Monday, March 29, 2010

What Liabilities Do Board Observers Have?

A few years ago, I was sitting in a board meeting for one of my fund’s portfolio companies, listening to an investor rant on about why the board should turn down an offer to purchase the business. Now, the offer terms were not great, but they meant that everyone would receive some gain on their shares. Given the state of this particular company, this was a gift from heaven and it was hard to see how the board could find that the offer was not in the best interests of all. And yet, here this person was, insisting on a different path. I happened to know that he was in the middle of raising his next fund, and suspected that his position was driven by his desire not to record a modest return on this investment until the fund closed.

The board probably should not have allowed him to co-opt the meeting to pursue his own agenda. He was, after all, an observer with no right to vote on the matter. But this is not an unusual event in private companies – observers often feel emboldened to try and influence board decisions, relying on the belief that their status somehow insulates them from personal liability for their actions.

They are wrong.

The active participation of observers in board affairs can change their status and their liability to a corporation. In Canada, for example, the law imposes liability on those who function as directors, not just those who are elected by shareholders. In the US, there is a similar concept referred to as the "de facto" director. And while there have not yet been reported court decisions in Canada where an observer has been found liable for breach of fiduciary duties, there are to my knowledge claims that have been made (and settled) against investor/observers on this basis.

Angel and private equity investors need to particularly careful about their interactions with investees. Even as observers, investors will often manage the business of a corporation, even leading negotiations for additional financing or sales. It’s not unusual for them also to take an active role in board meetings, or to participate in what are otherwise purely directorial decisions. When things go wrong, it is inevitable that they may well be named in any lawsuit.

It has been the usual practice for sophisticated investors to require a company to sign an indemnity agreement for observers, so that they are protected. I do not necessarily agree that this is appropriate, unless the agreement also contains provisions that bind observers to certain standards of conduct. What are those? Post coming up.

1 Comments:

Blogger startupcfo said...

Wow! As a frequent observer (who never quite manages to keep his mouth shut) this is good to know.

11:06 AM  

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