By Kelly Knotts
Fiduciary. The term applies broadly to cover all types of companies, as well as spouses in marriage, and is defined as “of, relating to, or involving a confidence or trust.” In the private business context, the company’s shareholders or members trust that their directors, managers and officers will make good faith decisions and act with loyalty to the business. When company leaders breach this trust and violate their fiduciary duties, however, they may become personally liable for any damages resulting from their improper conduct. This post focuses on the fiduciary duties that apply to private company leaders and reviews the legal guideposts that will help these company leaders, as well as the company’s shareholders and members better understand what constitutes compliance with these fiduciary obligations.
The Core Fiduciary Duties
Regardless of the entity structure, Texas law imposes fiduciary duties on company directors, managers and officers, which they owe to their company. Apart from Texas law, the fiduciary duties owed by company leaders are also typically addressed in the company’s bylaws, agreements, or regulations. What precisely are the fiduciary duties that Texas law imposes on business leaders, and do they vary based on the role as director, officer, or manager? The remainder of this post takes a closer look at these fiduciary duties.
- The Duty of Care
When making decisions for the company, the directors, managers, and officers are expected to exercise and adhere to the standard for the “duty of care.” Under Texas law, this duty is generally described as the obligation to use the amount of care an ordinarily careful and prudent person would use in similar circumstances. Gearhart Indus., Inc. v. Smith Intern., Inc., 741 F.2d 707, 720 (5th Cir. 1984). The decisions that company directors, manager, and/or officers make on behalf of the company involve a certain amount of risk as they seek to act for the benefit of the company. Recognizing that directors, managers and officers must make decisions for the company that cannot be fairly judged with the benefit of hindsight, Texas law applies the “Business Judgment Rule” to protect company leaders in their decision-making process. The Business Judgment Rule specifically precludes directors, managers, and officers from being held liable for business decisions that turn out poorly provided that they acted in an informed manner an on a good faith basis. To overcome the Business Judgment Rule as a defense, a shareholder or member who desires to assert a claim against a governing person at the company is typically required to show that this company leader engaged in self-dealing or other bad faith conduct. “. . . the Texas business judgment rule precludes judicial interference with the business judgment of directors absent a showing of fraud or an ultra vires act. If such a showing is not made, then the good or bad faith of the directors is irrelevant.” Gearhart Indus., Inc. v. Smith Int’l, Inc., 741 F.2d 707 (5th Cir. 1984);
The Texas Business Organizations Code does permit a company to limit or even eliminate a director’s personal liability for money damages to the company or its shareholders or members for breaches of their duty of care. Tex. Bus. Orgs. Code § 7.001. These so called “exculpation clauses” do not eliminate the fiduciary duty of care, but by limiting or eliminating the remedy of a cash payment for the breach of this duty, the practical effect is the same (a breach of the duty of care could give rise to non-monetary damages even when the company’s governing documents include an exculpation provision).
- The Duty of Loyalty
The duty of loyalty imposes upon directors, managers and officers the obligation to act in good faith for the company’s benefit. Loy v. Harter, 128 S.W.3d 397, 407 (Tex. App.—Texarkana 2004, pet. denied). Commonly, the duty of loyalty prohibits self-dealing, or engaging in a transaction for the personal benefit of the director, manager or officer rather than for the company’s benefit. The duty of loyalty also bars directors, managers and officers from usurping corporate opportunities for themselves, because they are not permitted to obtain a personal profit or advantage at the company’s expense. Notably, the duty of loyalty is not limited to instances of self-dealing, and courts have found the duty of loyalty is also violated when there is a failure to engage in any director oversight (for example, if a board completely abdicates its responsibilities and fails to exercise any judgment), which reflects the absence of good faith.
Unlike the duty of care, the Texas Business Organizations Code does not allow a company in its governance documents to eliminate the duty of loyalty owed by officers, directors, or managers or to exculpate them from liability for engaging bad faith. However, when a director, manager or officer fully discloses a corporate opportunity to the company when it arises and the company declines the opportunity, the governing pension is permitted to proceed with the opportunity without breaching the duty of loyalty. Further, a company may properly renounce an interest or expectancy if it is offered an opportunity to participate in specified classes or categories of business opportunities that are presented to the company or to one or more of its officers, directors, or shareholders. Tex. Bus. Orgs. Code § 2.101(21).
- The Duty of Obedience
Under Texas law, the duty of obedience requires a director to avoid committing ultra vires acts—i.e. actions beyond the scope of the company’s powers in its governance documents and under Texas law. Although this duty of obedience is cited in Texas statutes (many other states do not have it), there are few cases in which a director or officer has been held liable breach of this duty, because most companies define the powers of company leaders expansively and also include broad company purposes in the certificate of formation. Further, a director or officer is not typically held personally liable for an ultra vires act of the company unless the act violates a specific statute or is against public policy, and the director or officer either directly participated in the act or had actual knowledge of the act. Resolution Trust Corp. v. Norris, 830 Supp. 351, 357 (S.D. Tex. 1993).
Director, Officer, or Manager—Do Duties Differ?
The core fiduciary duties are virtually the same for directors, managers and officers of corporations and LLC’s. With this backdrop, some of the types of conduct by directors, managers and officers that violate their fiduciary duties are set forth below:
- A corporation’s officers and directors who realized profits when they sold their personal stock at a price less than what the corporation was selling stock for at the same time. Int’l Bankers Life Ins. Co. v. Holloway, 368 S.W.2d 567 (Tex. 1963).
- Receipt of bonus payment from corporation where individual acted on both sides of transaction as president of the corporation and recipient of bonus and payment was not authorized (or even disclosed to) other director. Landon v. S & H Mktg. Grp., Inc., 82 S.W.3d 666 (Tex. App.–Amarillo 2002, no pet.)
- A corporate officer funding distributions by incurring unauthorized loans and failing to pay vendors. DeNucci v. Matthews, 463 S.W.3d 200, 204 (Tex. App.—Austin 2015)
- Although less common, primarily as a result of the common use of exculpation clauses, a breach of the duty of care may include situations where an officer, director, or manager fails to undertake a reasonable review of a corporate matter, fails to regularly, attend board meetings, or fails to adequately supervise staff which ends up damaging the corporation. ETRG Invs., LLC v. Hardee (In re Hardee), Nos. 11-60242, 11-6011, 2013 Bankr. LEXIS 949, at *1 (Bankr. E.D. Tex. 2013) (manager who entered into unauthorized lending relationship, diverted funds from the LLC, and failed to tender required tax payments to IRS on behalf of IRS).
On the other hand, shareholders generally do not owe fiduciary duties to the company or to one another, and although there is a dissenting view, it is generally held that members of an LLC do not owe fiduciary duties to the company simply by virtue of their member status.
Keeping in mind the core fiduciary duties that apply to private company leaders under Texas law—care, loyalty, and obedience—directors, officers, and managers of Texas corporations and LLCs should consider the following to avoid violating their fiduciary duties:
- Provide Full-Disclosure – if a director, manager or officer in a private company is going to engage in any type of business transaction with the company in which he/she has a personal interest, all details of the person’s interest in the deal must be fully disclosed to the other non-interested governing persons before the transaction takes place.
- Secure Approval from Disinterested Parties – for all transactions in which the director, manager or officer has a self-interest, the terms of the proposed transaction should be submitted for approval by other disinterested governing persons. The interested governing person should not seek to approve any transaction in which he/she has a personal interest even in the sincere belief the transaction is fair to the company.
- Hands Out of the Company Cookie Jar – In many cases involving breach of fiduciary duty claims against private company leaders, the shareholders or members allege that these governing officials misused company funds or property for their personal benefit. The message is clear. Company leaders need to be scrupulous in using the company’s cash, property and assets exclusively for company business. As just a few examples, company leaders should not: (i) have family members or friends on the company payroll unless they provide legitimate services for the business; (ii) use company assets for vacations; (iii) make loans to or receive loans from the company without written approval by disinterested parties; and in addition, (iv) company leaders should take steps to ensure their compensation, including their bonuses, are approved by disinterested parties.
As noted above, Texas law provides companies with the discretion to limit or eliminate the fiduciary duty of care by directors, managers and officers, but companies cannot also remove the duty of loyalty that applies to all governing persons. It is therefore essential for governing persons in private companies to review their company’s governing documents, and determine what fiduciary duties apply to them. As a general rule of thumb, if company leaders are mindful of the fact that as trusted directors, officers, and managers, they are required to act with honesty and candor and in the best interests of their business, their decisions as company leaders will likely naturally fulfill their fiduciary duties under Texas law.