When Temptation Trumps Restraint: Limits of the Protection of LLC Managers

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“The only way to get rid of temptation is to yield to it.” -Oscar Wilde

“I generally avoid temptation unless I can’t resist it.”  -Mae West

“That which is hateful to you, do not do unto your neighbor.”  -Rabbi Hillel the Elder

Temptation is powerful.  We all know this well, which is why these quotes by author and bon vivant Oscar Wilde and actress and legendary sex symbol Mae West evoke nods of agreement.  But giving into temptation can result in significant harm to ourselves and others.  That is why more than 2000 years ago, the revered Jewish religious leader and biblical sage, Rabbi Hillel, implored his followers to treat others as they would want to be treated.

In the modern business world, temptation wins out when managers and majority members of Texas limited liability companies (“LLCs”) exploit their controlling power for their own benefit to the detriment of the company’s minority investors.  These self-serving actions by governing persons may result in breach of fiduciary duty claims being filed, causing them to turn to the Texas Business Organizations Code (“TBOC” or the “Code”) seeking a legal defense.  The TBOC does not provide governing persons with a “get out of jail free card,” but the Code does contain an “Interested Director” provision that may be helpful to LLC majority owners and managers who have to defend against breach of fiduciary duty claims.  See TBOC § 101.255.  This post evaluates the scope and the limits of the TBOC’s Interested Director provision.

Scope of Fiduciary Duties Owed by LLC Managers and Members

Surprisingly, the duties that managers and majority members of Texas LLC’s owe to their companies are not expressly set forth in the TBOC, although the Code implies that managers and members owe certain duties.  For example, the prohibition against self-dealing and the duty of loyalty to the LLC is implicit in TBOC provisions that address transactions that involve governing persons who have a personal interest in the transaction.

Texas common law, however, has long held that the governing persons managing private companies owe fiduciary duties to their companies.  Indeed, contracts and transactions involving governing, interested persons have been subject to scrutiny by Texas courts for more than 100 years.  See Tenison v. Patton, 95 Tex. 284, 67 S.W. 92 (1902).  Specifically, governing persons who are parties to an interested transaction are required to prove the transaction was fair, and an interested governing person is disqualified from acting alone for the company.  Id. at 92, 95.  A transaction between an interested governing person, on the one side, and the company, on the other side, that receives no approval other than from the interested governing person is voidable for that reason alone.

Review of the Interested Director Rule – Not An Absolute Safe Harbor

The TBOC entered the picture in 2003 to provide a statutory framework regarding the scope of duties that interested persons owe to their companies, as well as providing governing persons protection against claims by minority owners when the governing persons meet these statutory requirements.  Specifically, Section 101.255, also known as the Interested Director Rule, provides interested governing persons (“Int. Gov. Persons”)—under certain conditions—with a “safe harbor”—immunity from claims for breach of fiduciary duty based on what would otherwise be deemed improper, self-dealing transactions if the Int. Gov. Persons can satisfy one of three conditions.  The three conditions are discussed below.

First, the Int. Gov. Person must disclose all material facts related to the transaction to the company, and a majority of non-interested members or managers (i.e., governing persons with no self-interest in the transaction) must approve the transaction in good faith.  Alternatively, the Int. Gov. Persons can appoint a special committee to consider the transaction, 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.

The second condition protecting Int. Gov. Persons from liability for a self-dealing transaction requires the Int. Gov. Persons to disclose all material facts to the members who must then approve the transaction in good faith.  Material facts are all facts relevant to fairness, including, but not limited to, the extent of the conflict, the price terms, and the effect of those price terms on the members.  Disclosure of all material facts relevant to why Int. Gov. Persons might approve or disprove the transaction is required.

The Texas Legislature did not include a definition of “good faith” in the TBOC and case law is sparse regarding this provision.  The good faith obligation is likely part of the governing person or officer’s fiduciary duties, however, because Texas law has long held that good faith is included in the duty of loyalty.  This good faith requirement forbids conduct by the Int. Gov. Persons contrary to the interests of the entity to which the fiduciary duty is owed, regardless of whether another is benefited.  The other common meaning of good faith is contractual in referring to implied duties of parties to a contract, but Texas law does not favor or generally adopt implied duties.  Thus, a Texas court would likely rely on fiduciary duty case law when considering the meaning of “good faith” in the TBOC.

The Texas statutes themselves also indicate that “good faith” is rooted in the fiduciary context.  For example, TBOC Section 7.001(c) does not permit the company to limit or eliminate liability for a governing person who: (1) breaches their duty of loyalty, if any, to the organization or its owners or members; (2) engages in an act or omission that not in good faith that (A) breaches a duty the person owes to the organization or (B) involves intentional misconduct or a knowing violation of law; (3) participates in a transaction from which the person received an improper benefit, regardless of whether the benefit resulted from an action within the scope of the person’s duties; or (4) engages in an act or omission for which the liability of a governing person is expressly provided by an applicable statute.

It may seem that good faith and loyalty are separate fiduciary duties as they are listed separately in the second and third exceptions.  But that notion is discredited by the inclusion of the third exception.  Clearly, receiving an improper benefit is a violation of the duty of loyalty.  Arguably, the fourth exception may also be considered a breach of loyalty, because it is in the company’s best interests to obey the law and acting contrary to these best interests would be disloyal.  This statutory overlap reflects the Legislature’s desire to be thorough.

The final statutory condition protecting Int. Gov. Persons from liability from claims for fiduciary duty based on alleged self-dealing transactions is the fairness defense – Int. Gov. Persons are not liable if the transaction is fair to the company.  This essentially codifies the common law fairness requirement.  Under this statute, you could assume that approval of the transaction by the first two conditions may result in an unfair result in reference to the connector “or” used in the statute.  Fully informed, disinterested decision makers, however, will reach an arm’s length, market transaction that is fair to the company.

Importantly, the third condition in the statute does not require that the governing persons be informed of material facts, that they be disinterested, or that they act in good faith.  This leads to the conclusion that the third condition in the statute will be viewed as a legislative catch-all.  When Int. Gov. Persons cannot prove that the first two conditions were satisfied when applied to the transaction or contract at issue, they can still argue that they are protected by the provisions of the statute if they can show that the contract or transaction was fair to the company.

Thus, Section 101.255 of the Code, the Interested Director provision, does afford some protection to Int. Gov. Persons who face claims by minority owners that these Persons engaged in self-dealing.  Importantly, however, the statute is not a safe haven that will protect all conduct by Int. Gov. Persons.  To ensure that the Int. Gov. Person receives the full benefit of this statute, the reading of the provision that best protects Int. Gov. Persons is that once a claim has been made challenging a self-interested transaction, the Int. Gov. Person bears the burden to show full disclosure of all material facts, that he/she acted in good faith, and/or that the result of the challenged transaction or contract was fair to the company.  Thus, the statutory protections of the Interested Director provision may not be as broad as majority LLC owners and managers may have hoped.  Further, when Int. Gov. Persons cannot meet any of the three conditions that are 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.

Corporate Opportunity Rule

Usurpation of a corporate opportunity is a specific type of interested transaction engaged in by an Int. Gov. Person.  Stated in a non-legal and plain-spoken way, this claim alleges that an Int. Gov. Person took advantage of their position with the company to steal an opportunity that belonged to the business.  This conduct is improper because LLC managers owe a fiduciary duty to provide their uncorrupted business judgment for the sole benefit of the LLC.  Ritchie v. Rupe, 443 S.W.3d 856, 868 (Tex. 2014).

The corporate opportunity rule is a common law rule that requires corporate fiduciaries to exercise the utmost good faith in regard to the company they represent.  See Imperial Grp. (Texas), Inc. v. Scholnick, 709 S.W.2d 358, 363 (Tex. App.—Tyler 1986).  Corporate fiduciaries must therefore fully disclose opportunities within the company’s business to other non-interested governing persons.  It does not matter that an after-the-fact determination is later made that the company would have rejected the opportunity.  That decision to accept or reject the opportunity belongs to the company alone, and this decision can only be made when total disclosure of all material facts is provided to all fiduciaries.  In sum, the Int. Gov. Persons of an LLC cannot thwart the company’s ability to take advantage of the opportunity to profit for themselves.

Conclusion

The Texas Legislature recognized that temptation by those who control and operate LLCs needs to be held in check.  As a result, while the Interested Director provision in Section 101.255 provides a defense for Int. Gov. Persons who are charged with violating their fiduciary duties to their LLCs, this provision in the Code did not legislate away common sense and fundamental fairness.  Instead, Section 7.001(c) preserved liability for conduct by Int. Gov. Persons who act in a manner that is disloyal to their company.

Therefore, Int. Gov. Persons did not receive a “get out of jail free” card from the Texas legislature that they can plan when they act in a disloyal manner that is harmful to their companies.  Instead, Int. Gov. Persons who engage in self-interested transactions will be protected by the Interested Director provision only when they provide full disclosure of all material facts, act in good faith, and can show their challenged conduct was fair to the Company.

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