Don’t Get Caught With Your Hand In The Cookie Jar

Fiduciary Duties of Directors and Officers of Closely Held Corporations

As a controlling shareholder of a closely held corporation, were you ever tempted to take a higher salary in a profitable year even if it meant decreasing bottom-line profits available for distribution to other shareholders? Were you ever tempted to do a “side job” and take cash for yourself, rather than running business through your corporation? Have you ever claimed lack of knowledge of internal financials and tax returns as a defense against early detection of wrongdoing? If so, think again before acting on these temptations, as you don’t want to end up in court.

Corporate directors and officers have legal and ethical obligations to the corporation called fiduciary duties. These duties demand that directors and officers act, at all times, in the best interest of the corporation. The same fiduciary duties exist for directors and officers of large, publicly traded corporations and smaller, closely held corporations (CHCs). However, in the majority of states, courts hold directors and officers of CHCs to a higher standard due to the potential for wrongdoing with regard to minority shareholders.

There are a few key differences between publicly traded companies and CHCs that justify enhanced fiduciary duties in CHCs. First, most shareholders in publicly traded companies do not have an active role in the management of the corporation. (In a publicly traded company, the shareholders elect the board of directors to manage company policy. The directors then select officers to carry out the resolutions of the board.) In contrast, directors and officers of CHCs often wear multiple hats. Shareholders commonly act as directors and officers of the corporation. Potential for abuse increases when control of corporate matters is concentrated in the hands of a mere few.

Second, a shareholder’s investment in a publicly traded company usually comprises only a portion of his or her net worth (like owning Coca-Cola stock). In contrast, a shareholder’s interest in his or her CHC is often the largest asset in their personal estate. Further, shareholders who actively participate in the business often rely on the corporation for their annual income.

Third, shareholders of CHCs rely more on existing non-business relationships (i.e., familial relationships) than on fiduciary duties to ensure that all shareholders are treated fairly. Therefore, CHC shareholders often fail to contractually formalize director, officer and key employee obligations. When business is good and everyone is making money, this loose setup often works just fine. However, when a sudden change in ownership (due to incapacitation or death) or in economic conditions occurs, and there’s less money to go around, business relationships become tense, even among family members. Shareholders in desperate situations may be tempted to put their own interests ahead of the company and other shareholders.

To prevent a suit for breach, directors and officers of a CHC must understand their fiduciary duties. In turn, shareholders must understand when they have a cause of action against a director or officer.

Fiduciary Duties

Duty of Care
In most jurisdictions, the duty of care encompasses many responsibilities, including duty to monitor, duty of inquiry and duty to make reasonable decisions. Directors and officers must take an active role in the management of the business. They must attend board meetings, keep and review minutes of board meetings and have knowledge of, and ensure the accuracy of, company books and records, including tax returns.

Duty of Loyalty
The duty of loyalty ensures that directors or officers do not engage in self-interested transactions. They cannot use their positions for personal financial gain. If a conflict of interest arises, they have a duty to disclose this to their fellow shareholders.

Duties Applied

The majority of states apply enhanced, partnership-like fiduciary duties to directors and officers of CHCs, primarily to protect the interests of minority shareholders. This trend was initiated in the 1975 Massachusetts case of Donahue v. Rodd Electrotype Co. of New England. In Donahue, a minority shareholder sued two director- shareholders for breach of fiduciary duty when the director- shareholders caused the corporation to redeem their father’s shares but refused to redeem the minority shareholder’s shares at the same price. In requiring that the corporation buy back the minority shareholder’s shares at the same price for which the corporation redeemed the exiting father’s shares, the court insisted that, like partners in a partnership, shareholders of a CHC owe one another the finest degree of loyalty.

Since 1975, most states followed the precedent set by Massachusetts in Donahue in holding that controlling shareholders owe fiduciary duties to the corporation and to the minority shareholders. Controlling shareholders need not own a majority of shares to be controlling. Some states take the precedent in Donahue a step further and hold that all officers, directors and shareholders (even minority shareholders) are fiduciaries of each other. This extension of fiduciary duties to minority shareholders is similar to partnership law in that all partners owe a duty not only to the partnership, but also to their fellow partners.

The minority approach, led by Delaware, applies fiduciary duties more like publicly traded companies than partnerships. In these states, controlling shareholders owe fiduciary duties to the corporation, not to other shareholders individually.

Common Breaches

  1. A controlling shareholder prevents a minority shareholder from becoming a director or officer.
  2. A controlling shareholder prevents a minority shareholder from exiting the business by refusing to buy out shares.
  3. A controlling shareholder refuses to distribute profits.
  4. An individual votes to increase one’s own compensation to the detriment of other shareholders (i.e., taking an excessive salary rather than letting profit drop to the bottom line and distributing profits according to the pro rata share).
  5. An individual uses corporate funds to purchase unneeded assets rather than letting profit drop to the bottom line, again, preventing opportunity for distribution.
  6. An individual takes business away from the corporation by doing a “side job” instead (often reported on Schedule C of 1040).
  7. An individual fails to have general knowledge of the books. Failure of directors and officers to keep up with books and records negatively impacts the corporation. For example, when directors and officers fail to recognize that a bookkeeper has been embezzling or that the company’s 941s haven’t been paid in months, this drains company funds. As such, the company has fewer funds available for distribution to shareholders.
  8. An individual refuses to give all directors or officers roles in decision making. This is common when a founder of the corporation begins to transfer shares to family members. If new shareholders take active roles and are made directors or officers, a founding shareholder cannot continue to dictate. All shareholders’ personal financial situations are at stake.

The first four points in the previous list are common ways to “freeze out” minority shareholders. Courts may consider these actions a breach of controlling shareholders’ fiduciary duty of loyalty to minority shareholders. Many courts demand specific performance. A controlling shareholder accused of breach has the burden of proving he did not breach his fiduciary duty by demonstrating that his actions had a “legitimate business purpose.” Generally, the statute of limitations for bringing an action for breach is three years.

Duty to Creditors in Insolvency

Director and officer fiduciary duties extend to creditors when the corporation becomes insolvent. Once insolvency occurs, creditors, rather than the shareholders of a corporation, stand to gain or lose from corporate actions taken during insolvency. Creditors have standing to sue the directors and officers for breach of fiduciary duty for actions taken which decrease the corporation’s value (for example, unnecessarily selling or risking the corporation’s assets). Recent court cases have further defined the scope of fiduciary duties owed to creditors, but this area of law remains shaded with gray.

In the 1992 case of Geyer v. Ingersoll Publications Co., the Delaware court decided that the duty to creditors is triggered at the moment of insolvency rather than the filing of an insolvency proceeding (i.e., bankruptcy filing). Therefore, creditors have a standing to sue before bankruptcy is filed. But when does the actual moment of insolvency occur? Courts have considered a corporation’s cash flow situation and ability to pay debts on time as just a few factors to determine when insolvency has occurred.

The Delaware Supreme Court narrowed creditors’ rights to sue for breach of fiduciary duties in North American Catholic Ed. Programming Foundation Inc. v. Robert Gheewaller (2007). It restricted a creditor’s right to bring direct suit against the directors and officers for breach either when the corporation is insolvent or in the “zone” of insolvency. The court differentiated between insolvent corporations and corporations in the zone of insolvency, in holding that creditors have the right to bring a derivative suit for breach on behalf of the corporation when the corporation is insolvent (but not in the zone of insolvency).

Many jurisdictions have followed or referred to the law decided in Delaware. To protect themselves against liability, directors and officers should begin to consider the effect of their actions on creditors even before the company is insolvent. When the corporation is in the zone or vicinity of insolvency, creditors will begin to look for methods to protect the value of the corporation. Even if directors and officers are confident that their actions would pass muster by the court, no one wants to deal with an unwanted lawsuit.

Now, more than any other time in recent history, small business owners must think of creative ways to increase and retain their livelihoods. Shareholders of CHCs have an obligation to consider the well-being of a corporation, as well as their fellow shareholders (in most states), BEFORE looking at their own self interests. A controlling shareholder does not want to get caught with his hand in the cookie jar. With fewer cookies to go around these days, minority owners will first look to who was in control of the kitchen when they find nothing but crumbs in the jar!