Corporate Opportunities

This section of the blog will examine corporate opportunities – the one category of COI that is singled out by stock exchange rules for inclusion in codes of conduct.

“Tailoring” the duty of loyalty

A prior post provided an overview of “corporate opportunities” – an important and somewhat distinct type of COI. Last week, writing in the Harvard Corporate Governance Blog, Gabriel Rauterberg of Michigan Law School and Eric Talley of Columbia Law School described some fascinating research they conducted regarding companies allowing their respective directors and officers to engage in conduct that would otherwise violate the corporate opportunities doctrine. The full paper is available for download here.

By way of introduction, they note that the duty of loyalty is widely perceived as “’immutable’—impervious to private efforts to dilute, tailor, or eliminate it.” However, the authors state: “That perception is false: Beginning in 2000, Delaware dramatically departed from longstanding tradition, amending its statutes to enable corporations to waive a critical component of loyalty—the corporate opportunity doctrine—which forbids corporate fiduciaries from appropriating new business prospects for themselves without first offering them to the company. From that moment forward, Delaware corporations and managers were free to contract out of a significant portion of the duty of loyalty…”

Rauterberg and Talley studied the experience of public companies that took this route. They found that literally thousands of companies adopted such waivers, showing: “Public companies have an enormous appetite for tailoring the duty of loyalty when freed to do so.” They further note that “there are…several plausible economic rationales for a corporation to embrace a COW [corporate opportunity waiver] for the sake of shareholder value. Indeed, in the years leading up to Delaware’s initial reform, a growing chorus of critics argued that the exacting requirements of the duty of loyalty had begun to impede corporations’ ability to raise capital, build efficient investor bases, and secure optimal management arrangements. This claim was based in part on the recognition that many then-emerging sources of capital, such as private equity, venture capital, or spin-off transactions may subject their financial sponsors to fiduciary duties in profound conflict with either their larger business plans or with fiduciary obligations they owe to other business entities.” The authors found as well that “COW adopters … tend to deliver larger overall market returns to their capital investors by comparison to other public companies….it does not appear that companies that execute waivers are systematically the unscrupulous bottom feeders of the corporate ecosystem.”  Finally, they assessed “whether the adoption of a waiver tends to add or dilute value on the margin, by analyzing market reactions to issuers’ first public disclosure of a COW. [Their] event study analysis reveals that market reactions are generally favorable, resulting in an average positive abnormal stock return of between 1.0 and 1.5 percent in the days immediately surrounding the announcement date…The positive market response does not seem sensitive to whether the waiver also covers officers and/or dominant shareholders…”

All told, Rauterberg and Talley present corporate opportunities waivers as often desirable based on the logic born of an efficient markets perspective.  This largely makes sense to me (although, as noted below, I have do have one area of concern about their analysis). Indeed, in an earlier post I argued that waivers of the duty of loyalty involving board representatives of joint venture partners were not troublesome, given that such partners can be seen as “consenting adults” in deciding whether a full-fledged duty of loyalty was indeed desirable in any given JV . Somewhat similarly, I’ve previously argued that client COIs arising from advertising agency mergers can readily be addressed by market forces.  (However, in other situations – particularly involving financial services professionals giving investment advice to retail clients – cutting back on the duty of loyalty seems less defensible.)

But, I am troubled by the above-noted part of the authors’ findings about officers, given that the legitimate need for a waiver should be less significant for an officer than for an outside director – as the latter is presumably more likely have business roles with other companies involving identifying business opportunities.  Also, I think (though am not sure) that the likelihood of harm flowing from a director’s usurpation of a corporate opportunity is less than that of an officer’s doing so, in that officers tend to be more knowledgeable about a company’s operations than are directors – and so on average would have the greater chance to misuse such knowledge in the pursuit of the corporate opportunity in question.

In effect, this aspect of the study’s findings can be seen as an effort to gauge the compliance and ethics risk assessment implicitly undertaken by shareholders of publicly traded companies when they learn of a COW.  Given how difficult  C&E risk assessments are even for professionals in the field, I wouldn’t view these particular findings as the final word on the downside of corporate opportunity waivers. Put otherwise, some markets are more efficient than others – and the C&E information market seems pretty inefficient to me, at least at this level of granularity.

Finally, a practice pointer for C&E officers. NYSE listing requirements (section 303A.10) strongly encourage (but do not actually require) companies to have corporate opportunities provisions in their codes of conduct, and a great many codes do this. However, if a company has adopted a COW then presumably it should  not to have such a provision, which could make the code seem deceptive.  For more on possible liability for making false claims about a company’s compliance standards  see this post.

Corporate Opportunities – a distinct and important type of conflict of interest

Recently, the revelation that the CEO of  the beleaguered  energy company Chesapeake also ran a hedge fund which traded in energy products caused a Forbes  journalist to ask if this constituted a violation of the corporate opportunities doctrine: ” The fund was not disclosed to shareholders. Its operation was not undertaken for the benefit of shareholders. Its profits were neither shared with shareholders nor disclosed to shareholders. Why not? It’s not like Chesapeake was a stranger to trading — the company has booked profits of $8.4 billion on its corporate oil and gas hedging in recent years. If the co-founders of the company identified new ways to profit from trading natural gas, why didn’t they present that opportunity to the company instead of keeping it for themselves? This has raised a host of questions. Did they profit off of non-public information about Chesapeake’s trades? Were they front-running? Did the hedge fund pay rent to Chesapeake for being allowed to operate from a Chesapeake building? ” 

The Chesapeake case – which provides many teaching opportunities – gives us occasion to consider this important area of COI about which too little is generally known in the C&E field.

First, what exactly is a “corporate opportunity? According to the American Law Institute’s (ALI) Principles of Corporate Governance,  it is “(1) Any opportunity to engage in a business activity of which a director or senior executive becomes aware, either: (A) In connection with the performance of functions as a director or senior executive, or under circumstances that should reasonably lead the director or senior executive to believe that the person offering the opportunity expects it to be offered to the corporation; or  (B) Through the use of corporate information or property, if the resulting opportunity is one that the director or senior executive should reasonably be expected to believe would be of interest to the corporation; or  2) Any opportunity to engage in a business activity of which a senior executive becomes aware and knows is closely related to a business in which the corporation is engaged or expects to engage.” So, this last part of the definition would seem to fit the Chesapeake case.   

Second, what restrictions govern a director or officer when presented with a corporate opportunity? She may not take the opportunity for herself or a third party unless she first offers it to the corporation and, as part of this offer, make appropriate disclosures to the company’s board of directors.

Third, how do corporate opportunities relate to C&E programs? In 2003, the New York Stock Exchange amended its corporate governance-related listing requirements to include, among other things, a requirement of a code of conduct for directors, officers and employees. Corporate opportunities are among the topics specified for inclusion in such codes.

Fourth, what are the consequences of violating the doctrine?  There can be many – with the most obvious one being suit for damages by shareholders. And consider that not long ago a member of the board of directors of a leading U.S. company was convicted of a securities-law violation in what was essentially a corporate-opportunities case.  Indeed, this case – as well as the whole area of corporate opportunities  – may be worth covering when training directors.  (Note – training directors on COIs will be the subject of our next post.)

Conflict of Interest Risk Assessments – Part 4: Capacities

Risk assessment is generally seen to be the most important – and often the most challenging – aspect of any compliance program, and for this reason we are exploring COI risk assessment in a six-part series in the Blog. The first two postings in this series addressed legal expectations regarding COI risk assessments and the C&E program uses to which information derived from a COI risk assessment should be put.   The third posting began the discussion of methodology by addressing one of three principal risk assessment dimensions – “reasons.”  In this posting, we examine the “capacities” dimension of COI risk assessment (and after this we’ll explore measuring the impact of COI risks).

“Capacities” – in the compliance risk analysis context – means a party’s ability to engage in harmful behavior.  In some industries, such capacities for harmful conflicts-based conduct are widespread.  An obvious example is the financial services industry.  Indeed, as noted several years ago by the SEC’s then Chief of Enforcement :  “Conflicts of interest are inherent in the financial services business. When you are paid to act as an intermediary, like a broker, or as another’s fiduciary, like an investment adviser, the groundwork for conflict between investment professional and customer is laid.”  More recently, and as described in a recent posting, there is a vast array of capacities for COIs in private equity firms that have been identified as of  possible concern to the Securities and Exchange Commission.  

Turning from client conflicts in the financial services field to internal ones in organizations of all kind, a key consideration for this aspect of risk assessment is the extent to which an individual exercises discretion over matters that could involve COIs.  Most obviously in this category are individuals in management or procurement positions.  But there are also many other, less obvious, functions that could have COI-risk creating capacities.

For instance, in a government contractor, HR could be seen as having the capacity to violate COI rules concerning hiring government personnel.  Or, in some companies, “corporate opportunities” will present real COI risks — e.g., particularly investment-related ones – for some employees (or agents) but not others.  (This type of COI – which will be the topic of future postings – refers to situations where as part of her work a director or employee identifies a business opportunity and takes advantage of it without making sure the employer has first had the opportunity to consider it.)  Similarly, for insider trading – which is partly COI-related – a capacities analysis would embrace the extent to which various individuals had access to material, non-public information from their employer.

Of course, a COI risk tends to be highest for individuals or functions where both “reasons” and “capacities” are significant, and in such instances companies should consider deploying a full range of C&E mitigation measures, e.g., targeted training, auditing and other controls.  The same is true with regard to COI risks for which only one of these dimensions is significant but the potential impact of a COI (to be addressed in the next post) is high.