Imagine playing in a sporting event with a player on your team who injures his own teammates. Worse, you suspect he’s doing it on purpose, so he can boost his own scoring opportunities. You check the rulebook, but it is silent on what to do about this. Some of the injured players are already threatening to sue not just the “bad apple” but the franchise for letting him play. Can the team survive?
In a way, creating a business that has no governing agreement is similar to participating in this frustrating and even dangerous activity. The people who get together to create a profit venture might start out believing they are in harmony with each other and the enterprise, all focused on a common goal, but over time, misunderstandings or disagreements about their respective rights and responsibilities, or perceived unfair or illegal conduct of one or more of the participants can challenge or extinguish their hopes and expectations and turn them against one another.
Although some business forms may not require governing agreements (particularly LLCs and partnerships in many states), in the first three modules, we have considered factors weighing in favor of having one in place and why the agreement should be in writing. In this module, we’ll take a closer look at some of the ways entrepreneurs use governing agreements to anticipate potential conflicts and provide means to resolve them.
A company’s owners and managers can be subject to many kinds of legal liability claims, such as breach of contract, wrongfully discharging an employee, engaging in behaviors that trigger antitrust laws or tort liability to third parties. We will confine our analysis to claims of intra-company malfeasance that a business can attempt to head off or resolve through appropriate provisions in its governing agreement.
As a general rule, those who work together to create and run a business owe each other basic duties including loyalty, fair dealing, good faith and full disclosure of potential conflicts of interest. These duties originated as common law court decisions even in the absence of any written laws requiring them. Today, state and, in some cases, federal statutes have codified much of the common law.
Fiduciary Duties in Corporations
A corporation’s board of directors (collectively and individually), officers, and shareholders who have controlling interests in the business all have fiduciary duties of care and loyalty to each other, to the company and to the shareholders.
Section 8.30 the American Bar Association’s Model Business Corporation Act, on which most states have based their corporation statutes, requires corporate directors in the performance of their duties:
- To act in good faith and in a manner the director reasonably believes to be in the best interests of the corporation;
- To discharge their duties with the care that a person in a like position would reasonably believe appropriate under similar circumstances; and
- To disclose material information in their possession to other board members who do not know that information.
Section 8.42 requires corporate officers who have discretionary authority to act on behalf of the company to observe effectively the same fiduciary duties as those of directors.
Corporate stakeholders also owe each other and the company the duty of loyalty, which manifests itself most often in actual and potential conflicts of interest. Conflicts that raise duty of loyalty concerns are often ones in which a director, officer or controlling shareholder participate in both side of a transaction, or if that person expects to receive personal financial benefit from a transaction instead of the transaction benefitting the corporation or its stockholders as a whole. Examples of activities that can lead to accusations of breach of the corporate duty of loyalty include:
- A director’s sales to or purchases from the corporation;
- Transactions between a parent company and its subsidiary;
- Unfair treatment of minority shareholders by majority shareholders;
- Using corporate monies to improperly retain control over the company;
- Excessive compensation;
- Usurpation of a corporate opportunity;
- Competition with the company on the part of directors or officers;
- Insider trading; and
- Sale of control over the company.
Note that not all of these are prohibited, but many require “entire fairness” to the corporation. The parameter of the duty and its attendant rules are taken up in other LawShelf courses.
Fiduciary Duties in LLCs
Section 409 of the Revised Uniform Limited Liability Company Act, which is the foundation for LLC law in nineteen states, imposes variable duties of loyalty and care on LLC members, depending on whether the company is governed by its members (a “member-managed” LLC) or whether it uses managers (“manager-managed”). The Act defines these duties as follows:
The duty of loyalty requires:
- Accounting to the company and to fellow members for properties, profits and benefits that a member gains while performing LLC business (including winding up the company), or from use of LLC property, or from appropriating an LLC business opportunity;
- Not dealing with the LLC while having an adverse interest to it, personally or while acting on behalf of someone else with an adverse interest; and
- Not competing with the LLC in the performance of its business.
Similar to the duty of care for corporate directors under the Model Business Corporations Act, members must act with the same degree of care as another reasonable person would in the same position and in similar circumstances. The RULLCA duty of care goes one step further than the Model Business Corporations Act to require members to act in a manner they reasonably believe will be in the best interests of the LLC.
Duties of good faith and fair dealing: The RULLCA applies contract law-based duties of good faith and fair dealing on members and managers in the performance of their duties of loyalty and good faith.
For manager-managed LLCs, the duties of loyalty and care apply to the managers but not to non-manager members; as Section 409(g) of the Act states, in a manager-managed company “A member does not have any fiduciary duty to the company or to any other member solely by reason of being a member.” Although the duties of loyalty and care don’t apply to ordinary members, though, the duties of good faith and fair dealing do still apply to all members.
Fiduciary Duties in Partnerships
For partnerships, Section 409 of the Revised Uniform Partnership Act- variations of which form the basis of partnership law in 49 states- requires partners of a general partnership to uphold the duties of loyalty and care to one another and to the partnership. The Act has built-in definitions for these two duties:
Duty of loyalty: The partnership duty of loyalty parallels that of LLCs, down to the same section number and terms.
Duty of care:
- Not engaging in purposeful or willful misconduct in the performance of partnership business; and
- Not engaging in reckless or grossly negligent behavior while performing partnership business.
Ultra Vires Actions
Another source of potential conflict involving management and control over a company, especially a corporation, is an act by a member of the business that is outside of the company’s scope of authority. This means actions taken on behalf of the company that are not allowed under the company’s organizing documents (such as articles of incorporation, bylaws, partnership agreement, etc.). Such unauthorized actions are called “ultra vires” activity and can create breach of contract disputes and legal violations. The sources of ultra vires claims are often shareholders who file lawsuits against the offending individual, the company or both.
Examples of ultra vires activities include corporate directors entering into contracts without obtaining approval of the board of directors when the governing agreement requires such approval, the company president selling significant parts of the company’s assets without first securing shareholder approval and the board of directors approving a loan to a corporate officer when the bylaws prohibit it.
Ultra vires used to be a more significant source of business litigation and liability than it is today, mainly because most state business entity laws now permit company owners and managers to engage in activities that used to be disallowed as long as they can demonstrate that the actions were undertaken in good faith and used sound business judgment. Still, engaging in acts prohibited by the company’s organizational documents or governing agreement can result in an ultra vires claim, so it remains important to understand how governing documents can help mitigate the risks.
How Governing Agreements Can Reduce Liability Risks
Forward-thinking business creators and owners can use the company’s governing agreement to provide guidance on what to do when foreseeable events like rogue members, disgruntled shareholders or conflicts of interest occur. Properly drafted bylaws, operating agreements and partnership agreements can prevent or resolve intra-company disputes while remaining in compliance with state laws.
Although acting contrary to a company’s governing agreement can result in exposure to claims of legal liability, the agreement can also serve as a shield for the organization’s senior personnel. What follows are a few of the ways that governing agreements can anticipate and preclude some sources of vulnerability.
Indemnification and Ratification Provisions
Corporation, LLC and partnership laws allow for “escape hatch” provisions in the governing agreements that authorize the company to ratify some activities that might otherwise constitute breaches of fiduciary duties or ultra vires acts. For example, a corporation’s bylaws can contain a clause allowing the board of directors to indemnify an individual director from having to pay legal fees, court costs and monetary damages arising from lawsuits against that director based on actions she took in her capacity as a director.
In a partnership setting, although Section 105(b)(5) of the Revised Uniform Partnership Act prohibits a partnership agreement from altering or eliminating the duty of loyalty, Section 409(f) states that “All the partners may authorize or ratify, after full disclosure of all material facts, a specific act or transaction by a partner that would otherwise violate the duty of loyalty.” Indemnification and ratification provisions in a partnership agreement can be effective as long as the behavior in question is not “manifestly unreasonable,” but it is also good practice to identify in the agreement specific behaviors that do not violate the duty of loyalty.
Frivolous Lawsuit Barriers
Corporate shareholders can file lawsuits against a corporation if they believe that the board of directors or officers have done something that violates their obligations to the company and the shareholders. Some of these lawsuits can be well-grounded, but on occasion, shareholders may file lawsuits that are meant more to interfere with or harass the board or officers, or to engage in a power struggle, than for any protective or restorative purpose.
Some corporations have sought to insulate the board of directors from the possibility of frivolous shareholder lawsuits by crafting corporate bylaws that limit the circumstances under which shareholders can sue. The enforceability of such restrictions depends on factors including whether the shareholders approved of them in advance after full disclosure and review, or – if the board of officers acted without such prior approval – whether the restrictions are reasonable and whether they interfere with vested shareholder rights.
Many kinds of contracts require the parties to interpret agreements in accordance with one state’s law, and some go further to restrict the legal mechanisms the parties can use against other parties to enforce the agreement. Governing agreements are no exception to these practices and are sometimes platforms for novel provisions designed to preclude frivolous, multi-state jurisdictional and class-action lawsuits. Not all of the restrictions are allowable in all states, but in the context of corporations, some of them include:
- Minimum party numerical thresholds: Some bylaws might include a requirement for a minimum number of shareholders (such as at least 3 percent of them) to consent to a derivative lawsuit against the corporation before it can commence. Some provisions even attempt to preclude class action lawsuits.
- Choice of forum clauses: These restrictions can require a party – regardless of where she resides – to use a given state’s court system to resolve claims against the company (typically the state where the business legally exists). A variation of this is a requirement to resolve disputes through alternative means, like mandatory arbitration.
- Fee-shifting clauses: In Delaware, courts have permitted bylaw provisions requiring the losing party in a lawsuit to pay the prevailing party’s legal fees and costs. In Oklahoma, state law requires such “loser pays” fee shifting in shareholder derivative lawsuits. Other fee-shifting examples include securities-related class action lawsuits under federal law and in private agreements among stockholders.
Aside from corporations, an LLC operating agreement can determine whether one member can sue another member in her individual capacity to do things like enforcing reimbursement of contributions to the company, or to force another member to withdraw from the LLC in accordance with a membership agreement provision. Agreements can also determine how to value that member’s interests when they are forced to withdraw or are bought out. All such provisions should be explicit in the agreement to have any chance to be enforced in court.
Partnership agreements can also include terms and conditions that affect how to resolve partner claims against each other or the partnership, such as requiring majority or unanimous consent of all partners to commence a claim. The partnership agreement can also be instrumental in authorizing the removal of a partner without triggering the dissolution of the partnership or provide for particular remedies for breach of the partnership agreement, such as liquidated damages or specific performance.
The best business contract may be the one you never need to refer to after signing it. The next best contract is the one that, when you need it to cover a critical issue, does so. Business governing agreements can go beyond simply fulfilling a state’s requirement to have one. To the extent those writing a governing agreement can anticipate sources of disputes and understand the pertinent state contract and business laws, they can build in dispute avoidance and resolution measures that offer more control-certainty compared to relying on statutory language or generic agreement forms.
Having this control and certainty when a dispute arises among the people who own and direct the company can be the deciding factor in whether they resolve that dispute amongst themselves or need the governing agreement as evidence in court.
 Model Business Corporation Act § 8.30(2010).
Revised Uniform Limited Liability Act §409(b) (2006).
 Revised Uniform Limited Liability Act § 409(c) (2006).
 Revised Uniform Limited Liability Act § 409(g)(5) (2006).
Revised Uniform Partnership Act § 409(b).
 Revised Uniform Partnership Act § 105(b)(5).
 Revised Uniform Partnership Act § 409(f).
 Robert Brown, “Delaware and the Consequences of an Excessively Management Friendly Approach to Corporate Governance (Part 2),” RacetotheBottom.org, (Nov. 13, 2014), http://www.theracetothebottom.org/home/.
Boilermakers Local 154 Retirement Fund v. Chevron Corporation, 73 A.3d 934, 939 (Del. Ch.2013).
 ATP Tour, Inc. v. Deutscher Tennis Bund, No. 534, 2013, slip op. at 10, 13 (Del. May 8, 2014).
Oklahoma Senate Bill No. 1799 (approved into law May 23, 2014).