Passive Investor, Beware!

October 2018

Passive investors in small businesses often take a seat on the board of directors as a way to keep an eye on their investments. But the recent decision in In re Mundo Latino Market, Inc., shows the peril of a director’s failure to actively supervise the business’s employees. 

Mundo Latino was a food and household supply business in upper Manhattan. It was capitalized with $1 million from Kathryn Bedke, who owned 70% of the shares of the business, and $100,000 from Kathryn Holler. Ms. Bedke held the titles of vice president and director, and Ms. Holler was president, treasurer and a director. Ms. Bedke had a full-time job elsewhere and did not operate the business or work at the premises.

In late 2013 or early 2014, Bedke hired Giovanni Rodriguez to start and operate Mundo Latino on her behalf. Rodriguez took charge of the initial build-out of the store, purchasing and inventory and equipment, and hiring and training the staff. When the store opened in late 2014 or early 2015, Rodriquez oversaw day-to-day operations.

The business lost money during the entire time it was open due to bad management and bad acts by Rodriguez. According to the decision, Rodriguez bypassed the computer system, paid employees informally “off the books,” and used business funds for personal purchases, including a computer and other electronics.

When the business became a chapter 7 debtor in 2016, the trustee brought three claims against Ms. Bedke, alleging that she breached her fiduciary duties as majority shareholder, vice president and director by failing to properly supervise Rodriguez and oversee the debtor’s business. Bedke moved to dismiss the complaint, and the case came before the court on that motion. In the litigation, the trustee sued Bedke for $1.3 million, all of the claims filed by third-party creditors, contending that her negligence was the cause of their losses.

Judge Stuart M. Bernstein, relying on New York law, held that a shareholder had no duty to manage the business of the corporation and dismissed the claim against her in that capacity. He similarly dismissed the claim against her in her capacity as a vice president, noting that under New York law, a vice president has no fixed duties, only those assigned by the corporation or its directors. He noted that the complaint failed to allege that Bedke, as a vice president, had duties to supervise Rodriguez and ruled that in the absence of such duties, she could not be held liable.

But he held that Bedke could be held liable in her capacity as a director. He first noted the existence in New York of the “business judgment rule,” which generally holds that a director is not liable so long as he or she acts in good faith and with the degree of care that a prudent business person would apply in similar circumstances. Given that rule, he said that to survive a motion to dismiss, the complaint must “plead around” the business judgment rule.

But he found that the that trustee in Mundo Latino had successfully pled around the business judgment rule by alleging that Bedke, as a director, “closed her eyes to the Debtor’s affairs and failed to take reasonable steps to inform herself about Rodriguez’s activities and the Debtor’s operations.” Relying on New York law, he cited with approval a decision that held that directors “cannot assume the responsibilities of their fiduciary position, then simply close their eyes to what is going on around them and thereby avoid the consequences by the mere failure to act.” One of the interesting aspects of Mundo Latino is that bankruptcy courts are increasingly analyzing claims against directors and officers in accordance with state corporate governance law.

One further element of Mundo Latino is worth noting: in its certificate of incorporation, the debtor did not elect to utilize the provision of section 402(a) of the New York Business Corporation Law that authorizes a corporation to limit a director’s liability based upon a breach of the duty of care. One clear takeaway for passive investors in small businesses is that, if they utilize the corporate form, they should insist on including the section 402(a) provision in the certificate of incorporation.

But the bigger lesson of Mundo Latino is that passive investors should not serve as directors unless they are prepared to fulfill their duties of care and loyalty. So, what should a passive investor in a small business do to protect its investment? As Mundo Latino makes clear, directors cannot ignore their duty to supervise, but must exercise the level of care and diligence that a prudent business person would use. As the case further points out, a passive investor can avoid the risk of being sued for a breach of fiduciary duty by limiting his or her role to that of a shareholder, which does not carry the same obligations.

But all is not lost: an investor who wants to avoid fiduciary duties while maintaining the ability to protect his or her investment should consider using a shareholders’ agreement or investor rights agreement instead of serving as a director. In such an agreement, a majority shareholder can identify transactions or situations that would require shareholder approval, such as 1) a merger, sale of assets or significant acquisition, 2) an issuance of debt or equity securities, 3) borrowing money and/or granting liens, or 4) authorizing annual employee salaries over a specified limit. Moreover, because a shareholders’ or investor rights agreement is flexible, the situations that require shareholder approval can be tailored to the needs of the business.

For more information on this alert or other restructuring & bankruptcy matters please contact:

Stephen B. Selbst at +1 212 592 1405 or [email protected]

© 2018 Herrick, Feinstein LLP. This information is provided to keep clients and interested parties informed of legal developments that may affect or interest them. The information is not intended as legal advice or legal opinion and should not be construed as such.