So You Want to Run a Business—Fiduciary Duties 101
Whether you are a company founder, a corporate officer or director, general or limited partner or simply an investor, if you are involved in a private company, it pays to understand the basics of fiduciary duties. The phrase “fiduciary duty” may conjure up images of a dusty, wood-paneled trust and estates department, but it is a critical element in the healthy functioning of a private company. Reduced to its essence, fiduciary duty reflects the commitment of anyone managing or controlling a business to do a good, honest job. The legal elements of fiduciary duties take some explaining, but much of it is common sense.
Who owes fiduciary duties?
Generally speaking, all officers, directors, managers and general partners of companies owe fiduciary duties to their business. For a corporation, directors and officers owe these duties to the corporation. For a general partnership, all general partners owe fiduciary duties to the partnership and to the other general partners. For a limited partnership, the general partner owes fiduciary duties to the partnership and also to the limited partners. In an LLC, whoever is assigned the management responsibilities (either managers or members) owes fiduciary duties to the LLC. When we use the term “corporate actors” in this Post, we are referring to officers, directors, general partners, and managers.
The big three fiduciary duties: obedience, care, and loyalty
The three major fiduciary duties are: the duty of obedience, the duty of care and the duty of loyalty. All three duties are reviewed below, but loyalty is often the most critical of the three.
The duty of obedience—don’t do anything illegal
The duty of obedience gets the least attention among the fiduciary duties, because it is the least applicable in modern businesses. In short, this duty requires corporate actors not do anything illegal or that would violate the purposes of the business. But most firms have a broad charter in their founding documents that permits the company to pursue any lawful business activity. As a result, it is uncommon for corporate actors to be found to have engaged in actions that violate their fiduciary duty by pursuing some type of business that is outside the scope of the company charter.
The duty of care—pay attention and read the materials
The duty of care answers the basic question “is an officer or director personally liable for bad business decisions?” In short, no. Corporate actors are bound to act in good faith and without a corrupt motive (see duty of loyalty), but they will not be held liable to the company’s investors if their business idea or action turns out poorly. Corporate actors are not liable for their good faith mistakes, because they are protected by a legal doctrine known as the business judgment rule. Under this rule, corporate actors are not liable when they are negligent in the performance of their duties, i.e. corporate actors are permitted to make “mistakes of business judgment that damage corporate interests.”
Exceptions to The Business Judgment Rule
There are a number of important exceptions to the business judgment rule. First, the business judgment rule does not protect corporate actors who violate the duty of loyalty they owe to the company or who engage in acts of gross negligence. Courts find gross negligence when corporate actors have actual awareness of an extreme risk and they nevertheless act with conscious indifference to it (e.g., refusal to spend money on safety equipment knowing that the company’s employees are at risk of serious injury).
Second, the business judgment rule does not protect corporate actors who fail to exercise any judgment at all or who completely disregard their duties. These exceptions may seem vague, so Texas law provides some guidance on the effort required from corporate actors to receive the protection of the business judgment rule. Simply stated, those managing the business should be informed of “all material information available to them before making a decision.” In addition, a corporate officer can rely on information, opinions, reports, or statements presented by officers or employees of the business, outside professionals, or even the work of a board of directors committee.
The duty of loyalty—keep company and personal interests separate
The two most common breaches of the duty of loyalty are: (1) using the company’s funds to pay for personal expenses (classic self-dealing) and (2) taking a corporate business opportunity and handling it for the corporate actor’s own benefit (usurping a corporate opportunity).
The financial temptation for corporate actors to exploit their power in an improper way can be hard to resist: many believe that if they can convince (or intimidate) the company’s controller or outside accounting firm to treat their personal expenses as deductible business items, they will save 30% or more in taxes over paying for the same thing with after tax compensation. Common personal expenses that corporate actors seek to treat as business expenses include: country club memberships, attendance of family members on business trips and payment for vacation homes. Similar abuses include putting family members on the payroll who do no work for the company, providing company cars for spouses and providing health insurance benefits to family members who are not employed by the company. The list of creative ways to run personal expenses through the business is limitless, but it is corrosive to trust among business partners. The rule here is simple: company funds can be used solely for company business. If this simple rule becomes difficult to apply, it may be easier to ask if the company’s mailroom clerk can use company funds for the same expense.
Usurping a corporate opportunity takes place when a corporate actor takes for himself a business opportunity that rightfully belongs to the company. The corporate actor may usurp the opportunity company directly for himself or he may do it indirectly by transferring or assigning it to another company in which he has an interest. In this situation, the corporate actor is using the position of trust to obtain a personal benefits. Business opportunities that are within the scope of the company’s business belong to the company, and a corporate actor breaches his duty of loyalty to the company when he takes this opportunity for himself.
Can corporate actors limit their fiduciary duties to the company by contract?
Corporate actors can negotiate to restrict the fiduciary duties they owe to the company. First, the company’s certificate of formation and/or its bylaws can eliminate the liability of corporate actors based on a breach of the duty of care. That exemption can’t go much beyond the business judgment rule, however, so it adds little protection. More importantly, the company can agree to permit corporate actors to freely engage in outside business activities that directly compete with the company, and the company can renounce its right to participate in certain business activities that its corporate actors are permitted to engage in outside of the company. These changes in the company’s governing documents would significantly lessen the fiduciary duty of loyalty the corporate actors owe to the company
Best practices for not getting sued for breaching fiduciary duties.
The rules for corporate actors who want to avoid breaching their fiduciary duties is akin to a business variation of “All I Really Need to Know I Learned in Kindergarten.”
1. No secrets – corporate actors should strive for transparency and disclose any/all significant matters regarding the business to all stakeholders — officers, directors, shareholders, managers, or other partners. These disclosures should include: bad operating results, business opportunities, material information, profits, compensation plans. Keep open books and make sure all decisions are made with full information.
2. Ask permission not forgiveness – breaches of the duty of loyalty — self-dealing and usurping opportunities — are allowed if certain clear rules are followed in advance. In short, corporate actors should seek permission before engaging in any corporate deals in which they have a personal stake. This request for written permission should be sought and obtained in advance from uninvolved directors, partners, or shareholders after unconditional full disclosure. Corporate actors should ensure that the company is keeping clear, accurate corporate records with many signatures detailing exactly what happened.
3. Company property (and opportunities) belongs to the company – corporate actors must avoid the temptation to save on their taxes and keep their business and personal expenses completely separate. All compensation plans should be approved by the Board and company credit cards must not be used to pay for personal expenses, even as a convenience.
As this discussion points out, the rules are simple and straightforward for corporate actors to follow who wish to fulfill their fiduciary duties to the company. Following these rules won’t prevent bumps in the road from happening, but corporate actors who do follow them should be able to maintain relationships with investors that are free of distrust and to avoid unexpected surprises that create frustration and disappointment.