As published in Insights, March, 1998
David A. Swerdloff is a partner at Day, Berry & Howard in the Stamford, Connecticut office.
The Connecticut Supreme Court has adopted a "safe harbor" rule for directors and officers of corporations considering pursuit of an activity that may be a corporate opportunity.(1) In Ostrowski v. Avery, the court held that adequate disclosure of a corporate opportunity is an absolute defense to fiduciary liability. Absent such disclosure, the fiduciary still can succeed in defending his or her conduct by proving that the conduct did not harm the corporation. The fiduciary must prove this defense, however, by clear and convincing evidence. The court further held that usurpation of a corporate opportunity can be an unfair or deceptive trade practice under Connecticut's Unfair Trade Practices Act, or CUTPA.(2)
FACTS
The plaintiffs in Ostrowski were two minority shareholders in Avery Abrasives, Inc., a closely held Connecticut corporation that manufactured large abrasive cutting wheels. The principal defendants were two employees of the corporation, one a vice president and the other a supervisor. The vice president was the son of the president of the corporation, who held 54% of the outstanding common stock. The vice president was also a director.
In 1976, the two employees approached the father to ask whether they could retain their positions at Avery Abrasives while running their own corporation to manufacture small cutting wheels. Avery Abrasives had abandoned the manufacture of small cutting wheels in 1970. The father consented, and the defendants formed a new corporation to manufacture small cutting wheels in 1977. The next day, the father asked the Board of Directors of Avery Abrasives whether the corporation wished to expand to the manufacture of small wheels. Importantly, he did not disclose to the minority shareholders that the defendants had already formed a corporation to pursue this purpose.
The new corporation was operated by the defendants for about 14 years. Among other things, it purchased large wheels at a discount from Avery Abrasives, sold finished wheels to Avery Abrasives, hired several Avery Abrasives employees and shared some customers with Avery Abrasives. The Yellow Pages advertisement for the new company listed the Avery Abrasives telephone number as its own, and the defendants sometimes conducted business for the new company while at Avery Abrasives. Average gross revenues of the new company were more than $25,000 annually.
The minority shareholders sued on behalf of the corporation on several grounds, including unjust enrichment of the defendants by the salaries and benefits received from Avery Abrasives, negligence and unfair trade practices. The most significant claim, for purposes of the Supreme Court's decision, was breach of fiduciary duty and particularly usurpation of a corporate opportunity.
The trial court rejected the determination of a special litigation committee appointed by the Avery Abrasives Board of Directors, which recommended against pursuing the claim. Nevertheless, the trial court dismissed the claims, stating that it would not punish the defendants for failing to seek formal board of directors approval when they had received the approval of the president and principal shareholder.(3) The trial court further found that (i) any misconduct by the defendants in working for the new company while at Avery Abrasives was de minimus and did not adversely affect their job performance, (ii) the plaintiffs had not proven that the defendants had misappropriated Avery Abrasives property and (iii) the defendants did not engage in unfair trade practices. The Supreme Court reversed.
BURDEN OF PROOF
The Supreme Court began with a discussion of the burden of proof in a fiduciary duty case. Under Connecticut case law, once a plaintiff has established the existence of a fiduciary duty, the burden of proof shifts to the fiduciary to prove fair dealing by clear and convincing evidence. A director who enters into a transaction that will inure to his or her individual benefit must bear the burden of proving that the transaction is "fair, in good faith and for adequate consideration."(4) With respect to a claim of usurpation of a corporate opportunity, the court held, a plaintiff bears the dual burden of establishing both a fiduciary relationship to the corporation and the existence of a corporate opportunity. Once the plaintiff meets these two tests, the burden shifts to the fiduciaries to establish, by clear and convincing evidence, the fairness of their dealings with the corporation.(5)
In Ostrowski, the defendant vice president was a fiduciary as both an officer and vice president.(6) The trial court had assumed that the supervisory employee, who was neither an officer nor director, was also a fiduciary, and this implicit finding was not appealed. The finding of fiduciary status alone required reversal of the trial court. Because the defendants were fiduciares, the burden of proof of fair dealing was shifted to them. They would be required to meet their burden by clear and convincing evidence.
ELEMENTS OF CORPORATE OPPORTUNITY
The court next considered the elements of a corporate opportunity. Citing its own decision in Katz Corp. v. T.H. Canty & Co. and the seminal Delaware case of Guth v. Loft, Inc..,(7) the court stated that the existence of a corporate opportunity is a question of fact. The factors for a corporate opportunity, taken from Guth and Katz Corp., are a business opportunity that (i) the corporation is financially able to undertake, (ii) is in the corporation's line of business or falls within its avowed business purpose, (iii) has a practical advantage to the corporation, (iv) is one in which the corporation has an interest or reasonable expectancy, and (v) creates a conflict between the self-interest of the officer or director and the interest of the corporation.(8) While the Katz Corp. decision applied both the "interest or expectancy" test and the "avowed business purpose" test, the Ostrowski court holds that the dominant inquiry is whether the corporate opportunity falls within the corporation's avowed business purpose. Applying these factors, the court determined that a corporate opportunity existed.
The next step for the court was to consider whether adequate disclosure was made. Relying on analogous case law on self-dealing and the language of the Connecticut Stock Corporation Act(9), the court held that disclosure must be made to either the shareholders or disinterested directors. Further, rejection of the opportunity by disinterested directors will be sufficient to bar any challenge to the exploitation of the opportunity.(10) In addition, shareholders can ratify the transaction.(11)
In Ostrowski, disclosure solely to the president of the corporation was inadequate for two reasons, the court held. First, the minority shareholders were never informed of the opportunity.(12) Second, because the president of Avery Abrasives was also the father of the vice president pursuing the opportunity, he could not be deemed "disinterested," and therefore, he could not approve the transaction.
CONSEQUENCES OF FAILURE TO DISCLOSE
The court analyzed three approaches to the consequences of a fiduciary's failure to disclose adequately the existence of a corporate opportunity. The first, set forth in the ALI Principles of Corporate Governance,(13) requires full disclosure to avoid liability, regardless of the fairness of the transaction to the corporation. The court declined to follow this bright-line, "one-size-fits-all" approach.(14) The second, followed by the court in its Katz Corp. decision, focuses on the fiduciary's ability to prove his or her affirmative defenses.(15) For example, if the fiduciary can prove the corporation's inability to finance the proposed transaction, then the fiduciary will succeed in his or her defense.(16) The court also rejected this broad approach, stating that special weight must be given to the significance of disclosure. The third approach, adopted by the court, creates a safe harbor.(17) Under the safe harbor, timely and appropriate disclosure of the opportunity to the board would automatically discharge the fiduciary's obligations. Without adequate disclosure, however, a fiduciary may still prove by clear and convincing evidence that the corporation was not harmed by his or her conduct. Special weight must be given to the effect of nondisclosure on the corporation's business opportunities.
Usurpation of a corporate activity was also found to be an unfair and deceptive trade practice under the Connecticut Unfair Trade Practices Act. Purely intracorporate conflicts do not constitute a CUTPA violation, the court stated. However, actions outside the scope of the employment relationship that are found to be usurpations of corporate opportunities or clientele "fit squarely within the provenance of CUTPA."(18)
CONCLUSION
A few relevant issues were not addressed by the court. First, it did not set forth the duties of the board of directors once it is informed of a corporate opportunity. Under the safe harbor, however, even if the board takes no action, the fiduciary who has made adequate disclosure is free to pursue the opportunity without liability. Second, the court did not address the impact of later ratification by the board of directors or shareholders of a fiduciary's pursuit of a corporate opportunity. However, under the court's tests, ratification may not excuse the fiduciary from liability for any harm suffered by the corporation prior to the time of ratification. Third, the finding that disclosure to the majority shareholder was inadequate because "the minority shareholders were never informed" could be read to require disclosure to minority shareholders as well as the board of directors.(19) This seems unlikely, because the court elsewhere refers to approval solely by disinterested directors. More likely, the court was expressing concern that disclosure be made to a group--whether disinterested directors or shareholders-- that represents the interests of all shareholders.
Accordingly, when faced with a potential corporate opportunity, the prudent fiduciary should make full disclosure of the opportunity to the board of directors prior to pursuing it for his or her own benefit. In a closely held corporation, the fiduciary also should consider making disclosure to the minority shareholders, at least where the board of directors is not disinterested.
1. Ostrowski v. Avery, 243 Conn. 355 (1997).
2. Conn. Gen. Stat. §§ 42-110a et seq.
3. Ostrowski v. Avery, unreported decision, 1996 Conn. Super. LEXIS 2557 (1996) at 23.
4. Rosenfield v. Metals Selling Corp., 229 Conn. 771, 795-96, 643 A.2d 1253 (1994), Osborne v. Locke Steel Chain Co., 153 Conn. 527, 534-535, 218 A.2d 526 (1966); see also Klopot v. Northrup, 131 Conn. 14, 20-21, 37 A.2d 700 (1944); Massoth v. Central Bus Corp., 104 Conn. 683, 688-89, 134 A. 236 (1926).
5. Ostrowski at 362; see Katz Corp. v. T.H. Canty & Co., 168 Conn. 201, 207-208, 362 A.2d 975 (1975).
6. See Katz Corp., supra, at 207.
7. 23 Del. Ch. 255, 5 A.2d 503 (1939).
8. Id. at 272-73.
9. Rosenfield v. Metals Selling Corp., supra at 797. Connecticut adopted a version of the Model Business Corporation Act, effective January 1, 1997, and repealed the Stock Corporation Act. The conflict of interest framework is not significantly different under the new act. See Conn.Gen.Stat. §33-783.
10. The court cited Note, "Corporate Opportunity," 74 Harv. L. Rev. 774 (1961).
11. The court referenced a possible requirement of unanimous consent of shareholders, although the applicable statutory language on self-dealing requires only a majority vote of shareholders. See Massoth v. Central Bus Corp.., supraat 689; Conn.Gen.Stat. § 33-323(a)(2) (since repealed); W. Fletcher, Cyclopedia of the Law of Private Corporations § 862.05, p. 314 (1994).
12. The court seems to suggest that disclosure was required to the minority shareholders in their role as shareholders. This would be inconsistent with its view that disclosure to disinterested directors is sufficient.
13. Principles of Corporate Governance, supra, § 5.05 (1992).
14. Ostrowski at 374.
15. Katz Corp. at 210.
16. See, e.g., Irving Trust Co. v. Deutsch, 73 F.2d 1121, 124 (2d Cir. 1934), cert. denied, 294 U.S. 708, 55 S.Ct. 405, 79 L.Ed. 1243 (1935).
17. The court follows the Delaware rule enunciated in Broz v. Cellular Information Systems, Inc., 673 A.2d 148 (1996).
18. Ostrowski at 379, quoting Fink v. Golenbock, 238 Conn. 183, 212, 680 A.2d 1243 (1996).
19. Ostrowski at 371.