Private equity general partners today are both propelled towards public board membership and repelled from it by two opposite and powerful forces.
On the one hand, limited partners, now more than ever, expect to see evidence of operational value add at every stage of portfolio company’s development, including after it has been taken public. Private equity professionals are often supremely qualified to guide a post-IPO portfolio company to further growth, perhaps by dint of an intimate knowledge of the market and the company’s strengths and weaknesses, perhaps because of financial markets expertise and a large Rolodex. Where a private equity fund has a significant stake in a portfolio company, it is only natural that one or more talented GPs of the fund join the company’s board as outside directors when it goes public.
But being a director of a public company today isn’t what it used to be. The threat of litigation is higher, the responsibilities of board membership are greater and more time consuming, and, according to legal experts, board members are increasingly likely to lose lawsuits that several years ago they would have won, such are the expectations of good faith in service to stockholders.
According to Stephen Poss, a partner in the Boston office of law firm Goodwin Procterand an expert on securities litigation and SEC enforcement practice, changes to the liabilities of board membership should be taken seriously. ?You need to go in with your eyes open and make sure you have time in your calendar, says Poss. ?The old model of showing four times a year, having lunch and then leaving doesn’t cut it anymore. There are more meetings and you need to pay more attention.?
While all the liabilities that apply to board members apply to board members from invested private equity funds, there are certain aspects of being a GP board member that are fairly unique. Most board members are also shareholders, but board members from private equity funds are usually significant shareholders through a fund with a sometimes different economic dynamic to the corporation.
Private equity GPs that sit on corporate boards are therefore fiduciaries to two entities: the private equity fund and the corporate shareholders. Usually what is good for one entity is good for the other. But in rare cases potential conflicts can emerge, and GP board members and their firms should construct policies to minimize the risks presented by these conflicts. As Poss puts it: ?When you’re wearing multiple hats, you need to remember at any point in time which hat you’re wearing and you have to have it on straight.?
One potential conflict should be evident to anyone who benefited from reading the 1992 best-seller Den of Thieves – insider trading. Certainly a board member must not trade stock based on information to which only company insiders are privy. But beyond that his or her private equity firm should have clear rules in place to guard against deliberate or inadvertent insider trades. ?Although it’s easy to go back to the office and say, ?Wow, guess what I just learned about the company at the board meeting,? you can’t be telling everyone, willy nilly, what’s going on, says Poss, who adds that in his experience, not every private equity firm has such rules.
In the US, the potential problem of loose lips around the office has become more acute since 2000, when the SEC adopted Regulation FD (Fair Disclosure), which requires that if any person acting on behalf of a publicly traded company discloses non-public information, even unintentionally, that information must be promptly released to the public.
Another conflict that arises from time to time for GP board members has to do with the timing of transactions. Corporate board members must approve mergers, acquisitions, disposals and major decisions that are in the best long-term interests of the company. But as any merger arbitrage hedge fund partner will tell you, such decisions can often lead to short-term value impairment before creating the synergies envisioned by their architects. A private equity GP that knows his fund wants to exit its position in a publicly traded company within a year, for example, may be conflicted as to how to vote for a corporate transaction if he suspects that the deal may mean a lower IRR upon exit. In these cases, says Poss, the GP board member must vote in the best interests of the company over the fund, or abstain from voting.
A related conflict can appear when a portfolio company is in dire straights (see ?Whose side are you on?? ). In certain cases, the company’s management, employees, creditors and shareholders will naturally see a next round of financing as in their best interests, as further equity capital will keep the company alive. But a private equity fund may follow the ?sunk costs are sunk costs principle and not put further equity capital at risk. In doing so, fund affiliated board members may vote against further financings in favor of allowing the company to slip into bankruptcy.
I SHOT THE DEPUTY
Where an angry plaintiff wants to prove that a board member has put first the interests of his or her fund, instead of the company, Poss says ?deputization issues arise. In these cases, the board member in question is seen as a deputy of the private equity fund, and the plaintiffs charge that the GP board member was essentially ?doing the bidding of the limited partnership.
As with all other forms of risk control for board members, private equity GPs wishing to avoid becoming deputized need to institute policies of clear documentation, or lack of documentation. A board member who also happens to be a general partner to a fund with an investment in the company must be careful to avoid a paper trail that might indicate he or she is taking orders from the fund. An email from a founding partner to another partner on the board of a portfolio company suggesting how to vote on an important issue may suggest in court that you were actually serving on the board as a representative of the fund, not as an independent director ?like everybody else, says Poss.
Similarly, a private equity firm may want to institute a policy that GP board members of public companies may not be part of the decision-making process for when and how to unload shares in those companies. Such a ban reinforces the image of the board member as an independent agent doing the bidding of the corporation alone.
TIME AND EFFORT
Even when a US GP has mastered the science of separating fund duty from board duty, liabilities remain, thanks to burdens of Sarbanes Oxley and recent court cases (see ?Triple duty? ). Now that directors can be held accountable for essentially not trying hard enough to uncover wrongdoing, board membership brings with it an increased need to monitor and document the monitoring.
The new environment has fundamentally changed the culture of the board room. According to a joint survey conducted last year by PricewaterhouseCoopers and Corporate Board Member magazine, time pressure is forcing outside board members to curtail the number of boards on which they sitdown to an average of three. In 2004, 29 percent of responding outside directors said they were limited to additional board seats, compared with 16 percent in a similar 2003 survey.
The demands of board membership are such that private equity GPs must think carefully about each new opportunity. ?People who are successful in private equity often don’thave time for meaningful participation on multiple boards, warns Poss. ?The first thing that will happen if there’s a scandal is you’ll be asked how many meetings you attended, how many questions you asked at the meetings, how prepared you were. Don’t kid yourself if you don’t have time for this.?
While rare, the penalties for being found asleep at the wheel can vary from settlements where no money changes hands to directors being forced to write personal checks for damages. Directors found to be in breach of their fiduciary duties can be barred from serving on other public boards.
The recent regulatory focus on the board may be designed to put a bit of religion in the hearts of directors. Still, with proper policies in place, says Poss,?There is nothing unreasonably risky about general partners sitting on the board of a business in which the fund has invested. If you’re willing to do the work and do it right, you can be a valuable asset to the company and to your fund.?
The traditional duties of corporate board members in the US have been reinterpreted in recent time to take on more urgent, proactive meanings. Whereas in the past, board members were held to ?hear no evil, see no evil standards, recent scandals, legislation and court decisions have meant that outside directors must now take pains not only to respond to wrongdoing when it is detected, but to establish systems that will detect problems, as well as to spend more time engaged in actively scouring their companies for signs of trouble.
Legal experts often organize the various duties of board members into ?duties.?
- ? Duty of care:This means a director should execute their duties with the same degree of care that a prudent person would apply under similar circumstances.
- ? Duty of loyalty:This is often defined as the director placing the interests of the company and its shareholders above his own (or his family members’) interests. If a director has an opportunity to profit as a result of being a board member, he or she must be able to prove that the transaction was not in any way injurious to the company and that the transaction was fair. A breach of the duty of loyalty would be considered self-dealing. Board members must disclose issues that may present conflicts of interest and, when those potential conflicts arise, board members should recuse themselves from a vote on the matter.
- ? Duty of good faith: There is some disagreement as to whether this duty should be separate from or part of the duty of loyalty. It is sometimes expressed a ?business judgment rule where, even where attention to care and loyalty were paid, a decision turns out to be a bad one. In this case, the question becomes one of whether the board member acted in good faith and made a reasonable decision given the information available at the time. However, two Delaware court cases in the past ten years have removed some of the benefit of the doubt traditionally given board members who fail to detect corporate trouble.
In 1996, a Delaware Court of Chancery found that the directors of Caremark Inc., a pharmaceutical services company, could have been personally liable for losses at the company had they not implemented correct compliance programs. Caremark had been indicted in 1994 for violating certain healthcare laws, and was ordered to pay a $250 million penalty. Shareholders later sued the unindicted board members for failing to detect the criminal wrongdoing. William Allen found for the directors because they had established a relevant compliance system but noted that, in theory, the judgment could have gone the other way if the directors had failed to establish such a system.
More recently, the duty of good faith was given another day in a Delaware Chancery court during the suit against the directors of Walt Disney. The media giant’s board sued over an enormous severance paymentmade to outgoing president Michael Ovitz, who received roughly $140 million after serving for only a year. The case closed lastmonth on the side of the board members, putting advocates of more corporate governance on the densive. But the court’s decision merely to allow the Disney case to go as far as it did has led some legal experts to read a shift toward directors being held accountable for not seeking adequate information (and not documenting the seeking of such information) when making important decisions.
All this adds up to one reality – directors of companies now need to prove that where corporate evil has taken place, they tried hard to hear or see it before it came to light.