22 Oct Majority Be Warned: Fiduciary Duties Persist Despite Contractual and Statutory Rights
By Michael A.H. Schoenberg, Esq.
It is a well-settled precept of the law that majority owners of business owe certain fiduciary duties to the minority owners, including the duties of loyalty, good-faith, honesty and fair dealing. Sometimes, the majority’s duties come into conflict with their contractual and statutory rights to take certain actions given the negative impact those actions will have on the minority.
Imagine, for example, an operating agreement that allows a simple majority of the members to amend their agreement giving them a way to diminish the minority owner’s say in the company. Can the majority amend the operating agreement to allow capital calls even though they know that, given the minority member’s financial status, it will disproportionately impact that minority member’s ability to remain a member of the company or it will cause a significant dilution of the minority member’s ownership interest? Will the majority members’ actions, seemingly authorized under LLC Law § 402, result in a breach of their fiduciary duties even though their contract with the minority member allows the action?
In Shapiro v. Ettenson, 2015 NY Slip Op 31670(U), a landmark decision issued on August 16, 2015, the Supreme Court in New York County addressed this issue finding that the majority members did not breach their fiduciary duties. The Court found that, under LLC Law §§ 402 and 408, the majority members of a company were on terra firma when they, without the minority member’s input or consent, adopted an operating agreement two years after the LLC’s formation that severely curtailed the minority member’s rights in the company, including allowing the majority to make capital calls that would dilute the minority owner’s interests if he did not pay. The Appellate Division, First Department unanimously affirmed the lower court’s ruling (2017 NY Slip Op 00442 [1st Dept Jan. 24, 2017]) paving the road for majority business owners to adopt operating agreements and amend existing operating agreements (assuming the agreement allowed such action by a majority vote) without regard to the minority owner’s interests.
In a September 28, 2018 decision in Yu v. Guard Hill Estates, LLC, 2018 NY Slip Op 32466[U], however, Justice Scarpulla of the New York County Commercial Division put the brakes on majority owners relying on Shapiro, finding that a majority’s contractual right to take certain actions does not necessarily shield them from a breach of fiduciary duty claim if they acted in bad faith. Justice Scarpulla denied the defendants-majority owners’ motion to dismiss, finding the plaintiff’s allegations of defendants’ amendment to the operating agreement and subsequent capitals stated a viable breach of fiduciary duty claim, explaining:
Conduct is not a breach of fiduciary duty if there is a formal written agreement covering the precise subject matter of the alleged fiduciary duty, and no showing that defendant was seeking to advance its or a third party’s interests over plaintiffs. Where one has a right under a contract, that right may not be exercised solely for personal gain in such a way as to deprive the other party of the fruits of the contract. A fiduciary may breach his duties by exercising his contractual rights in an unfair or inequitable manner.
Here, affording the complaint liberal construction, accepting the facts alleged therein as true, and according the plaintiff the benefit of every possible favorable inference, I find that Patrick sufficiently alleged facts to support a cause of action for breach of fiduciary duty. Defendants argue that they properly exercised their contractual rights by initiating the capital call and effecting the promissory notes and pledge agreements. Patrick alleges that defendants’ actions were not taken in good faith and in legitimate furtherance of corporate purposes, rather, they were taken as part of a family vendetta to oust him from the family entities. He describes the history and background of the family dispute and describes how the actions taken by his siblings and Guard Hill were in furtherance of the family’s agenda, rather than to fulfill a need in the company. Because of the actions taken, he now owes $590,887 on the promissory notes executed by Raymond and Catherine on his behalf, and his shares in Guard Hill are pledged. While Raymond and Catherine did have certain rights under the Guard Hill operating agreement, whether they exercised those rights in good faith and in an equitable manner is disputed and must be determined through the course of litigation.
Justice Scapula’s decision should give lawyers and their clients substantial pause before taking corporate action that will impact negatively the minority owners of the business. Only after a full analysis of the issues, the parties’ contractual rights, and the relevant laws can they properly weigh the pros and cons of the intended actions.