When Controlling Shareholders Excessively Compensate Themselves Is It a Disguised Dividend?

Minority Shareholders in California Can Sue Controlling Shareholders for Breach of their Fiduciary Duties Where They Have Paid Themselves Disproportionately as Officers of the Corporation

By Gerald P. (“Jerry”) Burleson, Member of the California Bar, and Robert Kaufman, Senior Law Student, University of San Diego School of Law

 

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In California, minority shareholders can sue controlling shareholders for damages where they have paid themselves a disproportionate share of the corporation’s profits as executive salaries or bonuses.  As part of the fiduciary duty that controlling shareholders owe to the minority shareholders, they must use their ability to control the corporation in a fair, just, and equitable manner.  This duty requires that controlling shareholders not act in a way that is preferential to themselves to the detriment of the minority shareholders.

In Jara v. Suprema Meats, Inc. (2004), the two controlling shareholders of a closely held corporation, who were also officers and directors of the corporation, paid themselves bonuses and increased their executive compensation by several hundred thousand dollars without the consent or approval of the minority shareholder.  Jara v. Suprema Meats, Inc. (2004) 121 Cal.App.4th 123, 1247-48.  The minority shareholder, who owned 30% of the stock in the corporation, sued the controlling shareholders and the corporation for breach of their fiduciary duty to him as a minority shareholder.  Id.  The minority shareholder claimed that by awarding such excessive compensation to themselves as officers, the controlling shareholders were distributing corporate profits disproportionately and were therefore breaching their fiduciary duty by using their power to control the corporation to benefit themselves and in a manner detrimental to the minority shareholder.  Id. at 1242.  The court agreed with the minority shareholder and recognized these payments to the controlling shareholders as “disguised dividends.”

In coming to this conclusion, the court in Jara relied on an earlier case, De Martini v. Scavenger’s Protec. Assn. (1935), in which a corporation made monthly payments, describing them as “wages,” only to shareholders who were employees of the corporation.  De Martini v. Scavenger’s Protec. Assn. (1935) 3 Cal.App.2d 691.  Several non-employee shareholders sued and the court ruled that a corporation cannot deprive shareholders of their share of the profits in the business simply by characterizing distributions as “wages.”  Id. at 698.  A corporation can certainly pay salaries and wages to its employees, but it cannot deprive a shareholder of her share of the profits by denominating what really are dividends as salaries or wages or by paying excessive or extravagant compensation to the employee shareholders as a disguised dividend.  Id.

This important decision in Jara allows a minority shareholder to sue the controlling shareholders for breach of fiduciary duty where they compensate themselves excessively as a means to distribute a disproportionate share of the corporation’s profits to themselves and to the exclusion of the minority shareholders.  The court recognized that the payments that the controlling shareholders gave themselves as officers were not in compensation for their employment but were taken from the corporation’s profits that should have been shared with the minority shareholder.  Therefore, the court allowed the minority shareholder to bring a personal action against the controlling shareholders and ordered that the minority shareholder receive his fair share of the corporate profits.  Jara at 1259-60.

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