By Daniel H. Weintraub, Kyle S. Crossley and Tyler J. Sewell, Morrison & Foerster LLP
Generally, a breach of fiduciary duties is a cause of action that belongs to a company and/or its equity holders; therefore, any private equity professional who serves as a director of a portfolio company should be mindful of his or her fiduciary duties when evaluating a material transaction affecting the portfolio company. The risk associated with a breach of a fiduciary duty within a privately held portfolio company is typically significantly less than that of a public company. Whether a portfolio company is brought public or remains private, private equity sponsors and private equity professionals serving on portfolio company boards should take steps to mitigate the risks they face.
Nevertheless, risk of the breach of a fiduciary duty can never be fully erased through planning alone. Delaware courts, for example, will only permit the most explicit disclaimer in organizational documents to waive fiduciary duties of a director, and even in such cases, the court only applies these explicit disclaimers to certain duties, such as the corporate opportunity doctrine, but not the duty of loyalty overall. Therefore, private equity sponsors and private equity professionals serving on portfolio company boards need to be continuously cognizant of potential violations of all fiduciary duties.
Below is a list of some key issues that a private equity sponsor and private equity professionals should consider when structuring an investment in a potential portfolio company, or serving on the board of directors of a portfolio company. While this article looks to the Delaware General Corporation Law for guidance, fiduciary duties will vary by state of incorporation and by the type of entity.
All directors, not just private equity professionals, must satisfy the following fiduciary duties:
Duty of Care. Directors must use that amount of care that ordinarily careful and prudent people would use in similar circumstances. Directors should inform themselves of, and consider, all material information necessary to make an informed decision. To satisfy this duty, directors may rely on advice of counsel, accountants, investment bankers, and others who they reasonably believe are acting in areas of their professional expertise and have been selected with reasonable care.
Duty of Loyalty. Directors must act in a manner they reasonably believe is in the best interests of the company and its equity holders, and not engage in fraud, bad faith, or self-dealing. Directors may not act out of self-interest, such as to preserve positions or compensation. Since, under Delaware law, personal liability of a director for a breach of the duty of loyalty cannot be disclaimed by a corporation, the duty of loyalty has recently taken on an expanded meaning, and most breach-of-fiduciary-duty claims are being constructed as breaches of the duty of loyalty.
Duty of Good Faith. Directors must act with a sincere and rational belief, as well as due care, in furtherance of corporate purposes. Under Delaware law, this is not a separate duty, but contained within the duty of care, described above. Generally, a director satisfies his or her duty of good faith by having neither an actual intent to do harm, nor an intentional dereliction of duty.
Summary. Directors must inform themselves of material facts, exercise reasonable judgment, and act honestly in what they believe in good faith to be in the best interests of the company and its equity holders. With these factors in mind, generally, the business judgment rule provides the presumption that a board has satisfied this standard and, unless a heightened standard is imposed, the burden in litigation is on the plaintiff to prove that the business judgment rule was not satisfied by the board. To retain this presumption, courts generally focus on the process of decision making by the directors.
Role of Board. A board of directors is, ideally, not involved in day-to-day operations, but, rather, is involved in the material decisions of the company regarding strategy, growth, and liquidity events. For many smaller private companies, however, directors may be involved in financial and marketing activities, and lend a hand wherever else needed.
Typically, boards of portfolio companies meet more often than public company boards, have fewer members, and may even tackle more daily operational tasks such as employment matters. A private equity sponsor, as a majority investor, is often instrumental in determining the composition of the board of its portfolio company. Even in a minority investment, a private equity sponsor will usually negotiate for the right to appoint directors to the board in proportion to its investment.
However, to mitigate fiduciary duty risk while maintaining Venture Capital Operating Company compliance, in a minority investment, a private equity sponsor may prefer only to appoint a board representative with observation rights. Depending on the structure of its investment, a private equity sponsor should also consider whether to indirectly maintain control of a subsidiary operating company through its representation at an equity holding company level instead of having direct board representation at the operating company.
There is no right answer for private equity sponsors and professionals, but each should at least assess its potential exposure to and tolerance for risk before jumping into a new role as majority owner or board member of a portfolio company.
LLC vs. Corporation. In Delaware, a limited liability company (and other forms of entities) can waive certain fiduciary duties as a matter of contractual interpretation. The fiduciary waiver must be clear and unambiguous in the operating agreement to ensure that no fiduciary duty is owed. If a waiver is clearly drafted, the only implied covenant that will remain will be that of good faith and fair dealing. However, if the waiver is not clear, there is a risk that all traditional corporate fiduciary duties will remain intact. Regardless of whether a waiver is drafted clearly or not, because a court has the potential to determine whether the waiver is ambiguous and apply all traditional fiduciary duties to limited liability directors, a private equity sponsor should consider following the best practices of ensuring the appropriate processes and formalities, and being cognizant of, and disclosing, potential conflicts of interest in all instances.
The Delaware case In re Trados and its progeny highlight the importance of structuring an investment in a portfolio company. While Trados involves a venture capital fund's investment in a portfolio company, it highlights the risk of structuring an investment with a significant preferred equity interest. The Trados court imposed a heightened state of review of the board of directors' duties as they relate to the common equity holders in a sale transaction. This heightened state of review was imposed because the venture capital fund, together with the other preferred equity holders, received approximately $52 million of the $60 million sale price. Management received the difference, while the holders of the common equity received nothing. The board of directors, stacked with directors appointed by the venture capital fund's preferred equity holders, was too financially interested to have acted independently, and therefore violated its fiduciary duties to the common equity holders.
While in a best-case scenario every investment is a success and the preferred and common equity would receive sufficient proceeds in a sale transaction, this is not always the case. Thus, it may be prudent for a private equity sponsor to try to mitigate some of the Trados risk by structuring its investment (i) as common equity (with its management teams participating in the equity of the company through performance-based options, or similar equity incentives); (ii) as an equity strip of common and preferred equity in which the other equity holders participate on equal footing - pari passu; (iii) with management receiving bonuses payable when certain return metrics are met; or (iv) through some combination of the above. In summary, a private equity sponsor should be mindful that its professionals serving on a board of directors have particular duties to all equity holders of the company, regardless of the form of equity, and should consider structuring its investment in a manner that will minimize any potential conflicts that may arise between the various classes of equity in an exit transaction.
Private equity professionals serving as directors of portfolio companies have two sets of constituents to which fiduciary duties are owed. The first is the set of fiduciary duties that the private equity professional owes to the fund's investors/limited partners, and the second is set of the fiduciary duties owed to the portfolio company and its equity holders. To avoid conflicts of interest, a private equity professional should be mindful of blurring the line between these two sets of potentially diverging obligations. When serving as a director of a portfolio company, a private equity professional may, and should, abstain from certain votes and allow independent board members to vote, or ensure his or her vote is completely independent of the private equity sponsor's interests, relying on the private equity sponsor to protect its interests as an equity holder.
Additionally, in order to mitigate the risk of breaching its fiduciary duties, a private equity sponsor should consider having a senior representative, separate from the portfolio company's board of directors, who is responsible for utilizing the sponsor's shareholder veto rights. This role allows the sponsor to demonstrate clear separation between the board's decisions and the sponsor's shareholder rights.
Conflicts of interest between the duties owed to the private equity sponsor's investors and the duties owed to the private equity sponsor's portfolio companies can manifest in several ways. Some examples are:
A private equity sponsor can mitigate this risk through various methods, including:
While a private equity sponsor may be mandated with maximizing returns for its investors/limited partners, a private equity sponsor, and its private equity professionals, must be cognizant of the fiduciary duties owed to portfolio companies and portfolio companies' equity holders while serving on these boards of directors. With foresight and appropriate attention to process, a private equity sponsor can mitigate a significant portion of the risk posed by fiduciary duties owed by its professionals serving on the boards of directors of its portfolio company, while still fulfilling its mandate to maximize returns for its investors/limited partners.
Daniel H. Weintraub is Managing Director and General Counsel, Audax Group. Kyle S. Crossley is Counsel for Audax Group. Tyler J. Sewell is an Associate in the Private Equity and Buyouts Group at Morrison & Foerster LLP.
While fiduciary duties are a constant refrain in the board meetings of a publicly held company, these duties are no less relevant to any private equity professional serving as a director of a portfolio company.
© 2012 Morrison & Foerster LLP and Audax Management Company, LLC
This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.
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