of incorporation or an agreement among the shareholders imposes such duties. [10] Consequently, the “protections afforded to minority stockholders in closely-held corporations under Delaware common law are no different than those in publicly-held corporations.” [11] 

Majority shareholders in a closely held Delaware corporation, or shareholders who otherwise exert control over the close corporation, may act in a manner that unintentionally harms the interests of minority shareholders as long as such actions do not contravene the best interests of the corporation itself.[12] The same holds true in the context of Delaware LLCs, except that managing members still owe fiduciary duties to the company and its passive members.[13] However, if majority/controlling shareholders are found to have engaged in a transaction in which they would uniquely benefit, such shareholders must demonstrate that the transaction was entirely fair to the corporation, in terms of both price and dealing, and conducted with the utmost good faith.[14] In Delaware, remedies for such breaches usually are  limited to either monetary damages or equitable rescission of the contested transaction.[15]

Contractually Limiting Fiduciary Duties

Contracts, which govern shareholder conduct, may supersede common law or statutory fiduciary duties. In Massachusetts, “[a]lthough a shareholder in a close corporation always owes a fiduciary duty to fellow shareholders, good faith compliance with the terms of an agreement entered into by the shareholders satisfies that fiduciary duty.”[16] Consequently, claims for breach of fiduciary duty with respect to things such as employment or stock purchases may only arise when a prior agreement among the parties “does not entirely govern the shareholder’s actions.”[17] To the extent an agreement does not directly address an issue, fiduciary duties apply.[18] 

In the LLC context, Massachusetts allows for greater flexibility regarding the limitation of fiduciary duties. Massachusetts Gen. Laws c. 156C, § 63, specifically provides that “[t]o the extent that, at law or in equity, a member or manager has duties, including fiduciary duties, and liabilities relating thereto to a limited liability company or to another member or manager . . . the member’s or manager’s duties and liabilities may be expanded or restricted by provisions in the operating agreement.”[19] Additionally, “[t]he certificate of organization or a written operating agreement may eliminate or limit the personal liability of a member or manager for breach of any duty to the limited liability company or to another member or manager.”[20]  Contractual language limiting or modifying fiduciary duties “should be strictly, not expansively, construed.”[21]   

In JFF Cecilia LLC v. Weiner Ventures, for example, the plaintiff and defendant were members of a Massachusetts LLC that was primarily formed to develop a large real estate project. The plaintiff asserted claims based on the defendant’s failure to provide notice that it was publicly announcing the canceling of the development project. [22] The Superior Court recognized the enforceability of a clause in the LLC agreement, which stated that its members owed no fiduciary duties to the company or each other “except to the extent such duties are expressly set forth in this Agreement.”[23] The court, however,  found that the plaintiff still had a cause of action based on another section of the agreement, which imposed a duty upon its members to “consult with one another openly, fairly and in good faith,” to “work collaboratively” and to “use their reasonable efforts to keep one another informed of all known and material information with respect to” the company.[24] Likewise, in Butler v. Moore, the relevant LLC agreement stated that its members were not “obligated to present an investment opportunity to the Company even if it is similar to or consistent with the business of the Company. . . [and they had the] right to take for their own account or recommend to others any such investment opportunity.”[25] Nonetheless, the court refused to interpret such provisions as allowing its members to take, “for their own personal benefit,” those opportunities that  already had been presented to the company. [26]

Similar to Massachusetts, in Delaware where a corporate “dispute arises from obligations that are expressly addressed by contract, that dispute will be treated as a breach of contract claim . . . [and] any fiduciary claims arising out of the same facts that underlie the contract obligations would be foreclosed as superfluous.”[27] Likewise, Delaware statutorily allows provisions in LLC agreements in which a member or director’s fiduciary duties are “expanded or restricted or eliminated.”[28] For example, in Marubeni Spar One, LLC v. Williams Field Servs. – Gulf Coast Co., L.P., the Chancery Court dismissed a claim for breach of fiduciary duty because the LLC agreement stated that the “Operating Member shall have no liability under this Agreement or otherwise to the Company or any Member for any actions taken in its capacity as Operating Member or for any actions it fails to take unless it breaches its obligations under this Agreement as a result of its gross negligence, fraud or willful misconduct.”[29] 

 Although parties to a Delaware LLC agreement are not allowed to waive “the implied contractual covenant of good faith and fair dealing,” even this limitation is narrowly applied.[30]  As the Chancery Court explained, when an LLC “agreement eliminates fiduciary duties as part of a detailed contractual governance scheme, Delaware courts should be all the more hesitant to resort to the implied covenant. . . . “[r]especting the elimination of fiduciary duties requires that courts not bend an alternative and less powerful tool into a fiduciary substitute.”[31]

Indemnification

Both Massachusetts and Delaware allow closely held corporations and LLCs to indemnify their directors and managers for any defense costs, settlements or judgments, which might arise from an alleged breach of their fiduciary duties. Pursuant to Mass. Gen. Laws c. 156D, § 8.51, a corporation may indemnify a director against any liability as long as the director: (1) has acted in “good faith;” (2) “reasonably believed that his conduct was in the best interests of the corporation or that his conduct was at least not opposed to the best interests of the corporation;” and (3) “had no reasonable cause to believe [the ] conduct was unlawful.”[32]  Massachusetts law also mandates that a corporation indemnify a director for their defenses costs if such director “was wholly successful, on the merits or otherwise, in the defense of any proceeding to which he was a party.”[33]

In the context of LLCs, Massachusetts law provides even wider latitude in determining the scope of indemnification. Indeed, the burden of denying indemnification may be placed on the company. LLCs can indemnify their members and managers “against any and all claims and demands whatsoever,” without having to establish that the member actually acted in good faith or with any particular intention or knowledge.[34] An LLC may not provide any form of indemnification if the member or manager is specifically found in the course of a proceeding “not to have acted in good faith in the reasonable belief that his action was in the best interest of the limited liability company.”[35]

In Delaware, the circumstance under which a corporation may indemnify a director is similar to Massachusetts in that the person must have acted in good faith with the reasonable belief that he, she or they were acting in the best interest of the corporation, and with no reason to believe his, her or their conduct was unlawful.[36] Delaware corporations are required to provide indemnity for  defense costs incurred by qualified individuals who succeed on the merits of their case.[37] Delaware provides additional statutory guidance to determine when a person qualifies for indemnification. In this regard, the termination of an action by judgment, order or settlement (except where such judgment is based on a guilty plea) “shall not, of itself, create a presumption that the person did not act in” a manner entitling him, her or them to indemnification.[38] A company cannot provide any indemnification if a person has “been adjudged to be liable to the corporation unless and only to the extent that the” relevant court makes a separate determination that despite such judgment the person is still entitled to indemnification.[39]

In Delaware, “[n]o criteria are established by statute to govern the indemnification that limited liability companies may offer.”[40] Pursuant to 6 Del. C. § 18-108, “a limited liability company may, and shall have the power to, indemnify and hold harmless any member or manager or other person from and against any and all claims and demands whatsoever.”[41] The statute “defers completely to the contracting parties to create and delimit rights and obligations with respect to indemnification and advancement,” and does not in itself create any right or limits to indemnification.[42]

Conclusion

In the context of closely held corporations, Massachusetts and Delaware take somewhat divergent approaches to the imposition and waiver of fiduciary duties among shareholders. Shareholders in closely held Massachusetts companies owe each other heightened fiduciary duties, and such duties can only be eliminated by contractual agreements that specifically address the duties or situations under which such duties may arise. Consequently, founders of, or investors in, closely held companies who seek heightened protections against the potential misconduct of their fellow shareholders, may favor Massachusetts incorporation. In contrast, shareholders in closely held Delaware companies generally do not owe each other fiduciary duties, and Delaware takes a more expansive approach with respect to allowing the elimination of fiduciary duties that could be imposed upon such shareholders. Accordingly, parties whose priority is to avoid potential liability, or the threat of such liability, from their fellow shareholders, may prefer Delaware incorporation.

In either state, potential shareholders should carefully review any contractual arrangements among the shareholders, including by-laws, purchase agreements and employment contracts. Such contracts may supersede, modify or eliminate what would otherwise be the parties’ default fiduciary duties. Awareness of these key distinctions between Massachusetts and Delaware corporate law is essential to making informed decisions about incorporation, investment and litigation.

[1] Harrison v. NetCentric Corp., 433 Mass. 465, 471 (2001). The majority of states adhere to the internal affairs doctrine. Notably, California and New York have particular statutory exceptions to the doctrine, which require consideration of whether the company has substantial contacts with the forum state. See Cal. Corp. Code § 2115; N.Y. Bus. Corp. L. §§ 1317–20.

[2] Donahue v. Rodd Electrotype Co. of New England, 367 Mass. 578, 586 (1975) (holding that the categorization of company as a “close corporation” is a factual inquiry); Allison v. Eriksson, 479 Mass. 626, 636 (2018) (in determining whether an LLC is closely held company, a court also examines the manner “in which a particular LLC is structured”).

[3] Id. at 593 (1975); Butler v. Moore, No. CIV. 10-10207-FDS, 2015 WL 1409676, at *61 (D. Mass. Mar. 26, 2015) (“As a matter of logic and fairness, there is no reason why the fiduciary duties of members of a closely held LLC should be materially different from those of shareholders of a closely held corporation.”); Blank v. Chelmsford Ob/Gyn, P.C., 420 Mass. 404, 408 (1995) (“They may not act out of avarice, expediency, or self-interest in derogation of their duty of loyalty to the other stockholders and to the corporation.”).

[4] Donahue, 367 Mass. at 598.

[5] Wilkes v. Springside Nursing Home, Inc., 370 Mass. 842, 851-52 (1976).

[6] Donahue, 367 Mass. at 593; Zimmerman v. Bogoff, 402 Mass. 650, 658 (1988)

[7] Selmark Assocs., Inc. v. Ehrlich, 467 Mass. 525, 536 (2014) (“Freeze-outs can occur when a minority shareholder is deprived of employment.”); Pointer v. Castellani, 455 Mass. 537, 551 (2009).

[8] Brodie v. Jordan, 447 Mass. 866, 870–71 (2006) (internal quotations omitted)    

[9] Allison v. Eriksson, 479 Mass. at 638.

[10] Pursuant to Del. Code Ann. tit. 8, § 342, a Delaware company may incorporate as a close corporation. Such corporate form places restrictions on the number of stockholders and types of stock transfers, as well as prohibits any “public offering” of the company’s stock. However, the statute does not impose any additional fiduciary duties.

[11]  Blaustein v. Lord Baltimore Capital Corp., No. CIV.A. 6685-VCN, 2013 WL 1810956, at *14 (Del. Ch. Apr. 30, 2013), aff’d, 84 A.3d 954 (Del. 2014) (explicitly contrasting its view with the approach of Massachusetts courts).

[12] Id. (citing Gilbert v. El Paso Co., 1988 WL 124325 (Del. Ch. Nov. 21, 1988))

[13] Feeley v. NHAOCG, LLC, 62 A.3d 649, 662 (Del. Ch. 2012) (“Managers and managing members owe default fiduciary duties; passive members do not.”)

[14] Nixon v. Blackwell, 626 A.2d 1366, 1376 (Del. 1993)

[15] Basho Techs. Holdco B, LLC v. Georgetown Basho Inv’rs, LLC, No. CV 11802-VCL, 2018 WL 3326693, at *49 (Del. Ch. July 6, 2018), aff’d sub nom. Davenport v. Basho Techs. Holdco B, LLC, 221 A.3d 100 (Del. 2019).

[16] Merriam v. Demoulas Super Markets, Inc., 464 Mass. 721, 727 (2013).

[17] Id.

[18] Selmark Assocs., Inc., 467 Mass. at 539 (“[T]o supplant the otherwise applicable fiduciary duties of parties in a close corporation, the terms of a contract must clearly and expressly indicate a departure from those obligations.”).

[19] Mass. Gen. Laws Ann. ch. 156C, § 63.

[20] Mass. Gen. Laws Ann. ch. 156C, § 8.

[21] Butler v. Moore, No. CIV. 10-10207-FDS, 2015 WL 1409676, at *73 (D. Mass. Mar. 26, 2015); Selmark Assocs., 467 Mass. at 539 (2014)  (“[T]o supplant the otherwise applicable fiduciary duties of parties in a close corporation, the terms of a contract must clearly and expressly indicate a departure from those obligations.”).

[22] JFF Cecilia LLC v. Weiner Ventures, LLC, No. 1984CV03317-BLS2, 2020 WL 4464584, at *11 (Mass. Super. July 30, 2020)

[23] Id.

[24] Id.

[25] Butler, 2015 WL 1409676, at *73.

[26] Id. at *74.

[27] Nemec v. Shrader, 991 A.2d 1120, 1129 (Del. 2010)

[28] 6 Del. C. § 18-1101

[29] Marubeni Spar One, LLC, 2020 WL 64761 at *10; see In re Sols. Liquidation LLC, 608 B.R. 384, 407 (Bankr. D. Del. 2019) (finding that plaintiffs’ claims for the defendants’ alleged breach duty of loyalty and good faith were precluded by the LLC agreement, which eliminated such duties).

30] 6 Del. C. § 18-1101.

[31] Lonergan v. EPE Holdings, LLC, 5 A.3d 1008, 1018 (Del. Ch. 2010).

[32] Mass. Gen. Laws Ann. ch. 156D, § 8.51

[33] Mass. Gen. Laws Ann. ch. 156D, § 8.52.

[34] Mass. Gen. Laws Ann. ch. 156C, § 8

[35] Del. Code Ann. tit. 8, § 145.

[36] Id.

[37] Id.

[38] Id.

[39] Id.

[40]Branin v. Stein Roe Inv. Counsel, LLC, No. CIV. A. 8481-VCN, 2014 WL 2961084, at *4 (Del. Ch. June 30, 2014).

[41] 6 Del. C. § 18-108.

[42] Majkowski v. Am. Imaging Mgmt. Servs., LLC, 913 A.2d 572, 591 (Del. Ch. 2006).

Nicholas Nesgos is a Partner in the Complex Litigation Group at Arent Fox. He handles a wide variety of business disputes including disputes among shareholders in closely held companies.

Benjamin Greene is an Associate in the Complex Litigation Group at Arent Fox LLP.   Benjamin represents a range of individual and corporate clients in complex commercial, employment and real estate litigation.