Fiduciary duties of directors appointed by private equity firms: pitfalls and best practices
October 2019 | SPOTLIGHT | PRIVATE EQUITY
Financier Worldwide Magazine
October 2019 Issue
It is a bedrock principal of Delaware law that a board of directors is responsible for managing the business and affairs of a corporation and that, in exercising that authority, the directors owe certain fiduciary duties to both the corporation and the corporation’s stockholders. The well-known duties of care and loyalty require directors to advance the best interests of the corporation by seeking to promote value for the benefit of stockholders.
But, as noted by the Delaware Court of Chancery in Frederick Hsu Living Trust v. ODN Holding Corp., “[i]n a world with many types of stock ... and many types of stockholders ... the question naturally rises: which stockholders?” In the case of a private equity (PE) firm and its appointed portfolio company directors, the answer to that question can present challenges.
PE firms often appoint their own employees to the boards of the portfolio companies in which they have acquired substantial interests. This practice can have many advantages for the sponsoring PE firm, such as further insight into the portfolio company’s state of affairs and participation in the company’s decision-making process. However, in situations where the interests of the PE investor and the corporation diverge, it can also lead to exposure for claims of breach of fiduciary duty due to the so-called ‘dual fiduciary’ nature of the fund-sponsored director.
Most commonly, these conflicts of interest surface at times when the corporation is experiencing financial stress, or when a PE firm is preparing to exit the investment, and the appointed director is seemingly presented with the choice between acting in the best interests of the PE firm and the best interests of the corporation and its common stockholders. In these situations, the Delaware Court of Chancery has made clear that appointed directors can put themselves (and their firms) at risk for breach of fiduciary duty claims for failing to put the common stockholders’ interests ahead of the PE firm.
This article discusses key decisions in the Delaware Court of Chancery impacting the fiduciary duty obligations of PE firm appointed directors, and provides practical guidance on how sponsoring firms can best insulate themselves and their appointed directors from exposure for breach of fiduciary duties in conflict of interest situations.
The Delaware Court of Chancery’s stance on dual-fiduciary obligations
Frederick Hsu Living Trust v. ODN Holding Corp. provides a helpful roadmap for how the Delaware Court of Chancery examines such claims. In that case, vice chancellor Laster declined to dismiss breach of fiduciary claims against a company’s board of directors and its controlling stockholder, a venture capital (VC) firm, in connection with a series of transactions that essentially liquidated the company ahead of the venture capital firm’s contractual redemption right.
As background, in 2008, Oak Hill, a VC firm, invested $150m in a technology company in exchange for shares of preferred stock and the right to redeem its stock beginning five years after its investment. In 2009, Oak Hill became the company’s controlling stockholder and its representatives held three out of eight seats on the company’s board. The other five directors were alleged to have various personal, professional and economic connections to Oak Hill. According to the complaint, in 2011, Oak Hill changed the company’s business strategy in preparation for exercising its upcoming contractual redemption right. The company stopped focusing on growth and instead began stockpiling cash, including by selling three of its four lines of business, terminating certain executives and reducing the overall workforce. By 2015, the company’s annual revenue had dropped to $11m, a 92 percent decline from the company’s 2011 annual revenue.
In 2012, with Oak Hill’s redemption right approaching, the board formed a two-member special committee to evaluate the company’s alternatives for raising capital for the redemptions and to negotiate with Oak Hill concerning the terms. The committee engaged in limited negotiations with Oak Hill and in 2013, recommended that the board accept Oak Hill’s proposal for an immediate redemption of $45m, which would leave the company with only $5m in cash. The board approved the redemption, though the three Oak Hill-appointed directors abstained from voting. In 2014, after selling the company’s third line of business and reducing its workforce, the board determined that the company had sufficient surplus to make a further redemption payment of $40m to Oak Hill.
No stockholder votes were taken on the redemptions themselves, or any of the transactions leading up to the redemptions. Rather, the plaintiff, Hsu, who was one of the company’s original founders, learned of the board’s actions after receiving the company’s audited financial statements. Hsu brought claims for breach of fiduciary duty against the individual directors and against Oak Hill, in its capacity as controlling stockholder, contending that the defendants sought to maximise the value of Oak Hill’s redemption right rather than seeking to maximise the long-term value of the corporation for the benefit of all stockholders.
On the defendants’ motion to dismiss, vice chancellor Laster made clear that the fiduciary-based standard of conduct requires directors to focus on promoting the value of a corporation for the benefit of its stockholders “in the aggregate ... which means the undifferentiated equity as a collective, without regard to any special rights”. Because a Delaware corporation exists in perpetuity by default, directors must act “to maximize the value of the corporation over the long-term for the benefit of the providers of presumptively permanent equity capital”. The fact that some stockholders might be market participants who are eager to exit the investment and “would prefer a higher near-term market price” does not alter a director’s long-term fiduciary focus. Vice chancellor Laster further rejected the defendants’ arguments that the fiduciary-based standard of conduct was inapplicable in the face of the company’s contractual obligations to Oak Hill, noting that, while fiduciary status does not give directors “Houdini-like powers to escape from valid contracts”, a board still owes fiduciary duties in considering how to handle those obligations. Vice chancellor Laster pointed to the doctrine of efficient breach, under which a board may decide that its most advantageous course is to breach a contract and pay damages if the broadly conceived benefits exceed the costs.
Vice chancellor Laster determined that the board faced actual conflicts of interest and, after conducting a director by director analysis, found that there were not enough sufficiently disinterested or independent directors acting for the board with respect to the challenged transactions. Accordingly, the defendants’ conduct was evaluated under Delaware’s most onerous standard of review, entire fairness.
In the face of actual or potential conflicts of interest, procedural protections such as forming an independent committee and holding a majority-of-the-minority vote can restore the more deferential ‘business judgment’ standard of review.
However, in this case, the board implemented only one of those measures and vice chancellor Laster concluded that the committee was not effective given the allegations that the members favoured Oak Hill and took charge of the company’s restructuring initiative that made additional funds available for redemptions. Finally, the fact that the Oak Hill directors abstained from voting on the redemption had no exculpatory effect on the breach of fiduciary claims against them, as the directors were sufficiently involved in the events giving rise to the breach of fiduciary duty claims, according to vice chancellor Laster.
Throughout his opinion, vice chancellor Laster was careful to note that his determinations were pleading stage decisions at which point the plaintiff receives the benefit of all reasonable inferences. In emphasising this point, vice chancellor Laster acknowledged that it was possible that the directors would be able to show that they engaged in the now-challenged course of action because they believed it was in the best interests of the undifferentiated equity.
Vice chancellor Laster provided similar guidance with respect to the obligations of dual-fiduciary directors in an earlier opinion, In re Trados Incorporated Shareholder Litigation, though, after trial, ultimately found the challenged transaction to be fair and ruled in favour of the defendants under the entire fairness standard. In Trados, common stockholders brought breach of fiduciary claims against a company’s board in connection with a merger transaction whereby the common stockholders received nothing and the preferred stockholders, which included venture capital firms with representatives on the board, received $52m.
As in Frederick Hsu, vice chancellor Laster’s opinion makes clear that “in circumstances where the interests of the common stockholders diverge from those of the preferred stockholders, it is possible that a director could breach her duty by improperly favoring the interests of the preferred stockholders over those of the common stockholders”. Though vice chancellor Laster determined that the challenged transaction was fair, his opinion cautions that “the defendant directors did not adopt any protective provisions, failed to consider the common stockholders, and sought to exit without recognizing the conflicts of interest” inherent in the challenged merger transaction.
Best practices for the PE firm appointed director
While a breach of fiduciary claim ultimately depends on the facts specific to each case, Delaware’s well-developed case law on this subject can provide helpful guidance for the PE firm appointed director (and the PE firm) on how best to limit exposure for breach of fiduciary duty liability.
Appoint independent directors. PE firms and their appointed directors should take efforts to ensure that the boards of their portfolio companies contain several truly independent directors without ties to the PE firm. When the board is faced with conflict of interest situations, these directors, if truly independent and disinterested, can serve as a special committee charged with protecting the company’s and common stockholders’ interests. While the inquiry into a director’s independence is case-specific, keep in mind that courts will generally focus on whether the director has any relevant economic or personal incentives, such as employment or financial gain related to the PE firm, or even a social relationship with the firm.
Be transparent with your decision-making process. Clear and accurate records should be maintained for all board and special committee meetings, but such records are especially important with actions involving conflicts of interest, as the board may later need to defend its decisions. Records should be specific and articulate a thoughtful and reasonable decision-making process, including factors taken into account by the board and the reasons why a particular decision or course of action serves the best interest of all stockholders.
Consider seeking approval from common stockholders. With respect to decisions involving conflicting interests between the common stockholders and the interests of the PE firm sponsor, the board may want to consider seeking a majority-of-the-minority vote as an additional protective measure to avoid heightened judicial review.
Julia Beskin is a partner and Samantha Yantko is an associate at Quinn Emanuel Urquhart & Sullivan LLP. Ms Beskin can be contacted on +1 (212) 849 7482 or by email: firstname.lastname@example.org. Ms Yantko can be contacted on +1 (212) 849 7583 or by email: email@example.com.
© Financier Worldwide
Julia Beskin and Samantha Yantko
Quinn Emanuel Urquhart & Sullivan LLP