Elon Musk’s recent buyout of Twitter – over the objections of Twitter’s board of directors – prompted threats of suits for breaches of fiduciary duty. Business owners and managers may rightly ask: could my business be bought out from under me? If your business has other owners – even if it’s privately-owned and you know every other owner – you should be aware of the balancing act that fiduciary duties require in business buyouts.
What Is a Fiduciary, Anyway?
The first question is: what exactly is a “fiduciary duty?” In plain English, it means someone (the fiduciary) is obligated to put the interests of another person (the beneficiary) above his own. Partners who manage a business are fiduciaries towards each other and to limited partners who don’t manage it; the same often applies to members of a limited liability company. Officers and directors of a corporation are fiduciaries to the corporation – in other words, to all of its shareholders together, but not to one of them specifically.
One way to breach a fiduciary duty is by “self-dealing,” which means using the fiduciary position for personal benefit. One classic example of self-dealing is when a business’s manager hires his own company to provide services to the business. Since the manager is “negotiating” for both sides of the deal, courts presume this type of deal is unfair – the manager has to prove the deal was fair. This includes deals where the fiduciary gets a benefit that the beneficiary does not (or doesn’t get as much of as the fiduciary).
The Buyout No-Win Scenario
This is why buyouts of corporations can be especially hazardous. Corporate fiduciaries usually have a personal stake in rejecting a buyout – a new majority owner usually means new directors and (sometimes) new officers. Officers don’t want to be fired and replaced, and directors want to keep their positions of power – and so they may oppose the buyout. This is often accomplished with a shareholder rights plan – also called a “poison pill” – where the company allows current shareholders to buy shares at a discount. While effective, this means investors who support a buyout can claim (usually with the help of the buyer) that management deliberately undercut the company’s stock price for its own benefit.
Another way to breach fiduciary duty is failure to disclose. In arms-length business deals, the parties aren’t required to volunteer information – only to refrain from lying and to correct known mistakes. By contrast, fiduciaries are required to volunteer all facts that would affect the beneficiary’s decision to enter the deal. For corporate buyouts, this includes payments or guarantees made to the company’s directors and officers in the buyout. When this information is not provided (or allegedly is not “fully” provided), investors who oppose a buyout can claim that management was effectively bought out by the new owner against shareholders’ best interests… and claim a breach of fiduciary duty.
This no-win scenario is a problem because there are often good reasons for the stockholders for a corporation to oppose a buyout. In the 1980s and 90s, so-called “corporate raiders” engaged in buyouts to strip companies of their valuable assets, leaving only an empty shell after the buyout. More commonly today, so-called “activist shareholders” may pursue their personal agendas via the corporation.
Both of these actors can disrupt or even destroy a company’s business with the threat of a buyout, putting other minority stockholders (not to mention the company’s employees and business partners) at risk of harm. Directors and officers of corporations are rightly concerned about such tactics – but to an outside observer (like a court), protecting “other” stakeholders can often resemble self-dealing, requiring a costly lawsuit to resolve.
If this situation sounds unfair to you, you’re not alone – Delaware courts (where most of these disputes occur, and Texas law generally follows) see the problem when directors of a corporation can be sued whether they approve a buyout or not. Delaware applies the business judgment rule to solve this problem – which means that if the corporation’s directors are “independent” (aren’t connected with a party for/against the buyout) and “disinterested” (don’t benefit other than as a stockholder from the buyout), then shareholders can’t presume the directors acted improperly. Texas has applied this rule not only to directors, but to shareholders and officers of closely held (small, usually family-owned) corporations. If you’re considering selling your small business, and you suspect your co-owners may not buy into your buyout plan, legal counsel is essential to help you walk the fine line of fiduciary duty.