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Rethinking Corporate Opportunities: Part I

This post begins the second in a series of experimental posts designed to do “real” scholarship in the blog format. In each series, I take an area of the law where I think I have something to contribute, but to which devoting the time and effort inherent in writing a traditional law review article seems unwarranted. Collectively, the posts constitute a short monograph on the subject. In this series, we will rethink the corporate opportunities doctrine.

This post introduces the problem and then summarizes the relevant Delaware law.

The doctrine generically known as “organizational opportunities” deals with situations in which an agent usurps a business opportunity that rightfully belongs to the principal. In doing so, the agent has violated his fiduciary duty to the principal by usurping this opportunity for his own gain. This prohibition of against usurping organizational opportunities is found in agency law, partnership law, and, in its most developed form, corporate law.[1]

A prohibition of some sort against usurping organizational opportunities is almost certainly a majoritarian default. Consider the most famous fiduciary obligation cases, Meinhard v. Salmon.[2] Meinhard and Salmon formed a joint venture to lease an office building. Shortly before expiration of the lease, Salmon began secret negotiations with the lessor, as a result of which Salmon’s real estate corporation was able to lease the building and several adjoining lots. Salmon planned to eventually replace the existing building with a new and considerably more profitable facility. Meinhard did not learn of Salmon’s new arrangement until after the new lease was finalized. At that time he demanded that the new lease be held in trust for the joint venture. Salmon refused and the lawsuit ensued.

If partners can withhold new information—such as the discovery of a new business opportunity—from each other, then each has an incentive to drive the other out so as to take full advantage of the information. As each incurs costs to exclude the other, or to take precautions against being excluded, the value of the firm declines. A legal rule vesting the firm with a property right to the information and requiring disclosure is more efficient than forcing the partners to draft disclosure agreements and monitor one another’s behavior. Note that this rule does not discourage the production of new information, because the partners still have incentives to produce information because they share in its value to the firm. As no one will withhold information, however, the firm’s productivity is maximized.[3] As a result, we can confidently predict that the partners would agree ex ante to bar any one partner from taking an organizational opportunity for his personal gain.

While some such prohibition thus emerges from our hypothetical bargain as a majoritarian default, the form such a prohibition ought to take is less obvious. Does it matter if one partner is actively managing the business (as was Salmon) while the other is passive (as was Meinhard)? Should all outside business ventures be proscribed or only some? If the latter, how do we decide which are proscribed? Should we adopt a bright-line rule or a flexible standard? What should be the remedy?

In a justly famous passage, Judge Cardozo adopted a wonderfully vague standard to govern these problems:

Joint adventurers, like copartners, owe to one another, while the enterprise continues, the duty of the finest loyalty. Many forms of conduct permissible in a workaday world for those acting at arm’s length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the “disintegrating erosion” of particular exceptions. Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. It will not consciously be lowered by any judgment of this court.[4]

In applying this standard, Cardozo focused closely on the specific circumstances of the case. As such, he converted the vague majoritarian default into one specifically tailored for the parties at bar. Hence, Cardozo emphasized that Salmon was “in control with exclusive powers of direction . . . .”[5] Salmon “was much more than a coadventurer. He was a managing coadventurer.”[6] Cardozo further acknowledged that:

A different question would be here if there were lacking any nexus of relation between the business conducted by the manager and the opportunity brought to him as an incident of management. . . . For this problem, as for most, there are distinctions of degree. If Salmon had received from Gerry a proposition to lease a building at a location far removed, he might have held for himself the privilege thus acquired, or so we shall assume. Here the subject-matter of the new lease was an extension and enlargement of the subject-matter of the old one. A managing coadventurer appropriating the benefit of such a lease without warning to his partner might fairly expect to be reproached with conduct that was underhand, or lacking, to say the least, in reasonable candor, if the partner were to surprise him in the act of signing the new instrument. Conduct subject to that reproach does not receive from equity a healing benediction.[7]

Whether a “different question” also have been presented if the entity in question had been a corporation rather than a partnership is the subject of this series of posts.

Delaware’s standard

Guth v. Loft, Inc. remains Delaware’s classic statement of the corporate opportunity doctrine.[8] Loft was a manufacturer and retailer of candy, syrups, drinks and food. It did not manufacture a cola syrup, instead selling Coke in its retail outlets. Charles Guth was the president and a director of Loft. To greatly simplify a complex set of facts, Guth obtained effective control of the then-struggling Pepsi-Cola Corporation. Guth then began a clandestine program of using Loft funds, facilities, and employees to get Pepsi off the ground. Loft later sued Guth on the grounds that the chance to acquire Pepsi was a corporate opportunity. In other words, Loft alleged that Guth had a duty to give Loft an informed chance to acquire Pepsi before doing so himself. Put yet another way, Loft essentially claimed that Guth had to give Loft a right of first refusal to acquire Pepsi.

At that time, there were three common law tests used by the courts to determine whether or not something was a corporate opportunity. The Guth court invoked all three: First, it identified what is now known as the line of business test. Is the business venture in question intimately or closely associated with the existing or prospective businesses of the corporation? On that score, the court held Pepsi was squarely within Loft’s lines of business. As noted, Loft was both a manufacturer and purchaser of soft drink syrups. Although it was not presently in the business of making cola syrups, the court held that the line of business test had to allow for future development or expansion of the firm. Making cola syrups was within Loft’s reasonable future business. Loft had a continuing business need for cola syrups to supply its retail outlets. Then, as now, cola-flavored syrups were the major soft drink product. Indeed, because Guth had used the powers of his position as president to terminate Loft’s contract with Coca-Cola, that on-going need had been greatly exacerbated.[9] Loft also had the knowledge, experience and resources necessary to exploit the Pepsi opportunity. The combination of the need and the ability brought the Pepsi opportunity within Loft’s line of business.

Second, the court asked whether Loft had a prior interest or expectancy in the opportunity. Arguably, one could distinguish between an interest and an expectancy. A director or officer takes the corporation’s “interest” if he takes something to which the firm has a better right. The director or officer takes an “expectancy” if he takes something which, in the ordinary course of things, would come to the corporation—i.e., something the corporation could expect to receive. If an officer bought land to which the corporation had a contractual right, for example, the officer took an “interest.” If the officer took the renewal rights to a lease the corporation had, the officer took an “expectancy.”

As a practical matter, however, courts do not make such fine distinctions.[10] When Guth discontinued Loft’s contract with Coca-Cola, for example, it became a matter of business necessity that Loft acquire an alternative source of cola syrups. Because Guth’s actions created the need, the court opined, Loft had an equitable interest in the opportunity to buy Pepsi. Loft also had an equitable interest in Pepsi because of the way in which Guth handled the transaction. Guth’s use of corporate funds and facilities to operate Pepsi for his own personal profit amounted to stealing from the company, giving the company an equitable right to the fruits of his theft.

Finally, the court looked to the capacity in which Guth discovered the opportunity. Pepsi’s prior owner had not approach Guth in his personal capacity, but rather as Loft’s president. If it had been the other way around, however, Guth might have been allowed to take the opportunity. The capacity standard is highly problematic. Every director or officer will claim that the opportunity was presented to him in his individual capacity. Courts therefore should ignore the form of the transaction, on the assumption that the deal was structured to create an appearance of individual capacity, and put a heavy burden of proof on the director to show that it was presented to him as an individual. Where the sole evidence is the director’s word, the court should presume that the opportunity was presented to him in his capacity as a director or officer.

Guth, of course, is an easy case. Not only did Guth appropriate an opportunity that Loft could have exploited, but he also engaged in a massive campaign of self-dealing and outright theft. Analysis by platitude more than sufficed. Subsequent cases involving less egregious conduct therefore have helped flesh out the doctrine.

In Broz v. Cellular Information Systems, Inc.,[11] Robert Broz was the sole shareholder and President of RFB Cellular, Inc., a small cell phone company. Broz was also a member of the board of Cellular Information Systems, Inc., which also provided cell phone service. David Rhodes, a broker, informed Broz of an opportunity to acquire a cellular telephone service license called Michigan-2, which would entitle the buyer to provide cell phone service to an area in rural Michigan. RFB Cellular already owned and operated a similar license known as Michigan-4.

Broz bought Michigan-2 for RFB Cellular without formally offering it to Cellular Information Systems. Before doing so, Broz did mention the opportunity informally to Richard Treibick, Cellular Information Systems’ CEO and to Peter Schiff, a Cellular Information Systems board member, both of whom expressed a lack of interest on Cellular Information Systems’ behalf. During the relevant time period, Cellular Information Systems was in financial difficulty and was in the process of being acquired by PriCellular, Inc., yet another cell phone operator. PriCellular was bidding on the Michigan-2 license, a fact of which Treibick was well aware. Broz outbid ProCellular. Because of financing difficulties, PriCellular’s acquisition of Cellular Information Systems was not completed until shortly after RFB Cellular’s successful bid for the license. Once PriCellular completed its acquisition of Cellular Information Systems, it caused Cellular Information Systems to sue Broz for breach of fiduciary duty, claiming that Broz had usurped the Michigan-2 opportunity.

The Delaware supreme court held Broz had not violated his fiduciary obligation to Cellular Information Systems by failing to formally offer the Michigan-2 license to Cellular Information Systems. The court identified four relevant considerations: (1) Is the corporation financially able to take the opportunity? (2) Is the opportunity in the corporation’s line of business? (3) Does the corporation have an interest or expectancy in the opportunity? (4) Does an officer or director create a conflict between his self-interest and that of the corporation by taking the opportunity for himself?

The line of business factor obviously was satisfied. Cellular Information Systems was in the business of operating cellular phone franchises. Michigan-2 was a cellular phone franchise. Yet, Cellular Information Systems’ stated business plans did not contemplate further expansion of its cellular phone business. To the contrary, Cellular Information Systems was divesting some of its existing licenses. Accordingly, Cellular Information Systems had no interest or expectancy in the license. The court further emphasized that Cellular Information Systems lacked the financial capacity to acquire the Michigan-2 license. Cellular Information Systems had only recently emerged from a bankruptcy reorganization and remained in a precarious financial position. Finally, just as Guth was clearly a bad guy, Broz was a good guy. The court took pains to stress that formal processes were not required. Broz did not have to formally present the opportunity to Cellular Information Systems’ board, not did that board have to formally reject the opportunity, before Broz was free to take it. Formal processes may create a safe harbor, but they are not required.

The standard that emerges from cases like Guth and Broz is not very precise. The lists of relevant considerations differ not just in number but also in substantive content. In Guth, the capacity in which the director or officer learned of the opportunity is one of the relevant factors. In Broz, the court merely “note[s] at the outset” that Broz learned of the Michigan-2 opportunity in his individual capacity and, moreover, emphasizes that “this fact is not dispositive.”

The listed considerations also seems somewhat arbitrary. One could readily construct a longer laundry list of factors that seem at least as relevant as those on which the Guth and Broz courts relied. For example, one might readily consider such facts as: (1) Were there prior negotiations with the firm about the opportunity? (2) Did the director conceal the opportunity from the firm? (3) Did the director make use of corporate funds or property in exploiting the opportunity? (4) Will the opportunity involve competition with the firm or otherwise thwart firm policy? (5) Did the corporation have a substantial need that the opportunity would have filled? (6) Did the corporation have the necessary technical resources to exploit the opportunity? (7) Is the director an insider.

Additional imprecision follows from the court’s insistence that the listed considerations are factors not elements. Put another way, the court evaluates the director or officer’s conduct under the totality of the circumstances.[12] From a transactional planning standpoint, the lack of clear guidance places considerable value on obtaining a safe harbor. Formal presentment of the opportunity to the board may not be required by Delaware law, but it is surely the prudent course of action.

An interesting application of the Broz test is provided by In Beam ex rel. Martha Stewart Living Omnimedia, Inc. v. Stewart.[13] Plaintiff Beam raised a corporate opportunity claim the court described as follows:

In January 2002, Stewart and the Martha Stewart Family Partnership sold 3,000,000 shares of [Martha Stewart Omnimedia] Class A stock to [a consortium of investors and investment funds] designated in the amended complaint as “ValueAct.” In March 2002, Kleiner, Perkins, acting through its general partner, Doerr [a member of MSO’s board of directors], sold 1,999,403 shares of MSO to ValueAct. …

Count III of the amended complaint alleges that Stewart and Doerr breached their fiduciary duty of loyalty, usurping a corporate opportunity by selling large blocks of MSO stock to ValueAct.

In other words, plaintiff alleged that Stewart and Doerr took a corporate opportunity by selling some of their MSO stock to a group of investors. The opportunity allegedly usurped from MSO was one of raising capital by selling stock, which was preempted by Stewart’s and Doerr’s sales.

Chandler held that in the 4 factor-test set out in Broz v. Cellular Information Systems, “no single factor is dispositive. Instead the Court must balance all factors as they apply to a particular case.” After doing so, Chandler held that Stewart and Doerr had not usurped a corporate opportunity from MSO.

As for the line of business prong, Chandler described it as asking whether the opportunity entails “an activity as to which [the corporation] has fundamental knowledge, practical experience and ability to pursue.” He then held: “Simply stated, selling stock is not the same line of business as selling advice to homemakers.  Further, I would presume that a company’s “line of business” is one that is intended to be profitable.  By definition, a company’s issuance of its stock does not generate income.”

Chandler then stated that: “A corporation has an interest or expectancy in an opportunity if there is ‘some tie between that property and the nature of the corporate business.’” He concluded: “Here, plaintiff does not allege any facts that would imply that MSO was in need of additional capital, seeking additional capital, or even remotely interested in finding new investors.”

Finally, as for the conflict of interest prong, Chandler held that: “Delaware courts have recognized a policy that allows officers and directors of corporations to buy and sell shares of that corporation at will so long as they act in good faith.”

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[1] See generally Victor Brudney & Robert C. Clark, A New Look at Corporate Opportunities, 94 Harv. L. Rev. 997 (1981); Kenneth B. Davis, Jr., Corporate Opportunity and Comparative Advantage, 84 Iowa L. Rev. 211 (1998); Richard A. Epstein, Contract and Trust in Corporate Law: The Case of Corporate Opportunity, 21 Del. J. Corp. L. 5 (1996); Harvey Gelb, The Corporate Opportunity Doctrine—Recent Cases and the Elusive Goal of Clarity, 31 U. Richmond L. Rev. 371 (1997); Eric L. Talley, Turning Servile Opportunities to Gold: A Strategic Analysis of the Corporate Opportunities Doctrine, 108 Yale L.J. 277 (1998).

[2] 164 N.E. 545 (N.Y. 1928).

[3] Michael P. Dooley, Enforcement of Insider Trading Restrictions, 66 Va. L. Rev. 1, 64-66 (1980).

[4] Meinhard v. Salmon, 164 N.E. 545, 546 (N.Y. 1928) (citations omitted).

[5] Id. at 547.

[6] Id. at 548.

[7] Id.

[8] Guth v. Loft, Inc., 5 A.2d 503 (Del. 1939).

[9] In his capacity as Loft’s president, Guth terminated the supply contract with Coca-Cola. Guth then caused Loft to enter into a supply contract with Pepsi. Note that Guth’s conduct thus also implicated the conflict of interest transaction doctrine discussed in the preceding section. A corporate officer or director may only compete with the corporation if the competition involves no breach of duty. Here there was a clear cut breach of duty because of Guth’s self-dealing. He controlled Loft and thus could force it to buy syrup from Pepsi; he controlled Pepsi and thus could set the terms on which the syrup would be supplied. By being on both sides of the transaction he had a rather pronounced conflict of interest.

[10] See, e.g., Southeast Consultants, Inc. v. McCrary Engineering Corp., 273 S.E.2d 112, 117 (Ga. 1980) (asking whether the corporation had a “‘beachhead’ in the sense of an equitable expectancy growing out of a pre-existing relationship”); Shapiro v. Greenfield, 764 A.2d 270, 278 (Md. App. 2000) (after noting that Maryland uses the interest or expectancy standard, which it said is focused “on whether the corporation could realistically expect to seize and develop the opportunity”).

[11] 673 A.2d 148 (Del. 1996).

[12] See Broz v. Cellular Information Systems, Inc., 673 A.2d 148, __ (Del. 1996) (“the totality of the circumstances indicates that Broz did not usurp an opportunity that properly belonged to CIS”); see also Schreiber v. Bryan, 396 A.2d 512 (Del. Ch. 1978) (“a claim that a corporate opportunity has been wrongfully taken is wholly dependent upon the facts presented. . . . The application of these principles depends on the facts.”).

[13] 833 A.2d 961 (Del.Ch. 2003), aff’d, 845 A.2d 1040 (Del. 2004).

© Stephen M. Bainbridge, William D. Warren Professor of Law, UCLA School of Law, 2007