Duty of Loyalty

When to Go For it: The Duty of Loyalty

By Bruce D. Marks

First a phone call, then a lunch meeting, the next thing you know you’re getting the offer of a lifetime. Can you take it? This is a question that often confronts us during our careers. Directors and officers of corporations, through their business connections, or otherwise, frequently come across, or are propositioned with business opportunities outside of their employment. When is it possible for that individual to take advantage of them?

Not taking into account non-competition clauses and contracts, it has long been settled that a director’s and officer’s obligations to the corporation and to the shareholders of that corporation are fundamental. The Courts impose on directors and officers what is commonly referred to as the Duty of Loyalty. Essentially this forbids a director or officer from diverting to him or herself a business opportunity that belongs to the corporation with which he or she is associated. A director or officer has the fiduciary obligation to work for the benefit of the corporation and any activity to the detriment of the corporation by a director is contrary to this duty. This extends not only to a director’s day to day duties but further to the promotion and enhancement of the activities of the corporation. This ties directly to the concept that a director of the corporation has an obligation to not compete against the corporation to the detriment of the corporation.

There exists differences in the test applied by the Courts in the U.S. and Canada. We'll explore these two together.

The U.S. Position

In the U.S. it has been held that “a corporate fiduciary cannot take a business opportunity for himself if it is one that the corporation can financially undertake; is within the line of the corporation’s business and is advantageous to the corporation; and is one in which the corporation has an interest or a reasonable expectancy”. (emphasis added) Guth v. Loft 5A.2d 503. (Del. 1939)

So what is a corporate opportunity?

A corporate opportunity exists when:

· the corporation has an interest or reasonable expectancy in the opportunity;

· the opportunity is within the usual line of business of the corporation;

· the opportunity is one which should be presented to the corporation in fairness to the corporation;

· the opportunity is one that the corporation can financially undertake; and

· any combination of the above.

So when can a director take an opportunity for him or herself?

Basically a director or officer can take an opportunity when:

· the opportunity came in his personal capacity rather than as a manager of the corporation;

· the corporation was precluded from taking advantage of the opportunity;

· the corporation rejected the opportunity after full disclosure;

· the corporation is statute-barred from engaging in the opportunity; or

· the third party engaging in the opportunity refuses to deal with the corporation, but only if the director has not instigated that refusal.

Lets briefly examine these five scenarios.

When the opportunity came in his or her personal capacity rather than as a manager of the corporation

Regarding this first element, it is very difficult to establish that a director has received an opportunity solely through that individual’s personal capacity when he or she is already engaged in the same area of commerce as the opportunity presented. The onus of proof lies with the director to prove that he or she was offered the adventure on a singularly personal basis.

When the corporation was precluded from taking advantage of the opportunity

The second element is also problematic. Commonly, directors take the position that the corporation was not in a financial position to undertake the opportunity when the opportunity arose. The courts have held that the corporation must essentially be insolvent in order to establish this. The reasoning of the courts has been that any opportunity of substance can draw investment and financing for the project. It is important to note that there exists no obligation on the director to advance funds to the corporation in order for it to pursue the opportunity, however, a reasonable effort should be made to obtain funding for the project if this is part of the director’s responsibility. Regardless, if the opportunity is not disclosed to the corporation, the director may not argue that the corporation was not financially able to take advantage of the opportunity. What could be used as a defence is that the infrastructure of the corporation is such that it can’t adapt to perform the project. Examples of this could be that all of the facilities of the corporation are already in use, or, the technology of the corporation is such that it isn’t compatible with the pre-existing requirements of the opportunity.

When the corporation rejected the opportunity after full disclosure

The third element, regarding disclosure, is the one complete defence to any question of whether or not it is proper for the director to accept and pursue the opportunity on his or her own. However, the director must be careful that he or she presents fairly and completely the opportunity to the corporation. To dispel all disputes of accuracy and completeness the disclosure should be presented to the board of directors. Also, the board should call a special shareholder’s meeting to present the idea.

When the corporation is statute-barred from engaging in the opportunity

The fourth element, the corporation is statute-barred is self-explanatory. This would apply to corporations to whom anti-trust or anti-competition legislation applies.

When the third party engaging in the opportunity refuses to deal with the corporation

This last scenario is also a complete defence. However, the courts have held that regardless that the third party refuses to deal with the corporation, the corporation should never the less be presented with the opportunity. The reasoning is that the director’s failure to disclose the third party’s unwillingness to deal with the corporation prevents corporation from taking action to change the third party’s position and renders the unwillingness to deal both too difficult verify (after the fact) and too easy to procure.

When disputed, the burden of proof lies on the director to prove that his or her seizing of the opportunity was fair to the corporation. The onus lies on the corporation to prove that the director did not disclose the opportunity as required in law. Further, if the disinterested directors or shareholders of the corporation have not approved or ratified the rejection of the opportunity the opportunistic director will have burden of proving that his taking of the opportunity was fair and that the rejection of the opportunity was fair to the corporation at the time of the rejection..

Whether a corporate opportunity must first be offered to a corporation will depend on one or more of the following:

the circumstances in which the director first became aware of the opportunity;
the significance of the opportunity to the corporation and the degree of interest of the corporation in the opportunity;
whether the business opportunity relates to the corporation’s contemplated or existing business; and
whether there is a reasonable basis for the corporation to expect that the director should make the opportunity available to the corporation.

The Canadian Position

In Canada, the leading case regarding director’s obligations in this regard is Canadian Aero Service Ltd. v. O’Malley et al. (1973) 40 DLR (3d) 371 SCC.

In this case, the three defendants were officers of a subsidiary and were under the supervision of the parent. The corporation performed aerial mapping of remote locations. The three became aware of an opportunity for which they were employed by the parent to pursue. They performed their duties for the parent in so far as they prepared plans for the corporation, but in the end decided to do it on their own. They quit the company, formed their own company and won the contract. It was held that they breached their obligations to their original employer. The Court found in favour of the company. The Court does not lay down any clear rule regarding director’s loyalty, rather it held that each case should be decided on the facts.

Synopsized, the Court, in Canada, will ask the following questions, at least:

· whether or not the position of the director or officer of the company is high enough to attract a fiduciary obligation flowing from the director or officer to the corporation;

· whether or not within the particular industry practice the standards of good faith and loyalty are met;

· whether or not the ripeness and specificness of the opportunity demonstrate that the corporation would have an interest in the opportunity;

· whether or not the relationship of the officer or director to the opportunity demonstrates that the officer or director was presented the opportunity outside of his employ;

· whether or not the circumstances in which the opportunity was obtained and whether or not it was a special opportunity or a private opportunity;

· whether or not the length of time after the director or officer has left the company before the opportunity is seized is appropriate to allow the director or officer the opportunity; and

· whether or not the director left the company for the purpose of taking the opportunity

Is the position is high enough

All directors and officers have fiduciary obligations to the corporation by virtue of the incorporating statutes. For the most part, therefore, directors and officers will be found to have fiduciary obligations to the corporation.

Industry Practice

This will depend on the circumstances every time, and will vary over time. Ask the question, does this happen all the time, or do you know others that have done the same thing, and what was the outcome.

Ripeness or specificness

Ask the question, is this just a concept that needs to be developed, or is this all ready to go and the position is specific defined role in a specific undertaking. The burden falls on the corporation to prove that the opportunity was something that the director knew was within the interest of the corporation.

Was the opportunity offered but for the director’s position

Unless the opportunity is unrelated to the business of the corporation, it will be difficult for the director to argue that the new opportunity was offered with out regard to the director’s position in the company.

Was the opportunity a special or private opportunity

The burden falls on the director to prove that the opportunity was a special private opportunity that was only offered to him or her and the corporation was precluded from the running. Ask the question, how was this contact made. Is it a work related contact, if so, this can be dangerous.

How long did the director wait before starting the new venture after leaving

This will depend on the circumstances every time, and will vary.

Whether or not the director left the company for the opportunity

Again this will depend on the circumstances. Obviously, if the director left the employ of the company for a reason other than taking the opportunity, this would demonstrate that the opportunity did not exist for the company and would serve as a defence.

This list is not exhaustive, and there may be many more that come to mind.

When opportunities do arise, take advantage of them. But pay close attention to the duty of loyalty. How does one protect one’s self? Ask yourself these questions and answer them honestly. If you follow this test, chances are you will be able to have a pretty good idea of whether or not it’s a risky proposition, and get legal advice. Perhaps the simplest and easiest way of protecting one’s self is to go through the above and ask whether or not the opportunity would pass scrutiny. If it doesn’t it should be presented to the corporation. If the corporation isn’t interested, the opportunity can be seized.

Mr. Marks is a commercial lawyer with Marks & Marks LLP, a Canadian law firm with offices in Ottawa Canada. If you would like to reach Mr. Marks you can email him at bdm@marks-marks.com

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