Introduction
Standing alone, the concept of fiduciary duty is relatively easy to understand. However, recognizing the circumstances and fact patterns where participants in a closely-held corporation typically fall short of fulfilling that duty is an essential risk management tool for the small businessperson.
The Basics
The term "fiduciary duty" is often used in discussing the standard of care and loyalty applied by the Courts to stockholders, officers and directors in closely-held corporations. The fiduciary duties of directors, officers and other decision-makers in an organization fall broadly into two categories: a duty of utmost care and good faith, and a duty of undivided loyalty to the corporation and its shareholders.
As a concept, it has risen to the level of the "golden rule" by which all conduct of participants is reviewed. While this "rule" is well developed in the law and well understood by business people and lawyers alike, there is an inexhaustible and ever developing list of circumstances to which the fiduciary duties of participants in a closely held corporation are implicated. For the officer, shareholder, and director of closely held companies, in particular, understanding fiduciary duty obligations, and the settings which they typically arise, is imperative to avoiding business disputes.
Simply put, there is an obligation under the part of each stockholder to exercise the utmost good faith and loyalty to each other stockholder. Stockholders in a close corporation may not act out of avarice, expediency or self-interest in derogation of their duty of loyalty to the other stockholders and to the corporation. This intense fiduciary duty is designed to prevent the unique opportunities available in close corporations to oppress or "freeze out" minority interests.
Judge (later Justice) Benjamin Cardozo's recitation of the standard of care owed by a participant in a joint venture is still frequently applied to directors, officers or shareholders of closely held corporations:
Joint venturers, like co-partners, owe to one another, or the enterprise continues, the duty of the finest loyalty. Many forms of conduct permissible in a work-day world for those acting at arms length are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone but the punctilio of an honor the most sensitive is then the standard of behavior. As to this, there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitions to undermine the rule of undivided loyalty by the ‘disintegrating erosion' of particular exceptions ... Only thus has the level of conduct for fiduciaries been kept at a higher level than that trodden by the crowd. It will not consciously be lowered by any judgment of this court. [1]
While easy to define, the application of fiduciary duty principles is difficult to follow because each particular situation, like sand, shifts with the changing circumstances of the players. However, there are several fact patterns that recur throughout reported decisions and are useful in understanding the circumstances in which one's fiduciary duty obligations may be implicated.
The Opportunist
As might be expected, many breaches of fiduciary duty are attributable to the apparent self-interest and avarice of individuals who see and seize opportunities to enlarge their power and increase their wealth. The circumstances in which participants stumble and fail to meet their fiduciary duties in this regard are infinite. Making more money at the expense of other shareholders or seizing control over the company by keeping other shareholders in the dark are certain to land individuals with an appetite for risk as defendants in breach of fiduciary cases.
Active vs. Inactive Shareholders
Trouble often develops within a small business after one of the original participants becomes inactive. Retirement, disability or merely other interests may be the cause of such inactivity. Naturally, the potential for friction between active and inactive participants in a close corporation is great. The active participants may understandably feel that the returns of the business are due to their efforts and may take steps to raise their compensation, decrease or stop dividends, or even take steps to squeeze the inactive shareholder. Conversely, minority investors may seek to assert or regain active involvement in a business. These conflicts between active and inactive shareholders require strict adherence to the players' fiduciary duties in order to avoid bitter disputes and expensive litigation.
Changing of the Guard
Founders of a closely-held business, accustomed to running it as a one-man show, commonly regard the company as his or her own property. In other circumstances, small corporations experience disagreements among corporate officers, directors and shareholders as more competent, and often younger, participants seek a more active participation in a management and operation of a business over time. Whether it is an aged founder or an able and aggressive participant in a growing enterprise, any fact pattern involving a change in the control of a close corporation requires a careful analysis of the participants' fiduciary duties to the corporation and shareholders.
Self Preservation
Often, changes within the company or in outside circumstances affecting the company lead to participants violating their fiduciary duties. Change often put the players at risk, causing self-preservation and self-interest to prevail over prudence and risk management. Any change in the fundamental structure of a business can create such a situation.
Corporate Ritual and Proper Records
If there is one certain way to create distrust and cause someone to call into question whether a participant is fulfilling their fiduciary obligation, it is failure to observe the formalities of corporate operation and neglect of proper paperwork. Traditionally, small businesses disregard corporate ritual and fail to maintain proper records. This is certain to produce serious trouble whenever a controversy arises among shareholders. Difficulty in establishing what corporate action has been taken on a matter in question or by whose authority an action was performed leads to suspicion and dissension. Likewise, the inability to document and explain company finances sow seeds of distrust among participants.
[1] Meinhard v. Salmon, 249 N.Y. 458, 463-64 (1928). It is clearly a lofty, unbending standard.
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