Keeping Things in Bounds: Private Company Owners Need toAbide by Clear Fiduciary Duties in Managing Their Companies

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In February 2009, Pittsburgh Steelers wide receiver Santonio Holmes made a toe tapping catch in the back corner of the end zone[1] to secure a thrilling, come-from-behind win and crush the hearts of Arizona Cardinals fans in Super Bowl 43. For private company owners running their own firms, the boundaries for their conduct are set by the fiduciary duties they owe to their companies. But in both sports and the management of private businesses, team leaders can find it challenging to remain inbounds. This post therefore reviews the legal lanes of proper conduct that owners will want to follow to avoid future claims.

The Scope of Fiduciary Duties

The fiduciary duties of corporate directors and officers are not included in the Texas Business Organizations Code (“BOC”), but Texas case law for more than a century makes clear that both directors and company officers owe duties of obedience, care, and loyalty, and these duties are owed to the company, not to the individual shareholders. See Tenison, v. Patton, 95 Tex. 284, 67 S.W. 92 (1902); Ritchie v. Rupe, 443 S.W.3d 856, 868 (Tex. 2014). These same fiduciary duties also apply to LLC managers and officers, and all of these parties are referred to in this post as “control persons.”

The Ritchie case focused on whether minority shareholders have a legal right to secure a court-ordered buyout of their minority ownership interest based on claims that control persons engaged in shareholder oppression. The Court held no claim for shareholder oppression exists in the BOC or at common law that would authorize a trial court to order the company or majority owners to buy the minority owner’s stake in the business. But, the Ritchie Court did uphold the right of minority shareholders to pursue claims against officers and directors for breach of their fiduciary duties, and recognized that these claims could be brought on a derivative basis.

In this regard, the Court stated that:

“Directors, or those acting as directors, owe a fiduciary duty to the corporation in their directorial actions,and this duty “includes the dedication of [their] uncorrupted business judgment for the sole benefit of the corporation.”
443 S.W.3d at 868.

The BOC permits the fiduciary duties of control persons to be limited in the company’s governance documents, but the statute does not permit a company to remove the duty of loyalty owed by control persons. The remainder of this post focuses on what the duty of loyalty requires from governing persons in their business relationship with their companies.

Conflicts Transactions by Control Persons Can Lead to Claims

Owners of private companies commonly engage in transactions with their businesses in their capacity as control persons. Majority owners may buy, sell and lease property from or to their companies, buy and sell products or services from other businesses they also own or control, and loan money to their companies to fund their business operations. All of these transactions are not at “arm’s-length” and, instead, they are “interested party” transactions, which are sometimes referred to as “conflict transactions.” These types of conflicts transactions may result in claims by the minority owners who allege that the transactions breached the control person’s fiduciary duties because they were not fair to the company.

Once again, the Supreme Court in Ritchie addressed this problem:

“[T]he duty of loyalty that officers and directors owe to the corporation specifically prohibits them from misapplying corporate assets for their personal gain or wrongfully diverting corporate opportunities to themselves. Like most of the actions we have already discussed, these types of actions may be redressed through a derivative action, or through a direct action brought by the corporation, for breach of fiduciary duty.
443 S.W.3d at 887.

There is a “safe harbor” provision in the BOC for company control persons when they engage in business with their company for their personal benefit. Section 21.418 of the BOC provides that when a control person enters into a transaction with the Company, which would otherwise be void or voidable, the transaction will be nevertheless be upheld as valid if certain conditions are met. We discussed this safe harbor statute in more detail in a previous post (Read Here). In summary, a conflict transaction by a control person will be upheld if (i) the details of the transaction were fully disclosed to and approved by a majority of the shareholders and/or by a majority of the disinterested directors or (ii) if the transaction is deemed to be objectively fair to the company.

Fairness is not defined in the BOC provisions, but fair is defined in Webster’s dictionary as “characterized by honesty and justice” and “free from fraud, injustice, prejudice or favoritism. Once the minority shareholder brings a claim and demonstrates that a control person engaged in a conflict transaction, the control person will then bear the burden of demonstrating in the case that the terms of the transaction were fair to the company. To avoid being forced to litigate the issue of fairness, control persons may want to avoid the following types of conflict transactions or, alternatively, they may want to take steps to head off the expected challenge from minority owners that the transaction was not fair to the company.

Examples of Conflicts Transactions

The following are the most common types of conflict transactions that control persons engage in with their companies, and for each of these, an approach is suggested that can either eliminate or reduce the potential for future claims.

  • Theft of corporate opportunity
    The duty of loyalty requires control persons not to take business opportunities for themselves that rightfully belong to the company. When control persons take company opportunities, this is referred to as usurpation or misappropriation and it is a breach of fiduciary duty. There is a clear way, however, for control persons to avoid this claim. In 2003, the BOC was amended to allow for a company to include in its certificate of formation, bylaws or in its company agreement an express waiver of the control person’s duty not to usurp a company opportunity. See. BOC Section 2.101(21). The specific language gives the company the power to:

. . . renounce, in its certificate of formation or by action of its governing authority, an interest or expectancy of the entity in, or an interest or expectancy of the entity in being offered an opportunity to participate in, specified business opportunities or a specified class or category of business opportunities presented to the entity or one or more of its managerial officials or owners.

As indicated by this provision, the certificate, bylaw or provision of the company agreement needs to make clear the specific type or category of opportunities that are being excluded from the duty. By including this limitation on the duty of loyalty, however, the control person will be immune from any liability for usurping a corporate opportunity of the company as it is defined in the bylaws or in the provisions of the LLC agreement.

  • Purchase or sale or lease of property to company, and loans to company
    It is common for control persons to either sell, purchase or lease property, assets or services to/from the company they control or to provide loans to the company. These are all conflict transactions that can, and often do, give rise to claims for breach of fiduciary duty and fights about whether the control person engaged in a transaction that was unfair to the company. To avoid or at least limit claims related to these types of transactions, there are a number of common sense, practical steps that control persons can take before they engage in the transaction.

First, the control person should fully disclose all material terms of the transaction to other shareholders, the board and/or managers of the company and seek their approval, which if given, should eliminate all future claims. Second, when there are objections raised to the transaction, the control person should consider securing input from outside experts to provide objective information. For example, if the control person is selling or leasing property to the company, the control person should arrange for an independent appraiser to provide a written appraisal to set the property’s market value. If a lease of property is at issue, an independent broker can provide market value lease rates for the type of property at issue. Third, when the company is receiving loans from the control person, bankers can readily provide loan terms that reflect market rates.

Finally, the control person should consider structuring the transaction in a way that provides the company with a better deal on terms more favorable than market rates. The control person does not need to give the company a gift in the transaction, but if the company receives a deal that is better than market rates, that will make it harder for the other shareholders or LLC members to complain that there was any lack of fairness in the transaction to the company.

  • Compensation and bonuses
    Finally, a hot button point with shareholders and members is often compensation, and more specifically, how much money is paid in base compensation and bonuses to the majority owner in his/her capacity as an officer, director or manager. The obvious concern is that funds paid in compensation should, instead, be issued as dividends or distributions to all owners, and that the compensation paid to the majority owner is considered a “disguised distribution.”

If the other shareholders or members express concern regarding the compensation and bonuses that are being paid to the majority owners, this issue should be addressed by hiring an experienced and independent executive compensation expert. The compensation expert will provide the company with a range of compensation that is being paid to executives at similarly situated companies in the same or similar industry and geographic region. As noted above, rather than choosing a compensation/bonus level at the top end of the range determined by the expert, the majority owner is advised to select a range of compensation in the 70-80% range to limit the likelihood of any claim being brought by minority owners on this basis.

Conclusion

In King Henry IV, Shakespeare wrote: “Uneasy lies the head that wears a crown.” One cause for this unease by private company owners who wear the mantle of leadership is that they are subject to suits by co-owners for breach of loyalty to the company. But staying inbounds is by no means an insurmountable challenge for majority owners, as control persons, if they follow a few simple ground rules. In short, majority owners need to be fully transparent in all of their transactions with the company, they should seek agreement when possible with other owners, but when an agreement is not possible, they need to secure specific input from outside experts who can validate the fairness of the transaction to the company before it takes place. And regarding that Santonio Holmes TD catch, let’s look ahead and hope the Cardinals get another chance at a Super Bowl win soon led by their exciting QB and No. 1 Draft Choice, Kyler Murray.

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[1] Cardinals fans like me continue to question whether Holmes actually managed to get his right toes down on the turf in the end zone before he was pushed out of bounds, and photographs of the catch prolong this debate

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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