Dan
Welcome to sound business insights. I’m Dan Watkins. This episode is about breach of fiduciary duty. This podcast is not intended to provide legal advice.

Neil
Dan, this episode is about fiduciary duty, which is a really, a little bit complicated, but also one of the most important facets of a legal responsibility here in California. What is fiduciary duty under the law?

Dan
Well, generally, a fiduciary duty is when one party has an advantage of power, knowledge, or resources over another party. And they’re doing business with each other. That’s basically where we get fiduciary duty. Okay. And then the laws have been built on that concept for hundreds of years. So you can imagine that today’s fiduciary duty lawsuits are much different than they were 50 years ago. Right? We’ve come a long way. Well, the laws changed.

Neil
Yeah. So when or how does a fiduciary duty begin?

Dan
A fiduciary duty, um, begins in several different ways. One, the legislature defines when there’s a fiduciary duty in trust and estates, there’s a fiduciary in banking.  It’s in the law, there is a fiduciary and it’s then redefined. And there’s legislative intent defining what they have meant. And then there’s courts defining what they meant and courts of appeals and so on and so forth. So it’s a very important concept and it changes as things happen in our society. So it doesn’t necessarily have to be written in a contract, explained and say, okay, I’m starting now. It’s an implied fact. This is the nature of this relationship. The other one is the common law,

Neil
Okay.

Dan
Defined by the courts where we talk about you are doing business with somebody and you’re going to buy a car from them. And they know that you’ve never purchased a car before. And they start telling you that this car might or might not make you the richest person in the world or might or might not this, or, and you believe them because you’ve always done business with them and they’ve always taken care of you.

Dan
And then they rip you off. (as a Fiduciary) you know that they are detrimentally, relying on you, a person in a position of trust, power, and more knowledge than them. And then you rip them off without giving them full disclosures or referring them to go get a lawyer and have yourself advised by somebody else.

Neil
The first car I ever went to buy,

Dan
yeah,

Neil
the guy would only show it to me at night. My, my Dad went with me and everything looked too good to be true. It was a Gran Torino and it was gorgeous.

Dan
Right.

Neil
And my dad pulls a magnet out of his pocket and he starts trying to stick it to the car and it won’t stick anywhere on the car, and so he looks the guy right in the eye and says, “how many times did it roll?”  You never know, right?

Dan
No. I mean, these situations happen all the time, right? And so that’s common law, fiduciary duties happen, statutory fiduciary duties happen. And then they change based on things that have happened in our society. For example, we’re not too young to remember Enron, right? Enron came along. A lot of people lost a lot of money. Then the next corporation on next corporation and all this shareholder scandals came along back then a CPA did not have a fiduciary duty to fill out these audit sheets. It wasn’t in the law. Now your average CPA is a fiduciary. Before we had brokers.

Dan
Now we have financial advisors you see on TV, all these ads. And I kind of chuckle, they brag about,” we are fiduciaries here” at this and this brokerage house. And we are your fiduciary. They’re saying that because that’s the law. They have to be your fiduciary.

Dan
Now, before they could just give you disclosures and you’re supposed to go research it yourself. Right now, the law has changed because too many people have been ripped off and legislatures have stepped in and the courts have stepped in. And so this is how the term fiduciary duty has evolved over the years. And if you’re ever in a situation where you feel like you’ve been ripped off, or you feel like someone’s unfairly accused you of ripping someone else off, but devil’s in the detail we got. If and when our clients come in with this situation, we advise them. We advise them before they get into business, when we form their companies. And then when they get in trouble or they get sued, we advise them what technically is the law and where the line is drawn. And that takes a little bit of research and keeping up with the law.

Neil
Sure. So what does the law require a fiduciary to do for their beneficiary?

Dan
A fiduciary is supposed to act openly, honestly, and fairly. They’re supposed to put the, beneficiary’s interest above their own, and they’re supposed to never self-deal,

Neil
Act in good faith…

Dan
Act in good faith.  Basically, not take money from your fiduciary client that they don’t know you’re taking, right?

Neil
So what are some examples in real life of those that carry a fiduciary duty?

Dan
Corporations, you own a corporation, you’re a shareholder and you find out your buddy down the street owns the same amount of shares as you, but he got twice the dividends as you did … corporations and their board of directors. They have an obligation and their officers to treat like shareholders in a like, and similar manner that doesn’t happen. Sometimes other things that happen with corporations, insider trading, it happens on the large market, big caps.

Dan
They go to jail, things like that, but it also happens on the small market. We see this every year, five to seven times a year, shareholder clients coming in, they call themselves partners, but it’s a corporation. And they say, you know, my company decided to go bankrupt. Then I found out that the principles opened up a new company over in England and they made $10 million, and we lost everything. Basically. They were hoping that you didn’t find out on those situations. Again, the sooner we find out the quicker we can get what we call temporary protective orders and asset seizures and levies with a judge to stop them from stealing.

Neil
So Dan, you mentioned insurance companies. What is the fiduciary responsibility of an insurance company to its insureds?

Dan
That’s probably the biggest area of litigation. When it comes to breach of fiduciary duty, that’s called bad faith. And when you pay your insurance company for 20 years and finally the day comes when you need them. And they have some adjuster, some lawyer who does research, writes you an automatic letter that says you are declined. It’s like that movie, great benefit has decided, Insurance has decided you’re not, you’re not entitled to coverage. That’s that happens every day and different states have different laws on what insurance companies can and can’t do. But in California insurance companies, we have a, a pretty good Department of Insurance. We have an Insurance Commissioner and we have a lot of lawyers filing bad faith insurance claims.

Dan
We have good laws, like we said, Cumis, and we have Cumis Counsel.  And we have a ton of cases out there that define all kinds of factual situations like yours and tells you whether you have coverage. And here’s finally the big one. If you might not have coverage or it’s a real close call, they still have to cover your defense costs.

Neil
Mm-hmm

Dan
they still have to pay your lawyer’s fees. And they still have to fight as hard as they can, even though in the end, they may not have to cover you. And since 95% of cases settle, you can see yourself defended, settled, and out of that lawsuit without having to pay a dime, just because you had some knowledgeable insurance lawyer or like our firm help you get coverage.

Neil
Do you think most clients are surprised to find out that the lawyers for the insurance company, their first duty under the law is to the policy itself and not to the insured?

Dan
It’s motivations. If you are being paid by an insurance company to represent insureds, people that they’re paying, and you’re encouraged to get the case settled or resolved, or to get you off the case as fast as possible, or you know that other people in your firm are getting promotions. And you wonder why. That’s why you need to have an advocate on your side. They can say “no. If, if you do that, we’re going to talk to the judge. You’re not throwing us under the bus.” Right?

Neil
Right.

Dan
But a lot of people don’t go seek a lawyer. A lot of businesses, just go try to resolve it themselves. And sometimes it’s too late. The damage is done. You’ve already given up declarations or evidence or letters or correspondence you might not have had to disclose. And it makes it a lot harder for your lawyer to save you.

Neil
So what are some of the examples of breach of fiduciary duty we’ve seen in this office?

Dan
in this office, we don’t call it breach of fiduciary duty. We call it bad faith.  And in the insurance code, there’s a whole section on how insurance adjusters have to handle your claim. It it’s actually a, a regulation, an insurance regulation that says they have 45 days to respond to your claim. They have to give you a yes or no answer. In so many days, they have to send you a written disclosure of all the reasons why, and why not they’re covering. They have to disclose their entire hand to you in a timely fashion. So they can’t wait nine months while plaintiff is chewing you up in court and you don’t have any money to defend yourself. They have to have their toes held to the fire. And then after they give you this, if they dare say no, we take that line by line and compare it to the laws and cases we know.

Dan
And we go into court for declaratory relief action with a motion, and we have a judge tell them, you have to cover them. If that ever happens, that’s almost a finding that they’re in bad faith and we’ll be getting attorney’s fees and punitive damages against the insurance company.

Neil
So Dan, what are the three prongs that are required to prove the breach of a fiduciary duty under the law?

Dan
First of all, you have to prove there was a fiduciary re relationship. And as I told you over the years, these change, so don’t automatically think there isn’t one. And don’t automatically think there is because it goes a lot of different ways. The courts in the legislature tend to define these over in, in different ways from decade to decade. Second, you’ve got to prove that they breached it in a material way. So you’ve got to say, look, they basically stole money from me and I didn’t know it.

Dan
And the third is that damages. You’ve got to have the damages in a fiduciary relationship. However, unlike most causes of action, you can Sue somebody for breach of fiduciary duty, with what we call nominal damages, because sometimes you can be hurt by a fiduciary and it won’t be a financial hurt. It’ll be something you want to get, get an injunction…

Neil
Right.

Dan
I mean like your doctor telling everybody about your procedures in your neighborhood

Neil
Right.

Dan
Or you go to a neighborhood dentist, or you go to somebody and they breach their duty. You know, you didn’t lose any money on a deal, but you should be able to get provisional remedies in the form of an injunction or something. And they, the law has that.

Neil
Well, after 30 or 40 years of experience with these matters, Dan, I mean, we handle both sides to this equation. Don’t we, we defend the fiduciaries and we’ll also pursue them on behalf of shareholders or those that have been taken advantage of?

Dan
We like these kinds of cases, because we get to do something a little differently from time to time than we would in a regular case. Of course, we want to get all the information first. But sometimes we like to work with our client to give the violating fiduciary enough rope to hang them.

Neil
Hmm.

Dan
So we will help our clients, right. Communications to this fiduciary and let them blatantly lie to them before we come on the scene and say, look, we’ve got you, and we want you to make this right.

Neil
Right.

Dan
And then what’s the key to defending accusations of a breach of fiduciary. As we know, we live in America and there are lots of people that are lawsuit happy. We’re in a cancel culture.

Neil
Yep.

Dan
You can’t say anything. You can’t do anything without somebody accusing you of breaching this and breaching that. And basically claiming there was some type of fiduciary relationship when there really wasn’t. And the contracts we write have clauses in them, most of the time, that say “not a fiduciary relationship,” you’re on your own to read this.  Contract law helps us. But like you said, A) establish, it was not a fiduciary relationship, B) establish, even if it was nothing was breached, do the accounting, get down into the details, go through all the communications. And then, of course definitely, make sure that they have to prove damages.

Neil
So one of the first things that I understand a fiduciary might say is, well, it was sound business judgment. It just didn’t go  well. What under the law is sound business judgment?

Dan
Well, sound business judgment is, basically saying you can’t second guess me because the market changed. There’s a couple of law firms in town that are very famous. Every time the stock market would go down 10 points, they’d be just watching. And they’d be trying to grab a plaintiff somewhere and file a class action and call it breach of fiduciary duty.

Neil
Hmm.

Dan
“You should have known that the stock market was going to do this and you will let us buy stock.” But for the average, Joe, me and you, there’s still lawsuits coming in from employees, from people you do business with, or have been doing business with for a long time. And then all of a sudden you take a different business direction and they grab a lawyer and they call that a breach of fiduciary duty or an implied partnership.

Dan
We’ve all seen that one, where you always buy your equipment from this person. They always give you a discount on over 10 years. And then you go some which some other way, and they say, you breach your fiduciary duty. So these things happen and you’ve just got to contact your lawyer. It’s cheaper in the beginning. We can give you a quick answer as opposed to trying to wait it out.

Neil
So is there a common shareholder type fiduciary case that often comes across our desks?

Dan
It’s usually the startup – “give me $10,000 and some sweat equity help me out with my company.” That happens a lot. And then somebody realizes that, first of all, if nobody makes money, everybody’s really good friends. But if somebody makes someone, the company makes strikes it rich, like they said, we were all hoping it’s going to strike it rich. And they got 10 friends that put in $10,000 and all of a sudden they get an offer to be bought out or an offer for this.

Dan
And that’s when we see the most bizarre things happening with the shareholders and the directors.

Neil
So Dan, how does fiduciary duty apply to a corporation versus a limited liability company?

Dan
That’s a great question. In a corporation, your corporation, when it’s formed, it comes with articles, bylaws, your listing of officers and directors. Later on you decide whether you want to be an S Corp or not. And that’s what you get. And you also get some recommendations from us, when you get a corporation formed, like what to do with your corporation and things to think about with a limited liability company. It comes with an operating agreement and your standard operating agreement has clauses in there about what you can and can’t do as an officer or member of the LLC. Whether you can take out up to $5,000, whether you can admit other members – dilution – when you have a corporation, you all get 10,000 shares, but then the people in charge decide to give another 10,000 shares and another 10,000 shares before you know it, you went from 10% of the company to 1% – you’ve been diluted.

Dan
A Limit liability company comes with something that’s called an operating agreement that specifically prohibits that in most the cases. And if it’s not in there, then you know that you have a limited liability company where they’re thinking about taking away your rights. So you have stronger rights as an investor and a limited liability company. You have more possibilities as an investor in a corporation. If you own the corporation, you can do more with it.

Dan
Yep. But for the corporation to have the same protection as a limited liability company, you’re going to want a shareholder agreement. You’re going to want them drafted so that you have a corporation with a shareholder agreement, which is just like your operating agreement and has a lot of things that the board of directors and officers can and can’t do. So, you know, your money’s going to be spent the way they said it would

Neil
Right.  So a lot of LLCs you use them, as an example, are downloading forms off of these legal websites. And these operating agreements are pretty generically structured, boiler plate. So you’re caution to an investor, If you’re going to invest in an LLC, an immediate red flag should go up, they should come see us.

Dan
Right. I think they’re pretty good starting points.

Neil
Yeah

Dan
But the authors have drafted them, I’ve seen them all, and they’ve drafted them in such a way, or they want to be right down the middle or one size fits all. But one size rarely fits all in a business situation. And when you’re bringing in people’s money, you are becoming a fiduciary. You take someone’s money, they invest in you, you owe them a fiduciary duty. You want an operating agreement or a shareholder agreement that protects you. You know what you want to do with the business? You told them what you want to do. You want to have something in your operating agreement that lets you do what you want to do.

Neil
And the incentives for the investor are different. And the protections they seek are different than the owner of the company.

Dan
It’s called a meeting of the minds. Everybody wants to have a meeting of the minds. Nobody wants to be involved in a lawsuit. So if you have an operating agreement that accurately reflects what people said in the beginning, then you won’t get sued. Most likely if it all turns out exactly as written, right? But if you have a generic agreement, it’s not going to fit exactly what you said and what they heard. So you want it clarified. Plus we have the parole evidence rule, which means you have this operating agreement, it’s a contract. And it says, this is what we said. And you may not bring in outside representations to sue me because this is the four corners of our agreement. And the courts will not look outside that so long as you get it right in a custom operating agreement, you should be protected from people saying, oh, I thought you were going to spend my money doing X instead of Y

Neil
Is there a financial threshold in your mind where you would counsel your friends and acquaintances, if you’re going to invest X amount of money, you really need to see an attorney and have them review the transaction before you get in?

Dan
I don’t know the number, the dollar amount, but I would say you, if you were worried and it’s, if it’s an off market investment, if it’s a stock market investment, go see your financial planner.

Neil
Sure.

Dan
But if it’s just a private investment, I would have a lawyer look at it and a CPA, who’s not investing in it. And your lawyer shouldn’t be investing in it to either. If you’re going to spend $500,000 or a million dollars on an investment, go see your own lawyer, who is a business lawyer. And if he’s a good one, he’ll tell you also have an accountant look at it.

Neil
Yes.

Dan
Because making money is different from an accounting point of view. They want you to make money and keep it away from the government. Structuring the transaction makes a huge difference in the ultimate tax consequences on and on.

Dan
And the CPAs we use, they look at something called EBITDA. And they look at the profitability and they, they do more than just taxes. They look at financial viability of a company. They actually look at books and records and say, you know, they claim they’re making this much profit, but the way I see it, they’re not because they’re not accounting for these assets or the depreciation here looks off.  So those kind of things, you can talk to your CPA, who does business advisements and a lawyer who can look at the terms and also spot all the legal issues that they might, or they maybe they’ll say it’s a great deal. Jump on it!

Neil
Go for it!

Dan
It happens all the time.

Neil
So what are the civil consequences for a breach of a fiduciary duty?

Dan
Civil consequences are going to be, an injunction, punitive damages and regular damages. Also sometimes it could be a license issue because a lot more professionals are being held to a fiduciary standards than just lawyers and doctors. We have, you know, like I said, accountants and other areas that have professional licenses and they can get in trouble and lose their license.

Neil
Very good. Thanks Dan,

Dan
Thank you.  Learn more about the Watkins Firm at watkinsfirm.com or call our office at (858) 535-1511.