A business relationship can begin with the joy, excitement and thrill of a new marriage. Unfortunately, the honeymoon inevitably ends and disputes between the owners of the business may arise. Disputes may arise when one owner feels that another is acting in his own interest, at the expense of the company or his fellow shareholders. These disputes may be magnified when the business is owned by a small group of individuals or a family, what is known in the law as a “closely-held” company. Depending on the circumstances, such disputes may involve violations of an owner’s fiduciary obligations and may lead to costly payouts by the violating owner or even termination of the business. Like partners in a good marriage, business owners should start with a solid foundation and work consistently to ensure that they are meeting their obligations to each other and their joint adventure. Here are some ways to do that.
Fiduciary duties in a closely held business
First, a few definitions. Controlling shareholders, directors and officers in a closely held business have a fiduciary duty to the company and their other shareholders (or members in the case of an LLC) to act in a way that reasonably protects and conserves the company’s interests and which is in the interest of all the shareholders/members. This fiduciary duty requires, in turn, two further obligations: the duty of care and the duty of loyalty. The duty of care requires that controlling shareholders, officers and directors exercise the level of care that a reasonably prudent person would use under similar circumstances. The duty of loyalty means that controlling shareholders, officers and directors act with absolute fidelity and that they place their duties to the corporation or LLC above every other financial or business obligations. When speaking of this duty of loyalty, lawyers and judges often invoke the heady words of the early 20th century jurist, Benjamin Cardozo, who famously wrote that “not honestly alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.”
The consequences of breaching one’s fiduciary duty can be dire. For one, a shareholder, director or officer can be held personally liable for the results of that breach. If, for example, directors fail to exercise reasonable care and instead invest in a questionable deal which results in a $1 million loss to the company, they may be ordered by a court to pay that loss back to the company out of their own personal assets.
Similarly, fiduciaries cannot exercise their power to enhance their position to the detriment of the other owners. Breaches of this duty may be obvious. In a recent case, one business owner was accused by his fellow owner of routinely characterizing his personal expenses as business expenses, including the purchase of a Ferrari sports car, numerous personal travel, jewelry and clothing items, as well as funding a race car team maintained for his personal enjoyment. Other times the breach may be less obvious, including a fiduciary who increases her own salary to above-market rates to reduce the company’s profit and enjoy a greater share of the company’s success. In fact, the diversity of fiduciaries’ breaches are limited only by the limits of human creativity: diluting other shareholders without an authorized reason, opening up a side business that allows the fiduciary to divert company profits to himself personally, or even freezing another owner out of the business altogether.
Instituting safeguards to ensure that you are meeting your fiduciary duties
As a fiduciary, the best way to avoid breaching your duties is to put the company’s (and your fellow shareholders’) interests on at least the same level as your own. Some safeguards that you and your fellow officers, directors and shareholders can institute to help ensure you are meeting your fiduciary obligations include:
- Institute clear and complete company policies detailing the fiduciary responsibilities of directors, officers and controlling shareholders and making clear that the company will not tolerate violations.
- Have regular board meetings and attend those meetings. Take comprehensive minutes that accurately reflect the discussions and actions taken.
- Ensure that the business accurately reports its financials on a regular basis.
- If it becomes necessary to take actions that implicate your fiduciary duties, such as diluting other shareholders, modifying their salaries or starting a new business, you need to disclose these issues with your fellow officers, directors and shareholders. Disclose the facts that support your decisions as well as countervailing facts. You may need to retain experts, including lawyers, investment advisors, or appraisers, who can advise you on the relevant issues.
- Put contentious issues to a vote by the other fiduciaries, after disclosing all relevant facts, and remove yourself from the vote.
Whether the business becomes fruitful and goes on to celebrate many happy anniversaries depends, in part, on whether the owners honor their fiduciary duties to each other, their company and its shareholders. Although it is best to honor these duties from the moment one says, “I do,” it is never too late to do the right thing.