The Private Company Cookie Jar: Who Decides How Many Cookies The Majority Owners Get to Eat (And Which Ones)?

by Winstead PC
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In the private company world, the buck stops with the majority owners, who generally hold the reins to running the business.  In our experience, however, it is not uncommon for some majority owners to push the limits of their control by engaging in self-dealing transactions that are for their own benefit.  The self-interested transactions in which majority owners may engage can take many different forms, including paying excessive bonuses to themselves, directing the company to enter into “sweetheart” deals with their other companies, taking company opportunities for their own gain, and using company assets or personnel free of charge.

When minority investors seek legal recourse from abuse of authority by its majority owners, the controlling owners will often point to a little-known Texas statute, which they contend renders them immune from liability for their actions.  See Texas Business Organizations Code § 101.255.  As we say in Texas, that dog won’t hunt.  This post explains why the existence of Section 101.255 does not provide majority owners with a “get out of jail free” card, and why this statute does not validate their improper conduct when they engaged in self-dealing.

Section 101.255 Applied to Transactions by Majority Owners Who Engage in Business Transactions with Their Company

For limited liability companies—the most popular form of business for private firms—when majority owners engage self-dealing transactions, they generally do so in their capacity as managers of the company.  In these situations, we have dealt with efforts by majority owners to shield themselves from liability to investor claims by relying on Section 101.255.  This Section provides majority owners some protection if the owner, acting as a manager, satisfies just one of three conditions.  If the majority owner can meet one of these three conditions, he/her will be immunized from liability for breach of fiduciary duty for entering into what would otherwise be an improper self-dealing transaction with the company.  The three conditions are as follows.

First, the majority owner must disclose all material facts related to the transaction to the company’s other managers, and a majority of these disinterested managers (i.e., managers with no self-interest in the transaction) must approve the transaction in good faith.  In the alternative, the majority owner can appoint a special committee, disclose all material facts regarding the transaction to the special committee, and a majority of disinterested special committee members must approve the transaction in good faith.  Because majority owners are often the only company managers, forming a special committee is often the only option the majority owner has to satisfy this first test.  The vote on the transaction, however, must take place in “good faith.”  Thus, a majority owner appointing his best friend, wife or family member to the special committee to rubber stamp the transaction should not pass muster.

The second condition that protects the majority owner from liability for a self-dealing transaction requires the majority owner to disclose all material facts to the members who must then approve the transaction in good faith.  We have not located any Texas case in which a court interpreted what “approval in good faith by the members” means in this statute.  Majority owners have tried to interpret this language, however, in a way that allows them to vote as a member to satisfy this second condition.  A recent Texas appellate decision interpreting a parallel statute for corporations (TBOC § 21.418) concluded that approval by the shareholders in good faith means that the approval of the transaction must be by a majority of the disinterested shareholders.  See Corley v. Hendricks, 2017 Tex. App. LEXIS 3846, at *8 (Tex. App.—Dallas Apr. 27, 2017, pet. denied).  Thus, minority investors have a strong legal argument that the approval in good faith requirement by the company’s members under the statute means approval by a majority of the disinterested members, i.e. the minority owners.

If approving a potential transaction in good faith meant that the majority owner could vote to approve the owner’s transaction in which he/she personally benefits, this legal standard would lead to notably unfair results.  If the majority owner’s own vote as a member could shield the owner from liability for self-dealing transactions, the owner would literally be able to steal from the company with no recourse available to minority owners.  The majority owner could just disclose all the terms of the deal—including what amounts to outright theft—and vote to uphold the transaction.  That interpretation is unlikely to be accepted by any court.

The third and final condition that will protect the majority owner from liability under the statue from fiduciary duty claims based on an alleged self-dealing transaction is that the result of the transaction is fair to the company.  To meet this condition, the majority owner has the burden of proving ultimate fairness to the company.  Except in the event of conduct that is clearly unfair or improper, the fairness standard will often require a battle of the experts.

Limits on the Protections of Section of 101.255 for Majority Owners

While Section 101.255 does afford some protection to majority owners who are subject to claims of self-dealing, the statute is not a safe haven, and its protections are not nearly as broad as majority owners may hope.  Specifically, when majority owners cannot meet any of the three conditions set forth in the statute, they are subject to investor claims and ordinary common law remedies, including claims and remedies for breach of fiduciary duty.

Thus, Section 101.255 did not legislate away common sense and fundamental fairness.  This Section does not provide majority owners of private companies with carte blanche to treat the business as their own piggy bank or cookie jar.  And majority owners who want to engage in transactions with the company are advised not to be the ones who vote to approve and validate their transactions with the business.  Instead, majority owners who want to engage in business with the company should allow the disinterested members to vote or the majority owners should appoint a committee of independent, third-party managers who can vote to approve/reject the transaction based on that are truly the company’s best interests.

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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