If you’re from Detroit, or a Lions’ fan, you surely remember when Calvin Johnson made that great, game-winning catch against the Dallas Cowboys to put the Lions in playoffs. Except he didn’t. The referee threw a yellow flat and ruled it was not a valid catch, and it was not a valid touchdown. The NFL later changed the rule, so it would be a touchdown today. But little solace to the Lion fans.
How can you, as a private-firm owner running your own company, avoid the yellow flag? Thankfully, Michigan law describes the boundaries of your conduct as the fiduciary duties that you must honor to a number of people. But in both football and in managing private businesses, team leaders can find it challenging to remain inbounds. And the rules can change.
In this blog, I review the legal lanes of proper conduct that you will want to follow to avoid future fiduciary-duty claims.
How Broad are Your Fiduciary Duties?
Michigan case law for more than a century has made it clear that a company’s directors and company owe duties of honesty, care, and loyalty to the company, albeit not to the individual shareholders. Michigan law makes the same fiduciary duties applicable to an LLC’s managers and officers. In this blog, I refer to all of these folks as “control-persons.” If you own and operate a business, in this blog you are a “control-person.”
A recent Michigan case focused on whether minority shareholders may obtain a court-ordered buyout of their minority-ownership interest based on claims that control-persons engaged in shareholder oppression. The court held that Michigan law does not recognize claims for shareholder oppression that authorize a trial court to require the company or the majority owners to purchase the minority owner’s interest in the business. But the court did uphold minority shareholders’ rights to pursue claims against officers and directors for breaching their fiduciary duties. Moreover, it recognized that they could bring these claims on a derivative basis.
In Michigan, you can limit your fiduciary duties as a control-person by including appropriate language in an LLC’s operating agreement or a corporation’s shareholders’ agreement. But, and this is a big but, you cannot eliminate your duty-of-loyalty. I use the rest of this blog to focus on what your duty-of-loyalty requires from you as a control-person in connection with your business relationship with your companies and fellow investors.
Minority Owners can Claim that your Conflict Transactions Damaged the Company
Owners of private companies, as control-persons, often undertake transactions with their businesses. You may, for example, (i) buy, sell, and lease property from or to your company, (ii) have your companies buy and sell products or services from other businesses you own or control, and (iii) make personal loans to their companies to fund their business operations. None of these is an arm’s-length transaction — they are “interested-party” transactions, which can more pejoratively be called “conflict-transactions.” Moreover, minority owners may allege that, if you undertake a conflict-transactions, you breached your fiduciary duty to them and company, because the transactions were not fair to the company.
As expected, Michigan courts address this problem using a strict, factual approach. You owe a duty-of-loyalty to your corporation and fellow investors that prohibits you from (i) misapplying corporate assets for your personal gain, or (ii) wrongfully diverting corporate opportunities to yourself. Ask yourself, did you undertake the transaction with the company at terms consistent with the marketplace? Courts generally will uphold a conflict-transaction by a control-person if (i) you fully disclosed details of the transaction to, and it was approved by, a majority of the shareholders or by a majority of the disinterested directors or (ii) the court or jury finds that the transaction is objectively fair to the company.
Various cases define “fair” relative to the facts at issue, and Webster’s dictionary defines “fair” as “characterized by honesty and justice” and “free from fraud, injustice, prejudice or favoritism.” If a minority shareholder demonstrates that you engaged in a conflict-transaction, you have the burden of demonstrating that the terms of the transaction were fair to the company.
I always preach litigation avoidance. Well, to prevent these disputes from arising, you may want to (i) avoid engaging in the transactions that I describe immediately below, or (ii) to take steps in advance to counteract allegations by minority owners that the transaction was not fair to the company.
Real-World Types of Conflicts Transactions
The following are the most common types of conflict-transactions that I have seen in which control-persons engage with their companies. For each of these, I suggest an approach that should eliminate or reduce the potential for minority-shareholder claims.
The duty-of-loyalty prohibits control-persons from taking the company’s business opportunities for themselves. The technical, legalistic phrases for control-persons taking company opportunities is “usurpation” or “misappropriation,” and doing so is a breach-of-fiduciary duty.
It is not difficult, however, for you to anticipate and avoid this sort of claim. Your company can include an express waiver of the control-person’s duty not to usurp a company opportunity in its articles-of-organization, bylaws, or operating agreement. Your company’s articles, bylaws, etc. need to clearly identify the specific type or category of opportunities that are being excluded from the duty. If you include this limitation on the duty-of-loyalty, however, you should be immune from liability for usurping a corporate opportunity of the company as it is defined in the bylaws or in the provisions of the operating agreement.
Real property transactions with your company, and loans to your company
Control-persons often sell, purchase, or lease to or from their company (i) property, (ii) assets, or (iii) services. Similarly, they often provide loans to the company. These are all conflict-transactions that can give rise to claims for breach-of-fiduciary duty and disputes over whether the control-person engaged in a transaction that was unfair to the company.
To limit the fiduciary-duty claims related to this sort of transactions, you can take number of common-sense, practical steps before you engage in the transaction.
- Full Disclosure: fully disclose all material terms of the transaction to other shareholders, the board, and managers of the company and seek their approval. If you receive it, this should eliminate all future claims.
- Real-Estate Transaction: if others raise objections to the transaction, you could obtain objective information from outside, independent experts. For example, if you are selling or leasing property to the company, you can arrange for an independent appraiser to provide a written appraisal to set the property’s market value. If a lease of property is at issue, an independent broker can provide market-value lease rates for the type of property at issue.
- Loans: if you are lending the company money, bankers can readily provide loan terms that reflect market rates.
Finally, you should consider structuring the transaction to give the company terms more favorable than market rates. You don’t need to give the company a gift in the transaction, but it is harder for other shareholders or LLC members to complain that your transaction with the company was unfair if the company receives a deal that is better than fair-market rates.
Compensation and bonuses
Shareholders and members often pay close attention to how much money you are being paid in base compensation and bonuses in your capacity as an officer, director, or manager. They will argue that (i) the funds that you are paid in compensation should, instead, be issued as dividends or distributions to all owners, and (ii) the compensation that you are paid should be considered a “disguised distribution.”
If the other shareholders or members express concern regarding the compensation and bonuses that the company is paying you, you should hire an experienced and independent executive-compensation expert. The compensation expert can provide you and the company with a range of compensation that is being paid to executives at similarly-situated companies in the same or similar industry and geographic region. As noted above, rather than choosing a compensation/bonus level at the top end of the range that the expert determines, you are better advised to choose compensation in the 70-80% range to limit the likelihood of minority owners bringing a claim against you on this basis.
If you’re a control-person in a company that you founded, the company’s success may be primarily the result of your efforts. And it may seem unfair that you become subject to a co-owner’s suits for a breach-of-loyalty to the company. After all, in your mind, it is your company.
But you can catch that ball and score a touchdown and avoid that yellow flag by following the few simple ground rules set forth above. In short, you need to (i) be fully transparent in your transactions with the company, (ii) seek agreement when possible with other owners, and if an agreement is not possible, (iii) secure specific input from outside experts who can validate the fairness of the transaction to the company before it takes place.
If you have questions about fiduciary duty or other business-law matters, reach out 24/7 to George Law at (248) 470-4300. Our lawyers do not only practice business law, they teach business law.