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Getting Personal

Could you be liable for your corporation's bad decisions?
March 1, 1997
URL: http://www.entrepreneur.com/article/13976

Suppose you own a small corporation where, at periodic board of directors' meetings, you and a few others make decisions about the company on behalf of all the shareholders. Now suppose some of the other shareholders don't like the way you're running the company. Can they sue for damages? Can you be held personally liable?

The answers are yes and maybe. "Lawsuits among shareholders are regular and common," says Robert B. Thompson, a professor at Washington University School of Law in St. Louis who specializes in corporate governance and shareholder disputes. Thompson notes that these lawsuits are even common in very small corporations, especially when the shareholders don't get along. Since the decision makers are typically majority shareholders who could benefit from self-dealing transactions, minority shareholders often protect their interests in the only way available: by going to court.

Consider the case of a group of California investors who formed a small corporation to buy and lease commercial property. It was intended to function like a co-op, with ownership equal among shareholders. But the treasurer bought 850 additional shares of stock without informing the other shareholders they were for sale, contrary to the articles of incorporation. He rented a company-owned apartment for less than market value, made a tidy profit from subleasing it at a higher rent, and collected a commission from the company for keeping it rented. He and two other directors voted to award themselves fees for serving as officers of the company, even though they'd already been paid.

When the other shareholders found out, they sued for damages. The Monterey County Superior Court found that the treasurer and his cohorts had violated the articles of incorporation and breached their fiduciary duties to the corporation and the other shareholders. They had to repay fees of $8,000 each, while the treasurer had to pay an additional $11,750 because of the apartment rental, plus other damages caused by the stock purchase. In June, the Court of Appeals of California upheld the ruling.

Under the law, directors and officers owe their corporation, first, a "duty of loyalty," which means they may not profit personally at the expense of the corporation. They may not pay themselves exorbitant salaries, compete with the corporation, or grab opportunities that should have gone to the corporation.

Second, they owe a "duty of care," which means they're expected to make business decisions in good faith, with the care a prudent person would use. They're expected to act in what they reasonably believe to be the best interests of the corporation, so making a quick decision without examining the facts can lead to legal trouble.

Third, they're required to avoid illegal, oppressive and fraudulent conduct. When majority shareholders try to keep all the profits for themselves and squeeze out the minority shareholders, they may have to answer for it in court.

These rules apply to corporations; similar rules apply to partnerships. Most experts believe similar rules apply to limited liability companies, but because the limited liability company is a relatively new creation, the law is unsettled on this point.

Traditionally, a shareholder who wanted to sue the corporation would have to file a "derivative lawsuit," suing the directors on behalf of the corporation. These lawsuits are cumbersome because procedural requirements typically require the shareholder to make a "demand" on the board--in effect, asking the directors for permission to be sued. "The biggest change in the past 10 years," Thompson says, "is that courts are allowing these [suits] to be brought directly by minority shareholders." This is especially good news for corporations with a small number of shareholders: One shareholder may sue the board of directors over a careless or self-dealing decision without having to seek permission first.

Follow The Rules

While courts wish to protect minority shareholders from high-handed and self-serving board decisions, they're not interested in second-guessing every decision the board makes. If company decision makers had to worry constantly about personal liability, they might avoid risk, which is central to entrepreneurship. That's why courts observe the "business judgment rule," a legal principle designed to protect officers and directors who are just trying to do their jobs. Courts normally assume directors or officers have fulfilled their duty to the corporation if they are reasonably well-informed about the subject of the decision, rationally believe their decision is in the corporation's best interest, and reveal any conflicts of interest.

Consider a case recently decided by the Supreme Court of Connecticut after 10 years of legal wrangling. Two brothers had been in business together since 1938, each owning half of a metal processing company and a business that made aluminum masts and sailboats. As the older brother moved into retirement, their relationship deteriorated. The younger brother refused to separate their business interests and made numerous decisions his brother disliked, including a $1 million outlay to expand a facility when the company's annual income was half that much.

The older brother sued to have the corporations dissolved, alleging gross mismanagement. However, the courts refused to interfere in these decisions because the younger brother had supervised the companies "in a manner consistent with due care." He had consulted experts, made sure the project was completed within budget, and avoided illegal and oppressive conduct.

In addition to the protection offered by the business judgment rule, most states now allow corporations to amend their charters to say that directors violate their duty of care only if they act recklessly or intentionally inflict harm on the corporation. You should check to see whether your corporation has this in its charter.

Also check for the third level of protection: a directors' and officers' (D&O) liability policy. Although expensive, such an insurance policy pays for your legal defense in case of a shareholder lawsuit, plus the judgment if you lose. Don't expect it to cover you, though, if you violated the duty of loyalty. "D&O insurance almost never covers self-dealing," Thompson says. If your company can't afford a D&O policy, try for a written commitment to reimburse directors and officers for litigation over decisions made in good faith. It's usually best to include the commitment in the corporation's bylaws.

Of course, the best defense is staying out of trouble. Some tips:




Steven C. Bahls, dean of Capital University Law School in Columbus, Ohio, teaches entrepreneurship law. Freelance writer Jane Easter Bahls specializes in business and legal topics.