A Recurring Business Divorce Feature: Usurpation of Corporate Opportunity
October 03, 2022
One of the earliest signs that a closely-held business is headed for divorce lies in how its owners treat new opportunities. When the relationship among the owners reaches a certain level of distrust, an owner presented with a potentially valuable opportunity is naturally tempted to pursue the opportunity independently, rather than through the business. That temptation explains why we business divorce litigators frequently see claims for “usurpation of corporate opportunity.”
A species of the breach of fiduciary duty claim, a claim for usurpation of corporate opportunity is derivative—asserted on behalf of the company—and disarmingly simple to allege (“You engaged in deal X personally, in violation of your fiduciary duties to bring that deal to the company”).
Despite its frequency and apparent simplicity, a claim for usurpation of corporate opportunity often is difficult to prove, requiring the plaintiff to confront a bevy of difficult questions: What about the company and the opportunity begets the legitimate expectation that the fiduciary was required to bring it to the company before pursuing it independently? What if the company lacked the funding or legal authority to pursue the opportunity? Did the fiduciary act in bad faith to personally profit from the opportunity? What if the counterparty was unwilling to deal with the company? And, perhaps most importantly, what state’s law applies to the claim?
Two recent cases out of the Manhattan Commercial Division and the U.S. District Court for the Southern District of New York provide a fine springboard to unpack these questions and explore the bounds of the corporate opportunity doctrine under New York and Delaware law.
New York’s Corporate Opportunity Doctrine
New York’s corporate opportunity doctrine in its current form is on display in the First Department’s 1989 decision in Alexander & Alexander v Fritzen, 147 AD2d 241 (1st Dept 1989), which announces the rule that “The doctrine of ‘corporate opportunity’ provides that corporate fiduciaries and employees cannot . . . divert and exploit for their own benefit any opportunity that should be deemed an asset of the corporation.” The claim has three elements: (i) the diversion of an opportunity from the corporation, (ii) from which the fiduciary personally profited, and (iii) damages.
In most cases, the dispute centers on the first element: whether the opportunity usurped is one in which the company has a sufficient interest. The Alexander court described three non-exclusive tests to determine whether a venture should be considered an “opportunity that should be deemed an asset of the corporation:” (i) the “initial understanding” test, (ii) the “tangible expectancy test,” and (iii) the “necessary or essential” test.
- Under the “Initial Understanding” test, the court examines whether, at the beginning of the fiduciary relationship, the parties understood that the fiduciary would simultaneously pursue other interests, even ones related to or in direct competition with the business of the corporation.
- Under the “Tangible Expectancy” test, the court considers whether the corporation has a “tangible expectancy”—something less than outright ownership, but more than subjective hope—in the allegedly diverted opportunity. The tangible expectancy test “clearly expresses the judgment that the corporate opportunity doctrine should not be used to bar corporate directors from purchasing any property which might be useful to the corporation, but only to prevent their acquisition of property which the corporation needs or is seeking . . . .” (Burg v Horn, 380 F2d 897, 899 [2d Cir 1967]).
- Under the “Necessary or Essential” test, an officer is deemed to have violated his fiduciary duty where the opportunity diverted is the same as, is necessary for, or is essential to the line of business of the corporation.
In addition to establishing that the company has a legitimate interest in the opportunity, a plaintiff bringing a usurpation of opportunity claim under New York law must further show that the fiduciary “personally profited at the expense of the company” (see Veritas Capital Mgt. LLC v Campbell, 22 Misc 3d 1107(A) [NY County 2008]).
Corporate Opportunity Claim Fails Because Company Lacked a Tangible Expectancy in Diverted Investment
Manhattan Commercial Division Justice Schecter recently highlighted the limitations of New York’s corporate opportunity doctrine in her post-trial decision in Shatz v Chertok, No. 655620/2018 (NY County Sept. 21, 2022).
Defendant Chertok was a successful venture capitalist and the manager of several different investment LLCs, including Vast Ventures V LLC (“Vast Five”) and Vast Ventures VI LLC (“Vast Six”). Chertok and the Plaintiff Shatz formed Vast Six as two equal 50% members to pursue investment opportunities in early-stage technology companies. The Operating Agreement gave Chertok “sole and absolute discretion” to select which investments Vast Six would make.
In July 2013, Chertok and Shatz discussed Vast Six’s potential investment in Ripple—now the immensely valuable currency exchange network—by participating in Ripple’s Series A equity raise. Chertok and Shatz agreed that Vast Six would make the investment, and Shatz wired Vast Six his portion of the funds needed. By August of 2013, however, Ripple had elected not to proceed with the Series A equity raise. Chertok returned Shatz’s money and advised him that the funding round had been put on hold.
Later that year, Ripple’s co-founder offered Chertok the opportunity to loan $100,000 to Ripple in the form of a convertible note. Chertok did not present the convertible note opportunity to Vast Six, but instead funded the loan on behalf of Vast Five.
Once Ripple became a success, Shatz sued Chertok alleging that he should have brought the convertible note opportunity to Vast Six. Vast Six’s potential investment in Ripple’s equity a few months earlier, Shatz argued, created a “tangible expectancy” in future Ripple opportunities, which Chertok usurped when he invested in the convertible note via Vast Five.
Justice Schecter’s post-trial decision pulls no punches in finding that Chertok was less than candid with Shatz about the Ripple investment opportunities, writing, “it would be an arduous task to address each of [Chertok’s] incredible factual contentions and all of his baffling conduct.” But, said the Court, Shatz failed to prove that Vast Six’s potential investment in Ripple’s equity made a tangible expectation in a later loan to Ripple:
To be sure, debt and equity investments may be economically equivalent or substantially similar such that a tangible expectancy in one makes the other a corporate opportunity. But, in this case, Shatz failed to prove that to be true. . . [P]laintiff’s comparison of the terms of the Series A and the convertible note is not sufficient to establish a breach of fiduciary duty . . . Both investments are complex transactions that present significant risk to sophisticated investors. . . Whether motivated by tax, regulatory, or even bankruptcy concerns, the structure matters.”
Justice Schecter also concluded that Shatz’s claim failed because he could not show that Chertok’s decision to invest via Vast Five was made in bad faith to enrich himself at the expense of Vast Six. The Court reasoned that there were potentially many legitimate reasons Chertok might have chosen Vast Five over Vast Six to fund the convertible note, and given those potential reasons, “Chertok’s choice to invest through Vast [Five] and thereby limit both his upside and risk lacks the hallmark of a fiduciary succumbing to sheer greed by chasing profit, and suggests other driving motivations.”
Delaware’s Corporate Opportunity Doctrine
The Corporate Opportunity doctrine is less stringent in Delaware than in New York. It requires that the (1) the opportunity be within the corporation’s line of business; (2) the corporation has an interest or expectancy (but not, as New York requires, a tangible expectancy) in the opportunity; (3) the corporation is financially able to exploit the opportunity (this element is not a factor in New York); and (4) by taking the opportunity, the corporate fiduciary assumes a position inimical to duties owed to the corporation (Triton Const. Co. v E. Shore Elec. Servs., Inc., CA No. 3290-VCP [Del Ch May 18, 2009]). Notably, it does not require that the defendant act in bad faith to personally profit from usurping the opportunity—one of the elements that Justice Schecter found lacking in Shatz.
Most importantly, Delaware law reverses the burden of proof: the “burden is on the fiduciary to show that he or she did not seize a corporate opportunity” (Grove v Brown, CV 6793-VCG [Del Ch Aug. 8, 2013]).
Usurpation of Opportunity Claim Survives Summary Judgment Under Delaware’s Less-Stringent Standard
Next door to Justice Schecter, at the Southern District of New York’s Pearl Street Courthouse, Judge Mary Kay Vyskocil recently considered Delaware’s broader corporate opportunity doctrine in a messy business divorce between members of a real estate investment business in Kulick v Gamma Real Estate LLC et al, No. 20 CV 03582 (SDNY Sept. 23, 2022).
Like in Shatz, the parties in Kulick formed an LLC, known as SLP, as an investment vehicle—in this case for investment real properties in the Southeastern United States. Kulick was the Chief Investment Officer of Gamma Real Estate LLC, and SLP was a joint venture between himself and Gamma. In February 2020, Gamma’s owners, who had grown frustrated with Kulick’s performance, terminated him as CIO effective March 31, 2020.
Before his termination became effective, Kulick became aware of an opportunity to purchase certain multifamily properties in Decatur, Georgia, known as the D&G deal. Rather than bring the D&G deal to SLP or Gamma, Kulick submitted a letter of intent to purchase D&G on behalf of Beacon Real Estate Group LLC, a company that Kulick founded with a friend after he received word that he would be terminated from Gamma.
After Kulick’s termination became effective, his work emails were forwarded to an owner of Gamma, who discovered messages addressed to the “Beacon Team” regarding Beacon’s purchase of D&G.
When the dispute between Kulick and SLP/Gamma boiled over, Kulick fired the first shot, suing Gamma and SLP for allegedly withholding fees he was due after his termination. Gamma and SLP fired back with counterclaims against Kulick for his usurpation of the D&G deal. The parties did not dispute that SLP was financially able to invest in the D&G deal, so the claim turned on whether the D&G deal was within SLP’s line of business and whether SLP had an interest in the D&G deal. On these elements, the parties offered competing evidence: Kulick offered evidence suggesting that at the time the D&G deal came along, SLP was interested solely in divesting its real estate holdings, not purchasing new ones. SLP, by contrast, introduced evidence suggesting that it was always looking for new deals on both the purchase and sale side.
Based on that conflicting evidence, the Court denied both sides’ competing motions for summary judgment:
This evidence in the record creates a genuine dispute of material fact as to whether an investment in D&G fell within SLP’s line of business at the time that it was diverted, and whether SLP had an interest or expectation in D&G. The Court thus denies both motions for summary judgment as it relates only to this theory of breach of a fiduciary duty. In doing so, the Court recognizes that the determination of whether a corporate fiduciary has usurped a corporate opportunity is fact-intensive and turns on, inter alia, the ability of the corporation to make use of the opportunity and the company’s intent to do so.
Unlike Justice Schecter in Shatz, Judge Vyskocil, applying Delaware law, did not consider whether SLP’s interest in the D&G deal was “tangible” or otherwise justified. Nor did she consider whether Kulick personally profited from bringing the D&G deal to Beacon. The fact that Kulick brought to Beacon an investment opportunity in the same field as SLP—real estate in the Southeastern United States—was sufficient to defeat summary judgment.
Practical Considerations
As is often the case in LLCs, a carefully drafted operating agreement can refine the contours of the corporate opportunity doctrine in any potential dispute. For instance, a specific purpose clause will help to determine whether an opportunity was truly within the business of the LLC. The operating agreement might also expressly give a member certain rights to pursue opportunities independently or broad discretion to select (and, consequently, reject) opportunities on behalf of the company.
But even with a carefully drafted operating agreement, the corporate opportunity doctrine is sure to remain an oft-invoked claim in business divorce litigation. As the above cases demonstrate, counsel considering bringing such a claim should be prepared for a deeply factual inquiry concerning the extent of the company’s expectancy in the opportunity, and in cases applying New York law, whether the fiduciary personally profited from the opportunity allegedly usurped.