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Fiduciary confusion: states, entities and illogic

honig-stephenThis column examines the confusion in understanding fiduciary obligations of owners and managers of certain types of entities in different states, specifically Massachusetts and Delaware.

Recognizing the different state judicial histories, and that law requires applying general principles to varied facts, the problem is with two different state legal schemes, and three different primary entity types (corporation, limited liability company and partnership), confusion remains over who owes what fiduciary duty to whom.

Massachusetts law

In Massachusetts closely held corporations, both majority and minority shareholders owe each other a fiduciary duty, the same duty of “utmost good faith and loyalty” owed to partners.

Even business decisions that make economic sense cannot harm another shareholder unless there is no practical “less harmful alternative.”

The definition of a Massachusetts closely held corporation has been generated through case law: entities with a small number of shareholders, illiquid stock, majority participation in operations. (The Massachusetts case law has developed differently with respect to more broadly held corporations.)

Fiduciary obligations owed to a corporation are long-lived. Even shareholders who have been expelled, and shareholders in a dissolved corporation, run into fiduciary problems when they attempt to compete, taking to themselves the goodwill of the enterprise. Lack of legal clarity in cases of dissolution can bring former shareholders seeking to compete with a defunct corporation to the courthouse steps.

Massachusetts fiduciary duties attach only to entities formed in Massachusetts; governance of entities traditionally follows the law under which that entity was formed. So two corporations working down the street from each other in Framingham, with identical fact patterns, may receive completely different legal treatment.

We lawyers have come to accept that as logical, but as a matter of public policy it may make little sense, except in cases in which entity selection was purposefully selected for that very fiduciary result.

Although in Massachusetts parties can (to an extent) alter fiduciary duties by expressly addressing behavior by contract, the contract will be closely construed so as to control the results only in situations that are specifically addressed.

These agreements inter alia may affect buying or transferring of shares, entitlement to employment, and handling of corporate opportunities. But even in matters covered by contract, oppressed Massachusetts minorities still enjoy protection through the implied contractual covenant of good faith and fair dealing. How one might apply that covenant to an oppressive contractual term is difficult to predict.

The Massachusetts LLC was invented by statute with the express purpose of providing certain corporate attributes, including liability insulation and flexibility in equity structure, to partnership-like entities.

LLCs in Massachusetts rest heavily on Massachusetts partnership law. An LLC, as well as a partnership of any type, may create great fiduciary obligations, echoed in a closely held corporation.

Delaware law

The story in Delaware is different. There, a “close corporation” is specifically defined by statute, with express limitation on the number of shareholders, and requirement that all stock be restricted from transfer.

The “close” designation requires an express adoption of that statutory status. If you don’t elect it, then no fiduciary obligations are imposed on any shareholders.

Further, forming a Delaware close corporation does not automatically place you into a fiduciary scheme such as in Massachusetts, see Subchapter XIV of the Delaware General Corporation Law. The close corporation also must elect to establish specific fiduciary obligations.

But even in Delaware corporations that are not “close” and that have not elected to contract for fiduciary ground rules, equitable principles imposed by Delaware courts prevent certain oppressive majority action.

Under longstanding case law developed in respect of larger and typically public corporations, where majority shareholders self-deal, they can be held to the “entire fairness test,” which specifies exactly what must be done by a controlling majority to undertake a transaction allegedly detrimental to minority shareholders. Delaware courts thereby created a limited fiduciary standard in M&A and related practices.

The requirements for authorizing a business transaction involving the controlling shareholders are complex and much-litigated. The confusing illogic of the evolving multiple layers of required process for authorizing various transactions has been previously addressed in this column, but suffice it to say that a majority in a Delaware corporation may bear the burden of proof that a transaction meets standards of both due process and economic fairness. This requirement can be applied not only in M&A, but in restructurings and similar circumstances.

Some comparisons

First, note an odd juxtaposition. In Massachusetts, the case law imposes fiduciary duty on smaller corporations but not generally on larger ones. In Delaware, absent an express statutory election, there is no case-law-imposed fiduciary duty on smaller corporations, but there is an analogous type of de facto fiduciary protection for oppressed investors in larger corporations. (This difference likely just reflects the kinds of corporations most typically formed, or litigated about, in these jurisdictions.)

Another distinction between the states relates to termination of minority shareholder employment. Absent a controlling employment agreement to the contrary, firing a minority shareholder from employment in Massachusetts may constitute a breach of fiduciary duty, but such is not the result in Delaware.

Further, under Delaware law, minority shareholders never owe fiduciary duties. They can be liable for theft, for fraud, for unauthorized competition, for a myriad of common law offenses. But any such failing must be asserted derivatively, and no duty is owed by the minority directly to the majority.

I have touched on the law relating to limited liability companies and partnerships. Practitioners know that they can write into an LLC’s operating agreement, or a partnership agreement, wide fiduciary flexibilities not likely tolerated in a corporate setting — even provisions permitting actions that otherwise would breach fiduciary duty. And indeed, historically, many partnerships that were designed for a particular opportunity (developing a product or a particular parcel of real estate) might contain statements that all participants have the right to undertake other similar ventures or seemingly competitive ones.

But even in Delaware LLCs, if an operating agreement is not drafted specifically, then in the words of Section 18-1104 of the Delaware LLC Act, “the rules of law and equity … shall govern.”

In Delaware, limited liability companies operated more like corporations (with managers and passive non-managing members), or operated more like a partnership with member management, may find that courts will apply corporate or partnership standards (as analogous) to fiduciary breach questions (see the Aug. 21, 2018, Chancery case of Goddin v. Franco).

The startup

Startups are an integral part of Massachusetts business culture, achieving almost iconic status.

We have seen that state for formation, and form of entity, can have material effect on fiduciary rights. Would you not expect that entrepreneurs would pay attention to these issues in selecting a state of formation and form of entity? Particularly since startups are highly volatile, and founders come and go for a variety of reasons? Lawyers in this space know that logic gets no practical traction.

Many startups are documented by founders themselves, or by services providing a standard package with minute book and bylaws. Many startups are formed based on an expectation that investors want a tax flow-through entity or not, or based on the financial goals of the entrepreneurs themselves, or on presumed investor preference for Delaware.

Entrepreneurs also are in an enormous hurry and lack tolerance for legal stuff, deemed not essential to perfecting their new algorithm or pharmaceutical.

Even when lawyers are consulted, founder reaction is that they are wasting time documenting what happens if things fall apart. Further, lack of money to compensate counsel leads to poor practice. When there are multiple persons involved in forming a new business, and the lawyer suggests that each needs separate counsel because interests differ, eyes begin to roll upward. The only thing less desirable to a startup than having one lawyer is having several.

The solution

The solution may be difficult but is clear: standardization of fiduciary rules across states and types of entity.

Given the way entrepreneurial entities are formed based on substantive business reasons having nothing to do with fiduciary issues, could we not benefit from having uniform fiduciary standards (subject only to specific drafting to the contrary)?

We could establish for all entities what the majority owes the minority; what if anything the minority owes the majority; how transactions creating conflicting economic interests are authorized regardless of type of entity; what happens when an equity holder is “fired” without an employment agreement; and what happens on dissolution.

Since selection of state and form of entity is driven by extrinsic issues and not fiduciary considerations, the answer should be clear.

If all else fails in enticing a cross-border agreement, cannot at least Massachusetts alone adopt an omnibus provision providing that, among different Massachusetts entity forms, equal facts create equal fiduciary ground rules?

Stephen M. Honig practices at Duane Morris in Boston.

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