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By Sean Brown and Ladd Hirsch

The majority owners of private Texas limited liability companies (LLC’s) enjoy a mixed blessing when they also manage their companies.  Majority owners have the power to direct their private companies as they deem fit, but when they disregard the interests of minority owners, they may breach their fiduciary duties to the company.  The members of member-managed LLCs and the managers of manager-managed LLCs owe their companies the fiduciary duties of care, loyalty and obedience under Texas law, which does not permit them to disclaim their fiduciary duty of loyalty.  This post discusses significant legal and business issues faced by managers of Texas LLCs in guiding their companies to success while striving to maintain good relations with their minority owners.

Three significant legal and business challenges that LLC managing owners confront are: (i) the degree of control and extent to which minority owners are permitted to block major company decisions, (ii) whether majority owners have total discretion over profits distributions or whether a minimum requirement exists that requires profits distributions and (iii) the level of financial reporting requirements and related issues of transparency.  In regard to these challenges, majority owners who do not unfairly exploit their control over the business, issue profits distributions when appropriate and engage in open communications are more likely to foster harmonious relations with all company owners through both good times and bad.

Veto Rights of Minority Investors

Majority owners must be careful when forming their companies to confirm who will have ultimate authority for decision-making. As a general rule, majority owners should give broad management authority to the company’s decision-maker.  However, certain management decisions will often require a supermajority or unanimous vote of the members or equity interests of the company, which gives veto rights to minority owners.

Majority owners should limit these “consent rights” of minority owners to material actions by the company that are outside the ordinary course of business.  Some examples of actions over which the minority owners frequently receive veto rights are: (i) the admission of a new member, (ii) issuing new equity interests in the company, or (iii) changes in redemption rights that affect the minority investor’s ownership interest. These consent rights do not impose significant constraints on the majority owners’ management of the company.  If majority owners are required to secure consent from the minority owners over recurring events that regularly arise in the day-to-day operations of the company, however, this will likely hamper management’s ability to meet the needs of the company’s clients and negatively impact the bottom line.

Discretionary Profits Distributions

Majority owners should also exercise caution in making the decision to distribute profits even when the LLC agreement gives majority owners absolute discretion over the issuance of distributions. Problems for majority owners may arise when the company is profitable and they retain all earnings, which require the company to issue K-1s that reflect “phantom income” assigned to the owners.  This assignment of phantom income will require the owners to pay income taxes on profits they never received from the company.  This is a legal gray area, because Texas courts have not yet held that the refusal by majority owners to issue distributions constitutes a breach of any fiduciary duty even if the company is profitable.

Two of the most common breaches of the fiduciary duty of loyalty by majority owners are: (1) using company funds or property for the manager’s own personal benefit (classic self-dealing) and (2) misappropriating a potential new line of business for the manager’s gain (usurping a corporate opportunity).  Even in the absence of clear Texas case authority holding that the failure to issue a profits distribution amounts to a breach of fiduciary duty, minority owners may claim a breach of fiduciary duty when majority owners refuse to issue any distributions from a profitable company.  In this circumstance, minority owners assigned phantom income that saddles them with substantial income tax liability may be disgruntled enough to file claims alleging breach of fiduciary duty against majority owners.  Therefore, even though it is not mandated by the LLC agreement, majority owners can head off a legal challenge by issuing distributions when the company is profitable that are sufficient, at a minimum, to cover the income tax liability of all owners.

Financial Reporting Requirements

Texas law requires LLCs to provide minority owners with access to the company’s books and records within a reasonable time upon written request.  See Section 3.153 of the Texas Business Organizations Code.  Most LLC agreements also include provisions that provide all owners with a similar right to obtain access to the company’s books and records, including financial statements and reports.  This is a minimum standard of disclosure, but it puts the onus on the minority owner to take steps to obtain access to information from the company.

To maintain good relations with minority owners, and before any request is made for access to books and records, the company’s management should take the initiative to provide written information/reports on a regular basis to all owners regarding the company’s financial performance and operations.  This type of reporting might seem unusual or unnecessary for a small, closely-held company, but providing transparency about financial matters in any company will help to maintain trust, build strong business relationships and avoid disputes among owners.

Similarly, most LLC’s are permitted to operate by written consent and forego holding any meetings of company owners.  For the same reasons that managers should consider issuing regular financial reports to all owners, managers also should give thought to scheduling and holding regular meetings of owners on least on an annual basis.  These meetings will provide all owners with the opportunity to hear management review the current financial performance of the business and discuss its future prospects.   Again, this type of transparency will enhance the majority owners’ business relationship with the minority owners.

Conclusion

The well-known expression that “power corrupts and absolute power corrupts absolutely” from 19th century British politician Lord Acton applies to the power wielded by LLC majority owners.  These majority owners may have absolute power when they manage the business, but their abuse of this power can have serious negative consequences if they breach their fiduciary duties.  Majority owners are therefore well-advised to: (i) manage the company without engaging in any self-dealing, (ii) issue profits distributions that cover the tax liability for all owners and (iii) provide regular reporting and routinely schedule owners meetings to review the company’s financial performance.   This approach to governance may help lessen the weight of the crown that majority owners wear when managing an LLC.  More importantly, this balance should help majority owners maintain solid working relationships with minority owners and thereby avoid claims that the majority owners breached their fiduciary duties as managers.