You work for a private equity firm (PE Firm), and sit on several boards of directors of portfolio companies as a representative of your firm, including one that is in the health care field (Company HC). You are approached during a cocktail party by an acquaintance who knows that you work for a private equity firm that makes investments in health care-related companies.
Your acquaintance’s business (Company T) is in the health care industry, and as it so happens, your acquaintance mentions that Company T is looking for an investor or buyer. Company T looks like an attractive investment, and one that both your private equity firm and Company HC might be interested in.
Now, a question: Is there any legal obligation that you have to Company HC in respect of the potential opportunity to invest in or buy Company T?
The answer is ... maybe. The opportunity to invest in or buy Company T may be a “corporate opportunity” of Company HC, the portfolio company for which you serve as a director.
The remainder of this article provides an overview of the doctrine of corporate opportunity and guidance for private equity firms to manage the legal requirements associated with a potential corporate opportunity situation, such as the hypothetical above.
The Doctrine of Corporate Opportunity
It should come as no surprise to private equity firm representatives to hear that they owe fiduciary duties to the portfolio companies for which they serve as directors.
In general, these duties are the duty of care – to make reasoned and informed business decisions — and the duty of loyalty – to avoid self-dealing and not to benefit personally at the expense of the portfolio company.
Delaware courts have made it clear that it is a breach of the duty of loyalty for a director of a company to pursue an opportunity that is a “corporate opportunity” of such company if the director did not first make the opportunity available to such company.
Turning back to the hypothetical described above, it may be a breach of your fiduciary duty of loyalty to Company HC if your PE Firm pursues the opportunity to invest in or buy Company T without first offering that opportunity to Company HC.
Many court cases have focused on what constitutes a “corporate opportunity” that must be offered by a director to the company, with the courts enumerating several tests focusing on, among other things, whether the opportunity is in the company’s line of business, whether the company has the ability to pursue the opportunity and whether or not the company has an interest or reasonable expectancy in the opportunity.
Suffice it to say, whether an opportunity is indeed a “corporate opportunity” will depend on the specific facts and circumstances at hand and may not always be clear.
Advance Waiver of Corporate Opportunity
The most favorable scenario for the PE Firm to be able to freely pursue the opportunity to invest in or buy Company T would be if you and the PE Firm had received a broad, advance waiver from Company HC for corporate opportunities.
Ideally, a private equity firm should obtain this waiver at the time that it invests in the portfolio company. This is when the private equity should be most free of conflicts of interest, by virtue of not yet controlling or having minority seats on the board of the portfolio company.
Furthermore, if the waiver is put in place at that time, the expectations of the parties as to corporate opportunities will be clear upfront, and the private equity firm should then be free to focus on what it does best — finding and investing in other companies (even if they compete with the portfolio company at hand) – without restriction and without worrying about its relationship with the portfolio company.
So, how are advance waivers obtained? Where the portfolio company is a Delaware corporation, the advance waiver can be obtained under Section 122(17) of the Delaware General Corporation Law.[1]
Section 122(17) allows a corporation to renounce in advance “any interest or expectancy of the corporation in, or in being offered an opportunity to participate in, specified business opportunities or specified classes or categories of business opportunities that are presented to the corporation or one or more of its officers, directors or stockholders.”
This can be done either within the certificate of incorporation of the portfolio company or by action of the portfolio company’s board of directors (such as through their approval of an agreement containing advance waiver language).
Furthermore, where a portfolio company is a limited liability company or another noncorporate entity, the advance waiver can be obtained by contract (for example, within a limited liability company operating agreement or a stockholder’s agreement).
The waiver language is often broadly written, to provide the private equity firm with the greatest flexibility as to its other business dealings.
In adopting Section 122(17), the Delaware legislature noted that business opportunities might be delineated by line or type of business, identity of the originator of the business opportunity, identity of the party or parties having an interest in the business opportunity, identity of the recipient of the business opportunity, periods of time or geographical location.
Despite the push for broad waivers by private equity firms, it is not unusual for the management of the target portfolio company and/or co-investors to resist waivers, and so we offer some alternatives.
Alternatives to broad, advance waivers
Every private equity firm transaction may not present the opportunity to obtain a broad, advance waiver of corporate opportunities from the target portfolio company.
Because investments by private equity firms are usually as much about the partnership of the private equity firm and the portfolio company’s management to grow the business as they are about the cash infusion, management and/or co-investors may be uncomfortable with waivers of future corporate opportunities, which suggest that the private equity firms are not going to be singularly focused on the investment at hand.
In addition, private equity firms may not feel that asking for the waiver sets the right “tone” with the management of the portfolio company and/or co-investors. Given those practical considerations, here are some alternative approaches to a broad, advance waiver that will still help protect the private equity firm:
Seek a tailored waiver.
The breadth and scope of the waiver is something that is negotiable and can be tailored to the particular transaction. For example, the portfolio company might only be interested in opportunities in a certain geographic location or in a certain line of its business, and those could be carved out from the advance waiver.
As another example, the waiver could carve-out any opportunities that a private equity firm designated Board member or the private equity firm itself learns of solely and expressly by virtue of such person being a member of the board or an officer or employee of the portfolio company.[2]
Allow for a co-investment right.
Consider designing a co-investment right that allows some or all of the members of the portfolio company’s management to invest alongside the private equity firm, if the private equity firm pursues a specified corporate opportunity outside of the context of the portfolio company.
Rely on disclosure at the time the opportunity arises.
If an advance waiver is not in place and an opportunity is one that, after proper analysis, does belong to the portfolio company, the private equity firm will still have the option of presenting that opportunity to the portfolio company and pursuing it if it is declined by the portfolio company.
Determine that the opportunity is not a “corporate opportunity” of the portfolio company.
All opportunities may not be considered a “corporate opportunity” of the portfolio company. If a potential corporate opportunity situation arises, the proper determination may be that the opportunity is one that can be pursued by the private equity firm without consultation with the portfolio company, given the facts and circumstances presented. Consultation with legal counsel is advisable in making this determination.
Tips to Remember Concerning Waiver of Corporate Opportunity
Tip #1 – Be on the lookout for potential corporate opportunity situations involving your firm’s portfolio companies, but know that there are a variety of ways to manage through the attendant legal parameters.
Tip #2 – Private equity firms are best protected if they obtain broad, advance waivers of corporate opportunities from portfolio companies.
These are best put in place at the time of the initial investment, when conflicts of interests generally should not exist and when the organizational documents of the portfolio company are often being revised anyway.
Tip #3 – Every transaction presents the chance to craft a specifically tailored waiver, which might be more acceptable to the parties than a broad waiver in certain situations.
Tip #4 – If an advance waiver has not been obtained but a potential corporate opportunity situation arises between a private equity firm and a portfolio company, all hope is not lost.
The potential opportunity might not be a true corporate opportunity of the portfolio company or, if it is, it might not be an opportunity the portfolio company desires to pursue. Discussion with the portfolio company and/or legal counsel may be advisable.
--By Chris E. Abbinante and Jessica B. Fairchild, Sidley Austin LLP
Chris Abbinante is a partner and Jessica B. Fairchild is an associate in the Chicago office of Sidley Austin LLP.
The views expressed in this article are exclusively those of the authors and do not necessarily reflect those of Sidley Austin LLP or Portfolio Media, publisher of Law360.
[1] This article focuses on Delaware law. The law of other states is beyond the scope of this article.
[2] Adopting this approach still leaves risk of disputes about how and when a corporate opportunity was discovered by a private equity firm or its representatives, and should be used with caution.