A PRIMER ON HOW OBLIGATIONS OF TRUST TO SHAREHOLDERS AND MEMBERS RESTRICT WHAT ACTIONS CORPORATE/LLC DIRECTORS, MANAGERS AND OFFICERS MAY TAKE.
WHY DO CORPORATION AND LLC DIRECTORS, MANAGERS AND OFFICERS HAVE FIDUCIARY DUTIES LIKE A TRUSTEE? When investors buy or pay for equity interests in an LLC or corporation, they are giving their money to the managers or directors of that entity trusting that the funds will be used in managing and furthering the entity’s business. In this way, LLC managers or corporate directors act like trustees or fiduciaries for the equity holders—and can also be deemed to be fiduciaries for other stakeholders including creditors or consumers. Directors and managers appoint officers to carry out the business activities under their oversight, and officers thus likewise owe these duties. These fiduciary duties typically are imposed under state statutes and caselaw, and the rules can vary from state to state depending on where the business is formed.
CORPORATION DIRECTORS AND OFFICERS, AND LLC MANAGERS AND OFFICERS, ARE THE ONES HOLDING FIDUCIARY OBLIGATIONS TO EQUITY OWNERS. In corporations, directors typically operate within a Board of Directors, which appoints officers. In LLC’s, the managers typically are the officers, and thus have both day-to-day control in addition to general oversight of the LLC’s activities.
The two essential duties that managers and directors will typically owe are, first, a duty of care, requiring that the fiduciary be informed and act with care when making decisions, and, second, a duty of loyalty, requiring that the fiduciary act in the best interests of the business entity, rather than in their own personal interest. Courts sometimes expand on these two essential duties, such as by finding a duty of good faith, or a duty to disclose, but such additional duties typically are just variants of the essential ones of care and loyalty.
WHAT A REASONABLE PERSON MIGHT DO IS THE STANDARD FOR REVIEWING WHETHER A FIDUCIARY BREACHED THE DUTY OF CARE. Most states have codified the directors’ and managers’ duties of care to require them to act with the care that a person in a like position would reasonably believe appropriate under similar circumstances. A director or manager breaches the duty of care by failing to take action in a situation where a reasonably careful person would have taken action, but not all decisions are always scrutinized for their reasonableness.
Taking risk is at the heart of nearly every business, just as risk is part of the equity holders’ own decision to invest into that business. For the good of the business entity the directors and managers need broad authority and freedom to undertake initiatives and to make decisions without fear of liability if a decision turns out to be a wrong one. The laws concerning fiduciary duties are drawn from the expectation that directors and managers take on a position of trust, but they are tempered by the knowledge that taking risks is the source of nearly all business rewards.
There is no fiduciary duty requiring the director to always be right, or for the manager to always make the best decision. Courts are often careful not to impose liability for a decision that seems wrong only in hindsight. State laws gives fiduciaries the flexibility needed to run the business successfully through the “BUSINESS JUDGMENT RULE”. The business judgment rule presumes that directors, managers and officers comply with the duty of care and imposes liability only for breaches committed with gross negligence. Further, most states allow the corporation’s articles of incorporation or LLC articles to eliminate or limit directors’ or managers’ personal liability for money damages to the business entity or its owners for breach of their duty of care, other than breaches committed in bad faith or under circumstances where a conflict of interest exists, both of which invoke the duty of loyalty.
The duty of loyalty is much different: THE DUTY OF LOYALTY REQUIRES DIRECTORS TO ACT IN GOOD FAITH FOR THE BENEFIT OF THE BUSINESS AND ITS OWNERS RATHER THAN FOR THEIR OWN PERSONAL INTERESTS. The duty of loyalty embodies not only an affirmative duty to protect the interests of the corporation, which is the purpose of the duty of care, but also an obligation to refrain from conduct that would harm the business and its owners.
Breaches of the duty of loyalty are treated more seriously than breaches of the duty of care in terms of both the initial standard of review and the consequences of a breach. Decisions or transactions involving a breach of the duty of loyalty, including a conflict of interest, are not generally protected by the business judgment rule. If the directors hold a personal interest in an action, either because the directors either appear on both sides of the transaction, or the directors expect to receive a personal financial benefit due to self-dealing, as opposed to a benefit for the corporation or all stockholders generally, a court will not presume they acted in the best interest of the corporation.
One way in which the duty of loyalty may be breached is if a director, manager or officer usurps a corporate opportunity. “CORPORATE OPPORTUNITY” is an opportunity for the business that can’t permissibly be steered away from the corporation or LLC for reasons of personal self-interest. Courts analyze several factors to determine whether a corporate opportunity rightfully belongs to the business, such as (i) whether the opportunity is in the same line of business as the LLC or corporation’s or arises because of the businesses’ goodwill; and (ii) whether the corporation would actually be financially and practically able to take the opportunity had it been presented.
HOW TO AVOID LIABILITY FOR BREACH OF FIDUCIARY DUTIES? Only equity owners who do not control company decision-making can make a claim for breach of a fiduciary duty, so one obvious way to avoid liability is to avoid bringing on additional shareholders or members. When there are a number of equity owners, courts hesitate to substitute their business judgment for the directors’ or to question business decisions with the benefit of hindsight, unless the decision of the board cannot be attributed to any rational business purpose. Directors and LLC managers have a duty to inform themselves before making a business decision. Directors can rely on information and opinions from consultants, management, and employees, but they must make a good-faith determination that those persons can competently produce the reports and make the analyses on which the board relies. Good faith is another defense. To act in good faith, a director or manager must act with honesty of purpose and in the best interest of the company.
ANOTHER WAY TO AVOID LIABILITY IS DON’T BE A FIDUCIARY. By contrast to directors, members and officers, those who merely own equity in a company typically have just two fundamental rights: (i) to elect directors or managers of the company; and (ii) to exit the company by selling their equity. Some groups of equity holders prefer to engage outside, or professional, managers for the companies they own—and one reason is to avoid the obligations of a fiduciary to other equity owners.