The law governing professional service corporations specifies that where an entity has two shareholders, both “shall be” the directors. N.J.S. 14A:17-6. This presents a dilemma to the professional who has been the sole shareholder of his own business, but now wishes to add a co-shareholder to the corporation. Does he or she have to choose between having a business partner and having full control of the business?

The Hobson’s Choice

For many years Dr. Krank has been the sole shareholder of a professional service corporation, Krank, M.D., P.A. He is not only a skilled physician, but also a shrewd and controlling business person who has always made the business and administrative decisions for his corporation. He likes it that way.

Krank’s young employee, Dr. Dubious, works well with him. Krank likes Dubious and so do the patients. Dubious has asked to be a “partner,” that is, a co-shareholder in the corporation. Krank has been thinking of “slowing down,” wants to keep Dubious, and has no objection to sharing the corporation’s profits with him.

When Krank asks the corporation’s lawyer to “draw up the necessary papers,” the lawyer, who knows that Krank is used to dealing autocratically with leases, loans, equipment purchases, and hiring and firing, alerts Krank to the pertinent text of section 6 of the Professional Service Corporation Act: “A professional corporation which has only 2 shareholders need have only 2 directors who shall be such shareholders.” N.J.S. 14A:17-6 (emphasis added).

The lawyer explains that the terms of the statute appear to require that Dubious become a second director even if Dubious became a “minority partner,” that is, even if the percentage of shareholdings favor Krank, whether it be 51 to 49 percent, or 90 to 10 percent. Should Dubious ever disagree with Krank, the corporate directors would be deadlocked and Krank could be stymied.

The following conversation ensues:

Krank: You mean I have to choose between losing Dubious or giving up control of my corporation? That’s utter nonsense. Jim Jones is the sole director of “his” company, Jones Medical Supplies, Inc., and that corporation has more than one shareholder.

Lawyer: Jones Medical Supplies is a business corporation governed by a different statute, the New Jersey Business Corporation Act. Although both the Professional Service Corporation Act (Chapter 17) and the New Jersey Business Corporation Act (Chapters 1 through 16) are both codified in Title 14A of the New Jersey Statutes, they are separate enactments. A business corporation need have only one director no matter how many shareholders it has. The law governing professional corporations is different because it specifies that where there are two shareholders, both “shall be” the directors.

Krank: But why?

Lawyer: It results from an unfortunate historical anachronism. At the time the Professional Service Corporation Act was going through the New Jersey Legislature in the 1960s, business corporations had to have three directors. Because it was recognized that professional corporations would often be made up of only one or two practitioners, the statute was written to provide relief from the three-director requirement. That is why it says “need have only 2 directors.” Although the business corporation law was changed to require only one director no matter how many shareholders, the Professional Service Corporation Act was never amended.

A Possible Solution

Krank explains that Dubious is a dedicated physician who has no interest in the business aspects of the practice, and inquires if there is any way around his dilemma. The lawyer responds that the Business Corporation Act contains a provision, section 5-21(2), that permits a corporation’s certificate of incorporation to eliminate the board of directors and vest all of the board’s power and authority in a single individual. There is, however, no similar provision in the statute governing professional corporations, and to the lawyer’s knowledge no ruling as to whether Section 5-21(2) of the Business Corporation Act may be applied to professional corporations.

To eliminate the board and place all of its power and authority in Krank, it will be necessary to amend the certificate of incorporation, to make a notation on the stock certificates and to explain to Dubious (in legal terms “put him on notice”) what is being done to accommodate his request to become a shareholder.

Will It Work?

Even though the statute governing professionals does not contain a provision similar to section 5-21(2), the suggested plan to resolve the dilemma is supported by the following:

1. The Professional Service Corporation Act contains express linkage to the business corporation statute:

The Business Corporation Act of New Jersey shall be applicable to a professional corporation … except to the extent that any of the provisions [of the professional act] are interpreted to be in conflict with the provisions of the [business act], and in such event the provisions and sections of [the professional act] shall take precedence with respect to a professional corporation ….”

N.J.S. 14A:17-15.

Eliminating the board of directors does not result in a statutory conflict. There are two primary policies that distinguish professional corporations from business corporations:

(a) Only an individual licensed in the profession can be a shareholder in a professional corporation. Any individual or entity can be a shareholder in a business corporation.

(b) Licensed professionals, unlike merchants or contractors, may not interpose an artificial entity between themselves and those to whom they render services. Thus shareholders in a professional corporation are personally liable for negligence in the performance of their professional services, whereas shareholders in a business corporation enjoy a greater degree of limited liability.

Both of these differences have a sound rational basis. As to the first, no unlicensed person should have the authority to direct a professional’s performance. Thus, if the professional vested with the authority of the board is licensed in the profession that the corporation practices, no violence is done to this concept. The law does not require that every professional who is a shareholder in a professional corporation be a director. A professional corporation with four or more shareholders can be governed by only three of them.

As to the second, the fact that one licensed professional directs the professional corporation’s business aspects does not interfere with the direct line of personal liability from another professional who, on behalf of the corporation, provides service to his or her patient (or client or customer).

Consequently, eliminating the board of directors does not conflict with the policies of the statute governing professionals, and the parties should be able to act under section 5-21(2) of the Business Corporation Act.

2. In addition to the fact that no policy of the Professional Service Corporation Act is violated, there is no public policy or basis to distinguish between co-shareholders in a business corporation from co-shareholders in a professional corporation. In either case, the two shareholders can negotiate and provide for control and protection through a shareholders’ agreement. Loss or lack of control should be disclosed, and if the nondominant shareholder consents, he or she should not later be heard to challenge the arrangement.

3. Notwithstanding the language of N.J.S. 14A:17-6, quoted above, the New Jersey Supreme Court adopted R. 1:21A(e), which permits a professional service corporation for the practice of law to have only one director no matter how many shareholders. There appears to be no rationale for other professionals to be treated differently. (Whether a Rule of Court governing the practice of law can trump the statute governing all professional corporations is a different issue not addressed here.)

4. When Krank began his practice, the only form of entity available to him was a professional corporation. Limited liability companies became available to physicians after 1993 and after the Board of Medical Examiners authorized physicians to practice as LLCs. Had Krank been able to form an LLC instead of a PC, he would not have this problem. An LLC with two members can be structured to make one the managing member. The situation should be no different, as a practical matter, when the practice takes the form of a professional corporation.

Another Possible Solution

A 1988 Amendment to the Business Corporation Act authorizes directors, instead of voting per capita, to have weighted votes. Although there is no similar provision in the act governing professional corporations, there would be no conflict with the policies of that statute if the certificate of incorporation of Krank M.D., P.A. were amended to provide for two directors, Krank with two votes and Dubious with one.

Whether the board of directors is eliminated or whether multiple votes are used, the clear public policy of modern corporate law is to permit “the conduct of lawful business with such variations and modifications from the form so provided as the interested parties in any corporation may agree upon ….”

Of course it would be preferable if the Professional Service Corporation Act were amended not only to make explicit what is implicit, but also to render it consistent with amendments made to the Business Corporation Act after 1969. Until that overhaul occurs, however, the methods suggested above arguably resolve the dilemma faced by a two-person professional corporation.n

Next Week…

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