When evaluating an investment opportunity, a would-be investor’s risk analysis is usually limited to the potential loss of principal and related opportunity costs of the investment. But substantial investments in startups or small, closely held businesses carry the additional risk of unintended fiduciary obligations. When the investor develops a fiduciary duty, the theoretical risk of loss becomes unlimited. An otherwise passive investor may unexpectedly gain duties of care and loyalty to other investors in the company and expose themselves to liability far in excess of their investment should the fortunes of the enterprise erode.
Unexpected fiduciary obligations may be imposed on investors in a number of ways. The most common fiduciary relationship arises through appointment to a board of directors, where seats are often offered in exchange for large investments. While having a board seat can give the investor comfort, and even some control, directors by virtue of their position automatically gain a fiduciary duty to the company. This fiduciary duty includes the duties of care and loyalty. These duties are also often interpreted broadly. For example, the duty of care includes not only a duty to act reasonably and prudently. It has also been interrupted to include a duty to exercise reasonable oversight. Similarly, the duty of loyalty has also been interpreted to include the duty of good faith and disclosure. While all these duties are owed to the corporation, the investor-director may find themselves in the crosshairs of litigation personally if the fortunes of the company turn and other shareholders look to hold the directors individually liable to recover losses.
But board membership is not the only way an investor can gain a fiduciary obligation. Controlling shareholders can have a fiduciary duty to other shareholders regardless of whether that investor owns the majority of the shares. Whereas the lines for the fiduciary obligations of a director are typically bright and clear, the point at which a controlling shareholder gains a fiduciary obligation is much more likely to catch one by surprise. Similarly, in many jurisdictions, investors in a closely held corporation are deemed to have fiduciary obligations toward the other investors, regardless of how much control they personally exercise. In those situations, the duties of an investor appear much more akin to a partnership than a typical corporation.
Most states impose fiduciary obligations on controlling shareholders. Whether an investor is a “controlling shareholder” requires consideration of the necessary level of “control.” Some states evaluate the question both generally or with respect to a single issue or transaction. For example, in Delaware, the general rule is that an investor gains a fiduciary obligation once they own either a majority interest or otherwise exercise control over business affairs. See Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334 (Del. 1987). But that control can come in many forms, and the test for control can be transaction-specific. For example, a minority investor can be held to owe fiduciary duties with respect to a single transaction, if that investor is able to control the outcome of the company’s decision-making through the exercise of veto rights, threats or other strong-arm tactics. See, e.g., Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994). Regardless of the investor’s actual voting power, the court may consider whether the investor exercised a level of actual control such that other voting members could not exercise independent judgment. See In re Tesla Motors, Inc. S’holder Litig., 2018 WL 1560293 (Del. Ch. Mar. 28, 2018).
But the threshold for a “controlling” shareholder is not the only way a fiduciary obligation may come as a surprise. In some jurisdictions, like Illinois, minority investors in a closely held corporation may be deemed to have fiduciary duties to one another more akin to the duties of partners in a partnership. See Hagshenas v. Gaylord, 199 Ill. App. 3d 60 (2d Dist. 1990); see also Donahue v. Rodd Electrotype Co. of New England, 367 Mass. 578, 592–93 (1975) (“Because of the fundamental resemblance of the close corporation to the partnership, the trust and confidence which are essential to this scale and manner of enterprise, and the inherent danger to minority interests in the close corporation, we hold that stockholders in the close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another.”).
Conflicts between the goals of a particular investor and the goals of others within the company are commonplace. Disputes over decisions that affect the timing of an exit or distribution, decisions that trigger tax consequences, and other similar situations may all tempt an investor to pull on any levers available to force a favorable outcome. While the test for whether the investor owes a fiduciary duty will always be fact-intensive and addressed case by case, wary investors must always give a thought to how the transaction or deal will be viewed with the benefit of hindsight, when the lawyers are involved. If a dispute arises later, the size of the investor’s voting power—though relevant—will not be the only factor considered.
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