Proving Compliance with Fiduciary Duties in a Stock Redemption

 

Elsewhere on this website and blog post, we have argued that majority shareholders and corporations owe fiduciary duties to minority shareholders in the context of a stock transaction. This is an incredibly important exception to the general rule, after Ritchie v Rupe, that majority shareholders owe no legal duties to minority shareholders. In Allen v. Devon Energy Holdings, L.L.C., 367 S.W.3d 355, the company redeemed a minority shareholder’s interest. The company later sold for almost twenty times the value used for the redemption price. Id. at 367. The court held that the majority shareholder owed formal fiduciary duties to the minority shareholder in the redemption. Id. at 392.

We conclude that there is a formal fiduciary duty when (1) the alleged fiduciary has a legal right of control and exercises that control by virtue of his status as the majority owner and sole member-manager of a closely-held LLC and (2) either purchases a minority shareholder’s interest or causes the LLC to do so through a redemption when the result of the redemption is an increased ownership interest for the majority owner and sole manager.

Id. at 395-96. The Texas Supreme Court in Ritchie v. Rupe cited Allen v. Devon twice with approval as an example of existing causes of action that survived the change in the law pronounced by the Ritchie decision.

How do these fiduciary duties operate in stock redemption? In Johnson v. Peckham, 120 S.W.2d 786, 788 (Tex. 1938), the Texas Supreme Court dealt with the buy-out of one partner by another partner in a Texas general partnership. Texas statutory and common law has always recognized that partners owe fiduciary duties generally. These are the same duties that apply in the context of a stock redemption in a closely-held corporation or LLC. In the context of a buy-out or stock redemption, the majority shareholder/corporation must consummate the transaction (1) in good faith, (2) with full disclosure, and (3) for a fair consideration. See id.; see also Gum v. Schaefer, 683 S.W.2d at 805; Johnson v. Buck, 540 S.W.2d 393, 399 (Tex. Civ. App.—Corpus Christi 1976, writ ref’d n.r.e.).

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The Business Judgment Rule in Civil Procedure

How is the business judgment rule applied procedurally? What impact does it have on pleading, motions practice, and jury charge?

Pleading

While the business judgment rule is referred to frequently as a “defense,” it is not an affirmative defense and need not be pleaded by the defendant.  On the contrary, it is the plaintiff’s burden to plead and prove that the business judgment rule does not apply when a breach of the duty of care is alleged.

In Sneed v. Webre, the Court characterized the business judgement rule as a matter that the “plaintiff must plead and prove.”  The Court wrote that it would be “insufficient” for a shareholder to merely allege mismanagement or neglect or an abuse of discretion in conducting the affairs of the corporation.  The El Paso Court of Appeals recently wrote that “a plaintiff carries the burden the on merits to plead (and then of course to prove) something more.”

Burden of Proof

The El Paso Court of Appeals recently held: “To best give effect to the policy rationale underpinning the business judgment rule, we conclude that it was part of [the plaintiff’s] case to disprove the business judgment rule.” 

Special Exceptions and Summary Judgment

The application of the business judgment rule is a legal question, so it would ordinarily be addressed in special exceptions or summary judgment. If the plaintiff pleads a claim of merely negligent mismanagement and fails to plead clearly an exception to the business judgment rule, then “[s]uch allegations may be disposed of on special exceptions or summary judgment.”

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There Are Fiduciary Duties to Minority Stockholders in a Stock Redemption

After Ritchie v. Rupe, it is clear in Texas that there is no fiduciary duty generally that majority stockholders owe to minority stockholders. This means that in many instances, majority stockholders are free to use their control over the corporation to treat minority shareholders unfairly. This conduct is generally referred to as “oppression” or a “freeze-out” or “squeeze-out.” The typical pattern of conduct is that the minority shareholder is cut off from information, excluded from management, and then terminated from employment. In most small corporations, dividends are not paid at all. If they are, then they will not be paid in a squeeze-out scenario. The intent and effect of these oppression actions is to make the minority shareholder feel helpless and to cut off any economic benefit of share ownership—in fact, in a Subchapter S corporation or an LLC, where the owners pay the taxes directly, then ownership becomes a financial liability because the minority shareholder must still pay taxes on corporate earnings but receive no money from the corporation. In this situation, the majority shareholder still owes fiduciary duties to the corporation, but so long as the oppressive conduct does not harm the corporation, the majority shareholder is under no legal duty to the minority shareholder.

The majority shareholder’s motivation is almost always to obtain the minority shareholder’s ownership interest in the corporation by forcing the minority shareholder to sell. The minority shareholder, faced with no information, no ability to influence management, no economic benefit from ownership, and perhaps the financial detriment of having to pay taxes, will often feel forced to sell. In these situations, the majority shareholder can usually name the price of the sale, and it will always be a low price.

The transaction will almost always be structured as stock redemption—that is, a sale of the minority shares back to the corporation, using the corporation’s money. This structure avoids having the majority shareholder having to dip into his personal funds even though the personal benefit to the majority shareholder is the same whether he buys the stock himself or has the corporation do it. If the buy-out is paid over time, as is usually the case, then the redemption structure also transfers the economic risk to the minority shareholder. If the corporation runs into economic trouble, then the minority shareholder won’t get paid. The majority shareholder will have received 100% of the benefit of the transaction, but the minority may not receive full payment. However, in this situation, Texas law still recognizes a very significant exception to the general rule that no fiduciary duties are owed to minority shareholders.

When a company purchases its own stock from one of its owners, unique fiduciary duties do arise. Allen v. Devon Energy Holdings, L.L.C., 367 S.W.3d at 393 (“a formal fiduciary relationship [arises in] the specific type of transaction in question: a purchase of a minority owner’s interest ….”). The reason is that, while co-shareholders do not owe fiduciary duties to each other, the corporation may owe limited fiduciary duties to its shareholders. Generally, the relationship between corporation and shareholder is “akin to one of trust.” Disco Mach. of Liberal Co. v. Payton, 900 S.W.2d 124, 126 (Tex. App.—Amarillo 1995, writ denied). The Texas Supreme Court has held that a corporation “is a trustee … and is under the obligation to observe its trust for [the shareholders’] benefit.” Yeaman v. Galveston City Co., 167 S.W. 710, 723 (Tex. 1914). See alsoHinds v. Sw. Sav. Ass’n of Houston, 562 S.W.2d 4, 5 (Tex. Civ. App.—Beaumont 1977, writ ref’d n.r.e.) (“[T]rusteeship of a corporation for its stockholders is that of an acknowledged and continuing trust . . . .”); Graham v. Turner, 472 S.W.2d 831, 836 (Tex. Civ. App.—Waco 1971, no writ) (“the relation of a corporation to its stockholders is that of a trustee of a direct trust.”); Rex Ref. Co. v. Morris, 72 S.W.2d 687, 691 (Tex. Civ. App.—Dallas 1934, no writ) (“A corporation stands in the relation of a trustee to its stockholders”). The Texas Supreme Court has held:

[T]he trusteeship of a corporation for its stockholders is that of an acknowledged and continuing trust. It cannot be regarded of a different character. It arises out of the contractual relation whereby the corporation acquires and holds the stockholder’s investment under express recognition of his right and for a specific purpose. It has all the nature of a direct trust.

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Fiduciary Duties of the Limited Partnership General Partner in Texas

Are Officers of a Corporate General Partner Liable for Breach of Fiduciary Duties in a Texas Limited Partnership?

A very common business organization structure in Texas is the limited partnership, which permits many of the advantages of partnership--particularly the tax advantages--but limits the liability of investors in the same manner as a corporation. Texas limited partnerships are a favored vehicle for investments in real estate. A limited partnership is comprised of one or more general partners and one or more limited partners. The limited partnership general partners operate the business and are subject to liability in the same way as general partners in a general partnership. Each limited partnership general partner has the right to control and has unlimited liability for the debts and obligations of the partnership. The limited partners, however, have no right to control or manage the business and have no liability for the debts and obligations of the partnership. Limited partners risk only their investment capital, in the same way as shareholders of a corporation. General partners owe fiduciary duties to each other, to the partnership as an entity, and (although there is some confusion in the case law) to the limited partners. Generally speaking, limited partners owe no fiduciary duties to the partnership or to each other.

The conceptual difficulty comes when persons or entities involved in the limited partnership wear "different hats" and act in different roles. Typically, limited partnerships are set up with a corporate general partner that has few or no assets. A very common structure would be as follows: The promoter of the limited partnership investment vehicle organizes a limited partnership with the equity owned 99% by limited partners and 1% by a corporate general partner with no assets. Typically, the promoter would be the sole shareholder of the corporate general partner and its sole director and officer. The 99% interest would be sold to passive investors, and quite often the promoter would own a large amount of the limited partnership equity as a limited partner and thus individually exercise control over the limited partnership through his control over the corporate general partner. As to third parties, the promoter is completely shielded from liability. Only the general partner corporation bears unlimited liability for partnership obligations, but the corporation is judgment proof. As the sole director, officer, and shareholder of the corporate entity, the promoter is shielded individually from liability by the corporate veil. As a limited partner, the promoter has the same protection from individual liability as other limited partners.

While this structure makes sense with regard to third parties, who presumably can protect themselves by refusing to deal with the limited partnership without adequate security or personal guaranties, it becomes far more problematic when the rights of the other limited partners are in question. Because of his control over the limited partnership, the promoter has the ability to benefit himself at the expense of the other limited partners by misappropriation of assets or other self-dealing transactions that would constitute a breach of the duty of loyalty if the promoter individually were the general partner. While the corporate general partner owes fiduciary duties to the limited partners, the corporate general partner is judgment-proof. The promoter's duties as an officer and director of the corporation run only to the corporation. Therefore, unless the promoter is individually charged with the duties owed by the corporate general partner, the other limited partners would effectively have no remedy against the promoter who abuses his power to enrich himself.


A recent decision out of the Dallas Court of Appeals exemplifies this absurd result. In Rainier Income Fund I, Ltd. v. Gans, the plaintiffs were two investment funds that became limited partners in two Texas limited partnerships known as R-75, L.P. and R-75 II, L.P. The other limited partner was FNS Holding, L.P., an entity owned and controlled by the promoter, Fred Gans. The limited partnership General Partner was Star Creek Construction GP, Inc., another entity owned and controlled by Gans. The purpose of the two limited partnerships was to develop and lease two office buildings in Allen, Texas. Gans, individually, guaranteed certain partnership obligations to the limited partners, but the guaranty was triggered only by specific liquidation events. Things did not go well, and the assets of the limited partnership were foreclosed on by creditors and sold, resulting in a total loss to the plaintiffs.

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Texas Civil Practice and Remedies Code 38.001 for Breach of Fiduciary Duty

Can a Plaintiff Recover Attorney’s Fees Under Texas Civil Practice and Remedies Code 38.001 for a Tort Cause of Action

Texas is one of the more liberal jurisdictions in allowing the recovery of attorney’s fees in breach of contract actions, but generally attorney’s fees are not recoverable in tort actions. The typical claim for wrongdoing among owners of closely-held companies sounds in tort—usually breach of fiduciary duties or conversion.

Section 38.001 of the Texas Civil Practice and Remedies Code provides: “A person may recover reasonable attorney’s fees from an individual or corporation, in addition to the amount of a valid claim and costs, if the claim is for: (8) an oral or written contract.” Texas courts have developed a significant exception to the general rule that permits recovery of attorney’s fees on a tort claim that is so intertwined with the contract which underlies the cause of action such that the tort action is “intrinsically founded on the interpretation of the contract.”[1]

[1] See High Plains Wire Line Servs., Inc. v. Hysell Wire Line Servs., Inc., 802 S.W.2d 406, 408 (Tex. App.—Amarillo 1991, no writ).

However, in 2006, the Texas Supreme Court in Tony Gullo Motors I, L.P. v. Chapa,[2] overruled a line of cases that had permitted the recovery of attorney’s fees incurred on tort claims where the facts of the tort claim were so “inextricably intertwined” with the facts of a contract claim, as to make segregation difficult. The doctrine was not based on the application of Section 38.001 to the tort claim but on the difficulty of segregation. Chapa overruled the “inextricably intertwined” doctrine and required segregation. However, in dicta, the Chapa Court made the sweeping statement that “For fraud, she could recover economic damages, mental anguish, and exemplary damages, but not attorney’s fees.”[3]

[2] Tony Gullo Motors I, L.P. v. Chapa, 212 S.W.3d 299 (Tex. 2006).

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Corporate Fiduciary Duties in Texas

“Corporation officers and directors are fiduciaries.” “Directors, or those acting as directors, owe a fiduciary duty to the corporation in their directorial actions.”

Traditional Formulation of Fiduciary Duties

Under the traditional formulation, corporate fiduciary duties constitute three separate duties. “Corporate officers and directors owe three distinct duties to the corporations they serve: obedience, loyalty, and due care.”
“The duty of obedience requires a director to avoid acting beyond the scope of their enumerated powers (also referred to as ultra vires acts).” The duty of obedience also requires the directors to comply with the law, the governing documents of the corporation, and any limits on their authority.
The duty of loyalty requires that that a director act in good faith and not allow his or her personal interests to prevail over the interests of the corporation. The duty of loyalty is concerned with self-dealing—whether or not a director is “interested” in the transaction. “A director is considered ‘interested’ if he or she (1) makes a personal profit from a transaction by dealing with the corporation or usurps a corporate opportunity; (2) buys or sells assets of the corporation; (3) transacts business in his director’s capacity with a second corporation of which he is also a director or significantly financially associated; or (4) transacts business in his director's capacity with a family member. “Transactions involving an interested director are subject to strict judicial scrutiny but are not voidable unless they are shown to be unfair to the corporation.” “[T]he burden of proof is on the interested director to show that the action under fire is fair to the corporation. A challenged transaction found to be unfair to the corporate enterprise may nonetheless be upheld if ratified by a majority of disinterested directors or the majority of the stockholders. An interested director who is also a shareholder is entitled to vote his shares to ratify his challenged act.”
And finally, the duty of care “requires a director to be diligent and prudent in managing the corporation’s affairs.” The duty of care is basically a negligence standard. It concerns “mismanagement” and is based on the negligence standard of conduct that the director must use ordinary care in the management of the corporation’s business.


Ritchie Formulation of the Duty of Loyalty

The Texas Supreme Court in Ritchie v. Rupe formulated the duty of loyalty in a particular way: “Directors, or those acting as directors, owe a fiduciary duty to the corporation in their directorial actions, and this duty ‘includes the dedication of [their] uncorrupted business judgment for the sole benefit of the corporation.’” The Court makes clear from its citation of Gearhart Industries v. Smith that this statement of the duty is not exclusive. Fiduciary duties “include” the duty to dedicate uncorrupted business judgment for the sole benefit of the corporation, but the duties continue to include duties of obedience and care. This formulation of the duty of loyalty is taken from International Bankers v. Holloway. However, the Ritchie Court reiterates this same formulation of the duty of loyalty five times on a variety of topics. The following year the Texas Supreme Court again used the same formulation in Sneed v Webre: “Directors, or those acting as directors, owe a fiduciary duty to the corporation in their directorial actions, and this duty ‘includes the dedication of [their] uncorrupted business judgment for the sole benefit of the corporation.’” Going forward the standard for the duty of loyalty is clearly whether the fiduciary utilized his uncorrupted business judgement for the sole benefit of the corporation.
The Ritchie formulation of the duty of loyalty is not really novel but the emphasis seems to be different from the traditional formulation. “Uncorrupted” business judgment seems clearly to point to the need for a disinterested status, but the further requirement of “sole benefit of the corporation” takes this concept much further. A director could be disinterested personally and yet still not be acting for the sole benefit of the corporation. The example emphasized in Ritchie is that a director may not act for the benefit of the majority shareholder over that of the corporation. A director may not act for non-business reasons. Also the Ritchie formulation makes no reference to harm to the corporation or the concept of fairness. It is easy to imagine a transaction—for example executive compensation—which is not harmful to the corporation but is not done for the sole benefit of the corporation. What about a self-dealing transaction that is otherwise fair to the corporation, such as leasing property from the majority shareholder at market rates? Such a transaction is almost certainly not for the sole benefit of the corporation. It is difficult to conceive that the Texas Supreme Court would hold that a fair transaction would violate the duty of loyalty, but the emphasis on avoiding divided loyalties under the Ritchie formulation certainly makes such a result possible.

This post is taken from HCWD, PLLC recently published White Paper, The Duty of Loyalty and the Business Judgment Rule in Texas. Download the full article with complete legal analysis of the issues and case citations.

Texas Business Judgment Rule

Texas Business Judgment Rule Defense

“The business judgment rule in Texas generally protects corporate officers and directors, who owe fiduciary duties to the corporation, from liability for acts that are within the honest exercise of their business judgment and discretion.” 

Application of Business Judgment Rule Defense

The business judgment rule protects corporate officers and directors from being held liable to the corporation based on actions that are “negligent, unwise, inexpedient, or imprudent if the actions were ‘within the exercise of their discretion and judgment in the development or prosecution of the enterprise in which their interests are involved.’”  “[T]he business judgment rule applies as a defense to the merits of a shareholder’s derivative lawsuit that asserts claims against the corporation’s officers or directors for breach of duties that result in injury to the corporation.”

The business judgment rule is the inverse of duty of loyalty. A self-interested transaction would never qualify as the “honest” or “uncorrupted” use of business judgment. Rather, as the El Paso court of appeals recently held, the business judgment rule is a defense to a claim for mismanagement—i.e., a claim based on the duty of care.  This is necessarily true, notwithstanding the Texas Supreme Court’s cagey footnote in Sneed v. Weber that seemed to leave open the question of to which duty the business judgment rule applied: “We refer to breach of duty claims generally because this case does not require us to consider which duties are subject to the business judgment rule.”  Nevertheless, it seems clear that the business judgment rule would never provide a defense to a breach of the duty of loyalty—which would not be an honest use of business judgment—or to a breach of the duty of obedience—which would involve actions outside the scope of an officer’s or director’s legitimate discretion. The business judgment rule deals only with claims based on the duty of care. As the Texas Supreme Court noted, “courts will not interfere with the officers or directors in control of the corporation’s affairs based on allegations of mere mismanagement, neglect, or abuse of discretion.”

Although the caselaw addressing the business judgment rule in Texas is quite limited, Texas courts frequently look to Delaware for guidance.  Texas courts routinely utilize Delaware corporate law on issues that have not yet been decided in Texas,  including business judgment rule issues.  The Delaware Supreme Court is regarded as the “mother court” for corporate law.  Under Delaware law, the business judgment rule is a rebuttable presumption that “in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.”  The business judgment rule in Delaware is comprised of four elements: (1) a business decision; (2) disinterestedness and independence; (3) due care; and (4) good faith. The presumption of the business judgment rule can be rebutted by demonstrating that one of these elements is not present.

This post is taken from HCWD, PLLC recently published White Paper, The Duty of Loyalty and the Business Judgment Rule in Texas. Download the entire paper with complete legal analysis and citations.

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When Does the Business Judgment Rule Not Apply?

When does the business judgment rule not apply to a claim of mismanagement?

Obviously, the business judgment rule does not apply to a claim not brought under the duty of care. If the management steals money, then the claim would be made as a violation of the duty of loyalty. If the board commits an ultra vires act, then the claim would be made as a violation of the duty of obedience. There would be no need for the plaintiff to take the extra step of proving negligence or a breach of due care. The business judgment rule would never be at issue.

The business judgment rule is an absolute defense to a claim based on negligence or imprudence, except when the business judgment rule does not apply. Claims of negligent mismanagement are viable only when some exception to the business judgment rule applies. There are several.

Self-Dealing

Under Delaware law, self-dealing in any transaction excludes the application of the business judgment rule: “First, its protections can only be claimed by disinterested directors whose conduct otherwise meets the tests of business judgment. From the standpoint of interest, this means that directors can neither appear on both sides of a transaction nor expect to derive any personal financial benefit from it in the sense of self-dealing, as opposed to a benefit which devolves upon the corporation or all stockholders generally.”  Texas law is equally clear that the business judgment rule does not protect self-dealing.

The only instance in which this principle would apply is in a transaction that is imprudent, but not necessarily unfair. For example, the directors might vote themselves extremely generous salaries, but within what might be provable as the market price for executive compensation in comparable companies. However, the plaintiff might be able prove that the decision to hire themselves at this salary failed to exercise due care because other candidates were readily available who could do the same job for much less. The plaintiff’s claim would be that a person of reasonable prudence would have hired the cheaper but equally qualified candidate. The corporation is damaged by this negligent or imprudent decision in the amount of the difference between the cheaper and more expensive salaries. Although the choice of candidates to hire is ordinarily a matter of business judgment, the self-dealing nature of the transaction would remove the protection of the business judgment rule. Under the Ritchie formulation of the duty of loyalty, the same result might be true even in a non-self-dealing transaction (e.g., outside directors hired the majority shareholder), where it could be proven that the directors did not exercise their business judgment for the sole benefit of the corporation.

Abdication of Duty

“In Texas, the business judgment rule protects corporate officers and directors from being held liable to the corporation for alleged breach of duties based on actions that are negligent, unwise, inexpedient, or imprudent if the actions were ‘within the exercise of their discretion and judgment in the development or prosecution of the enterprise in which their interests are involved.’”  The business judgment rule only protects the exercise of judgment and discretion. Simply rubber-stamping whatever a majority shareholder wants arguably is outside the protection of the rule because it involves no exercise of judgment. A board that abdicates its responsibilities has no protection.  “[T]he business judgment rule also fails to protect officers and directors who abdicate their responsibilities and fail to exercise any judgment.  This would include an action that “results from an obvious and prolonged failure to exercise oversight or supervision.”  A recent court of appeals case held that “[b]ound up within the duty of care is the obligation to actually manage the affairs of the corporation.”  However, that court also held that there was no “obligation to micromanage corporate affairs. Good corporate boards often rely on skilled employees to handle day-to-day operating decisions.”

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Sale-to-a-Looter Breach of Fiduciary Duty Claim

What if the majority shareholder sells out to a crook who subsequently loots the company? The minority shareholders may have a breach of fiduciary duty claim. An example of a claim that is brought under the duty of care is liability for selling control of a corporation to a looter.

No such cases have been decided in Texas, but the claim is well established in Delaware. Controlling shareholders and directors of a Delaware corporation owe fiduciary duties of care and loyalty to non-controlling shareholders.  These fiduciary duties include an obligation to investigate the bona fides of a potential purchaser of their controlling interest under certain circumstances.  Specifically, the controlling shareholders must investigate the buyer when the controlling shareholders are aware of facts that the buyer intends to or is likely to plan any depredations to the corporation.  The standard of care is whether the controlling seller is aware of facts that would give rise to suspicion by a reasonably prudent person.

Assume a situation in which a majority shareholder (with control of the board of directors) owns a controlling interest in a corporation. For whatever reason, the majority shareholder wishes to divest its ownership of the corporation and arranges for the sale of majority control to a third party. However, the third party turns out to be a crook and proceeds to loot the corporation once it has gained control. Obviously, the remaining minority shareholders could bring a derivative claim against the crook for misappropriation in violation of the duty of loyalty—but the crook may have vanished or be unable to pay the judgment. Therefore, the minority shareholders sue the former majority shareholder on the grounds that the sale to the looter had been negligent and a violation of its duty of care because the actions of the looter were reasonably foreseeable.

In Harris v. Carter, the Delaware Court of Chancery addressed the sale of controlling interest in Atlas Energy Corporation to a purported looter.  The plaintiff (a non-controlling shareholder of a Delaware corporation) alleged that the prospective purchaser made fictitious representations to the controlling shareholders both in the sale agreement and in the draft financials circulated prior to closing.  The CFO of the corporation raised several questions regarding the accuracy of the financial statements, but the controlling shareholders ignored these concerns and sold their interest without investigating the buyer. As part of the sale, the sellers agreed to resign as directors of the corporation and allow the purchasers to fill the director positions with their designees. Following the sale, the purchasers pursued a series of self-dealing transactions to the detriment of the corporation. 

Focusing on the fact that the controlling shareholders ensured that the buyers would assume control over the corporation, Chancellor Allen held that the plaintiff had stated a claim for breach of fiduciary duty.  Specifically, the Court found that the controlling shareholders placed others at risk of foreseeable injury, and that there was no privilege that would allow controlling shareholders to exempt themselves from this general principle:

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Attacking Shareholder Settlements

How can you buy-out a fellow shareholder (or have the company do so) and make sure that the deal is final? The law makes it very difficult. A situation that appears repeatedly is that an unhappy shareholder will sell out to the company or to his partner and sign a settlement agreement and release. Later, the shareholder learns that the former partner sold the whole company for a profit. The shareholder sues seeking to get out of the settlement on the grounds of fraud or breach of fiduciary duties. If the former partner was aware of the opportunity to sell at a profit and kept that to himself, he may have a problem.

Here are the ways under Texas Law that a settlement can be busted.

Fraud

1. Fraud in the Inducement

Fraudulent inducement is a “species of common-law fraud” that “arises only in the context of a contract.”  The elements of fraud in the inducement are: “(1) the defendant made a material misrepresentation; (2) the defendant knew at the time that the representation was false or lacked knowledge of its truth; (3) the defendant intended that the plaintiff should rely or act on the misrepresentation; (4) the plaintiff relied on the misrepresentation; and (5) the plaintiff's reliance on the misrepresentation caused injury.”  Fraud vitiates whatever it touches.  Any settlement or other agreement may be set aside if it was induced by fraud. Once raised, fraud is a very difficult claim to dispose of by summary judgment. Fraudulent intent is inherently a fact issue.  Fraudulent intent must always be inferred from circumstantial evidence.  The jury may consider motive, past conduct, related wrongful acts,  and subsequent conduct.

2. Fraud by Non-Disclosure

The most common theory to attack a shareholder settlement is fraud by nondisclosure.  The elements are “(1) the defendant failed to disclose material facts to the plaintiff that the defendant had a duty to disclose; (2) the defendant knew the plaintiff was ignorant of the facts and the plaintiff did not have an equal opportunity to discover the facts, (3) the defendant was deliberately silent when the defendant had a duty to speak; (4) by failing to disclose the facts, the defendant intended to induce the plaintiff to take some action or refrain from acting; (5) the plaintiff relied on the defendant’s nondisclosure; and (6) the plaintiff was injured as a result of acting without that knowledge.”  The fiduciary duties may create a duty to disclose.  Independent of the fiduciary duties, a party has a duty to disclose in the following situations: (1) when a party voluntarily discloses information, the party has the duty to disclose the whole truth; (2) if a party makes a representation, he has a duty to disclose new information when he is aware the new information makes the earlier representation misleading or untrue; (3) when a party makes a partial disclosure and conveys a false impression, the party has a duty to speak. 

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Can Fiduciary Duties Be Waived in a Settlement

Waiving Fiduciary Duties

Settlements of shareholder disputes may later be attacked and set aside if the settlement violated fiduciary duties owed by the defendant to the plaintiff. A normal disclaimer of reliance won't provide a defense because reliance is not an element of breach of fiduciary duties. You need an explicit waiver of fiduciary duties to achieve a truly final settlement. However, does the law permit such a waiver?

Validity of Advance Waivers

Fiduciary Duties

While no court has addressed the issue, there is a very real question as to whether an advance waiver of fiduciary duties is valid. Title Seven of the Texas Business Organizations Code specifies the scope of such “advance” waivers of fiduciary duties that are permissible in a certificate of formation. In a corporation  or an LLC,  the certificate of formation may grant broad limitations on the liability of governing persons  except that liability may not be limited for a breach of the duty of loyalty “to the organization or its owners or members,” or an act “not in good faith” that involves “intentional misconduct,” or a transaction from which “the person received an improper benefit.”  If a broad waiver of fiduciary duties were in a certificate of formation passed unanimously by all of owners of the company, there is no question that it would be unenforceable to reverse the presumption of invalidity. There is no reason to believe that Texas public policy would be any different just because such language is in a contract. Similarly, in both corporations  and LLCs  a transaction between a governing person and the company would be void unless the transaction is approved by a majority of the disinterested owners or managers after full disclosure, or unless the benefitting fiduciary can prove the entire fairness of the transaction. There is no reason to think that Texas public policy would be different in a contractual transaction between shareholders or between shareholders and the company. Similarly, duties of loyalty, good faith, and disclosure in a general partnership may not be waived.  Fiduciary duties imposed by statute on trustees cannot be waived.  Other jurisdictions frequently hold that advance contractual waivers of fiduciary duties are unenforceable.

Texas common law imposes strict and absolute duties when a formal fiduciary duty is implicated.  “One occupying a fiduciary relationship to another must measure his conduct by high equitable standards, and not by the standards required in dealings between ordinary parties.”  “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 petitioned to undermine the rule of undivided loyalty by the ‘disintegrating erosion’ of particular exceptions.”  “When persons enter into fiduciary relations each consents, as a matter of law, to have his conduct towards the other measured by the standards of the finer loyalties exacted by courts of equity. That is a sound rule and should not be whittled down by exceptions.”

Does Texas public policy make it difficult for a fiduciary to achieve a final settlement? Yes, but no more difficult than entering into any other contract. The law presumes every contract involving a fiduciary is invalid unless the fiduciary can prove that full disclosure was made or that the transaction is otherwise fair. A release or settlement agreement is, after all, only a contract like any other.   And Texas courts have applied the presumption of invalidity to settlements involving fiduciaries just like any other transaction involving fiduciaries.  The difficulties imposed on fiduciaries is a calculated choice of Texas public policy. However, it is not impossible for a transaction involving a fiduciary to survive judicial scrutiny. As the Texas Supreme Court held in Texas Bank & Trust Co. v. Moore, “It should be emphasized that the imposition by equity of a fiduciary relationship in such circumstances does no more than cast upon the profiting fiduciary the burden of showing the fairness of the transactions.”  A settlement is final if it was agreed to after full disclosure or the fiduciary proves the fairness of the transaction. If a fiduciary could satisfy his burden of proof merely by showing that the plaintiff entered the transaction, the public policy would be meaningless.

It is not at all clear that the line of case law dealing with the effectiveness of a disclaimer of reliance on a fraud in the inducement claim  applies to a claim for breach of fiduciary duties. Breach of a fiduciary duty is not equivalent to fraud. “A false representation of a past or representation of a past or present material fact, when one has a duty to speak the truth, is of course a frequent ground for recovery in fraud when another relies thereon to his detriment, even in an ordinary arms-length transaction in which no ‘fiduciary duties’ exist and only the ethics of the marketplace apply.”  However, when formal fiduciary duties apply, “the law imputes to the relationship additional and higher duties.”

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Joint and Several Liability for Breach of Fiduciary Duty

When may a defendant be held jointly and severally liable for the tortious conduct of another? Civil Conspiracy, Aiding and Abetting, Knowing Participation

The classic statement was given by Professors Prosser and Keeton as follows:

All those who, in pursuance of a common plan or design to commit a tortious act, actively take part in it, or further it by cooperation or request, or who lend aid or encouragement to the wrongdoer, or ratify and adopt the wrongdoer's acts done for their benefit, are equally liable.

W. Page Keeton, et al., Prosser and Keeton on the Law of Torts § 46, at 323 (5th ed. 1984) (quoted in Juhl v. Airington, 936 S.W.2d 640, 643 (Tex. 1996)).

Texas law provides three distinct bases for imposing on one person joint and several liability for the tortious conduct of another: contract, causation, and participatory conduct. Each of these bases involves different legal concepts, different public policies, and different elements and applicability. Unfortunately, Texas appellate courts often confuse the different theories, intermingle the elements, and use the incorrect terminology. The recent Houston [1st Dist.] court of appeals decision, Wooters v. Unitech Int'l, Inc., 01-15-00174-CV, 2017 WL 372165 (Tex. App.—Houston [1st Dist.] Jan. 26, 2017), is an apt example of the failure to distinguish these distinct bases of these different theories of liability.

In litigation involving shareholder oppression and other internal disputes in closely-held companies, these theories of joint and several liability are incredibly important. Often majority shareholders and directors who engage in oppressive conduct have no direct legal duty against the minority shareholders they oppress. Often the money and opportunities that corporate officers and directors misappropriate are funneled into other entities that are controlled by or aligned with the disloyal officer and directors, but the recipients of the stolen assets may not themselves owe any duty to the corporation. Often a judgment against the party owing the primary duty and committing the actual tort is worthless. In many such cases, justice can only be done if all the involved parties are held jointly and severally liable for the misconduct. We have previously explored these concepts in the context of joint and several liability for the breach of trust cause of action and the individual liability of majority shareholders and officers and directors for the tort of stock conversion.

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