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Directors and Controlling Shareholders May Be Liable for Paying Themselves Excessive Compensation

January 1, 2015

Most passive, minority shareholders invest in closely held corporations expecting to receive a share of the corporation’s profits in the form of dividends. Such minority shareholders may find themselves starved for dividends, however, when directors and/or controlling shareholders take generous salaries, bonuses or other compensation for themselves, leaving little or no profits to be distributed to shareholders.

One might think there is little minority shareholders can do in response to such behavior. After all, under California law, the payment of executive compensation and dividends rests in the sound discretion of the corporation’s board of directors, and only directors have the power to decide whether, when and how much of a dividend will be paid. In re Talbot’s Estate, 269 Cal.App.2d 526, 537 (1969). Even where the corporation has accumulated a large profit surplus, shareholders have no right per se to compel a distribution unless the articles of incorporation make dividends mandatory (which is rare). See, Richards v. Pacific Southwest Discount Corp., 44 Cal.App.2d 551, 558 (1941).

Notwithstanding the foregoing, it is firmly established in California that directors who refuse to declare dividends while voting excessive compensation to themselves and/or controlling shareholders can be held personally liable to minority shareholders if a court finds that all or a portion of that compensation was actually a distribution of corporate profits (or a “disguised dividend”) See, De Martini v. Scavenger’s Protective Ass’n., 3 Cal.App.2d 691, 698 (1935) (holding passive shareholders could bring an individual action against a corporation’s directors to recover their portion of profit distributions paid to working shareholders as “wages”).

For example, in De Martini, supra, a corporation made monthly payments, described as “wages,” to employee-shareholders only. Four shareholders, who were not employed by the corporation, obtained a judgment against the directors in the amount those payments exceeded the reasonable daily wage of the employee-shareholders, successfully arguing that the excess funds constituted distributions of profit. The appellate court affirmed, holding the corporation could not deprive the non-employee shareholders of their share of the profits by denominating the distributions as “wages.” In support of its decision, De Martini cited a Washington opinion holding a corporation “cannot, by paying excessive or extravagant wages to the working stockholders, deprive the appellant of her share of the profits of the business.” Id. at 698.

Put another way, it is the substance, not the form, of the payment that determines whether the payment is in reality a distribution of profits. To the extent such payment was made without consideration, or for inadequate consideration, courts will treat that payment as a disguised dividend which should have been distributed to all shareholders entitled to receive a portion of the corporation’s profits. Compensation paid to directors and/or controlling shareholders in excess of the fair value of their services to the corporation clearly is a form of disguised dividends for which directors can be held liable. See e.g., Kohn v. Kohn, 95 Cal.App.2d 708, 715 (1950); De Martini, supra, at 698.

In addition, controlling shareholders have a fiduciary duty not to exercise their control over corporate affairs in a manner that enriches themselves at the expense of minority shareholders. See e.g., Jones v. H.F. Ahmanson & Co., 1 Cal.3d 93, 108-109 (1969). Consequently, a minority shareholder may also have a cause of action for breach of fiduciary duty against controlling shareholders who cause their closely held corporations to pay themselves excessive compensation thereby depriving minority shareholders of their fair share of the corporation’s profits. See Jara v. Suprema Meats, Inc., 121 Cal.App.4th 1238, 1258-1260 (2004) (holding passive minority shareholder could bring individual action for breach of fiduciary duty against majority shareholders who allegedly deprived minority shareholder of his share of profits by paying themselves excessive compensation).

In determining whether compensation paid to directors or controlling shareholders is, in actuality, a disguised dividend that should be distributed to all shareholders entitled to dividends, courts have considered a variety of factors including the nature of the services rendered to the corporation, whether the compensation bears a reasonable relationship to those services, the ratio of salary to corporate earnings, how the compensation compares with that paid to other employees for similar work, and whether shareholders were paid regardless of whether or how much they actually worked. See e.g., De Martini, supra, 3 Cal.App.2d at 693-696; Kohn, supra, 95 Cal.App.2d at 715. In other words, the analysis of excessive compensation claims is highly fact driven.

There is a split of authority on whether excessive compensation claims are individual or derivative claims that must be brought on behalf of the corporation. Where the minority shareholders claim only to have been deprived of their share of distributed profits, the claim is treated as an individual claim. An excessive compensation claim which also asserts that corporate assets were looted or mismanaged, on the other hand, is more likely to be treated as a derivative claim because the wrongs alleged injured not only the minority shareholders but also the corporation itself. Compare Shenberg v. De Garmo, 61 Cal.App.2d 326, 331 (1943) (derivative claim) with Jara, supra, 121 Cal.App.4th at 1259 (individual claim).

Whether you are a minority shareholder seeking to recover profits misappropriated under the guise of excessive compensation or a director or controlling shareholder accused of such misconduct, you need an experienced business attorney to evaluate the relevant facts of your particular situation, determine the individual vs. derivative nature of the claim asserted and then develop an effective strategy for protecting your legal rights.

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This Alert is made available for educational purposes and to provide general information on current legal topics, not to provide specific legal advice. The publication of this Alert does not create any attorney client relationship, and this Alert should not be used as a substitute for competent legal advice from a licensed professional attorney.