Managing closely held corporations: a legal guidebook

Managing closely held corporations: a legal guidebook

Traditional Roles of Directors



Section 1: Basic Concepts

A. Corporation, Articles of Incorporation and Bylaws

B. Directors, Officers and Shareholders

C. Closely Held Corporation

1. Shareholders Frequently Are Also Directors, Officers

and Key Employees

2. Management Structure and Corporate Governance Rules

May Be Customized

3. There Is Little Liquidity of Investment

4. The Value of Shares Is Not Readily Determined

by a Market Price

5. Financial and Other Information Is Generally Not

Publicly Available

6. Deadlocks May Arise

7. Limited Resources and Other Practical Constraints

May Result in Inattention to Corporate Formalities

D. Types of Closely Held Corporations

1. Incorporated Proprietorships

2. Incorporated Partnerships

3. Family Corporations

4. Subsidiary Corporations

5. Corporate Joint Ventures

6. Outside-Investor-Backed Corporations

E. Tax Attributes of Closely Held Corporations

Section 2: The Structure of Corporate Action

A. Traditional Roles of Directors, Officers and Shareholders

B. Board Structure and Action

1. Size and Composition

2. Board Actions

a. Action at Meetings

b. Action without Meeting

c. Committees of the Board

C. Establishing the Agenda for Board Action

D. Quality of Information

E. Shareholder Actions

1. Voting of Shares

2. Meetings

a. Calling the Meeting

b. Notice

c. Voting by Proxy

d. Attendance by Electronic Means

e. Quorum and Approval

f. Election of Directors

g. Conduct of the Meeting

3. Action without Meeting

F. Minutes

G. Joining the Board as an Outside Director

H. Honorary Directors, Advisory Boards, Board Observers

and Monitors

Section 3: Director and Officer Duties and Rights

A. Directors

1. Board Responsibilities

2. Individual Responsibilities

3. Director Prerogatives

4. Fiduciary Duties

5. The Duty of Care

a. Regular Attendance

b. The Need to Be Informed

b. The Need to Be Informed
c. The Right to Rely on Others

d. Inquiry

6. The Duty of Loyalty

a. Conflicts of Interest

b. Corporate Opportunity

c. Fairness to the Corporation

d. Documentation of Conflicts

e. Written Policies

f. Independent Advice

7. The Duty of Disclosure or Candor

B. The Business Judgment Rule

C. Confidentiality

D. Disagreements

E. Responsibilities in Special Situations

F. Representative Directors

G. Officers

Section 4: Shareholder Duties and Remedies

A. Duties of the Controlling Shareholder

B. Rights and Remedies of Minority Shareholders

1. Appraisal Rights

2. Dissolution and Judicial Intervention Statutes

Section 5: Modifying Traditional Roles and Structure

A. Control Agreements

B. Voting Agreements

C. Voting Trusts

D. Multiple Classes of Shares

E. Veto Rights

F. Other Protective Provisions

Section 6: Buy-Sell Agreements

A. Restriction on Transfer

B. Right of First Refusal

C. Repurchase Rights in the Event of Shareholder Death

or Disability

D. Repurchase Option if Shareholder Terminates Employment

E. Purchase Price

F. Payment Terms

G. Co-Sale Rights

H. Put and Drag-Along Rights

I. Restrictive Legend on Share Certificates

Section 7: Raising Money, Issuing Shares and Distributing Assets

A. Financing the Corporation

1. Strategic and Practical Concerns

2. Corporation Law Concerns

3. Securities Law Concerns

B. Dividends and Stock Repurchases

1. Strategic and Practical Concerns

2. State Law Concerns

3. Tax Concerns

C. Giving Employees an Ownership Interest

Section 8: Liability Concerns

A. Director and Officer Liability

1. State Law Liability

2. Liability under Other Laws

B. Shareholder Liability–Piercing the Corporate Veil

C. Limitations on Liability for Money Damages

D. Indemnification

E. Advances for Expenses

F. Insurance

Section 9: Corporate Books, Records and Reporting

A. Minutes, Written Consents, Articles and Bylaws

B. Financial Records and Statements

C. Shareholder Records

D. Right to Inspect Books and Records

E. Annual Reports



This Guidebook, prepared by the Committee on Corporate Laws of the Section of Business Law of the American Bar Association, provides a concise, practical overview of important legal principles governing directors, officers and shareholders of closely held corporations. It is intended primarily for nonlawyers. There are other excellent books and articles for corporate directors, officers and shareholders as well as for owners and managers of businesses organized in noncorporate forms, such as limited liability companies (LLCs). A bibliography at the end of this Guidebook lists some of the materials most relevant to the closely held corporation.

This Guidebook is different from other available sources in a number of ways:

* It deals with the special concerns and challenges involved in closely held corporations–those with relatively few shareholders and no public trading market for their equity securities. Although LLCs have become the entity of choice for many closely held businesses since they came on the scene in the 1990s, the closely held corporation remains the most common form of business organization in the United States. There is a staggering diversity in the types and sizes of businesses operating as closely held corporations, but many of the legal issues facing directors, officers and shareholders are the same, from the smallest closely held corporation operating at a local or even neighborhood level to the largest operating across the globe.

* It covers legal concerns of directors, officers and shareholders. In publicly held corporations, most shareholders are passive investors with little connection to, or control over, management and little occasion to deal directly with the corporation. There may be little or no overlap between the decisionmakers (management) and the risk-takers (shareholders). In closely held corporations, on the other hand, much greater congruency of decision-making and risk-taking exists. Most of the directors and officers are also significant shareholders. Consequently, a guidebook addressing closely held corporations needs to address all three roles.

* It focuses on the law of corporate governance–the legal rules relating to the respective powers and duties of directors, officers and shareholders. This Guidebook does not purport to summarize all the various bodies of law relevant to closely held businesses. It focuses instead on crucial, common-denominator corporate law issues relating to structure, management and decision-making. Who has the power to approve which corporate actions? How are those actions taken? What fiduciary duties of care, loyalty, good faith, fairness or disclosure do directors, officers and shareholders owe each other? What liabilities may result from breaching those duties?

Section 1 of this Guidebook outlines some of the most basic and important concepts involved in the closely held corporate form. The next three Sections discuss the rudiments of corporate governance: Section 2 focuses on the structure of corporate action

As noted, closely held corporations come in a great variety of types and sizes. Many of the concepts discussed in this Guidebook apply with equal importance to all closely held corporations

A number of the concepts discussed in this Guidebook have close analogs in the world of noncorporate forms of organization, such as partnerships and LLCs. Choice of entity is an extremely important decision for those organizing a closely held business, involving a complex balancing of tax and other important considerations. Organizers of a closely held business need expert advice to make an informed choice. This Guidebook, however, takes choice of the corporate form as a given. The characteristics of noncorporate forms of organization and the considerations involved in choice of entity are beyond the scope of this Guidebook.

Every state in the United States has its own corporation statute available for business corporations. (1) Most closely held corporations are incorporated under the laws of the state in which they are headquartered or under the laws of a widely accepted corporate “home-away-from-home,” such as Delaware. Although the differences in corporation statutes from state to state are not enormous, there are some differences that may be important at times for closely held corporations. Unless specifically provided to the contrary, the terminology and legal rules discussed in this Guidebook conform to the Model Business Corporation Act (the “Model Act”). (2) Readers should be aware that the state statute applicable to their corporation in a particular state may differ from the Model Act. When faced with a specific problem, directors, officers, shareholders and counsel should examine the particular state statute governing the corporation.


This section explains a few basic legal concepts that all directors, officers and shareholders of closely held corporations must understand.


A corporation is an entity separate from its directors, officers and shareholders, having the legal attributes provided in the state corporation statute under which it is created. Unlike the sole proprietorship and general partnership forms of business organization, a corporation comes into being only if specific acts are taken: articles of incorporation (known in some states, including Delaware, as a certificate of incorporation) containing required provisions must be filed with the appropriate government office (normally the secretary of state) in the state of incorporation, and a fee must be paid. Once the corporation is properly formed, it will continue in existence until it is dissolved.

In addition to being the “birth certificate” of the corporation, the articles of incorporation also serve as a basic public record of legally required information about the corporation. Corporation statutes typically require that the articles of incorporation contain, at a minimum: (1) the corporate name, (2) the name of the corporation’s agent for service of process and its registered office in the state of incorporation, (3) the type and amount of authorized capital stock of the corporation and (4) the name and address of the incorporator (the person who caused the articles to be filed). In addition to required information, the articles are also the place in which the corporation may opt in or opt out of very important elective provisions under the governing corporation statute, such as:

* pre-emptive rights of the shareholders to subscribe for shares (see Section 7).

* cumulative voting for election of directors (see Section 2).

* limitations on director liability (see Section 8).

In addition, corporation statutes permit inclusion of practically any other provisions desired in the articles of incorporation. Typically, however, participants in closely held corporations prefer to keep the content of the articles sparse because the articles are available to the public and because provisions in the articles generally require a shareholder vote to change. The articles of incorporation or certificate of incorporation are sometimes referred to as the “charter” of the corporation.

The bylaws are a set of more detailed rules of corporate governance that are required by most corporation statutes. Corporate bylaws usually lay out rules for shareholder and board meetings (e.g., when, where, who can call, notice, quorum and voting requirements), officer titles and duties, indemnification of directors and officers and other important matters. Unlike the articles of incorporation, the bylaws are not required to be filed with the state government and are a private document typically kept in the minute book. The bylaws may generally be amended by action of either the board or the shareholders.


Shareholders or stockholders are the owners of the corporation. Unlike partners in a general partnership (who participate equally in the management of the partnership business unless agreed to the contrary), shareholders of a corporation are, by law, given the right to vote on only certain enumerated items of corporate business: election of directors, amendments to the articles of incorporation and bylaws and certain fundamental transactions (mergers, statutory share exchanges, major sales of corporate assets and dissolution). The board of directors has the unilateral authority to approve all other corporate actions. The Model Act and most state corporation statutes permit shareholders in a closely held corporation to vary this vesting of residual authority in the board of directors (and even to dispense with the board of directors altogether) through a control agreement. Shareholders in closely held corporations frequently customize voting control to ensure desired board composition or balance of power on key corporate actions through use of multiple classes of stock with differing voting rights, voting agreements or voting trust arrangements (see Section 5).

Directors are elected by the shareholders. Modern corporation statutes have generally eliminated requirements that directors be shareholders or meet any other statutory qualifications. Most corporation statutes permit as few as one director to make up the board.

Officers of the corporation are elected by the board of directors and have the authority and responsibilities delegated to them either in the bylaws or by specific board resolutions. Officers may also have implied authority by virtue of their positions, at least with respect to ordinary business transactions. The Model Act and most state corporation statutes permit the board great latitude in deciding what officers the corporation should have, what titles those officers should have and what responsibilities and duties they should have. Most corporations have an officer who serves the chief executive function (typically called President, Chief Executive Officer or CEO) and the chief financial and accounting function (typically called Vice President-Finance or Treasurer or Chief Financial Officer or CFO). The Model Act and nearly all state corporation statutes require that one officer be in charge of corporate records. That officer is generally called the Secretary. The Model Act and most state corporation statutes permit one person to serve more than one, or even all, officer functions.


A closely held corporation is most commonly defined as a corporation that has a relatively small number of shareholders and no active trading market for its securities. (3) The term is frequently used to refer to any corporation that is not a publicly held corporation. A publicly held corporation has an organized, separate trading market for its equity securities and may have thousands of shareholders. Closely held corporations include a very diverse range of business associations from one-shareholder corporations to family-owned businesses to wholly owned subsidiaries to corporate joint ventures. Although closely held corporations are often small businesses, closely held status has nothing to do with size. A number of the largest corporations in the world, in terms of assets and revenues, are closely held.

Although closely held corporations come in many types and sizes, they share common attributes. These attributes include:

1. Shareholders Frequently Are Also Directors, Officers and Key Employees

In publicly held corporations, most shareholders are passive investors with little connection to, or control over, management and little occasion to deal directly with the corporation. In closely held corporations, on the other hand, there is typically much greater overlap. Directors and officers are generally also significant shareholders and active participants in the day-to-day business of the corporation. They all know each other and know each other’s skills as managers and employees. Some important consequences flow from this attribute.

* Who becomes a shareholder is important. Shareholders in closely held corporations generally want to control transfers of equity securities so that unwanted outsiders do not become participants in the business. This is usually done through contractual restrictions on transfer (see Section 6).

* Conflicts of interest may be frequent. The overlapping roles of shareholder, officer, director and employee mean that transactions involving the corporation frequently involve conflicts between the interests of a director, officer or shareholder and those of the corporation. These conflict-of-interest transactions pose special problems for the board of directors (see Sections 3 and 8).

* Difficulty of multiple roles. When a shareholder serves as a director or officer, the self-interest of the shareholder may conflict with the interests of the other shareholders or the corporation as a whole. Even though a shareholder is free to vote and otherwise act in his or her own interest, a director or officer owes loyalty to the corporation. A shareholder who serves as director or officer must remember that a director or officer has fiduciary responsibilities to the corporation (see Section 3 for a further discussion of the director’s and officer’s duty of loyalty in conflict-of-interest situations).

The officer of a corporation who serves as a director also has a dual role. In matters involving compensation or other employment arrangements, the officer may have a personal interest that conflicts with the interests of the corporation. As employees, officers also have heightened duties to the corporation that differ from the supervisory duties of directors (see Section 3).

Customers, suppliers, bankers, lawyers and other people with relationships to the corporation may be asked to become directors. Inherent conflicts of interest may exist when a person with a business relationship with the corporation serves as a director. A lawyer for the corporation who also serves as a director faces special concerns.

2. Management Structure and Corporate Governance Rules May Be Customized

Management structure and corporate governance rules are frequently customized in closely held corporations through the use of shareholder agreements, multiple classes of stock with differing voting rights, voting agreements or voting trust arrangements. These arrangements may be used to ensure desired board composition or desired balance of power on decisions regarding key corporate actions. Shareholders forming a closely held corporation often have preconceived expectations regarding structure and governance that do not conform to the basic default rules under the relevant corporation statute (e.g., a desire that all shareholders must be directors or must approve expenditures over $50,000). Various techniques can be used to customize structure and governance to meet these expectations. Using arrangements to ensure expectations are met can be a crucially important part of the planning and organization for closely held corporations, especially where investors include factions or constituencies (e.g., branches of a family, venture capital investors) whose self-interests may clash. Directors of closely held corporations involving such customized balancing must learn to operate within the customized rules the corporation adopts (and the political realities they represent) and must be ready to deal with difficult cross-allegiances and conflicts that may arise when directors attempt to represent the interests of a faction or constituency while fulfilling their fiduciary duties to the corporation and to all shareholders.

3. There Is Little Liquidity of Investment

Because a closely held corporation has no active trading market for its shares, a shareholder who wants to sell shares may have little ability to find a buyer. Sales of stock frequently must be made at a substantial discount to value as a proportionate share of the business when a buyer can be found. A shareholder who has a falling out with other shareholders in a closely held corporation may find that the only market for his or her shares consists of those other shareholders with whom he or she is at odds. The economic pressure on an outcast shareholder in a closely held corporation may be even greater if the outcast’s primary income has been derived as an employee of the corporation.

* Buy-sell agreements are substitutes for market liquidity. Liquidity concerns of individual shareholders, as well as concerns of all shareholders regarding who can invest with them, can be at least partially addressed by putting contractual buy-sell mechanisms in place at the outset. Consideration of such agreements is an essential part of corporate planning and organization and can help reduce the risk of hardship and disputes. Buy-sell arrangements can provide for purchase of shares upon changes in circumstances, such as death, disability or termination of employment (see Section 6 for a discussion of the types of provisions found in buy-sell agreements).

* Buy-sell agreements are no guarantee against disputes, litigation and liability. Even well-conceived buy-sell agreements may not anticipate all problems arising from a falling out among shareholders. Courts in some jurisdictions have not viewed themselves as constrained by the terms of buy-sell agreements in fashioning remedies (such as shareholder buyouts) under judicial dissolution or intervention statutes.

4. The Value of Shares Is Not Readily Determined by a Market Price

Holders of stock in publicly traded corporations can determine the current market value of their shares by opening a newspaper. Without an active trading market, valuing shares in a closely held corporation is much more difficult and prone to dispute. Widely accepted valuation techniques may produce very different results. Disputes over valuation typically result in costly battles among valuation experts. Valuation disputes can arise in many different contexts and can pose very difficult problems for directors.

5. Financial and Other Information Is Generally Not Publicly Available

Publicly held corporations are subject to: (a) the audit requirements, periodic reporting obligations, proxy rules and other ongoing disclosure requirements of the Securities and Exchange Commission (SEC)

6. Deadlocks May Arise

Because of the relatively small group that typically makes up the directors, officers and shareholders of a closely held corporation, deadlocks are possible in management and among shareholders. Deadlock is a special concern where ownership of a corporation is evenly divided between two segments of a family or two investor groups, each with equal representation on the board of directors. State corporate statutes provide that, upon deadlock that severely interferes with the functioning of the corporation, a shareholder may petition a court for dissolution of the corporation or other relief aimed at breaking the impasse. To avoid the potential for deadlock, some closely held corporations include an additional neutral director on the board. Others include arbitration provisions in their articles of incorporation or bylaws or in a shareholder agreement. The benefits and problems relating to these and other dispute resolution mechanisms should be explored with counsel before adoption. There is no standard mechanism for resolving deadlocks.

7. Limited Resources and Other Practical Constraints May Result in Inattention to Corporate Formalities

The majority of closely held corporations are small businesses with very limited resources to spend on lawyers and corporate formalities. An important challenge for directors is to fulfill their fiduciary duty of care to the corporation and its shareholders and to preserve limited liability for corporate participants in spite of these limited resources. Shareholders and directors in many closely held corporations may fall into the habit of taking actions in an informal manner or not recording actions in corporate minutes on a current basis. Although the law might recognize the effectiveness of such informal actions for some purposes, if an action is challenged, the burden to prove that the action was legally approved will be on the party seeking to bind the corporation. Directors may also find it difficult to establish that they were adequately informed and duly deliberate in making a corporate decision if the decision and the process leading to it have not been adequately documented in the minutes.

Informality in corporate actions, failure to keep current minutes, inattention to corporate separateness of assets, books and records and confusion with respect to corporate payments to shareholders can have dire legal consequences to the corporation and its shareholders (see Section 8 on piercing the corporate veil and other liability concerns).


Closely held corporations come in a tremendously broad range of types, sizes and contexts. Although they all share the common traits of relatively few shareholders and no active public trading market for their securities, their remarkable diversity in other respects makes it difficult to discuss common legal problems and issues in a meaningful way. Some of the most common recurring types of closely held corporations include:

1. Incorporated Proprietorships

The one-person corporation in which the proprietor is the sole shareholder and director and wears all the officer hats is one of the most common types of closely held corporation. Conflict-of-interest and corporate governance problems, which may be of central importance in closely held corporations with multiple shareholders, are largely irrelevant to these one-celled corporate organisms. With only one shareholder, buy-sell agreements and voting arrangements are also irrelevant. However, documenting corporate action and otherwise respecting the formalities of corporate separateness are at least as crucial for these as for any other corporation.

2. Incorporated Partnerships

Another common type of closely held corporation is one with a handful of shareholders, all of whom are actively involved in the business as employees and managers. Conflict-of-interest and corporate governance issues are normally a very important focus in this setting. Customization of standard corporate governance structures may be very important. Buy-sell and voting arrangements must normally be part of the organizational process in order for the expectations of participants to be met.

3. Family Corporations

A variation on the incorporated partnership is the family corporation in which the shareholders are also family members. Family corporations have the potential for all the conflict-of-interest and corporate governance issues as other incorporated partnerships on top of the tensions and succession planning issues inherent in families. Here, too, customized corporate governance may be important, and buy-sell and voting arrangements may be valuable.

4. Subsidiary Corporations

The closely held corporation is the basic building block of corporate family groups. Subsidiaries in corporate families range from operating units in complex holding company structures to special-purpose financing subsidiaries to merger subsidiaries created solely to effect acquisition or disposition transactions. Although wholly owned subsidiaries may present none of the corporate governance or conflict-of-interest problems inherent in corporations with multiple owners, complex subsidiary structures create other concerns. Documenting corporate action and otherwise respecting the formalities of corporate separateness are, again, at least as crucial for these as for any other corporation.

5. Corporate Joint Ventures

Businesses frequently join forces to pursue certain opportunities or projects as joint ventures. Often, the joint venture will be structured as a new jointly owned corporation. Corporate joint ventures often embody highly complex and heavily negotiated balances of power and countervailing contractual rights and obligations. They may involve extreme customization of corporate governance and difficult conflict-of-interest issues. They may also involve specific identification of, and procedures for handling, corporate opportunities.

6. Outside-Investor-Backed Corporations

When outside investors, including venture capital funds, provide financing to closely held corporations, they do so with an expectation that the corporation may “go public” or be sold in the foreseeable future. Venture-backed start-ups are typically a transitional form of closely held corporation: closely held today, but with a possibility of becoming publicly held. Venture capital investors typically require a customized corporate governance balance of power through a combination of preferred or other stock rights and contractual veto powers. These custom elements must be put in place, however, in ways that do not impede anticipated future actions.


Corporate taxation under federal and state law is beyond the scope of this Guidebook. Management should ensure that the closely held corporation has appropriate tax advice from counsel and accounting professionals. Difficult income taxation issues relating (among other things) to compensation and other expenses paid to shareholders (or on their behalf) frequently arise in closely held corporations. In addition, important issues relating to corporate and shareholder income taxation are often closely entwined with issues relating to estate and gift taxation and estate planning by principal shareholders of closely held corporations. These issues can become quite complex and require expert advice in the planning stages.

A few basic concepts regarding federal corporate income taxation are, however, essential for managers to understand. Corporate income is normally subject to dual taxation: (1) the corporation pays corporate tax on its income, and (2) shareholders pay individual income tax on corporate earnings distributed to them in the form of dividends. Noncorporate forms of business organization, such as partnerships and limited liability companies, do not have dual taxation (although they can elect to be taxed like a corporation). Instead, partners of a partnership or members of an LLC are taxed directly on their allocable shares of partnership or LLC income, without regard to whether any earnings are actually distributed to them by the partnership or LLC. Whether dual taxation or this flow-through taxation is more advantageous for a business and its owners depends upon a balancing of many factors, such as prevailing corporate, individual and capital gains tax rates, projected income or losses as well as the ability to “zero-out” income at the entity level by making deductible expense payments to owners instead of nondeductible dividend distributions. Consideration of these factors as well as a variety of nontax factors is crucial in deciding whether a business should be organized in corporate or noncorporate form.

Some closely held corporations are eligible to become subject to a modified version of flow-through taxation by making an “S election” under the federal Internal Revenue Code. Shareholders of “S corporations” are taxed directly on their proportionate share of corporate income and may deduct directly their proportionate share of corporate losses. S corporations do not pay income tax at the entity level. However, S corporate taxation differs in other ways from flow-through taxation of noncorporate forms and is not appropriate for many types of businesses. In order to qualify for S election, a corporation must file an appropriate election with the Internal Revenue Service and must meet certain criteria, including having no more than seventy-five shareholders, no more than one class of stock and no stock ownership by anyone other than individuals resident in the United States and some trusts. In all respects relating to state corporation law and to the powers and duties of directors, officers and shareholders, S corporations are no different than corporations that have not elected this special tax treatment (often referred to as “C corporations”).

Although in many cases state income tax treatment of closely held corporations will parallel federal tax treatment, there can be significant differences. Management should consult with the company’s accountant and legal counsel to determine applicable state income tax law.

In addition to federal and state income tax, a corporation may be required to pay annual franchise tax for the privilege of being a corporation under the laws of its state of incorporation. Some states have no franchise tax. Others require annual franchise tax payments that may be quite substantial depending upon the amount of corporate assets, income, authorized shares and other factors used in the formula for calculating the tax in a particular state. Although most closely held corporations can effectively limit their franchise tax through proper planning, consideration of state franchise tax may still be a factor in choosing a state of incorporation.


Corporate governance is the term frequently used to refer collectively to the legal rules relating to the respective powers and duties of directors, officers and shareholders: Who has the power to approve which corporate actions? How are those actions taken? What fiduciary duties of care, loyalty, good faith, fairness or disclosure do directors, officers and shareholders owe each other? What liabilities may result from breaching those duties?

The more mechanical rules of corporate governance (Who decides what? How are decisions made?) are generally laid out in the corporation statute itself. Some of those rules are absolute and invariable, but most are default rules that can be varied in the articles of incorporation or bylaws or by contract (see Section 5). The corporate governance rules regarding fiduciary duties are more the product of judge-made caselaw and generally less variable than the mechanical rules.

This Section discusses the more mechanical, structural rules of corporate governance. The next two Sections discuss the duties owed.


Traditional corporate governance vests the residual authority to manage the corporation in the board of directors. Shareholders elect the directors. Shareholders must also approve certain other types of significant corporate action, including amendments to the articles of incorporation and certain fundamental transactions (mergers, statutory share exchanges, major sales of corporate assets and dissolution), but the board of directors has the authority to approve all other corporate actions.

The Model Act expresses this vesting of residual authority in the board as follows: “All corporate powers shall be exercised by or under the authority of, and the business and affairs of the corporation managed under the direction of, its board of directors.” This language emphasizes the responsibility of the directors to oversee management of the corporation, which is carried out on a day-to-day basis by the officers. The board carries out this oversight responsibility through a combination of (1) making decisions regarding key corporate actions, plans, strategies and directions and (2) monitoring the performance of the officers in day-to-day management.

The corporation statute explicitly requires that the board approve certain types of corporate actions, such as issuance of stock, grant of options or rights to purchase stock, amendment of the articles of incorporation and the fundamental transactions (mergers, statutory share exchanges, major sales of corporate assets and dissolution) that also require shareholder approval. In addition to decisions that require board approval under the specific provisions of the corporation statute, the board’s oversight responsibility also includes considering and acting upon other significant corporate actions, such as major debt financing, important contracts, contracts with officers and officer compensation. The board’s oversight responsibility also entails:

* reviewing and monitoring fundamental operating, financial and other corporate plans, strategies and objectives

* developing, approving and implementing succession plans for management

* evaluating the performance of the corporation and its management and taking action, such as changing corporate plans, strategies and objectives or changing management, when appropriate

* adopting policies of corporate conduct and monitoring compliance with those policies and with applicable laws and regulations as well as the adequacy of accounting, financial and other internal controls

* reviewing and evaluating the process of providing appropriate financial and operational information to decision-makers (including directors) and shareholders.

The officers carry out the day-to-day management of the corporation. They are appointed by the board of directors and have the authority and responsibilities delegated to them by the board either in the bylaws or by specific board resolutions. Officers may also have implied authority by virtue of their titles, at least with respect to ordinary business transactions. The CEO has great implied authority to enter into contracts and take actions on behalf of the corporation in the ordinary course of business. Other officers may have significant implied authority in their particular areas of responsibility

Frequently, questions arise regarding the actual authority of an officer to sign a particular contract or take a particular action on behalf of the corporation. In such cases, legal counsel may recommend that the board approve the contract or action and give specific authorization to the officer to avoid any uncertainty. Sometimes the other party in a major transaction or financing will require specific board approval in order to eliminate any uncertainty.

As noted, the traditional roles of director, officer and shareholder may, and frequently do, vary in closely held corporations. Section 5 discusses modification of traditional roles and structures.


1. Size and Composition

The size and composition of the board depend upon the nature of the corporation. In determining optimal size and composition in the context of a particular corporation, consideration should be given to: effective performance of the board’s oversight and decision-making responsibilities

Other factors that might influence board size and composition are the need of the corporation to maintain a community presence, to maintain relationships with customers or other constituencies and to respond to other factors that may be special to the corporation or its industry. In accommodating these needs, board size should not be expanded to the point that size interferes with effective functioning.

The Model Act and most state corporation statutes permit as few as one director to make up the board and impose no qualification requirements (such as share ownership or state residency) on who can be a director. The Model Act and all state corporation statutes also permit a director to hold any and all officer positions in a corporation. In a one-person corporation (a so-called incorporated proprietorship), the sole shareholder will typically serve as the sole director and have all officer titles as well. This is legally permissible and may be a practical necessity. In corporations with a handful of shareholders, all of whom are active in the business (so-called incorporated partnerships), all of the shareholders typically serve on the board and hold officer positions.

As any closely held corporation matures, it is often desirable to expand the board’s composition to include individuals with varying backgrounds, abilities and access to resources that will benefit the corporation. Many closely held corporations have recognized the benefit of having one or more outside directors. These outside directors, who are not involved in the management of the corporation, can provide independent advice, perspective and monitoring over the affairs of the corporation and the performance of its management.

In some types of closely held corporations, board composition reflects a precisely negotiated balance of power among investors. The board of directors of a corporate joint venture, for example, may be made up of negotiated numbers of representatives of each of the joint venturers. The board of some family corporations may reflect negotiated numbers of representatives from each branch of the family. In corporations financed by venture capital investors or other outside investors, the terms of the financing typically include a number of board seats for representatives of the investors and a limitation on the total number of board seats. Venture capital investors also frequently negotiate the ability to elect the majority of board seats in the event the corporation defaults on certain promises. Desired board composition in these balance-of-power situations is ensured through voting agreements or use of different classes of stock, each having the right to elect the appropriate number of directors. In these balance-of-power situations, one or more outside directors–unaffiliated with any particular faction or constituency–may often provide helpful mediation of differences.

2. Board Actions

The board of directors takes action by approving resolutions or otherwise indicating consensus with respect to matters presented to the board. Resolutions may be approved, or consensus recorded, at a meeting of the board or by written action in lieu of a meeting.

a. Action at Meetings

Meetings are referred to as “regular” meetings if they occur on a date and at a time designated in the bylaws or by a schedule reflected in board minutes. “Special” meetings are those called without such prearrangement. Meetings may be held either in or outside the state of incorporation. Special meetings may be called by anyone authorized to do so in the articles or bylaws but are generally called by the board chair or the CEO. Notice must generally be given to board members in advance of a special meeting. The notice need not describe the purpose of the special meeting, unless required by the articles or bylaws. Under the Model Act, notice generally may be in writing, by telephone or by other electronic means, including e-mail.

In order for the board to take action at any meeting, a quorum must be present. Unless the articles or bylaws provide otherwise, a majority of the total number of directors in office constitutes a quorum. In order for an action to be taken at a meeting, a majority of the directors present must vote in favor of it, unless the articles or bylaws require a greater number. Directors may not “give their proxy” to another person or, in other words, have another director or designee vote for them (in part because directors have duties and responsibilities that cannot be delegated).

Directors may participate in any meeting by conference telephone or any other means of communication by which all participating directors are able simultaneously to hear each other. A director participating by such electronic means is deemed to be present at the meeting for all purposes, including calculation of a quorum.

The number of meetings a board finds necessary or useful varies with the circumstances, but meetings should be held as often as is needed to adequately carry out the directors’ oversight responsibility. Some boards prefer more frequent and shorter meetings, whereas others prefer fewer but lengthier meetings. Many closely held corporations have regular board meetings at least quarterly.

Written materials to be considered, discussed or acted upon at a meeting should be distributed to board members a sufficient time before the meeting to permit a thorough review.

Time at board meetings should be budgeted carefully. There are no required formal rules of procedure dictated by statute for board meetings, and it is generally inadvisable to adopt complex rules of procedure, such as Robert’s Rules of Order, for board meetings. So long as fairness is observed, each board may generally conduct its business as it wishes. For boards with more than a few members, it is generally advisable to designate one of the directors as the chair to preside at meetings and to determine the pace and order of proceedings.

b. Action without Meeting

In lieu of holding a meeting, the board may act by written consent. Under the Model Act and most state corporation statutes, action by written consent must be unanimous. Directors may all sign the same written consent, or they may each sign a counterpart copy of the same consent.

c. Committees of the Board

The board may create committees of directors and delegate to such committees (with some limitations) the authority of the full board. Committees of the board are a legal and practical necessity for publicly held corporations, which typically have an audit committee, a compensation committee and a nominating or corporate governance committee. Standing committees such as these are rare in closely held corporations.

In addition to standing committees, boards may also create temporary committees for specific purposes. For example, a committee of disinterested directors may be formed to pass on a conflict-of-interest transaction between the corporation and a director, officer or controlling shareholder. Committees of disinterested directors may also be formed to pass on the advisability of bringing suit in the name of the corporation against a director or officer when a demand for such a suit has been made by a shareholder. Special committees such as these are less common in closely held corporations than in publicly held corporations but may serve useful purposes in either.

Committees of the board take action by approving resolutions at meetings or by written action without a meeting under basically the same rules as the full board.


The agenda setting forth matters to be discussed and acted on by the board is typically determined, in the first instance, by the CEO. However, individual directors should have an opportunity to place items on the agenda. Further, the board should satisfy itself that there is an overall annual agenda of matters that require recurring and focused attention.

Typically, a board will consider the following sorts of matters annually:

* annual financial results

* dividend policy

* capital expenditure budget

* management performance review

* status of financing arrangements

* adequacy of insurance

* corporate systems and controls

* selection of auditors, if necessary or desired

* agenda for annual shareholder meetings

* annual tax and corporate filings

* designation of signing authority pertaining to financial and other matters

* nomination of directors and election of officers

* compensation of officers

Items that may be considered at quarterly or other periodic meetings include:

* minutes of prior meetings

* progress on operational and financial plans

* quarterly financial results

* budgeting, financing arrangements and funding of operations

* transactions between the corporation and its shareholders, officers or directors

* litigation involving the corporation

* proposals to amend articles or bylaws

* establishing fair market value of the corporation’s stock for purposes of option grants or buy-sell agreements

* corporate policies and practices related to employee safety and health, environmental protection and product safety

* employee issues, such as equal opportunity and nondiscrimination policies, retirement and pension issues and privacy concerns (including corporate policies and procedures relating to maintenance and safeguarding of computer and corporate records and monitoring employee communications)

* philanthropic activities of the corporation

* long- and short-range planning

Management may bring specific operational or personnel matters to the board’s attention at any meeting or at another appropriate time in order to keep the board apprised of potential issues or to gain the board’s advice and perspective.


The quality of information made available to directors will significantly affect their ability to perform their roles effectively. Although directors who are involved day to day with the corporation may already have the necessary information, nonmanagement directors must make sure that they are adequately informed. Information submitted to the directors should be relevant, concise (but complete), timely, well-organized, supported by any background or historical data necessary to place the information in context and designed to inform directors of material aspects of the corporation’s business, performance and prospects. Data that allow the board to make comparisons to other corporations in the same industry group, or with similar characteristics, are also important.

Information should be provided sufficiently in advance of board meetings to provide time for careful review and thoughtful reflection, which will better lead to meaningful participation by the directors.


1. Voting of Shares

Unless otherwise provided in the relevant corporation statute or in the articles of incorporation, (a) each share of stock is entitled to one vote on each matter voted on by shareholders, and (b) all shares vote together as one voting group on each such matter. If a corporation has more than one class of stock (e.g., Class A and Class B common stock or common stock and preferred stock), the articles of incorporation must spell out when and how each share votes and whether the classes vote together or separately on particular matters.

The Model Act and state corporation statutes offer great flexibility with respect to the voting rights that may be specified for various classes of shares in the articles of incorporation. For example, the articles may provide that a particular class of stock has 100 votes per share or no vote at all, or no vote except with respect to certain designated matters. The articles may also provide that a particular class of stock votes along with all other classes with respect to certain matters but votes by itself with respect to others. Corporation statutes provide that, regardless of what the articles of incorporation say, individual classes of stock vote by themselves on certain amendments to the articles of incorporation that would adversely affect the rights of the class (see Section 5 for more discussion of multiple classes of stock).

Shareholders take action by voting their shares to approve resolutions either at meetings or by written consents in lieu of meetings.

2. Meetings

Corporations hold an “annual” meeting of shareholders each year to elect directors and transact such other business as may be presented. “Special” meetings may be held to take actions at other times. The annual and special meetings may be held either in or outside the state of incorporation.

a. Calling the Meeting

Under the Model Act, special meetings of shareholders may be called by the board of directors or by holders of at least ten percent of the outstanding shares (which may be decreased or increased to a percentage not exceeding twenty-five percent in the articles of incorporation). The articles or bylaws may designate anyone else as being eligible to call a special meeting of shareholders, but it is generally advisable to keep that authority as limited as possible under the relevant corporate statute.

b. Notice

Notice must be given to shareholders in advance of each annual and special meeting unless such notice is waived in writing. Notice must be given no less than ten nor more than sixty days before the meeting date under the Model Act. Notice must be in writing and delivered by mail, in person or by electronic means, such as e-mail. Notice is given at the time it is mailed with proper postage or when an e-mail is transmitted (if the shareholder has consented to e-mail notice). Notice of an annual meeting need not generally describe the purpose of the meeting, unless required by the articles or bylaws. Notice of a special meeting must, however, describe the purpose of the meeting, and the meeting may conduct only such business as is described in the notice.

c. Voting by Proxy

Unlike a director, a shareholder may appoint a proxy to attend the meeting and vote his or her shares. Shares represented at a meeting by proxy are treated as being present for all purposes, including calculation of a quorum.

d. Attendance by Electronic Means

Under the Model Act and many state corporation statutes, shareholders may not attend meetings by conference call or other means of communication. Delaware and other states, however, have begun to permit attendance by certain types of remote communication. In fact, Delaware permits shareholder meetings that are entirely by remote communication and have no physical location.

e. Quorum and Approval

In order for shareholders to take action at any meeting, a quorum must be present. Unless the articles provide otherwise, a majority of the votes entitled to be cast on the matter constitutes a quorum. For example, if a corporation has 1,000 shares outstanding and entitled to vote on a matter, each entitled to one vote per share, a quorum would be present if shareholders owning at least 501 shares were present.

Under the Model Act, if a quorum exists, a matter (other than the election of directors) is approved by shareholders if the votes favoring the matter exceed the votes opposing the matter. Many corporation statutes require the affirmative vote of a majority of the shares present at a meeting (or, in some cases, a majority of the shares outstanding) in order to approve a matter. Under such statutes, abstaining from voting on a particular matter at a meeting has the same effect as voting against the matter. Under the Model Act and the corporation statutes in states that follow it, an abstention is really an abstention, not the equivalent of a negative vote. For example, if the 501 shares present at the meeting described in the previous paragraph voted as follows: FOR-200

f. Election of Directors

Directors are elected by a plurality of the votes cast at a meeting at which a quorum is present. This means that, if a quorum is present, the directors receiving the highest number of votes up to the full number of board seats being filled are elected, even if one or more directors do not receive a vote equal to a majority of a quorum. This rule ensures continuity and avoids hold-over directors resulting from an inability to get a majority vote for new board members.

Normally, shareholders are entitled to vote their shares with respect to each board seat being filled. If a shareholder owns 100 shares and five board seats are being filled, the shareholder is entitled to vote no more than 100 shares for each nominee for the five board seats. This means that shareholders owning a majority of outstanding shares are able to elect all the directors if they so desire (by voting their majority shares in favor of each nominee they desire).

Cumulative voting is an alternative method of voting that is designed to permit minority shareholders some ability to elect directors to the board. Under the Model Act and most state corporation statutes, cumulative voting is permitted only if the articles of incorporation explicitly opt in. In a minority of states, however, cumulative voting is permitted unless the articles of incorporation explicitly opt out.

If a corporation permits cumulative voting, a shareholder may take all the votes he or she could cast for directors collectively (e.g., 100 shares x five board seats = 500 votes) and cast them all for one director. How many shares it takes to ensure the election, through cumulative voting, of one board member turns on a complex formula dependent upon the number of shares present and voting, the number of board seats open for election and other factors. Every time the number of outstanding shares or the number of directors on the board changes, the minimum number of shares required to elect one director also changes. In order for minority shareholders to use cumulative voting to their benefit, they must give timely notice of intent to vote cumulatively and must cumulate their votes in exactly the right manner

g. Conduct of the Meeting

As in the case of meetings of the board, time at meetings of shareholders should be budgeted carefully There are no required formal rules of procedure. For corporations with more than a handful of shareholders, it is highly advisable that the board chair or another person be designated to preside at the meeting and to determine the pace and order of proceedings.

3. Action without Meeting

Shareholders may act by written consent instead of holding a meeting. Under most state corporation statutes, action by written consent must be unanimous. The Delaware corporation statute and an increasing number of other states permit less-than-unanimous written action by shareholders. In either case, shareholders may all sign the same written consent, or they may each sign a counterpart of the same consent.


The Model Act and all state corporation statutes require that minutes be kept reflecting in writing the actions taken by the board and the shareholders. Minutes of all meetings and all written actions are compiled in the minute book. A copy of the articles of incorporation and bylaws are also generally kept in the minute book (see Section 9 for a description of required corporate record-keeping).


Outside directors have become an increasingly important part of governance of public companies in recent decades. In closely held corporations, where there is substantial overlap between the owners and management, outside directors have played a much less significant governance role. Individuals who are neither officers nor employees are often asked to serve on closely held corporate boards because they bring special expertise (e.g., legal, accounting or technical), because they represent important investors, customers, suppliers, distributors or other business partners of the corporation (or otherwise help cement an important relationship) or because they offer some other perceived advantage to the corporation. Outside directors who are not affiliated with particular investors or business partners of the corporation can be especially useful to boards of closely held corporations as objective observers of management and business operations. The role of the outside director may be especially important and challenging in the context of a closely held corporation dominated by a controlling shareholder or group of related shareholders (see Section 4).

An individual considering an invitation to join the board of a closely held corporation as an outside director should study both the corporation and the board and should accept a directorship only if confident of the competence and integrity of both the management and the directors of the corporation, as well as his or her own ability to monitor and add value to the enterprise. An individual asked to be a director should consider the following steps:

* meet the CEO and other top executives as well as major shareholders to review board organization and procedures, discuss the principal issues facing the corporation and determine the attitude of management and controlling shareholders toward board activity–principally, whether independent judgment is truly desired

* confer with any other outside directors currently or previously serving on the board

* review the corporation’s financial statements for at least the last two years

* review corporate minutes for the last two years to become familiar with the corporation’s business, important issues addressed by the board as well as the corporation’s attention to corporate record-keeping and other necessary formalities

* become familiar with the roles of the corporation’s accountants and counsel

* review examples of information regularly provided to directors

* review and discuss with the CEO and other top executives the current forecasts and plans of the corporation

* review press reports about the corporation to determine how it is viewed in the investment community and the business world generally

* if serving at the request of an employer, become familiar with the employer’s indemnification policies relating to service on boards at the request of the employer

* become familiar with the corporation’s director indemnification bylaw provisions, director and officer liability insurance coverage, if any, director indemnification contracts, if any, and pending litigation that (1) is material to the corporation, (2) involves the activities of the board of directors or (3) involves as a party an entity with which the individual is affiliated

* consider whether the individual has any present or potential conflicts with the corporation. An outside director serving as a representative of a customer, supplier, distributor or other business partner of the corporation may constantly be facing conflict-of-interest problems by serving on the board of the corporation.


Recognizing that not all individuals are willing or able to assume full responsibilities as directors, some corporations appoint valued advisors as “honorary directors” or make them members of an “advisory board.” It has also become increasingly common for lenders, venture investors and other financial or commercial partners with substantial interests in a corporation to negotiate to have a representative sit in on the corporation’s board meetings as an observer or monitor rather than serve as an actual member of the board.

Honorary directors, members of advisory boards, observers and monitors are not real directors and are not entitled legally to vote on matters considered by the board. Their rights and duties relating to obtaining board information, attending board meetings and participating in board deliberations depend completely upon what the corporation has agreed to permit or require.

* Honorary directors are typically asked to attend meetings, given board information in connection with meetings and encouraged to contribute to the deliberative process.

* Members of advisory boards usually do not attend board meetings, receive related information or participate in deliberations. Instead, the advisory board has its own meetings and formulates advice to be given to the board of directors on areas of designated interest or concern.

* Observers or monitors generally have the right to receive board information in connection with meetings and attend without participating in deliberations.

Clear demarcations must be made between the roles of actual directors and honorary or advisory directors or observers or monitors. Special care is needed to assure that an honorary or advisory director, or even an observer or monitor, does not act as a director and unintentionally assume director responsibilities and liabilities. In addition, if a matter subject to attorney-client privilege arises, the privilege may be lost if the meeting includes nondirectors in attendance.

Because honorary or advisory directors and observers and monitors may not be bound by the same fiduciary duty of confidentiality as actual directors with respect to information learned in connection with meetings or otherwise, the corporation should also ensure that appropriate confidentiality agreements are in place.



As a general matter, a business corporation’s core objective is to conduct its business activities to create and increase corporate profit and shareholder gain. Directors’ activities in providing leadership toward these economic ends can be described as comprising two basic functions: decision-making and oversight. The decision-making function generally involves both the formulation with management of corporate policy and strategic goals and actions taken respecting specific matters. Some matters–such as changes in charter documents, authorization of dividends, election of officers, mergers with other enterprises or corporate liquidation–may require board action (as well as shareholder action, in some cases) as a matter of law. The oversight function does not, in general, involve specifically required decisions or approvals but rather concerns periodic attention to corporate systems and controls, policy issues and other recurring attention to matters suggesting a need for inquiry. In pursuit of both their decision-making and oversight activities, corporate directors have, individually or collectively, various duties, responsibilities and rights, which are more fully described below.

1. Board Responsibilities

Stated broadly, the principal responsibility of a corporate director is to promote the best interests of the corporation by providing general direction for the management of the corporation’s business and affairs. The director should bring advice to the corporation based upon the director’s business experience and public and professional relationships. In bringing experience and judgment into the boardroom, a director should not be shy. Indeed, to be a “director” is to “direct”–which means to become informed, to participate, to ask questions and to apply considered business judgment to matters considered by the board.

The director should give primary consideration to the corporation’s economic objectives. However, a director should also be concerned that the corporation conduct its affairs with due appreciation of public expectations, taking into consideration applicable law, public policy and ethical standards. Furthermore, pursuit of the corporation’s economic objectives will often include consideration of the effect of corporate policies and operations on the corporation’s employees, the public and the environment. Several states have adopted legislation expressly confirming that corporate directors may consider, in the various decisions that they make, the effect of corporate action on constituencies other than shareholders, including employees, local communities, suppliers and customers. Nevertheless, as a general rule, the law does not hold the board directly responsible to constituencies other than shareholders in the formulation of corporate policy. Constituency considerations are best understood not as independent corporate objectives but rather as factors that may be taken into account in pursuing the best interests of the corporation.

2. Individual Responsibilities

To be effective, a director should become familiar with the corporation’s business, including the economic and competitive environment in which it operates. This knowledge should enable the director to make an independent evaluation of management performance and allow the director to join with other directors to make changes and to challenge, support and reward management as warranted. Accordingly, a director should have a basic understanding of:

* the principal operational, financial and other plans, strategies and objectives of the corporation

* the results of operations and financial condition of the corporation and its significant business segments for recent periods

* the relative standing of the corporation’s significant business segments vis-a-vis its competitors.

In addition, a director should be satisfied that an effective system is in place for periodic and timely reporting to the board on the following matters:

* corporate objectives and strategic plans

* current business and financial performance of the corporation and the degree of achievement of the board-approved objectives and plans

* financial statements, with appropriate segment or divisional breakdowns

* systems of controls designed to promote compliance with law and corporate policies

* material litigation and regulatory matters.