/>iThe one who has the gold often makes all the rules, but the majority owner of a private company who has minority partners in the business does not have complete freedom, because majority owners owe duties that apply to their operation of the company. Majority owners also typically serve as officers, directors, managers or partners in the business, and when they hold these governing positions, they owe fiduciary duties to the company.[1] The company bylaws (for corporations), the company agreement (for LLCs) and the partnership agreement (for LPs) may permit the company to restrict the scope of these fiduciary duties, but Texas law does not permit companies to eliminate the duty of loyalty that is owed by governing persons. This post reviews some of the ways that these fiduciary duties impact the way that majority owners can manage and direct their companies and avoid liability for claims by minority partners.
Majority Owners Must Treat Company Fairly in Business Dealings
As a general rule, the fiduciary duty of loyalty requires majority owners who act in a management capacity to put the interests of the company ahead of their own self-interest. More specifically, company officers, managers and directors cannot engage in one-sided transactions with the company (sales, purchases, leases, etc.) that provide them “sweetheart deals” that are more favorable than terms that are available in the marketplace, and they cannot take business opportunities for themselves that belong to the company. As just two examples, the majority owner cannot buy a tract of land or a piece of equipment from the company for a low-ball price, and similarly, the majority owner normally cannot buy a property next door to the company if it would deprive the business of the right to expand its operations.
The foregoing are general statements that apply to the conduct of majority owners, but they do have statutory and common laws defenses available when they face claims alleging that they breached their fiduciary duties. Specifically, under Sections 21.418 and 101.255, of the Texas Business Organizations Code (TBOC), also known as the Interested Director Rule, governing persons in corporations and LLCs — under certain conditions — are granted a “safe harbor” immunity when they engage in transactions with the business. This safe harbor applies to transactions when:
- The transaction was approved by a majority of disinterested directors with knowledge of material facts;
- The transaction was approved by a vote of shareholders with knowledge of material facts; or
- The transaction was objectively fair to the corporation when the contract or transaction was authorized, approved or ratified.
Thus, the safe harbor statue essentially requires the governing person to obtain advance approval for the transaction from disinterested parties at the company. If no vote happens on the transaction before it takes place, the governing person will have establish after the fact that the challenged transaction was fair to the company. In the absence of a vote held by disinterested parties approving the transaction in advance, the question of “fairness” will likely require a trial on this question rather than having the case dismissed by the court on a pre-trial motion based on the safe harbor provision.
The governing person can also assert the business judgment rule defense, which protects officers, directors and managers from claims for breach of fiduciary duties when the minority partner contends they were negligent, unwise or imprudent. The business judgment defense applies when the actions of the governing person were “within the exercise of their discretion and judgment in the development or prosecution of the enterprise in which their interests are involved” (Sneed v. Webre, 465 S.W.3d 169, 178 (Tex. 2015)). To overcome this defense, the minority owners generally need to show that the governing person engaged in some type of self-dealing that provided the director, officer or manager with a personal benefit.
Regarding the misappropriation of a corporate opportunity claim, the governing person also has several factual arguments available to assert in defense against this claim. These factual defenses include that the alleged corporate opportunity was not in the company’s line of business, that the company lacked the funds, personnel or other means needed to pursue the opportunity, or that the opportunity was not actually available to the company and could only be pursued by another party. Most of these defenses are fact intensive, and unless the facts are undisputed, a trial may be required to determine the outcome. Thus, to avoid having to prevail at trial in this type of dispute, a majority owner could choose to seek confirmation from minority partners that the opportunity falls outside the company’s line of business, or that it is not available to be pursued by the company for other reasons.
Majority Owners Have Discretion Regarding Distributions/Dividends
Another significant issue of concern to majority owners is whether they have complete discretion over the issuance of dividends/distributions. Most governance documents give full discretion to company management to decide whether to issue distributions, and if so, in what amount. Therefore, this is one area where the majority owners who are part of the management team have relatively unfettered authority. But most private companies are pass-through entities from a tax standpoint, which means that all owners are required to pay taxes on the company’s profits based on their specific percentage of ownership. As a practical matter, this tax obligation means that majority owners typically issue distributions each year, at a minimum, that will be sufficient to cover the income tax liability of all owners, including their own.
A related issue that arises in this context, however, is whether majority owners also have unlimited authority to issue bonuses to themselves for the services they provide to the business. Bonus payments to officers and other employees are not shared with the minority partners, who may not be employed by the company. The minority partners may therefore believe that bonus payments issued to majority owner/managers or officers are actually “disguised dividends” that should be issued as distributions, because bonus payments are not shared with the other owners.
The key question, then, is whether minority partners have a valid claim that a majority owner’s vote to issue themselves a bonus is a breach of the fiduciary duty of loyalty, i.e., that the issuance of the bonus is a self-dealing transaction. The Texas case law on this issue is fairly sparse, but majority owners can take specific steps to avoid or limit this claim. In this regard, the majority owner can direct the company to hire an outside compensation expert to provide a report regarding market compensation, and the company can make decisions based on this objective data. When management decisions regarding compensation/bonuses are based on reports from independent, third-party experts, these decisions should be protected by the business judgment rule, and a minority partner’s claim should not have much legal traction. This defense is even stronger when other directors or managers at the company (who are unrelated to the majority owner) also vote to approve the compensation or bonus paid to the owner.
Minority Partners Are Entitled Access to the Company’s Financial Information
Finally, majority owners need to keep minority partners reasonably informed about material events in the business. There can be debate about what level of disclosure is required, but minority owners have the affirmative right to insist on receiving information, particularly concerning the company’s financial performance. In most cases, the governance documents of the company, as well as Texas law, provide minority partners with the clear right to access the company’s books and records, including its financial information. The statute does require minority partners to have a proper purpose for seeking access to the company’s books and records, and courts should act properly to deny access when no proper purpose exists(seeTBOC Section 21.218 (for corporations) and Section 21.218(b) (for LLCs)). The “proper purpose” requirement is regularly given a broad interpretation, however, which includes requests seeking information necessary for the minority partner (or experts retained by the minority partner) to calculate the value of the minority partner’s interest in the business. Further, if the minority partner has to go to court to force the majority owner to provide access to the company’s books and records, and the court finds that the partner had a proper purpose and grants the request, the minority partner will be permitted to recover legal fees.
Courts will support companies when they seek to preserve their secrecy of confidential information, however, which includes preventing minority partners from misusing the company’s trade secrets and other business-sensitive information. This is handled through a protective order issued by the court in ongoing litigation, or in the absence of litigation, the company can request the minority partner to enter into a non-disclosure agreement. If there are disputes regarding the scope of restrictions requested by the company, these disputes may have to be decided by a court. A majority owner who requests the minority partner to agree to customary restrictions in this type of agreement to prevent the disclosure of confidential information is on solid legal ground.
Conclusion
Private company majority owners do call the shots in managing their businesses. But, when majority owners also have minority partners who have ownership interests in the company, the owners are subject to fiduciary duties that limit their discretion as directors, managers and officers. These fiduciary duties prevent majority owners from operating the company solely for their own benefit, and they also require the majority owners to provide minority partners with access to the company’s financial books and records when the partner has a proper purpose for seeking this information. Therefore, majority owners are on the best legal footing in dealing with their minority partners when (i) the owners seek advance approval for any transactions they enter into with the company, (ii) they base important management decisions on objective data from outside experts, including decisions relating to the award of compensation and bonuses, and (iii) they seek to apply reasonable restrictions that protect the company’s confidential information when their minority partners seek access to this information.
[1] The existence of fiduciary duties provides shareholders, members and limited partners of the company with the right to enforce these duties in claims against officers, directors, managers or general partners, which the minority owners can bring either directly or in derivative lawsuits filed in the name of the company.
