Originally published by Ladd Hirsch.
Last week, the Dallas Court of Appeals overturned a $98 million trial court judgment, which was based on a jury finding that BBVA had defrauded one of its commercial borrowers.[1] See BBVA Compass, et al. v. Bagwell, et al., Dallas App. Ct., No. 05-18-00860, December 14, 2020). The appellate court concluded the jury’s verdict had to be reversed because, as a matter of law, BBVA’s borrower could not have justifiably relied on allegedly false statements that had been made to the borrower by a representative of the bank. The Court’s holding and its focus on the element of “justifiable reliance” as a contractual defense to a fraud claim provides valuable guidance for private company majority owners in regard to their relationship with their minority business partners.
In light of the Bagwell decision, this post reviews key provisions that majority owners may want to include in their company governance documents to avoid future claims that may be made against them by their minority co-owners for fraud and/or for breach of the fiduciary duties that majority owners owe to the company acting in their capacity as governing persons. These provisions can be included in the company’s governance documents—in the by-laws of the corporation or in a company agreement for LLC’s—and they concern matters that frequently become the subject of disputes between private company co-owners.
Withholding of Profits Distributions/Dividends
One frequent area of conflict between majority owners and minority investors concerns the issuance of profits distributions. Private companies are typically “pass through” entities in regard to income taxes, which means that the business does not pay any taxes on the income that it generates and all taxes on the company’s income are paid by the business owners based on the percentage of their ownership interest. While majority owners may routinely issue distributions to the company’s owners to cover the amount of their tax liability that is attributable to income generated by the company, majority owners will want to retain flexibility to decide whether or not to issue profits distributions and, if so, in what amounts.
As just one example, when the company is experiencing growth, the majority owner may decide that the company should retain all or most of its profits to pay for expenses associated with this growth. The company’s governance documents should therefore make clear that the majority owner has total and complete discretion to decide whether or not to issue any profits distributions to the owners, and if so, in what amounts.
Including this provision in the governance documents will head off claims by minority partners, and specifically preclude them from successfully alleging they were defrauded by any statements the majority owner made regarding future profits distributions. Based on the recent BBVA decision, if this type of provision is included in the governance documents, a legal claim by a minority partner alleging that he or she was defrauded by the majority owner’s promises of future profits distributions should be summarily dismissed. In effect, this is an anti-fraud distribution provision that is designed to prevent a minority partner from successfully alleging a claim for fraud against the majority owner based on the owner’s decision to retain the company’s earnings and withhold issuing profits distributions.
Valuation Formula for Buyouts
Another frequent source of conflict between majority owners and minority investors concerns the price to be paid for the value of the investor’s ownership interest in the business when there is a buy-sell agreement in place that calls for the investor’s interests in the business to be purchased at the time of his/her departure. There are many different ways to calculate the value of the minority owner’s interest, but a common approach is for one or both sides to hire valuation experts to determine the value of the company and the specific value of the minority investor’s interest. The problem with this type of a valuation approach is that it can lead to an expensive, protracted battle of the experts, who will be arguing over the application of minority discounts, the correct percentage of personal goodwill and similar issues.
A different type of buyout provision that can avoid these conflicts is to include a specific, detailed formula the parties are required to use to calculate the value of the minority investor’s ownership stake in the company. In addition, the agreement will need to specify the timetable for payment of the purchase price and related issues such as interest and collateral. Developing this formula to include in the company’s governance documents will require time, effort and expense, because the majority owner will likely want to retain a valuation expert to assist in the creation of the formula. This upfront expense will be quite modest, however, in comparison to the legal and expert fees typically associated with the defense of a lawsuit over the amount to be paid to the minority investor in connection with a buyout of his/her ownership interest. Further, the majority owner may wish to direct the company to prepare and issue annual statements of the company’s value using this formula, which will make it difficult for the minority owner to object to the use of the formula at the time of his/her exit from the business.
Interested Party Transactions
Many business founders have multiple companies in which they are involved, and often, they are inter-related. These overlapping roles of the majority owner may give rise to concern by minority investors that the majority owner is acting with an improper conflict of interest. Texas law will not permit business owners to waive their fiduciary duty obligations when they act in a management capacity, but the parties can adopt provisions in their governance documents that expressly authorize the majority owner to own and actively participate in other businesses and to remove any liability on this basis.
Further, the majority owner can create what amounts to a safe harbor in the company’s governance documents from breach of fiduciary claims by minority investors who allege that the owner acted with a conflict of interest in his/her dealings with the company. Specifically, the governance documents can provide for the company to set up a special committee that is tasked with: (i) reviewing all interested party transactions between the company and the majority owner and his/her affiliated companies and (ii) making recommendations to the board or the managers as to whether it is in the company’s best interests to approve or reject the proposed transaction. Although following this process cannot prevent minority investors from making a claim against the majority owner, if the company adopts this approach, the minority investor will have a much steeper legal hurdle to surmount under Texas law to establish a claim for breach of fiduciary duty against the majority owner. These provisions are consistent with the Texas interested director statutes. See Tex. Bus. Org. Code (“TBOC”) §§ 21.551 and 101.451-463.
Power to Amend Company Governance Documents
Finally, as the company grows, the majority owner will likely need to modify the terms of the company’s governance documents to allow for the addition of new owners, to restructure the board or managers or to provide for different types of exit rights from the business. Under the TBOC, the default rule is that unanimous consent is required to change the company’s by-laws or the provisions of the LLC company agreement. This unanimous consent requirement can be modified, however, if the company’s owners agree to permit the company’s governance documents to be amended by a simple 51% majority of the ownership group, or if desired, by a super-majority, perhaps 66% or 75% of the company’s ownership.
The majority owner will not want to be hamstrung in the future when the time comes to revise the company’s governance documents by a requirement that permits these documents to be amended only by the unanimous agreement of all owners of the business. The process for amendment of company governance documents is often overlooked, but it is an important term that should be reviewed by the majority owner to ensure that it provides for both flexibility and continued control in managing the business on a long term basis.
Conclusion
The BBVA v. Bagwell decision continues a trend in Texas case law, which makes it more difficult for parties to successfully pursue fraud claims in litigation. Specifically, one clear take away from the Bagwell decision is that courts will not support fraud claims based on allegedly false statements that directly contradict the plain terms of the parties’ own written agreements. Courts are now holding that the element of “justified reliance” that is required to establish a fraud claim has not been met when the allegedly fraudulent statements are contradicted by the express terms of the parties’ contract.
For majority owners, the lesson from Bagwell is that courts will enforce the provisions of company governance documents in the same manner as any other contract entered into between business parties. Therefore, by including certain key provisions in the company’s governance documents, the majority owner may be able to entirely avoid or significantly limit the success of future claims for fraud or breach of fiduciary duties by minority co-owners in the business.
[1] With interest, judgment amount had grown to more than $110 million with interest by the time of the ruling.
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