United States: Steering A Closely Held Company Clear Of Claims Of Breach Of Fiduciary Duty

Published: New Hampshire Association of CPAs Connection Newsletter

June 13, 2023

Lately, there seems to be a run on internal disputes between the owners of closely held companies who also serve as corporate officers and directors. Some of those disputes are between family members, others arise because for the first time in a long time money is tight and some disputes have been caused by the mismatch in the owners' business objectives (and work ethic). Whatever the source of the strife, however, the rules of engagement are the same when it comes to the decision making in a closely held company.

Officers and directors have a fiduciary duty to the company's shareholders and, sometimes, to its creditors.

Corporate officers and directors (and majority shareholders with the right to control the decision making) have a fiduciary duty to the company and the other shareholders (or members in the case of a limited liability company) to make decisions that reasonably protect and conserve the company's interests and are in the interest of all the shareholders/members.

So, what defines a fiduciary duty? Fiduciary duty is actually comprised of two separate duties: the duty of care and the duty of loyalty. The duty of care refers to the officer's or director's responsibility to exercise the level of care that a reasonably prudent person would use under similar circumstances. The duty of loyalty means the officer or director will be guided in their decisions by the company's best interests, not their own self-interest.

If someone with a fiduciary duty fails in that duty, they can be held personally liable for the consequences. Of course, a fiduciary may have spheres of influence and can be held individually liable only to the extent of their discretionary authority over, and power to influence, the company's relevant actions. Just to underscore the risk, if a director fails in their fiduciary duty to the company resulting in an unwarranted $1 million or greater loss, the director or officer could risk being held liable for that loss out of their own personal assets.

Likewise, the fiduciary is barred from exercising their power to enhance their position to the detriment of the other owners. For example, a fiduciary with the power to do so cannot raise their salary up to above-market rates in order to drain the company of profit so that they alone enjoy the fruits of the company's success. Firing or reducing another shareholder's pay or other job benefits to accomplish the same thing may also expose the decision maker to liability (and end up in expensive litigation where everybody loses except the lawyers). There are plenty of other misuses of a fiduciary's power that are considered actionable: diluting the other shareholders without an authorized reason, opening up a branch of the business that allows the fiduciary to divert profit elsewhere, or just outright diverting assets to the fiduciary's sole personal benefit (e.g., commissioning a pool in the fiduciary's back yard with the bills going to the company).

The business judgment rule.

Having in mind that an officer/director or shareholder in a closely held company cannot manipulate the corporate finances to personal advantage, the so-called business judgment rule insulates them from most claims of perceived fiduciary breach.

Under the business judgment rule, courts presume that a fiduciary makes their decisions in good faith, with the company's best interests in mind, after having reasonably assembled and considered adequate information. The rule is predicated on the belief that corporate fiduciaries, not litigants and the courts, are best suited to make good business decisions. The rule is designed to protect against directors and officers making overly conservative decisions. As a practical matter, the rule sets a high bar for a party seeking to pursue a fiduciary duty breach.

The presumption afforded by the rule can, however, be destroyed where a party rebuts the presumptions implicit in the rule. For instance, a fiduciary loses the benefit of the business judgment rule if it can be proven that the fiduciary failed to exercise reasonable care in securing and considering pertinent information-like, for example, securing a compensation expert's opinion to establish that the raise they gave themselves and their allies is reasonable. Likewise, the business judgment rule evaporates where the director or officer engages in self-dealing or where the questioned decision-making is grossly negligent.

Concluding thoughts.

The best way for a fiduciary to avoid liability is put the company's (and their fellow sharaeholders') interests on at least the same level as their own. It also helps to document one's exercise of prudent decision making. Have regular board meetings, with regular financial reporting and a means of assuring that the reports are accurate. Airing countervailing views about the need to dilute certain shareholder, to alter salaries or to start ancillary business in the context of a business meeting may be difficult and contentious-its also a lot cheaper than litigation. These discussion, of course, need to be fact based. This may require that the fiduciary retain experts (e.g., lawyers, investment advisors, doctors and property appraisers) who can advise on issues of concern.

In addition to having sufficient background information, the fiduciary needs to evaluate it fully, and with an eye to the best interests of the company, not their individual best interests (or their interest in punishing another shareholder).

Two further means of protecting against claims of breach of fiduciary duty (or at least the negative repercussion that flow from them are: 1) the inclusion of an exculpatory clause in the company's corporate charter or operating agreement; and 2) the purchase of appropriate officers' and directors' insurance.

An exculpatory clause that frees the officer and director from liability for negligent decision making further insulates the officer or director from personal liability. Such a clause cannot eliminate or limit the liability of a director: (i) for any breach of the director's duty of loyalty to the corporation or its stockholders; (ii) for acts or omissions not in good faith; (iii) for acts involving intentional misconduct or knowing violation of the law; or (iv) for any transaction from which the director derived an improper personal benefit. Simply put, an exculpatory claims largely eliminates claims based on the duty of care.

Finally, officers and directors should work with an insurance broker so that the company or they secure adequate coverage for any claimed errors and omissions they may make or be accused of making. In establishing coverage, be sensitive to who controls and is entitled to the policies benefits. It can be problematic if the policy is written in favor of the company and the company files for bankruptcy protection. Because Director and Officer policies can be complicated, determining the one that fits the circumstances will benefit from expert guidance.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.