Corporate Law Monitor : Corporate Lawyer & Attorney : Cole, Schotz, Meisel, Forman & Leonard Law Firm : NJ, Mid-Atlantic Business Transactions & Finance Law

In the recent decision Cain v. Merck & Co., Inc., the New Jersey Appellate Division held that shareholders of New Jersey corporations are entitled to inspect board of directors and executive committees minutes, in addition to minutes of shareholder meetings. The Appellate Division made clear, however, that shareholders must demonstrate a “proper purpose” in exercising this right and that the scope of board of directors and executive committee minutes required to be made available for shareholder review are limited to only those minutes pertinent to that proper purpose.

In Cain, the plaintiffs made a written demand, pursuant to N.J.S.A. 14A:5-28(4), for the inspection of certain books, minutes and records of the company in connection with the plaintiffs’ claim that the company had engaged in wrongful conduct and mismanagement in failing to disclose the results of a clinical drug trial for a period of twenty-one (21) months. The trial court ruled that the plaintiffs were entitled to inspect all of the board of director and executive committee minutes for that period.

Section 14A:5-28 provides that: (1) a corporation is required to “keep the books and records of account and minutes of the proceedings of its shareholders, board and executive committee”; (2) upon request, a corporation shall provide certain financial statements to a shareholder; (3) a shareholder holding at least five (5%) percent of the outstanding stock of a corporation, or who has owned his stock for at least six (6) months, has the right to inspect “for any proper purpose” a corporation’s “minutes of the proceedings of its shareholders and records of shareholders”; and (4) a court may, “upon proof by a shareholder of proper purpose . . . compel production . . . of the books and records of account, minutes, and record of shareholders” of the corporation. In construing the statute, the Appellate Division acknowledged that shareholders have a qualified common law right, not limited to simply stock transfer records, to examine corporate books and records, provided that the inspection request was made in good faith and for a proper purpose. The Appellate Division further noted that unlike the language of subsection (3) of the statute, the language of subsection (4) was not specifically limited to minutes of shareholder meetings. Accordingly, the Appellate Division held that under N.J.S.A. 14A:5-28(4), a shareholder is entitled to inspect the minutes of the board of directors and executive committees of a corporation.

Recognizing that an unfettered right to inspect board of directors and executive committee minutes could be detrimental to the best interests of the corporation and its shareholders, the Appellate Division made clear that this inspection right is not unqualified. A shareholder has the burden of proving a “proper purpose” for its inspection demand, based upon “specific and supported, credible allegations of mismanagement.” “Fishing expeditions” by shareholders based upon general or unsubstantiated claims of mismanagement are not permitted. Additionally, a court has the power to specifically circumscribe the scope of the inspection, limiting the inspection to only those documents relevant to the shareholder’s demonstrated proper purpose. In Cain, therefore, the Appellate Division limited the scope of the minutes available for plaintiffs’ inspection to only those portions of board of directors and executive committee minutes dealing with the clinical drug trial during the period the plaintiffs alleged the company wrongfully withheld the results of the trial. The plaintiffs were not entitled to inspect all corporate minutes for that period, as previously allowed by the trial court.

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With the limited liability company (“LLC”) being the entity of choice for many new businesses, LLC members and managers need to understand their legal obligations with respect to the LLC and its members. While directors of a corporation have fiduciary duties to its shareholders, similar duties are not automatically in effect for an LLC.

Fiduciary Duties of Corporate Directors

Directors owe a corporation’s shareholders fiduciary duties of care and loyalty. A duty of care is a director’s obligation to act in good faith, in a reasonably prudent way, and with a degree of care which another in a similar situation would use. A duty of loyalty is a director’s obligation to act with the best intentions of the corporation in mind. It is meant to prohibit a director from acting out of self-interest or self-dealing. As a result of this duty, a director cannot, for example, divert a corporate opportunity to himself without fairly presenting that opportunity to the Board for consideration.

LLC Duties

The New Jersey Limited Liability Company Act, 42:2B et.seq. (the “NJ Act”) sets forth default provisions which identify the rights and obligations of members and managers of an LLC. However, the NJ Act is deferential in nearly every respect to the ability of members to establish rights and obligations pursuant to a written operating agreement. Courts have “consistently held that New Jersey’s statute governing LLCs … controls only in the absence of an operating agreement.” Brick Professional, L.L.C. v. Napolean, 2009 WL 2176699, p. 3 (N.J. Super. A.D.) (additional citations omitted). As to fiduciary duties, 42:2B-66(a) indicates that the NJ Act “is to be liberally construed to give maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.” Thus, if the members of an LLC agree in writing to terms which govern their actions, those terms will be honored, even if they contradict the default terms set forth in the NJ Act.

Subsection (b) also contains critical language with respect to assessing a member or manager’s conduct:

“To the extent that…a member or manager has duties (including fiduciary duties) and the liabilities relating to [an LLC] or to another member or manager: (1) any member or manager acting under an operating agreement shall not be liable to the [LLC] or to any other member or manager of the [LLC] for the member’s or manager’s good faith reliance on the provisions of the operating agreement; and (2) the member’s or manager’s duties and liabilities may be expanded or restricted by provisions in an operating agreement.”

The first premise is that IF someone has fiduciary duties, that person will satisfy those duties if he or she relies on the operating agreement. The second premise is that the operating agreement can expand or restrict one’s duties. Thus, there is no automatic or implied fiduciary duty thrust upon a member or manager; however, an written operating agreement can create such duties and adjust them as needed. If the operating agreement creates a duty, the member or manager can fulfill his or her responsibilities by complying with the terms contained in such agreement.

Given that the NJ Act is to be liberally construed, creating a fiduciary duty can be achieved by having the operating agreement state that members and/or managers shall have fiduciary responsibilities as if they were directors in a corporation.

Serious Implications to a Member’s Actions

Even if a member’s poor actions do not constitute a breach of a fiduciary duty (either because there are no fiduciary duties in the operating agreement or the actions are simply not bad enough to rise to the level of a breach), they could have other serious consequences for such member. Section 24(b) of the NJ Act identifies reasons that a member may be dissociated, or forced out, from an LLC by judicial determination, including if: “the member engaged in wrongful conduct that adversely and materially affected the [LLC’s] business”; “the member willfully or persistently committed a material breach of the operating agreement”; and “the member engaged in conduct relating to the [LLC] business which makes it not reasonably practicable to carry on the business with the member as a member of the [LLC].” Therefore, while a member’s actions might not enable another member to bring an action against the bad actor for a breach of duty, they could lead to such member’s dissociation.

In summary, one should not assume that being a member or manager of an LLC means that fiduciary duties exist. If, however, the LLC and its members wish to ensure that members and managers have fiduciary responsibilities as if they were directors of a corporation, it is possible to create such obligations.
 

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