Small Business Corporate Governance: Fiduciary Duties

Flexible standards provide small business owners tremendous leeway in fashioning management rules.

In developing their enterprise, majority and minority owners need to take stock of fiduciary duties they undertake as a matter of law with respect to each other and the business, itself.

Once an enterprise has been incorporated, whether as a standard, share-issuing, corporation (“Standard C Corporation”) or a limited liability company (LLC”), the usual next step is to consolidate the enterprise’s ownership structure, i.e. will the enterprise be owned by a single shareholder or member or by a number of persons and, if by a number of persons.

How will those persons collectively manage the enterprise?

In answering this last question, management documentation should be consulted. In the case of a Standard C Corporation, the relevant document is the Shareholders Agreement, supplemented by the enterprise’s Bylaws. In the case of an LLC, the relevant agreement is called an Operating Agreement.

Generally, these management agreements do not have to be filed with the government authorities.

The best way of viewing them is as contracts between and among owners and their enterprise designed to serve as guidance on questions about how corporate decisions are made, how interests are transferred, and how profits and losses of an enterprise should be allocated.

State law

Generally, state law, which controls the formation and enforcement of such agreements, affords owners great flexibility in fashioning how the enterprise will be managed.

Where the owners of a Standard C Corporation or LLC fail to adopt management documentation, the default guidance is governing state law—the law of the state in which the enterprise was incorporated.

Basically, the flexible standards of corporate governance provide owners tremendous leeway in fashioning management rules, but there are some standards that cannot be altered, i.e. cannot be waived, or abrogated even if owners are in agreement that they should be.

This body of standards governs certain duties that shareholders, members and partners have toward one another, and to the enterprise, itself. They are, in legal parlance, called “fiduciary duties.”

As explained by one commentator, “[a] fiduciary duty is a duty or responsibility to act in the best interest of someone else.

The person who is duty bound to another person, in a fiduciary relationship, is called a fiduciary.” [1]  The fiduciary relationship is, essentially, one of a person’s dependence on another to do the right thing by them, where the latter holds a position of power and influence over events.

Whether a relationship is a “fiduciary” one can be a matter of judge-made or statutory law. In the corporate context, statutory law generally has defined the relationship between and among owners of an enterprise and between owners and the enterprise, itself, as a fiduciary one.

What are the fiduciary responsibilities that corporate owners owe to each another and the enterprise?

There are two broadly cast duties:

1. The duty of care: That the owners in managing the enterprise shall exercise that standard of care which an ordinarily prudent person would exercise under similar circumstances.

2. The duty of loyalty: That owners, managing the enterprise, shall make decisions in the best interest of the enterprise and not engage in conduct that would be considered self-dealing.

Sub-categories of duties that would fall into one or both of the broadly defined categories include the duty of managing shareholders or members to act in good faith and timely disclose to the other owners all the material facts or matters affecting the enterprise; the duty to account transparently for the profits and property of the enterprise; and the duty not to engage in conduct whereby an owner would misappropriate for themselves a corporate opportunity or otherwise precipitate conflicts of interest that could harm the interests of the other owners.

According to the Model Business Corporation Act  and the Revised Uniform Limited Liability Company Act (ULLCA)—model codes developed by the National Conference of Commissioners on Uniform State Laws– on which most state corporate codes are based–the duties of  care and loyalty cannot be waived by owners of an enterprise or abrogated by freely-entered-into contractual arrangements among owners.

As expressly stated in the ULLCA, “[a] member of a member-managed limited liability company owes the company and . . . the other members the fiduciary duties of loyalty and care . . .”  In sum, the duties of care and loyalty imposed by the statutory codes define acceptable conduct in the corporate context. Breach of these duties by corporate owners, who also manage their enterprise, can result in lawsuits against them by other owners and even by the enterprise, itself.

The take away

The take away, here, is that in the case of a small, start-up enterprise comprised of a majority owner, holding predominant control over the management of the enterprise, it is critical for minority owners to understand that the principal owner does not have unfettered power to conduct themselves in any manner they choose.

Rather, their conduct is necessarily circumscribed by the non-waivable fiduciary duties they owe to other owners as well as to the enterprise.

Conversely, from the standpoint of owner-managers of an enterprise, it is critical to have operating procedures in placed to ensure that minority owners are timely informed regarding the enterprise’s health; that distributions of profits are fair, and that decisions made on behalf of the enterprise are being taken with the full knowledge of minority owners, regardless of the level of their shareholder or member interest in the enterprise or their level of activity.

Even a 1% owner of an enterprise can have a claim for breach of fiduciary duty.

The failure of majority owners to consider the impacts of their decisions on minority owners, on the theory that their control over decision-making obviates their need to consider matters of fairness and conflict of interest, can open themselves up to allegations that could result in significant civil and even criminal liability.

[1]Breach of Fiduciary Duty: Everything You Need to Know, Upcounsel [https://www.upcounsel.com/breach-of-fiduciary-duty, Online 2019]

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