The Corporate Opportunity Doctrine
The corporate opportunity doctrine prohibits a corporate fiduciary from exploiting an opportunity related to the corporation's business unless he or she first offers the opportunity to the corporation. Note that in most states this doctrine will apply whether there is a corporation, limited liability company or a partnership. Some states will allow the owners of an entity to waive the right, however (1) that is ONLY some states and (2) the waiver has to be explicit and generally in writing in the documents that form the business.
There is no question the doctrine applies to small businesses. Countless cases confirm that. The real question is how it applies, given the unique characteristics of many small businesses. In the small business setting, challenges arise as to:
The Disclosure Rule
- who the opportunity must be disclosed to;
- whether the holder of a distributional interest in the business can challenge a decision to turn down an opportunity;
- what happens when basic corporate formalities are not followed; and
- whether the persons taking the opportunity have violated any duty to the business' creditors.
The officers, directors, and shareholders of a small business owe a fiduciary duty to their company. This includes the obligation to not take “corporate opportunities” that rightfully belong to it. A corporate opportunity exists when a proposed activity is reasonably related to the company's present or prospective business and is one in which the company has the capacity to engage.
The corporate opportunity doctrine is a disclosure rule. When a company's fiduciary wants to take advantage of an opportunity in the company's line of business, the fiduciary must first disclose and make the opportunity available to the company. The basic point is that the corporation or association must be given the opportunity to decide, with full disclosure of pertinent facts, whether it wishes to enter into a business reasonably incident to its present or prospective operations.
Despite the emphasis on disclosure, the law of some states does not require a formal presentation of a potential opportunity when the company does not have any interest in pursuing the opportunity or the financial ability to engage in it. Delaware holds that presentation is a safe harbor which removes the problem of hindsight determination that the director or officer has improperly taken a corporate opportunity. Other states, including Georgia, Rhode Island, and Connecticut have adopted similar approaches.
The “safe harbor" is not universal. Illinois, for instance, views failure to disclose a corporate opportunity as undermining the purpose of the rule. In such circumstances, the failure to disclosure forecloses the interested fiduciary from exploiting the opportunity, even where he or she reasonably believes the company is incapable of claiming the opportunity. Illinois holds that the fiduciaries’ belief that the entity was precluded by law from capitalizing on an opportunity could not substitute for the duty to present the question to the corporation for independent evaluation.
Application to Small Businesses
Disclosure is theoretically a simple process. The interested fiduciary fully discloses all pertinent information and disinterested fiduciaries then evaluate whether the company should engage in the opportunity. The problem is this process does not always neatly apply in a small business, where (1) each fiduciary may want to pursue the opportunity for himself; (2) distributional interests may be held by someone other than an owner; (3) corporate formalities are not always observed; and (4) the company may be broke or nearly broke.
No Disinterested Fiduciaries
What happens when there are no disinterested officers, directors or owners to evaluate an opportunity for the business? It could be that every owner knows about or is personally interested in the opportunity. Must it be presented to a disinterested third party for independent evaluation?
Massachusetts was one of the first states to consider this issue. A former president, director, and sole shareholder of a bankrupt corporation appealed from a trial court decision that had imposed a constructive trust on property he personally owned. He had acquired the property in part with corporate funds and leased it back to his corporation. The bankruptcy and district courts found that he breached his duty to the corporation by using corporate funds to help purchase the property for himself rather than for the corporation.
The appeals court disagreed. Emphasizing he was the sole shareholder, director, and president of the company, it held the corporate opportunity doctrine was inapplicable because his actions necessarily involved the knowledge and assent of the corporation. The court also recognized that even though the shareholder and the corporation were separate persons, absent some element of defrauding, he was not obliged, in every action he took, to prefer the corporation's interests to his own.
A number of other states have applied similar reasoning to reach the same conclusions. Wisconsin holds that if an officer owns all the stock, he may use the corporate assets as he sees fit and there can be no misappropriation of corporate assets by him. New York courts dismissed a corporate opportunity claim because the corporation had necessarily consented to diversion of its assets through the acts of its sole owners and officers, who were accused of stealing the opportunity. Pennsylvania courts have reversed a usurpation finding because the corporate opportunity doctrine was difficult to apply to a small business where there were no other shareholders to whom the sole fiduciary owed a duty of disclosure and loyalty.
Maryland has held that a sole shareholder could not be liable for taking a corporate opportunity in the absence of any harm to creditors.
A few other courts have reached the same result through a doctrine of ratification. They say that even when a transaction is detrimental to the corporation, there is no case if all of the interested shareholders have ratified the transaction. They rule that there have to be non-consenting shareholders for there to be a case.
The bottom line here is that where taking a corporate opportunity from a small business necessarily involves the knowledge and assent of the corporation or ratification by all the shareholders, there is no claim under the corporate opportunity doctrine. Except for insolvency this rule is true even where the consenting or ratifying fiduciaries are personally interested in the opportunity.
Transfer of Distributional Interests
Many small businesses are limited liability companies. A distributional interest in a limited liability company is a transferable asset. It is not uncommon for an LLC member to transfer a distributional interest to a person who has no ownership interest in the business, like a creditor. That creates the question of how, if at all, the transfer affects a fiduciary's disclosure obligations under the corporate opportunity doctrine.
Transferring a distributional interest does not give an ownership interest or create a fiduciary relationship with the company's other members. This means two things.
Not Following Corporate Formalities
- The person or entity getting a distributional interest is not entitled to exercise the rights of a member. This includes challenging, directly or derivatively, the taking of a corporate opportunity.
- Corporate fiduciaries are not required to disclose an opportunity to an independent third party for evaluation just because a non-owner holds a distributional interest in the company.
Not adhering to basic corporate formalities, like documenting director meetings or recording shareholder votes, is common in many small businesses. Regardless why it happens, poor documentation can lead to significant problems with corporate opportunities.
Suppose every shareholder knows about a corporate opportunity and agrees the business should not pursue it. Some of the shareholders take the opportunity for themselves. There is no document of any sort of presentation of the opportunity to the business or official vote of the officers or directors. Sometime later, the shareholders who did not take the corporate opportunity sue those who did claiming the opportunity was not fully or properly disclosed to the corporation.
What could have been resolved quickly with proper documentation if corporate formalities had been followed now presents an expensive litigation problem. Proving the (1) opportunity was actually disclosed to the corporation, (2) pertinent facts were fully disclosed; and (3) board or shareholders in fact agreed the business should not pursue it all become subject to time and money eating discovery. This is because the answers are not in board meeting minutes or shareholder ballots. Not adhering to corporate formalities can make a mountain out of a usurpation claim.
An additional issue is whether the business was solvent at the time of the transaction. This is important. When a company is insolvent, the duties of its fiduciaries, including the duty to disclose corporate opportunities, extend to the creditors. Directors and officers owe fiduciary duties to their corporation. When solvent, those duties are enforced by shareholders because they are the ultimate beneficiaries of the corporation's growth and increased value. When a corporation is insolvent, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.
Once an insolvent company files for bankruptcy, its creditors can complain about the taking of corporate opportunities. In an Illinois case the bankruptcy trustee of a closely-held company sued the principal for transferring an opportunity to acquire another company in the same business away from the company. In defense, the principal argued he had breached no duty because he had disclosed the opportunity to the other members, who agreed that a separate entity should make the acquisition. The court rejected the argument because the duty involved was to the creditors, not the other members. According to the court, the agreement to transfer the opportunity made them jointly and severally liable for a breach of duty to the creditors.
In another case the president and majority shareholder of a family-owned business arranged to personally buy a mortgage at discount when the opportunity rightfully belonged to his corporation. The corporation filed for bankruptcy hours after the purchase was complete. The trial court found he had not breached a duty because the acquisition was agreed to with the knowledge and approval of all of the officers, directors and shareholders. The appeals court reversed, finding that as an officer, director and principal stockholder of an insolvent corporation he was duty bound to act with absolute fidelity to both creditors and stockholders. Because he arranged the transaction knowing the corporation was insolvent, approval by the fiduciaries did not free him to appropriate corporate opportunities to the detriment of the creditors.
The corporate opportunity doctrine can be a challenge to small business owners. It can be made worse when you don’t observe corporate formalities and whenever the corporation is insolvent and the rights of creditors are at stake. When insolvency is not an issue, there is case law support for the notion that small business owners have the right to treat their business as their own, including by taking corporate opportunities for themselves personally if there are no partners.
This material is provided for information and education purposes to members and others who may be interested in the subject matter. It is not professional advice, which can only be given on specific facts. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. This material is provided to Small Business Service Bureau, Inc. (SBSB) by Nicolai Law Group, P.C. SBSB is not a law firm and not a substitute for an attorney or a law firm. Any electronic message you send to SBSB will not go to a lawyer. You cannot create an attorney/client relationship using this website and you cannot expect that anything you put in a message to SBSB to be either privileged or confidential.