September 9, 2013

Friction in the Family Business: When Fiduciary Duties Become Compromised

Holland & Knight Shareholder Rights Blog
Michael J. Zdeb

Many people ask, "What duties are owed to a family member who has an interest in the business?" Before getting into this important topic, it is critical to understand the legal nuances of a particular jurisdiction. A wide range of rules exist among the states and any specific discussion has to take these differences into consideration.

The business corporation, partnership and limited liability company statutes of each state have specific provisions regarding what rights a participant in the entity is due. Typically, these provisions relate to matters such as voting rights, rights of inspection of records, accounting privileges and notice of meetings.

Beyond statutory provisions, the common law of each state applies. One of the most critical elements of the common law relates to the nature of the fiduciary duties for those who are in control of an entity and what they owe to the entity. These duties generally are a duty of care, good faith and a duty of loyalty.

Directors and officers owe these duties to the entity, otherwise known as the collective of the owners. Partners owe these duties to the other partners. Managers have obligations to the company and members. In some jurisdictions, these duties are expressly acknowledged by statute and, in many instances, allowed to be defined or altered by express agreement of the participants.

How to Determine a Derivative Action

These duties can be enforced by a particular shareholder or member in actions that are called derivative. What is meant by this word? Derivative comes from an action that is brought to correct an act, such as a failure, in the name of the entity that affects all the participants. For example, if a manager takes an asset or opportunity for personal benefit, an individual member could sue for recovery. The recovery — a financial settlement, award or corrective action —would then benefit all.

However, there are times when a controlling person uses the corporate authority in such a manner as to cause an injury to a particular shareholder. When an action is brought in this type of case, it is not derivative for the collective but rather only for the aggrieved member. Any such action would be considered a direct action and would exist only if a duty to that individual existed that was different than duties owed to all participants.

For example, actions of overreaching one's corporate authority include excessive compensation for those in control, firing a shareholder whose compensation included a return on the equity, exclusion from participation rights and freeze or squeeze out actions that could result in a finding of a direct action by the aggrieved interest.

In addition, oppression is an example of direct action that is generally considered a statutory matter. Oftentimes, a direct action results from the judicial creation of fiduciary duties owed by those in control to the minority. In some states, courts have constructed duties that run from the majority in control to the minority members. These duties were created to protect those who are not in control from being abused or unfairly treated by those in control. For instance, if the majority used its authority to artificially depress the value of the business while trying to buy out the minority, a court could find this to be a breach of duty of good faith or loyalty. Such squeeze out actions can be remedied by the court by ordering a buy out at the price the court sees as a fair value. Fair value in such cases is usually an amount substantially different than what the majority was offering and could very well reflect a form of punishment without being expressed as such.

The Duty of the Family Member in Control

A family member in control of an enterprise would likely owe a duty to the other family member to avoid oppression and, therefore, must act in good faith. In certain jurisdictions, this means not engaging in conduct toward the other family member that would be unduly prejudicial of his or her interests, including not being harsh, unfair or setting unreasonable expectations.

Best Practices to Mitigate Family Business Conflicts

Each family business challenge in regards to fiduciary duties must be evaluated on the specific facts. However, there are certain patterns of conduct that can be a problem for those in control. Examples include actions to depress the value of the business while trying to buy a family member out at a low price; terminating employment of a family member whose only return on the equity has been in the form of compensation; and abusing rights to vote and obtain information. It is advised to mitigate these types of conflicts and actions before they arise. Experienced shareholder rights attorneys are well-versed in creating strategies to help a family business steer clear of these issues.

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