A.W. Chesterton Co., Inc. v. Chesterton

• Decision Date: 09 September 1997
• Docket Number: No. 97-1268,97-1268
• Citation: 128 F.3d 1
• Parties: -7280, 97-2 USTC P 50,809 A.W. CHESTERTON COMPANY, INC., James D. Chesterton, Thomas Chesterton, Jr., Andrew W. Chesterton, Glenn E. Chesterton, Florence Chesterton, Boston Safe Deposit, Inc., Trustee of the Thomas Chesterton Trust, and Adele Forman, Plaintiffs, Appellees, v. Arthur W. CHESTERTON, Defendants, Appellant. . Heard
• Court: U.S. Court of Appeals — First Circuit

Page 1

128 F.3d 1

80 A.F.T.R.2d 97-7280, 97-2 USTC P 50,809

A.W. CHESTERTON COMPANY, INC., James D. Chesterton, Thomas Chesterton, Jr., Andrew W. Chesterton, Glenn E. Chesterton Florence Chesterton, Boston Safe Deposit, Inc., Trustee of the Thomas Chesterton Trust, and Adele Forman, Plaintiffs, Appellees, v. Arthur W. CHESTERTON, Defendants, Appellant.

No. 97-1268.

United States Court of Appeals, First Circuit.

Heard Sept. 9, 1997.

Decided Oct. 14, 1997.

Martin F. Gaynor, with whom Harry L. Manion III was on brief, for plaintiffs, appellees.

Lawrence P. Heffernan, with whom Michael D. Lurie and Peter L. Banis were on brief, for defendants, appellant.

Before TORRUELLA, Chief Judge, ALDRICH, Senior Circuit Judge, and LYNCH, Circuit Judge.

LYNCH, Circuit Judge.

This appeal involves the duties imposed by Massachusetts law on a minority shareholder in a closely held corporation. Arthur W. Chesterton ("Chesterton"), a minority shareholder in the A.W. Chesterton Company, frustrated in his efforts to dispose of his shares, proposed to transfer a portion of his stock in the Company to two shell corporations. Because such a transfer would terminate the Company's advantageous Subchapter S status under the Internal Revenue Code, the district court found that the proposed transfer violated Chesterton's fiduciary duty to the Company and enjoined him from proceeding with the transfer. Chesterton appeals this finding and injunction, as well as the district court's denial of Chesterton's counterclaim for relief under M.G.L. ch. 156B. We affirm.

I.

There is little dispute about the facts which emerged from the trial. While it is unclear whether Chesterton is asserting that the district court's factual conclusions are not supported by the evidence, we state the facts as the court could have found them. Cambridge Plating Co. v. Napco, Inc., 85 F.3d 752, 756 (1st Cir.1996).

The Company has been a closely held Massachusetts corporation since its inception in 1885, and is currently owned and operated by the descendants of the Company's founder, Arthur W. Chesterton. Chesterton, the defendant in this case and the grandson of the original Arthur Chesterton, is currently the Company's largest shareholder, with 27.06% of the Company's stock. The Company and its affiliates manufacture mechanical seals, packaging, pumps and related products, which are distributed throughout the world.

Two corporate events set the stage. The first occurred in 1975, when the shareholders of the Company approved the Company's Restated Articles of Organization ("the Articles"). The Articles provide the Company with a right of first refusal in the event that a shareholder seeks to transfer her shares to an individual or entity outside the immediate Chesterton family. The shareholder must give the Company 30 days notice; the Company may avoid the sale by opting to purchase the stock within the 30 days. If the Company declines the option, the shareholder may proceed with the sale as planned. Part of Chesterton's argument focuses on the fact that he had complied with these provisions of the Articles when he proposed his stock transfer.

The second occurred in 1985, when the Company's Board of Directors voted to change the Company's status under the Internal Revenue Code from a Subchapter C corporation to a Subchapter S corporation. The Board perceived Subchapter S status as advantageous to the Company because it allows shareholders in a small business corporation to avoid the double taxation of income to which shareholders in a Subchapter C corporation are subject. The income of a Subchapter C corporation is taxed first at the corporate level when the company earns income, and a second time at the shareholder level when the shareholders receive the income in the form of dividends. A Subchapter S corporation, in contrast, is not taxed at the corporate level; rather, each shareholder pays income tax individually in proportion to her share of ownership in the corporation. ¹ See 26 U.S.C. §§ 1361-1399.

In order to qualify for Subchapter S treatment, a corporation must be a domestic corporation which does not: (1) have more than seventy-five shareholders, (2) have a corporation or other non-individual as a shareholder, (3) have a non-resident alien as a shareholder, and (4) have more than one class of stock. 26 U.S.C. § 1361(b). Failure to abide by any of these limitations results in automatic termination of Subchapter S status. 26 U.S.C. § 1362(d)(2).

After the Company Board voted to adopt Subchapter S status, the officers and directors sought to inform the shareholders about the benefits and limitations of the S election, and recommended that the shareholders give their consent. Under the Internal Revenue Code, the unanimous consent of the shareholders of a corporation is required in order to finalize a Subchapter S election. 26 U.S.C. 1362(a)(2). As an officer and director of the Company at the time, Chesterton was heavily involved in this process. He led and participated in shareholder meetings regarding the Subchapter S election. At those meetings the shareholders were provided with information regarding the benefits of Subchapter S election, as well as the limitations it imposed. The shareholders unanimously consented to the Subchapter S election. Implicit in this consent was a general understanding among the shareholders that they would take no action that would adversely affect the Company's Subchapter S status.

In the early 1990's, Chesterton became discontented with the Company's performance, including its declining profits, heavy debt, and credit problems. ² Chesterton also objects to a financial arrangement that the Company has with Chesterton International, B.V. ("BV"), a Company affiliate. ³ Under the arrangement, the affiliate BV pays the Company a large management fee, ⁴ which has allowed the Company to continue to pay dividends to its shareholders, despite its poor financial performance. Chesterton believes that this arrangement masks the Company's dire financial straights. He also objects to the arrangement because much of the management fee is funnelled into Company pension plans, from which Chesterton does not benefit because he is not a current Company employee.

Because of his dissatisfaction with the Company, Chesterton sought to sell his Company stock. He found little interest because all he could offer was a minority of shares. ⁵ After some failed efforts to locate an investor willing to purchase his stock outright, Chesterton devised the scheme at issue in this case. Chesterton proposed to transfer a portion of his shares to two shell corporations which are wholly-owned by him. Chesterton complied with the Articles of Organization by providing the Company with the proper notice of his proposed transfer so that it could purchase his shares. The Company, however, declined because it lacks the ability to purchase the shares.

When the Company would not purchase his shares, Chesterton sought to proceed with the transfer. But that transfer would have a deleterious effect on the Company's tax status. The Company and its shareholders derive significant tax benefits from the Company's status as a Subchapter S corporation. Should a corporation become a Company shareholder, as it would under Chesterton's proposed transfer, the Subchapter S status terminates automatically. 26 U.S.C. § 1362(d)(2). If Chesterton were to consummate his proposed transfer to the shell corporations, the Company would revert to Subchapter C status. The Company's Subchapter S status enabled it to distribute an additional $5.3 million in dividends between 1985 and 1995. Reversion to Subchapter C status would represent a significant financial loss for the Company and its shareholders. Once a corporation loses its Subchapter S status, it cannot reattain that status for a minimum of five years. 26 U.S.C. 1362(g). In fact, loss of Subchapter S status would have a more severe effect on the Company because it is currently grandfathered under an old provision which exempted Subchapter S corporations from taxes on the sale of corporate assets. See 26 U.S.C. § 1374(c)(1). Even if the Company eventually regained its Subchapter S status, it would permanently lose its grandfathered status.

Fearing the loss of its Subchapter S status, the Company and its shareholders instituted suit, seeking to enjoin Chesterton from effectuating his plan. The original complaint alleged breach of fiduciary duty, breach of contract, breach of implied covenant of good faith and fair dealing, and interference with an advantageous relationship. Before trial, the parties stipulated to a dismissal of all claims, with prejudice, except for the breach of fiduciary duty claim. Plaintiffs also agreed to "waive their claims for damages, but [not] their claims for equitable relief." After a bench trial, the district court ruled that the proposed transfers would violate Chesterton's fiduciary duty under Massachusetts law and that they would result in irreparable harm to the Company. The court enjoined the transfers and denied Chesterton's counterclaim for monetary relief under Mass. Gen. Laws ch. 156B.

Chesterton argues that the district court improperly determined the scope of Chesterton's fiduciary duty under Massachusetts law. He asserts that the district court improperly resurrected the waived contract claim by discussing the general agreement among the shareholders not to disrupt the Company's Subchapter S status. He argues that the district court improperly concluded that the Subchapter S election imposed an implied restriction on transferability of stock, where the Company did not follow the legal requirements for imposing stock transfer restrictions under Mass. Gen. Laws ch. 156B. Finally, he argues that the district court improperly restricted Chesterton's presentation of evidence at trial concerning certain Company accounting practices. We reject Chesterton's arguments.

II.

We review ...