Fiduciary Duties in a Family Owned Business

The Family Business Resource Center received some inquiries over the last month about fiduciary duties in a family owned business.  Are there still fiduciary duties in a family owned business?  Are they different or relaxed because the stockholders all happen to be related to management?

The short answer is that yes, there are fiduciary duties, and no, they are not different or relaxed.  The law does not distinguish between fiduciary duties applicable to a family owned business and fiduciary duties applicable to any other business.  But there are a range of ways to form your family owned business to provide for the level of fiduciary duties appropriate for your needs.  To appreciate them, it is important to first get a sense of fiduciary duties and how they apply.  (Fiduciary duties in a business context have engendered scores of court decisions and volumes and volumes of academic commentary through the years.  So the following summary is obviously just that – a “quick and dirty” summary.) 

First, who owes fiduciary duties?  Fiduciary duties are imposed by the law in a variety of circumstances.  Trustees can owe fiduciary duties to the beneficiaries of their trusts.  Guardians can owe fiduciary duties to their charges – legally known as “wards.”  But in the business context, it is those responsible for running and managing a business.

In a corporation, this means the directors and corporate officers.  This does not necessarily include every junior, associate, back-up, assistant vice-president in charge of some task (if an organization has opted to give titles like that), but the courts have not been abundantly clear where to draw the line.  At a minimum, it seems safe to include any officer named in a company’s formation and governance documents.  But how far down the chain of command a court will impose fiduciary duties is still unclear.  Furthermore, while Delaware courts have made clear that officers owe fiduciary duties, they have specifically noted that the consequences for the breach of fiduciary duties may not be the same as they are for directors.  So, unfortunately, there is still a little gray area in the law there.

In a limited liability company, managers and officers are subject to the same fiduciary duties as directors and officers of corporations, unless the members of the LLC choose to waive these duties in writing.  This can be an enormous advantage of an LLC.  The shareholders of a corporation cannot waive their rights to fiduciary duties from the directors and officers, but members of a Delaware LLC. 

Second, what are fiduciary duties?  Generally speaking, fiduciary duties in the world of business entities are heightened duties owed by the directors, officers, and managers of businesses to the equity owners of such businesses.  These go beyond the basic duties to deal fairly and in good faith with others in a business setting.  Although there has been a wealth of case law on the topic and it is always in a state of some flux, the basic fiduciary duty imposed on directors and management generally break down into two categories: the duty of care and the duty of loyalty.

The duty of care requires that a director, officer or other individual perform his or her duties on behalf of the company and its equity holders with a level of care, including reasonable inquiry where appropriate, that an ordinarily prudent person in a similar office would use under similar circumstances.  This does not mean, however, that such a person cannot take business risks – even severe risks.  What it means is that, when considering whether or not to take such risks, the person thinks through and considers the situation with the same level of care that an ordinarily prudent officer or director might when facing the same situation.  A person’s conclusion after consideration could be completely novel or outrageous – but if he or she has thoughtfully considered the factors and made inquiries where appropriate, he or she will have generally fulfilled the duty of care.

The duty of loyalty requires those subject to the duty to act in good faith in the best interests of the business and its equity holders, and not for their own interest.  Just as with the fiduciary duty of care, courts will generally give great latitude to business leaders in presuming they are complying with their fiduciary duty of loyalty.  This presumption is known as the business judgment rule.  When a court applies the business judgment rule, it is saying that it sees nothing to suggest this presumption is incorrect or inapplicable and therefore defers to a business leader as he or she applies his or her business judgment.

There are certain situations, however, where a court will not be so deferential.  The most common example is when there is a conflict of interest between the director or officer and the (other) equity holders.  For example, when a director or officer is negotiating an agreement with the company, a court will not generally presume that the director or officer is acting in the best interests of everyone else.  In these sorts of situations, a court will apply a heightened standard of scrutiny in determining whether or not the fiduciary duties were met and the individual may have the burden of proving the entire agreement or transaction that resulted was fair to the company.

As noted above, this post only scratches the surface and glosses over countless nuances in the development of the law in this area.  But the salient point is that a family owned business is subject to all the same rules as any other business.  Therefore, in making decisions with respect to the family business, the business leader, whether a patriarch, matriarch or anyone else, still has legal obligations to equity holders that must be considered – even if those equity holders are family.