When Can My Investors Sue Me?

You’ve raised money from investors, through Crowdfunding or otherwise. You did everything right through the money-raising process, such as disclosing all the right information. What are your obligations to the investors/shareholders as you now operate the company? Or, to ask the question in a more negative but practical way, when can they sue you successfully?

The exact answer depends primarily on (1) the state you chose to incorporate, (2) whether you are a corporation or a limited liability company, and (3) whether you included provisions in your governing instruments (Certificate of Incorporation, Operating Agreement) to protect yourself. State laws are not uniform and there can be enormous differences between LLCs and corporations.

Nevertheless, we will assume that you are in a “normal” state and that your lawyer prepared “normal” documents. That allows us to generalize by saying you can be sued successfully under these two circumstances:

  • You make business decisions that are unusually bad and careless.
  • You take actions that unfairly benefit yourself to the disadvantage of your company.

Under the laws of “normal” states, if you try your best, pay attention, review relevant information beforehand, and have the best interests of the company at heart, it is fairly hard to make a business decision so poor that you can be sued successfully by investors. The hands-off approach taken by statutes and courts in this area – referred to as the “business judgment rule” – recognizes that management must often make decisions without complete information, that decisions are easy to challenge with the benefit of hindsight, and that if investors were allowed to sue for every poor decision, judges could never take vacations.

It is much easier to be sued successfully where you take actions that unfairly benefit yourself to the disadvantage of your company. Examples:

  • You lease office space to your company for higher-than-market rent.
  • You borrow money from your company when you shouldn’t, or on unfair terms.
  • Your company is in the business of developing digital imaging software, but when you are approached by an inventor with a new technique, you form a new company with the inventor and don’t offer the opportunity to your old company.

Investors are an odd group inasmuch as when they lose their money they tend to be unhappy. This means that even before raising money you should:

  1. Make sure your governing instruments include the right language;
  2. Get good legal advice; and
  3. Get a quote for Director and Officer (“D&O”) insurance.

Questions? Let me know.