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Part Three of a Series
Payne & Fears’ Business Litigation Group helps businesses and their owners with wide-ranging disputes. In our practice, we’ve noticed that in disputes among business partners there are common issues that often surface. This is part three of a series of articles highlighting some of the most common problems. The articles cover issues arising at several stages of the business relationship, from inception to ending the business. The topics in these articles are broadly applicable to all types of business entities from general partnerships, to LLCs, and corporations.
Business partners sometimes engage in conduct that benefits them personally. The negative impact of that conduct on their business often is not readily apparent. These less overt types of partner malfeasance may not constitute fraud, but they may still breach legal duties to partners or the company. These actions can result in partnership disputes down the line. This article discusses the most common problems and how to avoid them.
Who Owes Fiduciary Duties?
The law is set up to discourage business partners from taking advantage of their inside corporate positions. Fraud, of course, is legally proscribed, but perhaps the most important legal concept in this regard is the fiduciary duty. If you are in a fiduciary relationship, you owe fiduciary duties. Under California law, a fiduciary relationship is one in which “one of the parties is in duty bound to act with the utmost good faith for the benefit of the other party.” These duties prohibit certain transactions and conduct that, although possibly falling short of fraud, can still harm the business and subject partners to significant liability.
Do you sit on the board of directors or are you a controlling shareholder of your corporation? If so, you owe a fiduciary duty to the corporation and its shareholders. Are you a member of an LLC and charged with managing the business? Then you owe fiduciary duties to the company and your fellow members. Are you a partner in an LLP? Then you owe fiduciary duties to the partnership and likely to other partners as well.
The Duty of Loyalty: Three Common Breaches by Partners
The fiduciary duty imposes a variety of obligations, but perhaps the most important is the duty of loyalty. A fiduciary cannot use its position of trust to further private interests. In our experience, litigation often results from three common species of loyalty breaches: (1) self-dealing transactions, (2) usurpation of business opportunities, and (3) misappropriation of company funds for personal use.
Interested Transactions
Interested transactions or “self-dealing” transactions are subject to heightened scrutiny. The Corporations Code defines a self-dealing transaction as “a transaction to which the corporation is a party and in which one or more of its directors has a material financial interest.” Interested transactions often involve compensation or stock option agreements, buying or selling assets, leasing property, or vendor contracts.
While interested transactions are not per se illegal, they are scrutinized. For example, the Corporations Code permits approval of such transactions by the disinterested board or shareholders. This can be accomplished via board or shareholder vote. Otherwise, the interested director or shareholder can independently establish the fairness of the transaction if a dispute arises. The law similarly allows LLC members to get approval from disinterested members before engaging in a conflicted transaction, which can head off any future dispute.
Overall, to avoid disputes with partners over interested transactions, it is advisable for partners to seek formal approval before executing any agreement on behalf of the company that implicates the partner’s own personal financial interest.
Usurping Business Opportunities
Partners who owe fiduciary duties are also prohibited from pursuing, in their separate individual capacities, business opportunities that could have benefitted the company. When evaluating whether an opportunity belongs to the company, courts will determine whether the opportunity is reasonably incident to the company’s business and is one in which the company has the capacity to engage. For example, the opportunity to purchase an office building may be incident to the business of a realty company, but an interest in a tech startup likely would not be.
Before obtaining a business opportunity that belongs to the company for herself, a fiduciary should make full disclosure and give the company the first opportunity to pursue it. If the company elects not to pursue the opportunity, the fiduciary can do so.
Paying for Personal Expenses Using Company Funds
Business development is crucial for any business, and partners often are tasked with “wining and dining” customers. While such activities serve a business purpose, partners might take advantage of their expense account and begin charging personal expenses to the company. It is possible many or all l of the business partners engage in similar behavior. But this often comes back to haunt those partners who expensed personal charges when there is falling out and partners begin searching for partner misconduct to create leverage in their dispute. Indeed, charging personal expenses to the company may constitute not only a breach of a fiduciary duty, but also fraud, civil theft, and other legal claims.
Conclusion
The best medicine for potentially prohibited partner transactions is transparency. Partners can eliminate most, but not all, of their potential fiduciary duty liability by obtaining authorization from their partners for their proposed activities and transactions. If you have run into a partnership dispute involving potential breaches of fiduciary duty, please contact the business litigation attorneys at Payne & Fears.
