By: Molly McGreavy

Start-up founders typically take many steps to protect themselves and their businesses from future legal snags. Founders want to reduce liability, safeguard their assets, and learn how to create and enforce contracts with agreeable terms.

Often overlooked is a crucial consideration lurking behind all those documents and organizational forms: founders have duties as fiduciaries to their companies and investors. By operating a start-up without any awareness of these fiduciary obligations, founders could be putting themselves at risk for detrimental litigation down the road.

Founders, in their roles as directors, managers, executives, and even as shareholders/owners have certain responsibilities to act in the company’s best interest, sometimes to the exclusion of their own. These responsibilities are referred to as “fiduciary duties,” and the people who have these duties are “fiduciaries.” Essentially, fiduciaries are those in charge of running or managing a company, and the fiduciaries owe duties to the individuals who have stakes (usually financial stakes) in the company’s success. The fiduciary obligations are based on principles of trust; individuals who put money into a company must be able to maintain confidence that their investment is not being mismanaged.

Each state has its own corporate governance statutes and case law that specify what a fiduciary is and how one breaches her fiduciary duties in corporate law. It’s important that founders be diligent in researching the specific laws of the state in which a company is incorporated or organized. Most state laws focus on two key fiduciary duties: the duty of care and the duty of loyalty. Recognizing these two duties and what they generally entail is crucial to any founder hoping to raise capital through outside investment. If a shareholder finds that a director or executive has failed to act within her fiduciary duties to the company, that shareholder can hold the director and/or executive personally liable.

Duty of Care

Generally, the duty of care encompasses the responsibilities of fiduciaries to act in the same manner as a reasonably prudent person would in making decisions for the company. We often see courts boil down this duty of care to a duty of fiduciaries to be informed. That is, directors and executives cannot make decisions blindly — they must take reasonable steps to gather relevant information or data before exercising judgment. Consider the following scenario:

Director and financial guru X convinces angel investor Y to invest a large sum of money in New Corp. Y’s contribution ends with its financial investment — Y will have no management power in New Corp. Eventually, X becomes disinterested in board meetings and begins falling asleep and playing on her phone during important presentations. As a result, when it comes time for the board to vote on a proposed merger with Big Corp, X is uninformed and she carelessly makes the deciding vote of approval. Turns out, Big Corp was in a financial down spiral, which X would have recognized had she been paying attention to presentations of Big Corp’s earnings. Y can now bring suit against X for a breach of her fiduciary duty of care.

Many states allow fiduciaries to shield themselves from fiduciary duty claims ex ante. Companies will typically include in their articles of incorporation (corporation) or operating agreements (LLC) provisions that eliminate any liability for breaches of duty of care.

Duty of Loyalty

The duty of loyalty is distinct from the duty of care both in what it entails and in the abilities of companies to alter or eliminate it. Unlike the duty of care, companies cannot “contract out” of the duty of loyalty in their formation documents. The duty of loyalty requires that fiduciaries put the interests of the company over their own personal interests. While there are myriad ways in which a breach of this sort can occur, its easiest to discuss duty of loyalty in terms of self-dealing.

Self-dealing is any action done for the benefit of the fiduciary’s personal gain rather than for the benefit of the company.  Self-dealing can include mismanagement of company funds or inappropriate use of company information. Consider the following example:

Investor Y agrees to invest a sum of money into New Corp. Director X, who is facilitating the transaction, redirects Y’s capital into her personal bank account as a loan because she is late on her mortgage payment.

Alternatively, Director X has inside information that Apple is about to enter into a joint venture with New Corp, but the deal has yet to be made public. Director X buys up a large amount of New Corp stock while it is still inexpensive, knowing its value will soon skyrocket.

Self-dealing also includes instances where a fiduciary takes a corporate opportunity for her own, without first disclosing the opportunity to the company. A corporate opportunity is any business opportunity that may benefit the company. For example:

New Corp is a real estate company; the board has expressed interest in expanding business by buying properties in the Detroit. Director X is approached by an individual selling a large office building in the heart of Detroit. This individual knows X works for New Corp, and the individual heard about New Corp’s desire to expand. Rather than bringing the opportunity to the board, X personally pays the individual well-over her asking price for the office building, and thus takes the investment for herself.

Business Judgment Rule

Courts will usually give deference to directors, managers, and executives when fiduciary breach lawsuits are brought. There is a presumption that fiduciaries exercised sound business judgment and acted in the company’s best interest in their decision-making. This presumption is referred to as the business judgment rule. The business judgment rule places an incredibly high burden of proof on plaintiffs to discredit the actions of fiduciaries.

The purpose of this rule is to encourage risk. Often times, the safest investment is not the best investment. Investors trust directors, managers, and executives to make strategic and often risky decisions in order to increase capital in the long-run. If these fiduciaries were constantly worried that their decisions would be scrutinized and used against them in lawsuits, they would rarely take risks.

Taking a step back, founders should not look at the business judgment rule’s presumption as an easy way out of complying with fiduciary duties. Lawsuits are never a good thing, even if the company is ultimately on the victorious side. A founder’s reputation can be seriously damaged by fiduciary duty-related lawsuits, and these suits will surely make future investors weary. Moreover, litigation is costly — fiduciaries should seek to eliminate any danger of such an unnecessary expense.