Directors, officers and employees of a corporation owe a fiduciary duty to the corporation, the highest duty known to law. It is a duty to take no action that would harm the corporation and to always act in the best interests of the corporation to the best of their abilities. It may also impose a duty to take affirmative action to protect the corporation, as discussed at length in our web article on that subject.
Similar if not identical obligations are imposed upon fiduciaries in partnerships and limited liability companies. This article, however, shall concentrate on the corporate opportunity doctrine as it relates to California corporations.
In this world of shifting employment and rapid alteration of fiduciary commitments as companies come and go and as people find themselves working for companies that used to be competitors (or becoming competitors themselves) this simple concept of an obligation to protect one’s corporation has had to be tested and reexamined under increasingly complex situations.
Before launching out on any potentially competitive venture, or even making firm plans as to what to do, a fiduciary is well advised to obtain the necessary information to determine what continuing and vital duties to his or her current employer restrict activities. Likewise, the corporation, worried about key employees and officers seeking to commence their own businesses while still immersed in the company with access to corporate resources, should be versed in the legitimate restrictions on what that key employee or officer can do…and whether the new employer faces liability if they take your employee who began such competitive activities while still on the clock. See our article on Soliciting Employees Away From a Business-Unfair Competition? on this website.
One of the doctrines most crucial and the one discussed in this article is the Corporate Opportunity Doctrine: the concept that while there is a fiduciary duty to the company, the fiduciary can not take for him or herself a business opportunity that should, instead, be reported and given to the company.
The devil is in the details, of course, and this topic shall briefly outline the key elements of that doctrine.
CORPORATE OPPORTUNITY DOCTRINE: THE BASICS
An employee, a director, and/or an officer of a corporation owes a fiduciary duty to the corporation, as discussed in detail in the linked article above. Part of that duty is that they cannot seize for themselves a business opportunity that would otherwise go to the corporation’s benefit. This is true whether or not the opportunity was discovered while performing duties for the particular corporation.
A typical example will best illustrate how this theory works. Assume you are a sales manager for Company X which sells oranges. Assume you discover that a vendor of oranges is in economic trouble and willing to sell the product for a fifty percent reduced price. The company you work for has sufficient funds to purchase the oranges and customers waiting to buy them.
You cannot purchase the oranges for your own account. You cannot refer the vendor to another entity and hope to receive a commission or some other benefit. You cannot purchase the oranges and resell them to your own entity for a markup.
The reduced price oranges are a corporate opportunity and if the fiduciary takes it he or she may be personally liable to the corporation for the lost benefit.
What is required to create the violation of the corporate opportunity doctrine? What happens if the company you work for is not interested in those oranges or does not have the financing to buy them? What precisely is needed to constitute a violation of the doctrine?
- Under this doctrine, one who occupies a fiduciary relationship to the corporation is prohibited from acquiring, in opposition to the corporation, property or rights in which the corporation has an interest or tangible expectancy or which is essential to its interest. Kelegian v Mordichian (1995) 39 Cal. Rptr. 2d, 390; 33 Cal. App. 4th, 982.
- The “corporate opportunity” cannot be taken by one occupying the fiduciary relationship with the corporation when the proposed activity is reasonably incident to the corporation’s present or prospective business and is one in which the corporation has the capacity to engage. Ibid.
- Whether or not a given opportunity constitutes a corporate opportunity is a question of fact to be determined from objective facts and surrounding circumstances existing at the time the opportunity arises.
- In determining whether an officer may take advantage of a business opportunity in which the corporation is interested, the courts will consider whether the corporation had an interest, actual or expectant, in the opportunity and whether acquisition by the officer would hinder or defeat the plans of the corporation in carrying on or developing legitimate business for which it was created and, additionally, the courts may consider whether the corporation has the financial resources to take advantage of the particular opportunity. Thompson v Price (1967) 251 Cal.App.2d 182, 59 Cal. Rptr. 174.
THE THREE PRONG TEST
The various doctrines above have been often reduced to a more general three prong test: “Three tests have been recognized as standards for identifying a corporate opportunity: the line of business test, the interest or expectancy test and the fairness test. Under any test, a corporate opportunity exists when a proposed activity is reasonably incident to the corporation’s present or prospective business and is one in which the corporation has the capacity to engage. Whether or not a given opportunity meets the requisite relationship is largely a question of fact to be determined form the objective facts and surrounding circumstances existing at the time the opportunity arises. Whether or not an officer has misappropriated a corporate opportunity does not depend on any single factor.” 3 Fletcher Cyclopedia Corporations (1994 rev.), Section 861.10 p. 284 quoted approvingly by the Court in Kelegian, above.
PRACTICAL APPLICATIONS OF RULE
The fact that this is a factual matter in which “fairness” plays a role means that the activities of the fiduciary simply are judged in the overall context of the situation and the fiduciary pondering whether to seek to obtain a corporate opportunity for his or her own benefit can seldom know how a judge or jury, three years down the road, are going to consider the matter. As one lawyer once told the writer, “It’s a gut test. If the judge thinks what your client did was unfair, by God your client is going to pay.” That lawyer was right.
The usual defenses are that the corporation never did engage in that particular type of business or that the corporation did not have sufficient resources to engage in that particular type of business. The problems with those two defenses are that it can be argued that an opportunity does not necessarily have to be within the existing business of the company if it is a logical extension of the corporation’s business. Thus, if a corporation selling auto parts could have an opportunity to extend its market into a new territory or to sell auto cleaning products, it is likely (but not certain) that a trier of fact would conclude that this was a valid corporate opportunity. If the opportunity was to engage in sale of aircraft parts, that danger is far less likely.
Nor is lack of funding a very powerful argument since the corporation can always argue it could have found funds…indeed, perhaps could have found funds precisely because it could show a lender the opportunity exists!
The underlying problem, of course, is that the opportunity has value or the contest in the courts would not have ensured. For those opportunities which do not pan out, the corporation seldom sues the fiduciary for stealing it. The very fact that the fiduciary made money from the opportunity is powerful evidence that the corporation lost that very money.
It should be emphasized, however, that success of the corporate opportunity for the fiduciary is not a requirement for the law suit. One client of this writer came into the office feeling that he was in no danger since the opportunity had actually failed miserably. He had personally begun a distribution company to sell a product the manufacturer wished distributed into Europe instead of making sure the company whose Board he was on was given the chance. No money was made and he closed his new company about the same time the old company found out he had seized the corporate opportunity. He was sued anyway.
What he failed to realize is that the test was not whether he succeeded but whether the opportunity could have been of value to his old company and whether it could have succeeded. The old company made the powerful argument that with its level of expertise and funding, it would have succeeded where he had failed. He commented to me that he had thought it was a situation he could not lose: “If I succeeded, I’d have plenty of money to pay off the old company. If I lost the new business, no harm to the old company.” He was wrong and ended up paying a hefty settlement to his old company because the old company demonstrated that it had resources to exploit the opportunity that the fiduciary could not match. It is vital to note that such opportunities may arise from unexpected circumstances. Even a fiduciary, buying shares of the corporation, can be considered usurpation of a corporate opportunity if the corporation could have redeemed its own shares and the investment was a wise one.
If the asset, right, or opportunity is valuable or potentially valuable, the fiduciary must be very, very careful before usurping it. Further, merely resigning as a fiduciary and then seizing the opportunity is not a full defense since if the resignation was made to obtain the opportunity then the breach of the obligation to give the opportunity to the corporation occurred before the resignation occurred.
A wise elderly businessman who had been on a dozen boards once told the writer that it was transparent how to avoid problems with corporate opportunities. “If you want it, the corporation probably wants it. Offer it to them first. Period. If they don’t take it, it’s yours. If they do…well, it’s clear then that it’s an opportunity you should have offered them, right? That’s obvious, since they wanted it, took it and could afford to. What’s the mystery?”
The law is a little more detailed. Should a fiduciary wish to obtain a corporate opportunity, that fiduciary cannot usurp it minus prior full disclosure to the corporation giving it ample opportunity and first right to obtain the opportunity and, usually, the fiduciary must abstain from voting on whether to obtain the opportunity. Such disclosure, to avoid later conflicts, should be in writing and discussed with legal counsel before submission.
All sorts of complications can arise, of course. Assuming the fiduciary is in a position of power within the company and can hire or fire the directors; his implicit desire to have the opportunity for himself can intimidate the directors and make the offer to the corporation illusory. Further, if the fiduciary holds back any relevant information about the opportunity or in any way interferes with the corporation obtaining the opportunity, such “full disclosure” as a defense can wither.
A key salesman for a company known to the writer disclosed fully the opportunity to his employer to obtain a new product line but had previously advised the manufacturer over dinner that his employer had little financing and that its expertise was suspect in the field. This not only breached the employee’s fiduciary duty to his employer (a tort in itself) but gutted the corporate opportunity doctrine since the salesman was still “seizing” the opportunity by making it unlikely that the corporation could obtain the account. When the salesman quit six months later and began a new company with the new product line, the resultant litigation quickly revealed in discovery that dinner conversation and the salesman ended up paying damages to his former company.
The best and safest route for the fiduciary is to make full and open disclosure to the corporation; wait until the corporation makes its own decision, abstaining from the voting and indicating in writing that if the corporation does not want the opportunity, the fiduciary does. If the corporation declines the opportunity, again with full written disclosure, the fiduciary can then attempt to exploit that opportunity, keeping in mind the remaining issues of loyalty implicit in the fiduciary duty. If direct competition is involved, the fiduciary will probably have to resign from the corporation to exploit the opportunity absent written informed consent of the corporation.
As discussed elsewhere, the fiduciary duty is the highest duty known to law; the same duty a parent has to a child, a spouse to a spouse, a lawyer to a client…and an employee or officer to the corporation. When in doubt, the courts invariably enforce the duty against the fiduciary and this must be kept in mind by any individual uncertain as to whether an act could be in breach of the duty.
If you are running a company it is essential for you to communicate to the fiduciaries your expectations of their actions, both in any employment manual and in any board meetings, employee meetings or more informal discussions. It is vital that no words or deeds of the corporation lead to misunderstandings as to the corporation’s business goals and desire for corporate opportunities.
And should the corporation decline the opportunity, then the fiduciary does have the right to exploit it, perhaps remembering the words of the philosopher Friedrich Nietzsche: “One never dives into the water to save a drowning man more eagerly than when there are others present who dare not take the risk.”