Does the Rule Apply to Real Estate?
If you invest in and/or syndicate real estate what are the duties to your investors? You owe them a duty of loyalty. But how far does that go?
The issue of corporate opportunities is important. I wrote a whole chapter on it (from which part of this is excerpted) in my newest book “Veil Not Fail.” Before discussing its applicability to real estate lets review it in a business setting.
The simplest case involving a breach of the duty of loyalty is where a corporate executive expropriates for themself a business opportunity that rightfully belongs to the corporation. For example, assume that a company distributes window shades but a key executive takes the exclusive distributorship rights for a new type of awning. The corporation should have obtained the distributorship. It is in their core business.
The duty of loyalty requires officers and directors to apprise the corporation (or LLC or LP) of “corporate opportunities.” The corporation gets to decide if it wants it or not. If the company doesn’t move forward then the executive may be free to pursue it, or not. The decision may be at the company’s discretion.
A corporate opportunity is any investment, purchase, lease or any other opportunity that is in the line of the corporation’s business, and is of practical advantage to the corporation. If an officer or director embraces such opportunity by taking it as their own, they may violate their duty of loyalty, especially if by doing so their self-interest will be brought into conflict with the corporation’s interests. Will the officer be loyal to the company or their own business? The conflict is clear.
During their time in office, officers will likely discover business opportunities for the corporation. The officer may also have personal business opportunities that are somehow related to the corporation’s business. For example, if the officer is an inventor who focuses on telecommunications products, they will likely be interested in all such business opportunities. The corporation may be able to pursue some opportunities the officer discovers for the corporation, others it will not. If the corporation turns down one opportunity is the officer then able to pursue it?
Delaware courts have established a test for corporate opportunities. If an officer’s self-interest comes into conflict with the corporation’s interest, the duty of loyalty can be breached. The law will not permit an officer to pursue opportunities (1) that the corporation is financially able to undertake, (2) that is in the line of the corporation’s business, and (3) that is of practical advantage to the corporation.
On the other hand, if the corporation is not financially able to embrace the opportunity, has no interest in the opportunity, and the officer does not diminish their duties to the corporation by exploiting the opportunity, then the person may be allowed to pursue the opportunity.
Evidence that the opportunity was presented directly to the individual, and then not shared with the corporation, may be used to show that the corporate opportunity rules were not followed. In most states, the simplest way to avoid a problem is to present the opportunity to the corporation and allow it the chance to pursue or reject it. If the corporation cannot or will not take advantage of the opportunity, the employee, officer, or director may be free to pursue the opportunity.
Though formal rejection by the board is not strictly necessary, it is safer for the whole board to reject a corporate opportunity. The decision shouldn’t be based on individual board member’s opinions. There must be a presentation of the opportunity in some form.
After the corporation has rejected the opportunity, and before pursuing the opportunity, the employee, officer, or director should unambiguously disclose that the corporation refused to pursue the opportunity and ensure that there is an explanation for the refusal.
Resignation before completion of the questionable activity may not constitute a defense to liability arising from a corporate opportunity. Courts have found liability even where officers and directors resigned before the completion of the transaction. Although there are no certain guidelines for determining which opportunities belong to the controversy and liability may be avoided if officers use rigorous caution regarding corporate opportunities.
But again, what about real estate opportunities? Many syndicators are pursuing several investments at the same time. They always owe a duty to do their best. But does that prevent them from pursuing new projects without involving every investor?
The key to this issue is clarity. In a real estate based LLC Operating Agreement it must be stated that the principals are free to go after any investment. While existing investors may be offered the right to invest in future projects (always a good marketing technique) the syndicators must be allowed the freedom to pursue any and all opportunities for their own account.
Check your Operating Agreement and Offering Documents to make sure this important language is included.