Misappropriation of Corporate Opportunity: MobileActive Media, LLC under Delaware Law
February 28, 2013 by Bierce & Kenerson, P.C.
New ventures in Big Data, cloud-based computing, outsourced business process management (BPM), Internet-based SaaS services, IT-enabled marketing and mobile telephony face keen competition in the marketplace. However, when competition comes from a co-owner of the new venture, the results can be ugly, litigious and expensive for all parties. The MobileActive Media, LLC joint venture for mobile media advertising was formed in 2007 in Delaware and lasted only till 2010 before litigation about breach of contract, breach of fiduciary duty and dissolution. The MobileActive Media case offers insights into the importance of scope of business operations, joint control, relationship governance, vetoes, and personalities in achieving value and overcoming typical risks of joint ventures.
A January 25, 2013 decision of the Delaware Chancery Court decided that a 50% owner of a Delaware LLC was responsible for misappropriation (or “usurpation”) of corporate opportunities of the LLC by entering into business operations that competed with the LLC’s core purpose of business. The court awarded $3.08 million in damages from usurpation.
For new venture startups, friends and family investors, angel investors, venture capital investors as well as mid-sized businesses seeking growth, it is critical from the start to ensure that the new venture is designed well and implemented by all parties. The lessons apply to pre-nuptial agreements for strategic business relationships ranging from co-investment to supply chain and value chain relationships.
The New Venture. In 2006, a U.S. former senior executive of a national cable telecom company (the “Entrepreneur”) and a U.K. technology company (the “Platform Company”) formed a 50-50 Delaware LLC to exploit “interactive video and advertising” activities in North America. The Entrepreneur agreed to, and did, provide access to his broad industry contacts. The Platform Company, a United Kingdom business that owned proprietary mobile marketing technologies, would provide technical resources, and its 50% ownership would be held by a subsidiary.
Exclusivity of LLC’s Business Purpose. The Delaware LLC’s operating agreement contained an exclusive-dealing clause that stated that interactive video and advertising activities in North America by either joint venturer or their affiliates would take place exclusively through the joint venture. It excluded the UK company’s (and its subsidiaries‘) “North American non-video based mobile and on-line marketing businesses.” It expressly permitted the members and their subsidiaries to “engage in any business activities except those whose primary purpose involve the enabling and enhancing of interactive video programming and advertising content across multiple digital platforms.” In re: MobileActive Media, LLC, a Delaware LLC, Del. Chancery No. 5725-VCP (Jan.25, 2013), slip op. [Citations omitted]
Prospects for Success. The joint venture had bright prospects due to introductions provided by the Entrepreneur to executives in the telecommunications and advertising industries. These led to two business deals, but further growth was stunted due to a conflict of interest and lack of support from the UK Platform Company.
Struggles between the Members. Shortly after the operating agreement was signed, the UK Platform Company offered to buy out the Entrepreneur’s 50% interest. They realized it was a bad deal early, but did not resolve their differences. They ignored the disagreement without terminating the joint venture and made several acquisitions in related technologies. Over a period that started a few months after the signing of the LLC operating agreement for MobileActive, the UK Platform Company (and its subsidiaries) closed on acquisitions of companies that owned:
(1) an off-the-shelf SMS gateway and reporting package;
(2) a micropayments business that allowed users to send and receive a text message to authorize the purchase of virtual goods;
(3) a Toronto based advertising and marketing boutique that provided traditional types of marketing services;
(4) a Canadian analytics business that provided database solutions and predictive analytics; and
(5) a Canadian analytic search technologies company with technologies that allowed non-technical users ―to query very, very large databases and create customized reports in a very rapid fashion; and
(6) a Delaware corporation that had a sizeable SMS network of 17 million consumers and the technology to deliver advertising to the network.
The UK company never offered any opportunity to the Delaware LLC or the Entrepreneur to invest in such target companies.
Eventually, the subsidiary of the UK Platform Company that was the 50% member went through a restructuring and transferred all of its assets to a newly formed Canadian company for less than fair value. The Entrepreneur successfully disputed the value of the consideration the company paid in this transaction, claiming it violated the Delaware Uniform Fraudulent Transfer Act. The new Canadian company was then sold in 2011 for approximately $100 million. The Entrepreneur did not receive a cent from these transactions and chose to sue, claiming breach of fiduciary duty. The Court awarded him 3.08 million dollars and impressed a trust on the assets.
Elements of a Claim for Breach of Fiduciary Duty by Misappropriation of Corporate Opportunity. As a general reminder to all considering a new business venture, under Delaware corporate law (as recounted by Vice Chancellor Parsons):
“A claim for breach of fiduciary duty requires proof of two elements: (1) that a fiduciary duty existed and (2) that the defendant breached that duty. ―At the core of the fiduciary duty is the notion of loyalty—the equitable requirement that, with respect to the property subject to the duty, a fiduciary always must act in a good faith effort to advance the interests of his beneficiary. ―It forbids one joint adventurer from acquiring solely for himself any profit or secret advantage in connection with the common enterprise. ―The doctrine of corporate opportunity represents but one species of the broad fiduciary duties. The elements of misappropriation of corporate opportunity are: (1) the opportunity is within the corporation‘s line of business; (2) the corporation has an interest or expectancy in the opportunity; (3) the corporation is financially able to exploit the opportunity; and (4) by taking the opportunity for his own, the corporate fiduciary is placed in a position inimical to his duties to the corporation.” Id.
Lessons for New Ventures (especially Tech Ventures and IT-Enabled Business Process Management Ventures). This case highlights classic truths of business law.
- Clear Definition of Corporate Purpose. Every equity owner of a company should agree on the shared scope of business. The definition should serve as a clear guide for future conduct to avoid possible breaches of the fiduciary duty of loyalty.</li>
- Get All Parties to Approve. The senior management of all equity owners should exercise their business judgment and commit to the new venture’s scope. What the Delaware court failed to mention was that the board of directors and officers of the UK Platform Company are liable to the shareholders under UK fiduciary duty principles because they knew, or should have known, of the conflicts with the US Entrepreneur and sought to circumvent his rights anyway.
- Relationship Management. The US Entrepreneur was partially at fault for not getting all of the UK Platform Company’s management “on board” and fully committed. He also failed to manage the relationship through a specific management procedure under the Operating Agreement to ensure full disclosure and early resolution of conflicts.
- Valuation. The litigation occurred because the parties disagreed on the value of what was created and what was eventually to be divided among the owners. The $3.08 million damage award shows that disloyal conduct can be expensive. Both parties should consider use of appraisals or other methods for valuation when a dispute becomes irreconcilable.
- Dispute Resolution Process and Exit Plan. A well-drafted Operating Agreement will identify the method for resolving disputes. Under Delaware LLC law, liquidation and dissolution is the only solution permitted, unless the parties have agreed otherwise. Investors and other passive owners should be particularly concerned about the risk of dissolution, so they may wish to provide for some form of “work out” involving ongoing operations to be managed by an interim manager while a buyer is sought to buy the entire business.
- Legal Fees. Legal fees for enforcement of contract rights under an LLC’s Operating Agreement are not recoverable as damages, unless the contract requires it or unless statutes allow such recovery. The weaker party should consider the impact of such a clause.
- Fiduciary Duty. Some LLC’s may be managed by members (or managers) who have no fiduciary duty to the members. Depending on the applicable law, such exculpatory provisions could have a serious impact on the future of the enterprise and enable one member to take unfair advantage of the others. The equity owners who are not managers should consider the impact of such an exculpatory clause.
Code of Ethics for Auditors: Some Case Studies and Legal Principles in Auditing Standards
October 9, 2009 by Bierce & Kenerson, P.C.
Auditors have their own codes of ethics. Where there is no code of ethics, or where the code of ethics permits a degree of conflict of intere+/st, the auditors tread at their own risk. The following case study underscores the traditional common law obligations of auditors as fiduciaries, even before the adoption of the Sarbanes-Oxley Act of 2002. This section covers some basic issues in auditing standards.
Case Study #1: Cap Gemini and Ernst & Young, Potential Self-Dealing
Responding to SEC criticism of ostensible conflicts of interest, some major accounting firms, such as KPMG and Arthur Andersen, have spun off their consulting arms as independently owned and managed entities. Ernst & Young LLP chose another route. The story of E&Y and its alliance with Cap Gemini leads from a regulatory no-action letter to a court case alleging breach of the accountant’s fiduciary duty. The tale leads to “lessons learned.”
Independence of Auditors: SEC No-Action Letter to Ernst & Young LLP on Alliance with Cap Gemini Ernst & Young LLC.
By no-action letter dated May 25, 2000, the SEC’s Chief Accountant advised Ernst & Young LLP that it would consider E&Y to maintain its independence even though Cap Gemini Ernst & Young were to provide IT services to E&Y audit clients. The no-action letter imposed a number of conditions that ” (1) limit at the outset and within five years end E&Y’s equity interest in Cap Gemini; (2) impose limitations on Cap Gemini’s use of the E&Y name; (3) require a strict separation of E&Y and Cap Gemini’s corporate governance; (4) forbid any revenue sharing between E&Y and Cap Gemini; (5) forbid any joint marketing agreements between E&Y and Cap Gemini; and (6) restrict any shared services between E&Y and Cap Gemini. Letter of Lynn E. Turner, Chief Accountant of SEC, to Kathryn A. Oberly, Esq., Ernst & Young, May 25, 2000. http://www.sec.gov/info/accountants/noaction/lteyltr.phpLitigation Alleging Breach of Accountant’s Fiduciary Duty; Liability for Systems Integrator’s Nonperformance.
Unfortunately, an SEC no-action letter is not a vaccine against client lawsuits. Accountants engaged in management consulting should pay careful attention to a ruling against Ernst & Young, LLP (“E&Y”) and its successor in interest (by sale of consulting business), Cap Gemini Ernst & Young, U.S. LLC (“CGEY”). This case is instructive to anyone in a licensed professional capacity engaged in ancillary or multidisciplinary consulting practice.Pre-Trial Ruling.
In a pre-trial ruling in early January 2002 on a motion to dismiss, without deciding the final outcome, the court found that E&Y was potentially legally subject to claims of breach of fiduciary duty and punitive damages arising out of a failed software implementation by CGEY, a company in which apparently E&Y is a substantial owner. (The was no allegation or showing of a failure to exercise the skill and care of a reasonably diligent accountant, so the court noted that there were no claims of professional malpractice (whether relating to accounting or computer consulting).Alleged Misrepresentations by Accountants.
The alleged facts of the case, if true, would be particularly egregious. The following reports are provided according to the court’s pre-trial decision. Whether the allegations will be proven remains to be seen.
In June 2000, E&Y recommended to a client, a medical and nutritional company, to retain CGEY as the vendor to implement a commercial off-the-shelf software package that the client had selected, based on E&Y’s recommendation, for its short and long-term business needs. E&Y made a number of representations to the client to induce the client to hire CGEY, and the court concluded that, without those representations, the client would probably have selected another IT service provider. E&Y reportedly represented that (1) CGEY was competent, experienced and qualified to implement the system selected by E&Y, and (2) CGEY’s performance of services had already been “coordinated” with E&Y.Existence of Fiduciary Duty.
A fiduciary relationship existed between the accounting firm and its client for several reasons. First, the client had developed a relationship of trusting the accounting firm’s judgment based on prior professional services. Second, the accounting firm offered to provide additional consulting services. Third, the medical and nutritional company was less sophisticated than the accounting firm in the “specialty” for which the accounting firm and the services firm were hired.Potential Breach of Accountant’s Fiduciary Duty.
Thus, “[w]hen a fiduciary fails to disclose personal interests preliminary to contract, and/or represents the existence of a questionable competence and experience critical to the contract and procures a benefit such as that alleged to E&Y and the newly formed CGEY, the risk of liability for the negligent misrepresentations and a question of fraud is properly alleged.”Atkins Nutritionals, Inc. v. Ernst & Young, LLP,
NYLJ, Jan. 10, 2002. Accordingly, a fiduciary relationship arose and could have been breached if proven at trial.
Case Study #2: KPMG Canada: Lack of Independence.
In June 2005, the Securities and Exchange Commission entered into a settlement, in an enforcement action, with KPMG LLP (KPMG Canada), a Canadian audit firm, and two of its partners, Gary Bentham, the audit engagement partner, and John Gordon, the concurring and SEC reviewing partner. The SEC asserted that KPMG Canada, Bentham and Gordon lacked independence when they audited the 1999 through 2002 financial statements of Southwestern Water Exploration Co. (Southwestern), a now-bankrupt Colorado corporation.
The SEC claimed that KPMG Canada provided bookkeeping services to Southwestern and then audited its own work. Specifically, after KPMG Canada prepared certain of Southwestern’s basic accounting records and financial statements, it issued purportedly independent audit reports on those financial statements. KPMG Canada’s audit reports were included in Southwestern’s annual reports that were filed with the Commission.
The SEC found that KPMG Canada, Bentham and Gordon engaged in “improper professional conduct” within the meaning of Rule 102(e) of the SEC’s Rules of Practice by virtue of their violations of the auditor independence requirements imposed by the Commission’s rules and guidance and by generally accepted auditing standards in the United States.
Some Rules of Ethics for Auditors
The Sarbanes-Oxley Act sets new standards of independence for auditors.
Public Companies.
Such standards created such friction between public companies and their auditors that decisional gridlock set in. On May 16, 2005, the Public Company Accounting Oversight Board (established under the Sarbanes-Oxley Act, to oversee the auditors of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports) issued a policy statement on its Auditing Standard No. 2. The PCAOB’s Policy Statement sought to give ensure some level of reasonableness and flexibility in the conduct of audits. As it noted,In particular, the staff questions and answers seek to correct the misimpression that certain provisions of Auditing Standard No. 2 need to be applied in a rigid manner that discourages auditors from exercising the judgment necessary to conduct an internal control audit in a manner that is both effective and cost-efficient. The Policy Statement expresses the Board’s view that, to properly plan and perform an effective audit under Auditing Standard No. 2, auditors should –
- integrate their audits of internal control with their audits of the client’s financial statements, so that evidence gathered and tests conducted in the context of either audit contribute to completion of both audits;
- exercise judgment to tailor their audit plans to the risks facing individual audit clients, instead of using standardized “checklists” that may not reflect an allocation of audit work weighted toward high-risk areas (and weighted against unnecessary audit focus in low-risk areas);
- use a top-down approach that begins with company-level controls, to identify for further testing only those accounts and processes that are, in fact, relevant to internal control over financial reporting, and use the risk assessment required by the standard to eliminate from further consideration those accounts that have only a remote likelihood of containing a material misstatement;
- take advantage of the significant flexibility that the standard allows to use the work of others; and
- engage in direct and timely communication with audit clients when those clients seek auditors’ views on accounting or internal control issues before those clients make their own decisions on such issues, implement internal control processes under consideration, or finalize financial reports.
Private Companies.
Where the audit client is a privately owned business (such as a private enterprise customer or a private service provider), auditor independence rules still apply. Reviewing Case Studies #1 and 2, the auditors could probably have avoided the claims of breached fiduciary duty if they had made suitable disclosures and had remedied, or caused their consulting affiliate, to remedy a failed software installation.
In that case, the auditors should:
- disclose their conflict of interest to the client and obtain waivers (similar to the waivers obtained from medical patients undergoing surgery);
- remedy the flaws in the selection of off-the-shelf software, the systems integrator, and the systems integrator’s lack of skills to cure the defects impeding software performance; and
- learn from similar client-relationship mistakes that had been subject to prior, unrelated litigation.
The court’s ruling is based under existing rules governing independence of auditors.