Turning servile opportunities to gold: a strategic analysis of the corporate opportunities doctrine.

• Author: Talley, Eric

1. INTRODUCTION

   Perhaps no single motif permeates corporate law and governance literature like the problem of agency costs.(1) Though modest in concept, the canonical principal-agent framework yields fundamental insights into virtually every economic relationship involving the firm. These insights, in turn, not only animate prevailing positive accounts of the modern corporation, but they also provide a normative basis for regulating the oft-lamented gulf between ownership and control.

   Despite their pervasiveness, problems of agency costs are rarely more vexing than when an agent is also a potential competitor. A notable example of such a scenario occurs when a corporate manager acquires information about a new business prospect--one which she may be tempted to appropriate for her own personal benefit. In such instances the fiduciary's and shareholders' respective interests are not merely askew, but rather are in profound opposition to one another. Concern over such outright conflict provides the foundation for the "corporate opportunities doctrine" (COD), which is the law's attempt to regulate circumstances in which a corporate officer or director may usurp new business prospects for her own account without first offering them to the firm. The doctrine--a subspecies of the fiduciary duty of loyalty--has been a mainstay in the corporations law of virtually every state for well over a century.

   In most jurisdictions, COD litigation follows (at least superficially) some variant of the following legal "algorithm": Once a new project is deemed to be a corporate opportunity, a fiduciary may not appropriate it without first offering it to the firm and disclosing her conflict of interest. Pursuit of the project in the absence of full disclosure or without proper rejection from the corporation constitutes a breach of fiduciary duty, carrying rather formidable repercussions: The firm may obtain injunctive relief (if feasible), disgorgement of the fiduciary's gains, and even punitive damages.

   Regrettably, this doctrinal algorithm has proven as unwieldy in application as it is concise in recitation. Courts have struggled mightily over the years to formulate precise definitions of "corporate opportunity," "full disclosure," and "proper rejection." Repeated endeavors by litigants, judges, and legal scholars to clarify the doctrine have generated a panoply of tests, variations, and hybrids. But the end product of this collective effort appearsby virtually all accounts--more tautologous than diagnostic, replete with exceptions and indecipherable distinctions that provide little guidance either to theorists or to practitioners.(2)

   In the pages that follow, I attempt to chart a course out of this doctrinal quagmire by offering a normative account of the COD that emerges from the economic theory of contract. I argue that both the reach and the consequences of an efficient legal rule depend crucially on the information structure that imbues the agency relationship between fiduciaries and corporate shareholders. In particular, I demonstrate that the contours of an "optimal" doctrine turn crucially on the extent to which corporate fiduciaries possess private, unverifiable knowledge about the relevant characteristics of new projects. From a practical standpoint, this thesis suggests that more careful judicial attention to information structure may lead to a significantly more tractable COD.

   My argument proceeds from a simple observation. The COD is, fundamentally, little more than a default mechanism for allocating property rights between a corporation and those who manage it. Indeed, from a strategic perspective, the rules governing liability and remedy implicitly preordain the two defining economic features of any property rights allocation: first, who among the parties possesses ultimate control over some disputed activity; and second, how the parties will divide the returns that therefrom. Consistent with this observation, fashioning a rule that replicates (at least functionally) the allocation that the parties themselves would have bargained for ex ante had they anticipated such contingencies should be an important goal of the courts.(3)

   The pursuit of such a goal, however, implicates two competing normative concerns. On the one hand, since corporations are generally perceived to enjoy a comparative advantage over their fiduciaries when it comes to production, there is a plausible justification for encouraging managers to "channel" most new projects into the firm. On the other hand, absolute deterrence of fiduciaries may sometimes be socially wasteful, particularly for projects requiring talents, flexibility, or resources that the agent possesses but the corporate entity lacks.(4)

   Under ideal circumstances, in which transactions are frictionless, monitoring is costless, and all relevant information is verifiable, this balancing process is fairly unproblematic: A court should simply allocate the property right to whomever is the lowest-cost producer. Such an allocation would maximize expected joint wealth of the interested parties, which they could divide amongst themselves through appropriate side payments. Furthermore, even if courts were to fail in implementing such a rule, the corporation and the fiduciary could still effect an efficient allocation on their own, either at the ex ante stage (through express contractual terms) or at some later stage (through Coasean renegotiation).

   Circumstances, however, are rarely ideal. The costs of contemplating and drafting express terms to govern every possible future contingency are sometimes high, if not prohibitive, and inevitable contractual gaps or linguistic ambiguities will sometimes necessitate clarification by courts ex post. Compounding this dilemma is the fact that fiduciaries are frequently in a unique position to acquire information about the existence, nature, and characteristics of new opportunities, much of which is extremely costly (or impossible) for shareholders to observe or for courts to verify.(5) Indeed, the chief targets of the COD (directors and officers) share a common role as organizational "gatekeepers," evaluating new business prospects and recommending which ones the corporation should pursue versus those it should eschew. The shareholders, out of either limited motivation or lack of expertise, typically are not privy to such detailed knowledge. This informational disjuncture, in concert with the welt-known collective action problems that typify diffuse ownership structures, can thwart attempts at direct negotiation, thereby leaving much of the property rights allocation to be decided in litigation.

   I will argue that within such a context, private information substantially distorts the characteristics of an efficient COD. In particular, when agents possess proprietary knowledge about the relevant characteristics of new projects,(6) the optimal legal rule will tend--relative to its complete-information counterpart--to be over-inclusive (deterring the appropriation of certain projects in which the corporation is wholly uninterested) and may sometimes even be under-inclusive (failing to deter appropriation of projects for which the corporation is the most efficient producer). The intuition behind this thesis stems from an uneasy tension between maximizing wealth and providing fiduciaries with sufficient incentives to disclose information. When the relevant characteristics of new projects are publicly known, it is unnecessary to address the latter concerns thereby enabling efficiency-minded courts to concentrate solely on wealth maximization. When an agent possesses private information, however, she may have an incentive to misrepresent her knowledge for personal gain. In such situations, an optimal legal rule should attempt to counteract these (generally counterproductive) distortions. But creating such counter-incentives substantially limits the allocational choices that the parties (or a court) have available. Consequently, an optimal legal rule in a private-information environment may consciously permit some inefficiencies in order to obviate even greater efficiency losses.

   The implications of this central insight turn out to be significant for doctrinal clarification and reform. Most immediately, it suggests that when important characteristics about a disputed project are difficult (or prohibitively costly) to verify ex post, it may be prudent for a court to disregard the parties' competing claims about the project altogether, concentrating instead on the characteristics of the litigants themselves, such as the commonality of their respective areas of expertise. The analysis also suggests that in such situations, the optimal doctrine typically has a broad reach, imposing liability on fiduciaries for appropriating virtually any project. At the same time, however, the optimal damages associated with liability are somewhat "untailored" in nature (much like liquidated damages) and need not be so large as to deter the fiduciary from appropriating high-profitability projects.(7)

   Finally, my arguments lend support to a "meta-thesis" that recurs here as it does in many other applications of information economics to law: In order to fashion a legal rule that is optimal from an ex ante perspective, one must be willing to commit to that rule even if its application appears wasteful or inefficient ex post. Unless courts are willing and able to so commit, not only would it be impossible to realize the first-best outcome, but the anticipation of subsequent commitment problems could create perverse incentive effects that would render the second-best outcome unattainable as well. Similarly, if the parties themselves find it difficult to refrain: from renegotiating allocations ex post, the identical incentive problem may result. One way the law can ameliorate this latter commitment problem is to make it costly or impossible to contract around the optimal...