What are the risks in owning closely-held stock?

Closely Held Stock Nature and Structure of the Corporation

What is the nature and structure of a closely-held corporation?

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Dangers of Owning Closely-Held Stock

What Is a Closely-Held Corporation?

Closely-held corporations have a small number of shareholders, and closely-held stock is not bought and sold on any stock exchange. Legally, a closely-held corporation is no different from any other corporation.

"Statutory Close Corporation"

Sections 21.701 through 21.732 of the Texas Business Organizations Code provide special provisions and duties for “close corporations.” The rules are different for statutory "close corporations," which are governed and function more like partnerships; however, these statutory provisions apply only to corporations that elect to be statutory close corporations, and very few do so. Therefore, the law applicable to almost all Texas corporations makes no distinction between large publicly-held corporations and small closely-held corporations, even though the risks and benefits of stock ownership are vastly different as between those two types of organizations.

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"Subchapter S Corporations"

Some closely-held corporations are S-corporations. The only difference between an S-Corporation and a C-Corporation is that C-Corporations are taxed on their income at the corporate rate, and if the C-Corp pays out its profits to shareholders as dividends, those profits are taxed a second time when the shareholders receive them. If a closely-held corporation qualifies and files an election with the IRS, then it may become an S-Corp. for tax purposes, which means that the corporation reports its income but pays no taxes. Each shareholder pays taxes on his or her proportional share of the profits (or gets the deduction for any losses), and no additonal tax is paid on S-Corporation dividends. To qualify as an S-Corporation, the corporation must:

  • Be a domestic corporation
  • Have only allowable shareholders
    • May be individuals, certain trusts, and estates and
    • May not be partnerships, corporations or non-resident alien shareholders
  • Have no more than 100 shareholders
  • Have only one class of stock
  • Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

However, there is no difference between an S-Corporation and a C-Corporation when it comes to the rights and duties of shareholders, directors, and officers or to the law governing corporate abuse of power.

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Legal Structure of the Corporation

The corporate structure allows the owners of a business to shield themselves from liability for debts incurred by the business, to securitize their ownership (break it into chunks evidence by a document), to separate the ownership and control of a business so as to allow the existence of owners who are purely investors and are not required to manage the affairs of the business, and to make the business structure permanent and not subject to the whims of each of the participants. “A principal economic function of corporate organization is separation of ownership from control, so that entrepreneurs need not supply all the capital, and those who supply capital may diversify their investments and need not furnish managerial skills.” The corporate structure allows persons with talent to manage and persons with money to invest. By contrast, sole proprietorships and general partnerships are very different. In those entities, the owners are liable for debts of the business and are entitled (or required) to be involved in operations, and typically the business ceases to exists or is required to wind up and dissolve if any owner quits.

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distinct from the shareholders

A corporation is a separate legal person, distinct from the shareholders.

A corporation is a separate legal person, distinct from the shareholders. The shareholders are the equitable owners of corporate property, but the corporation is the legal owner. Shareholders do not directly control the corporation; rather, corporations are managed by directors, who are elected by the shareholders. TEX. BUS. ORGS. CODE ANN. § 21.401(a)(2) (“The board of directors of a corporation shall . . . direct the management of the business and affairs of the corporation.”). Because ownership is divided into multiple shares, except in situations where one person owns all of the shares or two persons own equal number of shares, it is a mathematical certainty that there will always be at least one person with a minority ownership interest in the corporation.

Directors are elected by the holders of a majority of the shares of the corporation and may be removed at any time, with or without cause, by a vote of the majority of the shares of the company. Therefore, whoever controls the majority of the shares, controls who runs the company.

A shareholder may only own 51% of the shares, but because of the doctrine of majority rule, that shareholder can place himself (or his friends and family) in 100% control of 100% of the corporate assets.

The legal structure of corporate personhood, centralized management, perpetual existence, limited liability, and free transferability of ownership interests, work well for large, public organizations with numerous owners. In the closely-held corporation, they are the recipe for shareholder oppression.

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Closely-Held Stock

Distinguishing Ownership of Closely-Held Stock

In public corporations, shareholders usually own stock with virtually no involvement in the business and management of the corporation. Shareholders participate in the financial success of the business both by receipt of dividends and increased market value of their shares, while taking absolutely no risk from their ownership other than the loss of the price initially paid for their shares. In public corporations, with a broad and diverse shareholder base, the principles of centralized control and majority rule rarely present a significant opportunity for corporate abuse of power against individual minority shareholders. Shareholders of public companies are also protected by a web of regulations requiring disclosure and financial controls imposed by state and federal law and by the rules of the stock exchanges on which the shares are traded. However, the vast majority of corporations in this country are not large public organizations, but are so-called “closely-held corporations,” which are largely unregulated, and in which the dynamics of management–owner interaction are very different.

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There are three practical differences between owning stock in a public corporation and owning closely-held stock. First, as a much smaller enterprise, a closely-held corporation is much less likely to be able to afford independent, professional management. A closely-held corporation is much more likely to be operated and managed by some or all of its owners. This situation creates inherent conflicts of interest among corporate managers to a far greater extent than in a public corporation. In a closely-held corporation, some stockholders will have accountability as officers and directors to other stockholders that would not exist in a public corporation, and some stockholders would be in a position to manage the enterprise to obtain a disproportionate share of the benefits of ownership, to the detriment of the other shareholders. Also, the fact that the shareholders are operating the business means that closely-held corporations may distribute profits as wages in addition to or instead of dividends.

Second, public corporations with a large and diverse population of shareholders rarely have a shareholder in a position of majority control. On the other hand, closely-held corporations usually have a majority shareholder or controlling group. Again, the presence of majority control creates the opportunity and temptation to abuse that control to obtain a disproportionate share of the benefits of ownership.

A minority shareholder in a closely-held corporation is trapped.

Finally, there is no public market for closely-held stock. Regardless of how valuable an ownership interest in a closely-held corporation might be in the abstract, a minority shareholder is not able to sell his closely-held stock, generally at all, and certainly not at anything approaching its full value. This situation means that capital appreciation is rarely an investment objective of a shareholder in a closely-held corporation, as there is no way to monetize it. A sale of the entire company can happen, but that scenario is generally a long time off and cannot be counted on by a minority shareholder as an exit strategy. A shareholder in a public corporation, however, can cash in on capital appreciation at any time by selling in the public markets and can also cut his losses and walk away from the investment if he becomes dissatisfied with management.

 A minority shareholder in a closely-held corporation is trapped if the other shareholders who control the vote and manage the company succumb to the temptation to take his share of the profits, to deny him a voice, to ignore his requests for information, or to effectively (or actually) ren
der him a non-owner. Conduct by the majority aimed at rendering a fellow shareholder effectively a non-owner might or might not be coupled with an effort to purchase his shares at a fraction of his proportional share of thevalue of the enterprise. This injury to the minority shareholder in a closely-held corporation, involving the loss or impairment or some or all of the privileges and benefits of owning a company, is what has been termed in modern jurisprudence as “shareholder oppression.”

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