Below is the third article in our “Fiduciary Duties” newsletter series discussing “Corporate and Partnership Fiduciary Duties.” If you missed our last newsletter, “Breach of Fiduciary Claims: Understanding the Elements,” click here to read.
Corporate and Partnership Fiduciary Duties
“Not honesty alone, but the punctilio of an honor the most sensitive,
is then the standard of behavior.”
Meinhard v. Salmon, 249 N.Y. 458, 464 (1928) (Cardozo, J.).
This admonition regarding fiduciary duties by the iconic former Chief Justice of New York’s highest court and later Associate Justice of the U.S. Supreme Court, Benjamin Cardozo, sings with the charm of a bygone era. But the sobering reality about which he spoke remains firmly intact in our current legal lexicon and system.
When a confidence is reposed by one person in the integrity of another, and where the person by such confidence controls the affairs of the other, a trust or fiduciary relationship is created. Wolf v. Superior Court (2003) 107 Cal.App.4th 25, 29; Eisenbaum v. Western Energy Resources, Inc. (1990) 218 Cal.App.3d 314, 322.
Put simply, a fiduciary relationship arises when confidence is reposed on one side, and domination and influence result on the other. Eisenbaum v. Western Energy Resources, Inc., supra, 218 Cal.App.3d at 322. In such relationships, the party in whom the confidence is reposed — if he voluntarily accepts or assumes to accept the confidence — has a fiduciary duty to not take advantage from his acts relating to the interest of the other party without the latter’s knowledge or consent. Wolf v. Superior Court, supra, 107 Cal.App.4th at 29.
Breach of fiduciary duty is a tort that may be committed by only a limited class of persons acting individually or by and through an entity. 1-800 Contacts, Inc. v. Steinberg (2003) 107 Cal.App.4th 568, 592. Generally, courts finding no fiduciary duty do so where other legal relationships clearly existed between the parties that “covered” the transaction in suit and which were inconsistent with the existence of fiduciary duty. Oakland Raiders v. National Football League (2005) 131 Cal.App.4th 621, 634.
Common types of fiduciary duties involve the real estate entities discussed below.
1. Corporate Fiduciary Duties
Corporate officers, directors, controlling shareholders and quite often members and managers of limited liability companies — the holding entities for many real estate assets — owe fiduciary duties to the corporation or LLC and, through the corporation or LLC, to the shareholders or members, as delineated by the governing state law.
Precisely defining fiduciary duty is not an easy task, as Supreme Court Justice Frankfurter identified the problem best in an oft-quoted passage from SEC v. Chenery Corp., 318 U.S. 80, 85 (1949):
But to say that a man is a fiduciary only begins the analysis; it gives direction to further inquiry. To whom is he a fiduciary? What obligations does he owe as a fiduciary? In what respect has he failed to discharge these obligations? And what are the consequences of his deviation from duty?
The fiduciary duties of officers and directors are generally subdivided into the duty of care and the duty of loyalty with the focus on the manner in which directors and officers perform their duties, not the correctness of their decisions. Directors and officers are required to perform their duties in good faith, with the care of ordinarily prudent persons in like positions and in a manner that they believe to be in the best interest of the corporation.
Under the “business judgment rule,” such persons generally are not responsible for mere bad business judgment. See Cal. Corp. Code § 310; Del. Code Ann. Tit. 8, § 144; N.Y. Bus. Corp. Law § 713. Judicial determination of whether actions by directors fall within the business judgment rule is often factually sensitive and, despite the exercise of good faith, directors may “unintentionally” breach their duty of loyalty.
Duty of loyalty issues may arise in the context of a variety of transactions, including:
- Sales to or purchases by the corporation from directors or entities in which the directors have an interest;
- Dealings between a parent corporation and its subsidiary;
- Unfair treatment of minority stockholders by a majority stock holder in matters such as corporate acquisitions and reorganization transactions;
- Use of corporate funds to perpetuate control;
- Sale of control;
- Demands of stockholders to commence derivative suits;
- Excessive compensation;
- Insider trading;
- Usurpation of corporate opportunities;
- Competition with the corporation by officers or directors; and
- Improper use of corporate position, property, or information.
The question of whether a director has breached a duty of loyalty often arises if the director has a self-interest in the transaction at issue. Directors are typically considered to be “interested” if they “appear on both sides of a transaction” or if they “expect to derive personal financial benefit from it in the sense of self-dealing, as opposed to a benefit that devolves upon the corporation or all stockholders generally.”
Even if not “interested,” a director or officer must be capable of rendering independent judgment to avoid violating his or her fiduciary duties. A director who can demonstrate that a decision is governed by the merits of the particular transaction, rather than by extraneous considerations or influences, is generally considered independent. Directors enjoy a presumption of independence that is rebuttable by proof that their relationships or behavior relative to a given transaction are driven by self-interest or improper ulterior motives.
One such improper ulterior motive occurs when majority shareholders take advantage of minority shareholders, since in California there is a “strong public interest in assuring that corporate officers, directors, majority shareholders and others are faithful to their fiduciary obligations to minority shareholders.” Steinberg v. Amplica, Inc. (1986) 42 Cal.3d 1198, 1210; Jones v. H.F. Ahmanson (1969) 1 Cal.3d 93, 106-112, et seq.
2. Partnership Fiduciary Duties
Fiduciary duties between partners are essential to partnerships and are reciprocal. The very nature of partnerships, in general, necessitates that all partners deal fairly with one another. Partners may not deal with one another at arm’s length. As Judson Crane & Alan Bromberg explain in the Law Of Partnership 389 (1968):
[E]ach partner is, roughly speaking, both a principal and an agent, both a trustee and a beneficiary, for he has the property, authority and confidence of his co-partners, as they do of him. He shares their profits and losses, and is bound by their actions. Without the protection of fiduciary duties, each is at the others’ mercy.
Courts uniformly hold that general partners are burdened with fiduciary duties in the context of a limited partnership and may be liable for breach of fiduciary duty, even where the transaction at issue has been approved by a super-majority (>66%) of the limited partnership interests.
Indeed, many cases suggest that general partners in limited partnerships owe greater fiduciary obligations than those in general partnerships. cf. Meinhard v. Salmon, supra, 249 N.Y. at 468 (for a managing co-adventurer “the rule of undivided loyalty is relentless and supreme”).
In most limited partnerships, a single general partner manages the business of the partnership. Consequently, courts hold that while each partner stands in a fiduciary relationship to all other partners, the fiduciary duties rest most heavily on a managing partner. See, e.g., Sherman v. Lloyd (1986) 181 Cal. App. 3d 693, 698-99 (because of the fiduciary’s role, plaintiff reasonably relied on advice of general partner of partnership in which plaintiff was investing).
Such logic is particularly relevant in the limited partnership context. Given the inherent control over all partnership assets, the general partner should bear the heaviest fiduciary responsibilities.
However, it should be noted that a limited partner in California does not owe fiduciary duties to the limited partnership or to any other partners solely by being a limited partner. Nonetheless, limited partners must discharge any duties to the limited partnership and other partners, and exercise rights consistently with the obligation of good faith and fair dealing.
Finally, a limited partner does not violate a duty or obligation under the Code or under a partnership agreement merely because that limited partner’s conduct furthers that limited partner’s own interest.
Whether maintaining a punctilio of an honor the most sensitive or simply being loyal, careful, transparent and bound to account, those who choose to do business in corporate, limited liability or partnership entities would do well to acquaint themselves with the intricacies of fiduciary responsibility or likely learn in due course the consequences of their failure to prepare, which, as UCLA’s esteemed Coach Wooden often said, you’re “preparing to fail.”
In the next newsletter, we will examine
“Institutional and Quasi-Institutional Fiduciary Relationships.”
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