Trust and Opportunism in Close Corporations

Abstract:     
The majority shareholder in a closely held corporation may use its control of the corporate machinery to appropriate wealth from the minority, and it is difficult for the majority to make a binding commitment not to do so. This paper models the interaction between majority and minority shareholders as a trust game in which the majority is constrained by the possibility of non-legal sanctions, including family or social disapproval and loss of reputation. The paper applies the analysis to the longstanding debate over appropriate exit rules for close corporation shareholders. Where the parties are well-informed and rational and judicial valuations are unbiased, giving the minority the unconditional right to e cashed out should reduce majority opportunism without producing opportunistic behavior by the minority. The paper suggests that the apparent failure of close corporation shareholders to bargain for such a right reflects the courts' success in using dissolution and fiduciary duty actions to deter majority misbehavior.

Number of Pages in PDF File: 27

working papers series