I. Caught Between a “Rock and a Hard Place”
Fact Pattern #1 (Venture Capitalist’s Nightmare):
You are a managing director of a venture capital fund and you sit on the board of directors of XYZ, Inc., a late stage technology company.
In the course of your professional activities, you are approached about the opportunity to buy the assets of ABC, a failed company that is in liquidation. ABC’s technology is related to XYZ’s technology and could be integrated into XYZ’s product, making ABC’s assets an attractive acquisition opportunity for XYZ. But DEF, Inc., another portfolio company which you sit on the board of, would also benefit from the acquisition of ABC’s assets.
Which portfolio company do you direct the acquisition opportunity to? Can you direct the opportunity to one of your portfolio companies without violating your duties as a director of the other?
Fact Pattern #2 (Business Development Executive’s Nightmare):
You are Vice President for Business Development at Global, Inc., a Global 2000 company You are also a director of XYZ, a minority strategic venture investment of Global. You too have been approached about the opportunity to buy the assets of ABC. ABC’s assets have a strategic value to both Global and XYZ. You think it is better for Global if Global makes a direct acquisition of ABC’s assets and exploits those assets for itself.
Can you, a director of XYZ and an officer of Global, pursue the ABC acquisition for Global rather than XYZ?
II. A Director’s Fiduciary Duties.
An individual who is a director or officer of more than one corporation may be faced with conflicting interests and loyalties in carrying out his or her fiduciary duties to each corporation and its stockholders. The two fact patterns above demonstrate the conflicts that arise when an individual is presented with a business opportunity that could be exploited by both corporations to which the director/officer owes a fiduciary duty. In a situation such as the fact patterns set forth above, how does a fiduciary decide where to direct the opportunity?
Directors and officers of a corporation have a fiduciary duty of loyalty to the corporation and its stockholders. Among other things, this duty prohibits self-dealing by directors and officers. The corporate opportunity doctrine was created at common law to address the disloyalty of a director or officer of a corporation who usurps a new business opportunity that should belong to the corporation. The doctrine requires a fiduciary of a corporation, when presented with a business opportunity that could be advantageous to the corporation, to make that opportunity available to the corporation before pursuing the opportunity for his or her own or an affiliate’s account.2
As fact patterns #1 and #2 demonstrate, the allocation of corporate opportunities can be a minefield for individuals with multiple fiduciary duties. Although the conflicting duties of interlocking officers and directors of a corporation and a majority stockholder have received attention3, the potential conflict created for directors of a corporation who are also officers or directors of a minority investor, or who are financial investors serving as directors of multiple portfolio investments, has been ignored. In our view, directors with fiduciary duties to minority investors are faced with the same potential self-dealing issues as are directors with fiduciary duties to controlling stockholders. If these fiduciaries are not wary of the pitfalls of the corporate opportunity doctrine, they can place themselves and their investor employers in harm’s way.
Fortunately, at least one jurisdiction has enacted a statute that allows fiduciaries acting in good faith to deal with the conflicts inherent in having multiple fiduciary duties. This article will provide an overview of the corporate opportunity doctrine and its pitfalls for venture capital and strategic investors taking director positions in emerging companies. It will then describe Delaware’s statutory solution and recommend a practical approach for protecting corporate fiduciaries from running afoul of these conflicting duties.
III. The Doctrine of Corporate Opportunity
While the corporate opportunity doctrine is not a recent creation it remains imprecise in its scope and application because of its nature. The Delaware Supreme Court recognized in Broz v. Cellular Information Systems, Inc.4 that it is not an easy task to formulate a set of rules or procedures that can be adapted to cover each and every situation.
The consequences of a corporate opportunity claim found against a director or officer can be severe. The standards that have evolved require that a fiduciary does not profit from retaining a corporate opportunity for his own (or his affiliates) purposes and that the corporation does not suffer any harm.5 A corporation which lost an opportunity as a result of a director’s or officer’s breach of this fiduciary duty could make a claim against the fiduciary for lost profits.6
The seminal case on the corporate opportunity doctrine is the Delaware Supreme Court’s 1939 decision in Guth v. Loft.7 Charles Guth, President of Coca Cola beverage bottler Loft Inc., obtained the Pepsi Cola trademark and formula individually. Guth then secretly used Luft’s resources to develop, manufacture and distribute Pepsi. The Delaware Supreme Court concluded that the opportunity to acquire the Pepsi trademark and formula belonged to Loft and that Guth violated his fiduciary duty to Loft by taking the opportunity for himself.
The Guth decision established a standard applicable to determining whether a director or officer has breached a fiduciary duty by usurping a corporate opportunity. The standard was most recently re-articulated by the Delaware Supreme Court in Broz.8 The doctrine has two legs: a “Can’t Test” and a “Can Test”.
The Can’t Test. Under the Can’t Test, a director or officer of a corporation cannot exploit a business opportunity if:
The corporation to which he or she owes a fiduciary duty is financially able to exploit the opportunity;
The opportunity is within the corporation’s line of business;
The corporation has “an interest” or “expectancy” in the opportunity; and
By taking the opportunity for his own, the fiduciary will be placed in a position in conflict with his duties to the corporation.9
The Can Test. The Can Test is a corollary to the Can’t Test and provides that a director or officer may take a corporate opportunity if:
The opportunity is presented to the director or officer in his or her individual and not corporate capacity;
The opportunity is not essential to the corporation;
The corporation holds no interest or expectancy in the opportunity; and
The director or officer has not wrongfully employed resources of the corporation in exploiting the opportunity.10
The tests leave a large gray area and suggest some counterintuitive results. For example, the tests suggest that a director or officer who encounters an opportunity entirely in his individual capacity (item 1 of the Can Test) has an absolute duty to offer that opportunity to the corporation if the opportunity is essential to the corporation (item 2 of the Can’t Test). In other words, all four elements of the Can Test must be satisfied before a director can safely pursue an opportunity as his or her own or on behalf of an affiliate. And the Delaware Supreme Court’s formulation of the Can Test appears to require the fiduciary to offer the opportunity to the corporation only if all items of the Can’t Test are present, even though the fiduciary may not have satisfied the “Can” test.
Other jurisdictions have articulated standards similar to those of the Delaware Supreme Court.11 In practice, Delaware courts have viewed the Guth Tests only as guidelines or factors to be weighed in each case that is brought to “second guess” a director’s or officer’s conduct, a practice that leaves lingering uncertainty for corporate fiduciaries. Delaware and most other jurisdictions have held that a director or officer has a “safe harbor” to pursue a corporate opportunity without breach of his fiduciary duty if the director or officer presents the opportunity to the board of directors of the corporation and the corporation elects not to pursue the opportunity.12 While this is a useful practical solution that is satisfactory in many situations, it does not help an individual with multiple fiduciary duties where the corporate opportunity doctrine compels him to direct the opportunity to more than one corporation. It also is not practical where circumstances like confidential duties to third parties would be violated or where disclosure of corporate objectives is a by product of using the safe harbor. When coupled with the law’s desire to decide these conflicts by weighing factors in court instead of through clear rules, corporate fiduciaries can be left in an untenable position.
IV. Delaware’s Allocation Statute
The Delaware legislature amended the Delaware General Corporation Law in 2000 to allow fiduciaries to stand on firmer ground when faced with conflicting corporate opportunities. Section 122(17) of the DGCC provides:
Every corporation created under this chapter shall have power to:
(17) Renounce, in its certificate of incorporation or by action of its board of directors, 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 of its officers, directors or stockholders.
Section 122(17) removes the uncertainty over a Delaware corporation’s ability to regulate corporate opportunity conflicts.13 The law also clarifies that stockholders rights to corporate opportunities can be regulated. This is troublesome because it implies that, in the absence of Section 122(17), stockholders may have fiduciary duties to direct their corporate opportunities to an entity in which they have an equity interest. While majority stockholders do have certain fiduciary duties to minority stockholders,14 we are not aware of any Delaware decision suggesting that one of these duties is the corporate opportunity doctrine.
Section 122(17) is also troubling in that it suggests that a Delaware corporation has the power to expand the fiduciary duties of a stockholder beyond duties that exist under Delaware law. Could the board of a corporation compel a minority investor such as Microsoft to direct all of its software, broadband, content or interactive media opportunities to that corporation? This would seem to be beyond the scope of what the Delaware legislative intended.
While Section 122(17) may have some unfortunate ambiguities, it is largely good news. Directors and officers of Delaware corporations now have the opportunity to operate under a set of coherent rules that should avoid conflicting fiduciary duties in all cases.
V. Putting the Delaware Statute to Work
Section 122(17) permits a corporation to adopt corporate opportunity allocation rules in its certificate of incorporation or by action of the board of directors. Any board action, however, must be done in a way that is not self-dealing.15 Would it be self-dealing for a board comprised predominantly of directors who are also officers of strategic and venture investors to adopt such allocation rules? To avoid uncertainty, we recommend that such corporate opportunity allocation rules be set forth in the corporation’s certificate of incorporation and approved by the stockholders.16
A set of Model Rules for the allocation of corporate opportunities by directors and officers with conflicting fiduciary duties is available on request from firstname.lastname@example.org or email@example.com. These have been prepared in a format that can be adopted as an article to a corporation’s certificate of incorporation.
A new investor or strategic partner in any business corporation in which one of its officers or directors will sit on the board of such corporation should insist that corporate opportunity allocation rules be adopted.
VI. How the Model Rules Work
The Model Rules set forth a fair allocation of opportunities between an investing stockholder and its portfolio company. Here are some of its features:
Absolute Freedom for Stockholders. The Model Rules make clear that no stockholder of a corporation, or any affiliate of such stockholder (such as another portfolio company) has any duty to refer opportunities to the corporation. In the absence of an agreement to the contrary, any stockholder and any of its affiliates may compete with the corporation, do business with any of its customers or hire any of its employees.
Officer Duty Trumps Director Duty. The Model Rules create a higher duty for an officer of a corporation than for a director. Accordingly, if a person is an officer of the stockholder or its affiliates and only a director of the corporation, any corporate opportunity will belong to the stockholder or any of its affiliates, unless the fiduciary is expressly offered the opportunity in writing solely in his capacity as a director of the corporation (in which case the opportunity belongs to the corporation). The converse rule applies if the individual is an officer of the corporation but only a director of the stockholder or its affiliates.
Identical Fiduciary Roles. If the fiduciary has identical roles in both the corporation and a stockholder (or its affiliate), i.e., he is a director or an officer (or both a director and officer) of both the corporation and stockholder, the Model Rules provide that the opportunity belongs to the stockholder or its affiliate.17
Stand-Aside Rule. The Model Rules expressly require the corporation or a stockholder (and its affiliates), as the case may be, not to pursue an opportunity which the Model Rules allocate to the other. If the entity entitled to a corporate opportunity abandons it, the other entity is then entitled to pursue that opportunity.
For investors taking board seats in emerging companies, the corporate opportunity doctrine has the potential to place a person with multiple fiduciary duties in an impossible situation. This risk is largely ignored by investor representatives designated as directors of portfolio investments. Yet we are certain that most people with multiple fiduciary duties have faced corporate opportunities that “belonged” to both corporations they served and have probably discharged those opportunities in a manner inconsistent with the corporate opportunity doctrine.
It is only a matter of time before some fiduciary is challenged for this corporation law transgression. Yet, Section 122(17) of the Delaware General Corporation Law provides a way to avoid this risk with little controversy. Every emerging company investment which includes board representation should be conditioned on the adoption of allocation rules like the Model Rules. Even if the corporation is not incorporated in Delaware, the Model Rules should still be adopted.18 They may be given effect and, in any event, should clarify the corporation’s and its stockholder’s standard of “reasonable interest and expectancy” under the Guth Can’t Test.
The Model Rules are a fair and uncontroversial solution to a problem waiting to happen. They should become standard practice.
1 Mr. Aidun is a partner and head of the Venture Capital Practice of Weil, Gotshal & Manges LLP, a New York-based international law firm. Ms. Atkinson is an associate in the Emerging Company and Venture Capital Practice of the Firm. The views expressed in this article are those of Mr. Aidun and Ms. Atkinson and do not necessarily reflect the views of Weil, Gotshal & Manges LLP, its client or partners.
Copyright September 2001 by Christopher K. Aidun and Sarah Atkinson.
2 Guth v. Loft, Inc., 5 A.2d 503 (Del. 1939).
3 Thorpe v CERBCO, Inc., 676 A.2d 436 (Del. 1996).
4 673 A 2d 148 (Del. 1995)
5 Siegman v. Tri-Star Pictures, Inc.,C.A. No. 9477 (Del. Ch. May 5, 1989, revised May 30, 1989)
6 Guth v. Loft, Inc., 5 A.2d 503 (Del. 1939).
7 5A 3d 503 (Del. 1939).
8 673 A.2d 148 (1995).
9 Id at 154.
11 See generally, Block, Barton & Radin, The Business Judgment Rule: Fiduciary Duties of Corporate Directors (1998) volume 1 at 293-308 (hereinafter “Radin”).
12 Broz 673 A.2d at 157. The Principles of Corporate Governance: Analysis and Recommendations, takes a different approach, requiring full disclosure by the fiduciary prior to taking advantage of any corporate opportunity. Courts in several states have adopted this approach. See Block at 305-306.
13 Siegman v. Tri-Star Pictures, Inc., C.A. No. 9477 (Del. Ch. May 5, 1989, revised May 30, 1989). The uncertainty continues in other jurisdictions. As recently as June 2001, for example, the California Secretary of State refused to file an Amended and Restated Articles of Incorporation that contained provisions regulating corporate opportunities like the Model Rules set forth in this article.
14 Kahn v. Lynch Communications Sys., Inc., 669 A.2d 79,84 (Del. 1995). See Radin at 342-499.
15 See Section 144 of the Delaware General Corporation Law.
16 This would satisfy the safe harbor in Delaware’s self-dealing statute, Section 144(a)(3).
17 While this rule could be modified in the appropriate circumstances, it is generally a fair result since the fiduciary’s relationship to the stockholder is usually prior to and the basis for the fiduciary taking on a board or officer role in the corporation.
18 Unless, in jurisdictions like California, the Secretary of State refuses to file a charter containing the Model Rules.