[Originally published in the Fall 2017 issue of Artisan Spirit magazine.]
In a prior article, I discussed the ways that smaller spirits businesses can solicit and receive equity investments from third parties by selling shares of company stock or limited liability company membership interests. If the cash is received from a traditionally friendly party — the distiller’s mother, for example — then the business may be pleased to get more favorable terms than might be available if the investment were obtained in a truly arm’s-length transaction from someone who doesn’t necessarily care about the distiller’s well-being (let alone the possibility that if the new venture fails the distiller will end up moving back in with the investor).
But even if the investment was received from his sweet and loving mother, as soon as our hypothetical distiller deposits mom’s check into the business’ account his relationship with her has changed. For as soon as the funds clear she is no longer simply his mother. She is now a shareholder in his corporation, a member in his LLC or a creditor of his business. In a very real sense, she is now his boss. This may represent a fundamental shift in the character of their interactions. The child has, in at least a business sense, become the parent.
Of course not all small businesses — let alone small distilleries — tap family and friends for their capital needs. But even for those that rely exclusively on unrelated third parties to fund their startup and growth, the relationship between investor and entrepreneur is essentially the same as the business relationship between our hypothetical mother and son. By accepting the investor’s cash, the entrepreneur will take on obligations which are directed to the company and — by extension — the investor. So before he thanks his mother and endorses her check over to the purveyor of a shiny new dephlegmator, let’s spend a few moments thinking about those new obligations, how our distiller will need to behave once his mother is a shareholder in his business and — more generally — the proper care and feeding of corporate stakeholders.
Generally speaking, directors and officers of a corporation owe “fiduciary” duties to the corporation itself. Fiduciary is a special word, connoting a special kind of obligation. In fact, a fiduciary duty is generally the highest level of obligation imposed under principles of corporate or agency law. Over centuries of jurisprudence, the specific obligations owed by directors and officers have been broadly categorized in the U.S. as falling within two basic categories of fiduciary duty: the duty of care and the duty of loyalty.
The Duty of Care. Under the law, our hypothetical distiller — who we presume for purposes of this article is a director and an officer of the corporation — owes a duty of care to the company. This means that the law requires him to manage the business with the same level of attention and care that a reasonably prudent person would exercise in a similar situation. You could be excused for asking whether a reasonably prudent person would choose to open a distillery in the first place, but that is a different issue. Once the company has been formed, this is the level of care he must exercise.
To satisfy his duty of care, our distiller needs to be certain that he keeps himself informed about all material aspects of the business. This means more than simply knowing how to separate the heads, hearts and tails. It means also that he needs to understand the projected cash flows, distribution strategy and risks of the business. He needs to draft a business plan and manage the business to that plan. Put less analytically, he needs to worry about and sweat the small stuff.
This doesn’t mean that our distiller must be independently omniscient in order to fulfill his duty. Rather, the law allows him to meet his duty of care by asking questions of and relying on experts so long as he reasonably believes they are in fact experts and has no reason to doubt their answers. So if our distiller isn’t great with accounting and spreadsheets, he can still meet his duty of care with respect to managing the company’s financial affairs by bringing in a chief financial officer, accountant or bookkeeper, letting that person do their work, asking them appropriate questions and then managing the business accordingly.
Sometimes, managing the operation prudently means looking into and handling unpleasant business. Directors have an obligation to do this and cannot simply ignore problems as they arise. Rather, they must take initiative, investigate when things go awry within the business and take appropriate corrective action. This can mean making hard decisions ranging from the necessity of going out and looking for additional capital (meaning, perhaps, that his mother has a smaller ownership stake in the business) to firing a troublesome employee (even if a friend or relative) to closing the doors if it has become clear that the business is failing and there is no realistic prospect of turning things around.
Of course, if our distiller really makes his mother angry with the way he runs the business, he may have to prove in court that he met his duty of care. That is where process becomes important. It isn’t enough for our distiller to meet his duty of care, he needs to be able to show that he did so. When our distiller is acting as a corporate director, this means having regular board meetings and keeping a record of the proceedings. Even if those board meetings are held at his breakfast table, he needs to keep accurate minutes. And when the meeting includes significant decisions (e.g., whether to spend the business’ precious cash to buy a second still even though he isn’t yet able to quickly sell everything produced with the first) the minutes need to reflect a deliberative decision-making process.
The Duty of Loyalty. A director’s or officer’s second general fiduciary duty is the duty of loyalty. Put simply, this obligation requires the director or officer (i.e., the fiduciary) to put the interests of the business ahead of his own interests.
The duty of loyalty will require our distiller to avoid engaging in self-dealing. So, for example, he should not take action as a director to set the salary that the company pays him. If possible, he should instead allow other directors of the company (who are not employees) to determine the amount of his compensation. Similarly, our distiller should avoid any situation in which he takes personal advantage of a benefit or opportunity that rightfully belongs to the company. This means that if he comes up with an idea for a new brand of spirit, our distiller can’t simply form a new company and pursue the opportunity. He must bring the opportunity to the attention of the existing company’s board of directors and give the company the chance to pursue it. Only if the opportunity is disclosed to the board and the company decides not to proceed can he then move forward independently without violating his duty of loyalty.
The duty of loyalty also requires our distiller to act in good faith, disclosing any conflicts of interest between himself and the company, and abstaining from board decisions on those items. Such conflicts aren’t limited to items like determination of our distiller’s salary. Rather, they can surface in connection with myriad business decisions. Suppose, for example, that the distillery wants to open a new tasting room and is looking for a good location. Further suppose that our distiller knows of some available commercial space in the general neighborhood in which the distillery wants to expand. The property is priced at an above-market rate, but the landlord just so happens to be someone in which our distiller has a romantic interest. If he can get the company to lease the space, our distiller figures he might have a shot at getting a date with the landlord.
What should our distiller do? If the company has taken in outside equity investment, the distiller can certainly bring the potential lease opportunity to the attention of the company. But in order to fulfill his duty of loyalty, he probably needs to disclose also to the board of directors that he has a romantic interest (albeit unrequited) in the landlord. And if the board (with our distiller abstaining from the vote) nevertheless approves the company’s entry into the lease in full knowledge that it is at an above-market rate, then the decision by the company to enter into the lease will likely be hard for a shareholder to challenge even if our distiller actually scores the date with the attractive landlord. Note that our distiller’s abstention from the vote on the lease is important because the duty of good faith requires not only disclosure of conflicts of interest, but also that directors act with the purpose of advancing the interest of the company. Clearly, our distiller’s motives in this scenario may have been less than pure. But if he discloses the conflict and abstains from voting on the matter, he has not in fact taken any action with respect to the lease and does not appear to have violated his duty.
The duty of care also imposes an obligation of confidentiality. One of the delightful aspects of the craft distilling ecosystem is the amount of sharing that takes place among the participants. But that sharing — which is certainly admirable in many situations — must take a back seat to a director’s duty to keep confidential the secrets of the company itself. Those secrets might include items related to the production process, but in all fairness there is relatively little in distilling which isn’t widely known among the imbibing public and the industry as a whole. The more likely secrets relate to financial and strategic matters, like whether and when the company may seek to be acquired by or acquire a competitor. In the context of the current flurry of industry consolidation, failing to keep this kind of information confidential may have very real negative consequences on the company itself.
What if My Business Isn’t a Corporation? In the foregoing discussion, we’ve analyzed the duties of care and loyalty in the context of a corporation. But the duties have relevance also in the context of other business forms. If you’ve accepted equity investment (from your mother or otherwise) without having formed a corporation or limited liability company, you’re probably operating your business as a general partnership. In that circumstance, these duties exist in their strongest possible form and you must comply to avoid liability. Alternatively, you may have formed a limited liability company. If that is your chosen structure, you may — or may not — be required to comply with some or all of these duties. Whether you must comply will depend primarily on the law of the jurisdiction in which you formed your LLC as well as the language included in your LLC Operating Agreement. Generally speaking, some jurisdictions allow a waiver of significant components of these duties so long as the waiver is included in the Operating Agreement and the waiver does not extend to the point that it violates the controlling statute.
What Changes When You’re Running out of Cash. Unfortunately, craft distillers — like most startups — are exceptionally good at running out of operating capital. So chances are pretty good that if you’re a small distillery, you’ve either nearly run out of cash before, you’re going to run out in the future or you’re currently looking at your bank statement and wondering how you’re keeping the business going. This is a really tough industry.
From a legal standpoint, when a company becomes insolvent, the directors of the company may need to begin considering not only the interests of the shareholders but also the interests of the company’s creditors. This doesn’t mean that the directors owe the creditors a fiduciary duty; the duty runs to the company itself. But creditors of an insolvent corporation — as the rightful ultimate owners of whatever assets may actually exist since insolvency means that there is no equity in the equityholders’ interests (i.e., the shares are without value while the company is insolvent) may be viewed as stepping into the shoes of the shareholders. So if our distiller convinced his mother to buy shares in his company, and then obtained a loan from some third party, his company’s insolvency means that he may need to consider that third party’s interests ahead of his mom’s interests — a challenging conversation at Thanksgiving to be sure.
Note that it can be tricky to determine when a company actually becomes insolvent. Generally speaking, insolvency will be found when either the company cannot pay its debts as they come due in the ordinary course or has liabilities which are in excess of its assets. Of course, reasonable people can disagree over whether either assets on a balance sheet are fairly valued and businesses frequently find that they have liabilities that arise of which they were not previously aware. Because of these difficulties, a board of directors likely needs to begin considering the interests of the company’s creditors when the business is within the “zone of insolvency” — that dreary situation in which there is a reasonable probability that the corporation may be insolvent.
What’s the Point of Complying? If you’ve made it to the end of this discussion, you may well be asking why you need to comply. What benefit do you get if you meet your fiduciary duties? The short answer is that it becomes more difficult for one of your shareholders to sue you for something you’ve done. So if you’re certain that none of your shareholders are going to sue you (e.g., you’re the only shareholder or you sold shares to your mom but you’re convinced she won’t hire a lawyer), then you may be thinking you’ve wasted your time. Perhaps you’re right. But then again, considering that your business’ creditors can effectively step into the shoes of your shareholders if you breach your fiduciary duties and the corporation happens to be insolvent — perhaps you’re mistaken.
By fulfilling their fiduciary duties to a corporation, directors get the benefit of one of the greatest features of our corporate law: the business judgment rule. Broadly stated, the business judgment rule holds that so long as the directors have fulfilled their fiduciary duties and a challenged decision by the board does not involve conflicts of interest, improper personal benefit or other obviously troubling impropriety, the court will not substitute its judgment for the judgment of the board. In other words, the court will respect the business judgment of the board. This means that you can be dead wrong in your corporate decision-making and, so long as you fulfilled your duty, you are unlikely to find legal liability. That’s a good thing.
Of course, if you really are dead wrong in your decision-making and your mom loses her investment, it is possible that she will not follow this longstanding legal precedent and will indeed criticize your judgment. I can’t help you with that one. You’re going to need to sort that out on your own.