Conflicts of Interest Among Partners

December 15, 2020 Corporate Finance

Each state has laws governing the operation of corporations, limited liability companies and partnerships.  Included in those statutes are rules outlining the duty of care each owner of the business owes to the other owners.  These state statutes also identify areas where the governing instruments of the entity (the partnership agreement, shareholder agreement/bylaws, operating agreement) can alter or modify these standards and rules.

Duty of Loyalty

Partners owe a duly of loyalty to their fellow partners. How this duty applies in practice is where conflicts among owners arise.  A properly drafted partnership agreement can address expectations of the partners, and in some areas limit or modify the state statute.  Clearly, each partner must hold for the benefit of the business all property, profit and other benefits related to the business.  Breaches of this duty of loyalty arise when a partner uses partnership property for his or her own personal benefit without permission or compensation to the business or her partners.

Conflicts-of Interest 

Owners of businesses often have other business and personal interests; each with the potential to create conflicts of interest.  The duty to disclose or avoid these conflicts varies depending on whether the entity is member managed, or managed by a manager and whether the partners are active or passive.  A properly structured agreement between the owners should identify what if any limitations partners have with respect to other business interests.  Do partners have to devote their full-time efforts to the business?  Can the business transact business with an entity owned by one or more of the partners or their family members?  Can relatives of the partners be employed by the business?  Generally, disclosure can cure most conflicts of interest.  Typically, when partners fail to disclose conflicts of interest, costly disputes ensue.

Corporate Opportunities 

In connection with managing or otherwise providing services to the business, partners often become aware of possible business opportunities.  Examples include learning that a competitor may be for sale or innovations developed within the scope of a partner’s duties for the business such as a new product idea. Active owners in the business must disclose these and other opportunities to their partners and offer the business the opportunity to evaluate whether the company wishes to pursue them. Similar rules apply to directors and officers of an entity – whether or not they are owners. Shareholder agreements may limit the obligation of partners to offer these opportunities to the business.

Fiduciary Duty to Others 

In some cases, owners, managers, officers and directors of a company may owe a fiduciary duty to the businesses’ creditors. Courts have recognized a fiduciary duty owed to creditors when a business enters what is called the “zone of insolvency.” If a business is insolvent or otherwise unable to pay its bills on a timely basis, courts have recognized that the duties of the owners, directors and officers shift from acting solely in the interests of the owners to also protecting the interests of creditors.  Businesses that are struggling should be cognizant of this duty and avoid taking actions that subject them to liability.

It is inevitable that conflicts of interest will arise.  Partners should address expectations when they surface within the partnership agreement and err on the side of disclosure to their partners to avoid claims that a fiduciary duty was breached.