Originally published by Winstead.
In February 2009, Pittsburgh Steelers wide receiver Santonio Holmes made a toe tapping catch in the back corner of the end zone[1] to secure a thrilling, come-from-behind win and crush the hearts of Arizona Cardinals fans in Super Bowl 43. For private company owners running their own firms, the boundaries for their conduct are set by the fiduciary duties they owe to their companies. But in both sports and the management of private businesses, team leaders can find it challenging to remain in bounds. This post therefore reviews the legal lanes of proper conduct that owners will want to follow to avoid future claims.
The Scope of Fiduciary Duties
The fiduciary duties of corporate directors and officers are not included in the Texas Business Organizations Code (“BOC”), but Texas case law for more than a century makes clear that both directors and company officers owe duties of obedience, care, and loyalty, and these duties are owed to the company, not to the individual shareholders. See Tenison, v. Patton, 95 Tex. 284, 67 S.W. 92 (1902); Ritchie v. Rupe, 443 S.W.3d 856, 868 (Tex. 2014). These same fiduciary duties also apply to LLC managers and officers, and all of these parties are referred to in this post as “control persons.”
The Ritchie case focused on whether minority shareholders have a legal right to secure a court-ordered buyout of their minority ownership interest based on claims that control persons engaged in shareholder oppression. The Court held no claim for shareholder oppression exists in the BOC or at common law that would authorize a trial court to order the company or majority owners to buy the minority owner’s stake in the business. But, the Ritchie Court did uphold the right of minority shareholders to pursue claims against officers and directors for breach of their fiduciary duties, and recognized that these claims could be brought on a derivative basis. In this regard, the Court stated that:
“Directors, or those acting as directors, owe a fiduciary duty to the corporation in their directorial actions,
and this duty “includes the dedication of [their] uncorrupted business judgment for the sole benefit of the corporation.” 443 S.W.3d at 868.
The BOC permits the fiduciary duties of control persons to be limited in the company’s governance documents, but the statute does not permit a company to remove the duty of loyalty owed by control persons. The remainder of this post focuses on what the duty of loyalty requires from governing persons in their business relationship with their companies.
Conflicts Transactions by Control Persons Can Lead to Claims
Owners of private companies commonly engage in transactions with their businesses in their capacity as control persons. Majority owners may buy, sell and lease property from or to their companies, buy and sell products or services from other businesses they also own or control, and loan money to their companies to fund their business operations. All of these transactions are not at “arm’s-length” and, instead, they are “interested party” transactions, which are sometimes referred to as “conflict transactions.” These types of conflicts transactions may result in claims by the minority owners who allege that the transactions breached the control person’s fiduciary duties because they were not fair to the company.
Once again, the Supreme Court in Ritchie addressed this problem:
[T]he duty of loyalty that officers and directors owe to the corporation
specifically prohibits them from misapplying corporate assets for their
personal gain or wrongfully diverting corporate opportunities to themselves.
Like most of the actions we have already discussed, these types of actions
may be redressed through a derivative action, or through a direct action
brought by the corporation, for breach of fiduciary duty.
443 S.W.3d at 887.
There is a “safe harbor” provision in the BOC for company control persons when they engage in business with their company for their personal benefit. Section 21.418 of the BOC provides that when a control person enters into a transaction with the Company, which would otherwise be void or voidable, the transaction will be nevertheless be upheld as valid if certain conditions are met. We discussed this safe harbor statute in more detail in a previous post. https://www.winsteadbusinessdivorce.com/2019/04/when-temptation-trumps-restraint-limits-of-the-protection-of-llc-managers/ In summary, a conflict transaction by a control person will be upheld if (i) the details of the transaction were fully disclosed to and approved by a majority of the shareholders and/or by a majority of the disinterested directors or (ii) if the transaction is deemed to be objectively fair to the company.
Fairness is not defined in the BOC provisions, but fair is defined in Webster’s dictionary as “characterized by honesty and justice” and “free from fraud, injustice, prejudice or favoritism. Once the minority shareholder brings a claim and demonstrates that a control person engaged in a conflict transaction, the control person will then bear the burden of demonstrating in the case that the terms of the transaction were fair to the company. To avoid being forced to litigate the issue of fairness, control persons may want to avoid the following types of conflict transactions or, alternatively, they may want to take steps to head off the expected challenge from minority owners that the transaction was not fair to the company.
[1] Cardinals fans like me continue to question whether Holmes actually managed to get his right toes down on the turf in the end zone before he was pushed out of bounds, and photographs of the catch prolong this debate.
Curated by Texas Bar Today. Follow us on Twitter @texasbartoday.
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