Corporate decision-making authority can be held in several ways, depending on the specific provisions of the company’s governing documents, whether that be a shareholders agreement for a corporation, an operating agreement for an LLC, or another agreement. In corporations, there are generally three groups of individuals that make decisions: the shareholders, the directors and the executive management. Sometimes, certain thresholds are required, such as 2/3 vote or unanimous consent, and certain shareholders may hold veto rights over specific decisions. That being said, in the absence of contractual provisions to the contrary, decisions are often made by majority vote.
Therefore, in theory, a controlling shareholder that holds more than 50% of the shares can unilaterally determine any issue that is up for a shareholder vote, and the minority shareholders have to go along with it. However, this authority is not ultimate, as majority shareholders (and officers and directors) hold fiduciary duties to the company and the minority shareholders. In California, this duty has been described as a requirement of “good faith and inherent fairness”.1 Directors, officers and controlling shareholders must act with “honesty, loyalty, and good faith”.2
Cannabis company operators should be aware of these fiduciary duties, as one recent high-profile case has demonstrated. Earlier this year, minority investors in Medmen sued several of the company’s executives, claiming that they breached their fiduciary duty by rewarding themselves to the detriment of other shareholders in the company. The suit ultimately ended in a private settlement, with one of the defendants resigning from the company’s board of directors. Thus, controlling shareholders should bear in mind their fiduciary duties so they do not find themselves involved in similar lawsuits. Some historical cases defining such duties are described below.
Sale of Shares
In one famous case, Jones v. H. F. Ahmanson & Co., the majority shareholders of a company formed a holding company for their shares and conducted a public offering of the shares in the holding company. Thus, the majority shareholders, who held about 85% of the original company’s stock, were able to sell their shares, while the minority shareholders were not. The court held that:
Majority shareholders may not use their power to control corporate activities to benefit themselves alone or in a manner detrimental to the minority. Any use to which they put the corporation or their power to control the corporation must benefit all shareholders proportionately and must not conflict with the proper conduct of the corporation’s business.3
In fact, Jones continues to be cited to this day for the proposition that majority shareholders owe fiduciary duties to minority shareholders.4 However, it has been limited to its particular facts. In Max v. Shih, a California court held that the defendant directors, who liquidated the corporation after the sale of its assets, did not violate its duties to common shareholders, where the return to common shareholders was less than to the preferred shareholders.
The court distinguished Jones from Shih because while in Jones the majority shareholders had several options for creating a public market for their shares, the directors in Shih had no such similar freedom to act, as they were limited by the corporation’s articles of incorporation, which specified certain liquidation preferences that must be met upon a liquidation event. Thus, while unfair contractual provisions may be subject to a finding of unconscionability or similar cause of action, they probably do not give rise to a finding of breach of fiduciary duty where the directors were acting pursuant to the company’s governing documents.
Business Judgment Rule
Directors are also protected by the business judgment rule, which states that:
in evaluating whether a decision by a director breached a fiduciary duty, the director is entitled to a presumption, under the so-called business judgment rule, “‘that directors’ decisions are based on sound business judgment, [which] prohibits courts from interfering in business decisions made by the directors in good faith and in the absence of a conflict of interest.’”5
Thus, while directors are bound by a fiduciary duty, they are often granted wide latitude by courts to act in the best interest of the corporation.
Conclusion
Shareholders, directors and officers all hold certain duties to other shareholders and the corporation. While courts sometimes grant discretion for business decisions, those acting in official corporate capacities should ensure they are acting in the best interest of the corporation and not unduly disadvantaging minority shareholders, or they may be in breach of their fiduciary duties. If you have questions about your corporation or legal entity, reach out to us—we’d be happy to help.
Contact one of our cannabis law firm specialists today by phone at 310-912-2960 or online.
1 Jones v. H. F. Ahmanson & Co., 1 Cal. 3d 93, 110 (1969).
2 Berg & Berg Enterprises, LLC v. Boyle, 178 Cal. App. 4th 1020, 1037 (2009).
3 Jones v. H. F. Ahmanson & Co., 1 Cal. 3d 93, 108 (1969).
4 Max v. Shih, No. B301010, 2020 WL 7021644, at *10 (Cal. Ct. App. Nov. 30, 2020), reh’g denied (Dec. 21, 2020).
5 Id. at *13.
Disclaimer: This article has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice.