Your Responsibilities as a Director of a Portfolio Company

 

Your Responsibilities as a Director of a Portfolio Company

As a director on a portfolio company board, a private equity professional can provide significant value to the portfolio company as a source of independent judgment and financial experience, and also to the private equity fund in monitoring the investment.  But there are, of course, important responsibilities that come with serving on a board of directors.1 

These responsibilities can present interesting challenges for a private equity professional serving on a board, particularly if the portfolio company is a public company.  Before discussing these challenges below, we will briefly highlight the general duties of a board member.

A Board's Responsibilities Generally

A board of directors is responsible generally for overseeing the management of the portfolio company.  The company's management, on the other hand, is responsible for day-to-day operations.  Generally speaking, the board should not be passive in its oversight role.  Rather, it should regularly evaluate the company's strategic direction, its policies and procedures and the effectiveness of its management.  Certain specific matters that a board of directors will typically oversee include:

If the portfolio company is public, the board's responsibilities in certain of these areas (e.g., audit committees, compensation committees, nominating/corporate governance committees and public disclosure matters) are also mandated by securities laws and/or stock exchange rules.  In these cases, therefore, it is particularly important for board members to consult with counsel  to ensure that they have a full understanding of the board's responsibilities (or public company investor expectations in that regard).  In certain situations, proxy and banking advisors can also be helpful in advising a board on the then-current expectations of public investors.

A director designated by a private equity fund owes fiduciary duties to the portfolio company and all of its shareholders, even when these duties may conflict with the fiduciary obligations to the fund's limited partners.

A director has fiduciary duties to act carefully and in the best interests of the portfolio company and all of its shareholders:  a duty of loyalty and a duty of care.  To provide background for the issues that may be of greater interest to private equity professionals that we discuss below, these obligations can be summarized as follows:

Certain courts have also recognized a "duty of good faith," which may be breached, for example, in the case of an "intentional dereliction of duty" or a "conscious disregard for one's responsibilities."  Other courts have viewed the duty of good faith as merely a subset of the duty of loyalty (or perhaps equally logically, of care).

The duties owed to the portfolio company and its shareholders are separate from the duties that the director may also owe to the private equity fund and its investors, and these duties may at times conflict.  It is thus important for a director designated by a private equity fund to be mindful of these potential conflict situations to avoid or best manage the pitfalls they can present.

One obvious reason why it is so important for directors to be attentive to these duties is the shared interest of the director, the portfolio company and the private equity fund to avoid problematic litigation.  Such litigation is particularly common in the context of public company sale transactions, but can occur in relation to any board decision.  It is thus critical for private equity professionals to be sensitive to potential conflicts or other issues, whether actual or perceived, that may cause shareholders to pursue claims against directors.  This is particularly true in the current environment where observers are critical of the interests of private equity funds relative to public company investors.

Practical Implications of the Duty of Loyalty

The board of a portfolio company will typically be asked to address a number of matters that may implicate the duty of loyalty for directors who are also private equity fund professionals.  For example:

Procedures to Satisfy the Duty of Loyalty.

A director's self-interest in a transaction is not, by itself, sufficient to establish a breach of the duty of loyalty.  Delaware law provides support for the principle that a director would not have breached the duty of loyalty if:

Because obtaining shareholder approval may be cumbersome, and a determination that the transaction is otherwise "fair" can later be disputed in litigation (particularly through the corrective lens of hindsight), the first approach is generally the most popular and prudent. 

Accordingly, when a board is considering a matter in which a director (or the director's private equity fund or affiliates) may have any direct or indirect interest, the potentially conflicting interest should be fully disclosed, the director may find it desirable to recuse himself or herself from participating in the decision and board approval of the matter should require a majority of the directors who do not have any such interest.  Any such disclosure should be as complete and as well-documented as possible.

Corporate Opportunity Doctrine.  

Another aspect of the duty of loyalty arises under the rubric of the "corporate opportunity doctrine," which generally requires that a director may not take any business opportunity that the corporation is financially able to undertake and is in the corporation's line of business or another line of business in which the corporation has expressed an interest.  In general, then, this doctrine might allow minority shareholders to argue that a private equity fund may not make an investment that would be appropriate for one of its portfolio companies if any of its professionals serves as a director on the board of that portfolio company, unless the director first offers the opportunity to the existing portfolio company.  Naturally, this may not be desirable from the perspective of a PE fund, which also owes its own fiduciary responsibilities to its own investors as a matter of law. 

The most common way to address this issue, at least while the portfolio company is privately held, is to include an effective waiver of this doctrine in its charter.  If inclusion of such a waiver is unpalatable from the perspective of marketing the IPO of a portfolio company, however, the charter may have to be amended to remove this waiver prior to the IPO.  Without such a waiver, a director designated by a private equity fund must keep this doctrine in mind when considering a decision that implicates both fund and portfolio company interests.

Use of Confidential Information. 

Although this can be challenging for private equity professionals as a practical matter, the duty of loyalty also requires that directors not use confidential information that they receive in their capacity as directors for any purpose other than fulfilling their board obligations.  This means, for example, that information learned as a member of the board of a portfolio company should not be used for other business initiatives, and cannot be shared with other portfolio companies.

Private equity funds also should establish guidelines for handling confidential information obtained by their representatives while serving as directors of portfolio companies.  Directors should be careful to share confidential information only with those individuals that have a need to know the information to assist them in fulfilling their responsibilities as directors.  Directors should advise the recipient of the confidential nature of the information, and ask the recipient to maintain its confidentiality (ideally, by executing a confidentiality agreement unless the recipient is otherwise bound by confidentiality obligations).  The guidelines should also include specific restrictions on communicating confidential information with other individuals or areas of the firm where potential conflicts of interest may arise (such as trading groups).

Exercise of Contractual "Veto" Rights.

Private equity funds often possess "veto rights" over certain actions that might be taken by the portfolio company or its subsidiaries.  If the "veto rights" are at the board level - i.e., requiring that specified members or a percentage of board members must approve the actions - the board members' duty of loyalty requires that the best interest of the corporation and its shareholders must take priority over any interests possessed by any director, officer or controlling shareholder that are not shared by the stockholders generally.  In contrast, if the contract requires that any such actions must be approved by a specified percentage of shareholders (or class of shareholders), each shareholder is generally permitted to vote its own interests, without considering the interests of other shareholders.  This distinction should be considered by private equity funds when negotiating shareholder agreements and other investment documents.

Serving as a Director of a Competitor.

U.S. antitrust laws generally prohibit individuals from serving as officers or directors of competing companies, even when there is relatively little overlap.  Accordingly, you should consult with counsel when this issue may (even arguably) arise.

Practical Implications of the Duty of Care

In the context of a private equity portfolio company, shareholder challenges based on an alleged breach of the duty of care are most likely to arise if the board becomes lax in its procedures, often due to the familiarity among board members.

Procedures to Satisfy the Duty of Care. 

While there is no "one-size-fits-all" approach, some steps may be useful in establishing that directors have satisfied their duty of care.  These might include:

Special Duties Applicable to Dividends, Distributions and Stock Repurchases

Delaware law provides that the directors at the time of a dividend, distribution or stock repurchase that is improperly made may be held jointly and severally liable to the corporation and its creditors for six years for the amount distributed plus interest.  An equity distribution would be improperly made if the corporation does not have adequate "surplus" (which can be translated in layman's terms to insolvency, but which has specific legal elements that need to be evaluated).  Accordingly, a board of directors should determine the corporation's "surplus" before declaring any dividend or distribution or authorizing any stock repurchase.  A solvency opinion or other third-party valuation may be useful support for this determination.

Additional Responsibilities of Directors of Public Companies

Finally, a number of additional legal and regulatory requirements apply to a director of a public company, including responsibility/liability for the company's public securities documents (e.g., annual reports, registration statements, etc.), the obligation to disclose non-public information under Regulation FD, the responsibility to establish appropriate policies to prevent "insider trading" and obligations to file reports under Section 16 of the Securities Exchange Act of 1934.  Please consult with your Davis Polk contact for more information regarding these requirements.


1 This newsletter assumes that the portfolio company is a Delaware corporation.  Although there are differences, the general responsibilities of the board of a portfolio company formed in another jurisdiction will likely be very similar to those described in this newsletter because of the influence of Delaware corporate law and its courts in the area of corporate governance.