Venture fund managers who serve on a portfolio company’s board of directors may, by that very fact alone, have precluded themselves and their fund from making investments in other companies operating in the same industry space as the portfolio company.
Such an unanticipated non-competition obligation arises under the often overlooked “corporate opportunity doctrine,” a long standing common law principal that prohibits corporate directors and officers from personally benefiting from opportunities that rightfully belong to the corporation they serve. Funds can avoid the risk posed by the corporate opportunity doctrine by affirmatively addressing the issue at the outset of their relationship with a portfolio company.
The corporate opportunity doctrine arises out of a director’s fiduciary duty of loyalty to the corporation. The doctrine requires that “in some circumstances … a director make a business opportunity available to the corporation before the director may pursue the opportunity for the director’s own or another’s account.”
In effect, the doctrine obligates a director potentially to subordinate to the corporation the director’s own interests or the interests of others to whom the director may also owe a fiduciary duty. Whether or not the portfolio company has the legal right to bar a director and the director’s fund from competing for a particular opportunity, it might nevertheless use the corporate opportunity doctrine as a club to assert right to the opportunity, thereby impeding the fund from actively pursing it. Absent a waiver approved by the portfolio company’s board, no recusal of the fund’s designated director or other contemporaneous, ad hoc maneuver will free the fund of the risk presented by such a claim.
This is the quandary the manager of an industry-focused venture fund recently found himself in when his fund was prohibited from bidding on a company it learned was for sale. The fund was blocked from pursuing the opportunity by a portfolio company of which the manager served as a director. The portfolio company wanted to bid for the target independently of the fund. It asserted that it owned the opportunity to acquire the target and that it would be a breach of the manager’s fiduciary duty of loyalty to the portfolio company for the manager and his fund to compete with it for the target.
Unfortunately for the manager and his fund, the corporate opportunity doctrine put the portfolio company on firm legal ground in making its assertion. As frustrating as this news was to the manager, what made it harder to accept was that under Delaware law, which governed the manager’s relationship as a director of the portfolio company, the circumstance could have been avoided.
The Delaware General Corporation Law was amended in 2000 with the addition of Section 122(17) to permit a corporation to “renounce … any interest or expectancy of the corporation in, or in being offered an opportunity to participate in, specified business opportunities or specified classes or categories of business opportunities that are presented to the corporation or one or more of its officers, directors or stockholders.”
Section 122(17) in effect permits a corporation to limit the scope of the opportunities to which it lays claim, even in advance of the those opportunities actually arising. A corporation might then renounce its interest in a category of opportunities defined as those that are presented to one or more of its directors (excluding directors who are also members of the corporation’s management). With such an advance disclaimer applied to outside directors, a venture fund may avoid having its freedom to compete and make investments potentially restricted because one of its principals serves on the board of a portfolio company with similar interests.
While the scope of Section 122(17) has yet to be defined by the courts, the potential to eliminate corporate opportunity conflicts that it appears to afford suggests that, absent a compelling reason not to, a venture fund is well advised to seek to include such a disclaimer in the terms of every investment it makes. Had such a provision been included in the corporate charter of the portfolio company described above, there would have been no question as to the right of the fund to bid on the target, even in competition with the portfolio company on whose board its manager served as a director.
As with many areas of law, the rules are not clear as to whether or not the corporate opportunity doctrine applies in a given circumstance. The most often cited judicial standard applied in corporate opportunity cases comes from Guth v. Loft, Inc. There, the Delaware Supreme Court laid out three principal factors to consider in evaluating a corporate opportunity issue: (1) Whether or not the corporation has the financial ability to undertake the opportunity. (2) Whether or not the opportunity is in the corporation’s line of business and is of practical advantage to it. And (3), whether or not the corporation has an interest or reasonable expectancy in the opportunity. Many courts also have applied a “fairness” test in determining whether or not a specific opportunity belongs to the corporation. These courts attempt to determine if the opportunity is one that “in fairness ought to belong to the corporation,” or if a fiduciary’s appropriation of the opportunity would satisfy “ethical standards of what is fair and equitable [to the corporation] in particular sets of facts.”
Courts have not consistently applied the Guth standards, the “fairness” test or any of the variant formulations and hybrids thereof in determining whether or not a director acted properly with respect to a corporate opportunity at issue. Some factors are given more weight in some circumstances than in others, and courts sometimes ignore one or more factors altogether.
Essentially, corporate opportunity cases are decided on their unique facts and circumstances, leading to muddled, inconsistent results lacking a common set of practical guidelines by which a director might determine his or her duty with respect to a specific opportunity. Absent clarity as to when a director or his or her fund is free to pursue an opportunity without regard to a portfolio company, potential plaintiffs with competing interests find it easier to threaten a corporate opportunity claim. The uncertainty of such threatened litigation may give pause to a director and his or her fund in pursuing a new opportunity.
It is commonly assumed by fund managers that an opportunity cannot be said to belong to the corporation if the director developed the opportunity, or the opportunity was presented to the director, in his or her individual capacity independent of his or her role as a director of the corporation. Thus, to avoid a corporate opportunity challenge, a fund principal serving on a portfolio company board may think that he or she need only establish that the opportunity was presented to such principal or his or her fund by virtue of the fund’s independent efforts, contacts or reputation and not by reason of its designee serving as a director of the corporation.
Such an argument, however, is by no means dispositive. As a factual matter, it is difficult to establish that the director’s contacts and other relationships independent of those arising by reason of his or her relationship to the corporation lead to the opportunity irrespective of the director’s relationship to the corporation. Conversely, it is easy for the corporation to assert that it is the director’s relationship to the corporation that is the genesis, or at least partial genesis, of the opportunity. That assertion creates a factual issue to be litigated and with it, the uncertainty that the corporation, by asserting the claim in the first place, no doubt hopes will chill the fund’s pursuit of the opportunity.
Further, an “independently developed” argument addresses only the corporation’s “reasonable expectation” to the opportunity, which is only one of several factors courts will weigh in resolving a corporate opportunity claim. As attractive as the independently developed argument might appear, it alone will not eliminate the uncertainty created by a corporate opportunity challenge.
Put It in Writing
Prior to the adoption of Section 122(17), some funds attempted to address the uncertainty created by the corporate opportunity doctrine contractually. These funds would require the corporation to acknowledge at the outset of the investment that the fund is in the business of making investments in companies similar to that of the corporation and that its continuing to do so going forward, even in companies that might compete with the corporation, will not be wrongful or improper.
As a further condition to the investment, the corporation was asked to disclaim any interest or expectancy the corporation might otherwise have in any opportunity either the fund or its designated director might undertake, even if the opportunity is in the corporation’s line of business and one that the corporation is financially able to undertake itself.
Section 122(17) leaves little question that such contractual waiver provisions are effective in eliminating corporate opportunity claims against the fund or the fund’s designated directors. The enforceability of such provisions in jurisdictions that have not adopted a Section 122(17) provision is not as clear. However, given the specificity with which such provisions address the Guth and other factors courts have applied to corporate opportunity issues, including such provisions at the start of a fund’s relationship with a portfolio company no doubt discourages would-be plaintiffs from asserting corporate opportunity and related breach of loyalty claims.
Attorney Leonard Q. Slap is a Partner with the Private Equity & Venture Capital Practice Group of Edwards & Angell, LLP. He may be reached at: