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
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. 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.
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.
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.
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
that 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.
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
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.
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.
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.