Private equity firms are increasingly investing in a broader range of privately held companies. As an investor, the private equity firm will typically have at least one seat on the board of directors of the portfolio company.
The board of directors of a company is responsible for overseeing the company’s business and affairs, rather than participating in the day-to-day activities of the company, which are the responsibility of the company’s officers and employees. The board will typically become involved in the following types of decisions:
1. Setting executive compensation, including stock option and grant programs, and evaluating management performance.
2. Approving contracts, leases, loans, and other material agreements.
3. Approving corporate strategic, operational, financial and management plans.
4. Approving transactions involving financing and equity raises.
5. Approving the sale, merger and/or reorganisation of the company.
6. Adopting policies of corporate conduct.
In addressing these kinds of issues, the private equity director owes the fiduciary duties of care and loyalty to the portfolio company. The duty of care requires the private equity director to keep reasonably informed about the affairs of the portfolio company, and the duty of loyalty requires the private equity director to place the interests of the portfolio company above his or her personal interests and the interests of other parties, including that of his or her private equity firm employer.
The duty of loyalty requires the private equity director to place the interests of the portfolio company above the interests of other parties, including that of his or her private equity firm employer
If the private equity director sits on other boards of other portfolio companies of the private equity firm, additional conflicts of interests may arise in that two or more portfolio companies may decide to enter into business transactions with each other, the private equity director may learn confidential information of one portfolio company that may be of benefit to another portfolio company, or the private equity director may learn of a business opportunity that may be valuable to two portfolio companies but available to only one of them. These types of situations present opportunities for a private equity director to be faced with a claim of breach of fiduciary duty when he or she addresses these matters at a board meeting of the portfolio company.
The private equity director can implement protective measures in the portfolio company to help insulate the private equity director from claims the private equity director breached his or her fiduciary duties. These measures include:
1. Having management prepare comprehensive board packets reasonably in advance of the board meetings to enable the private equity director to adequately prepare for the meetings.
2. Having board members attend board meetings in person, if at all possible.
3. Having management or corporate counsel prepare board minutes which adequately reflect the substance of the board discussions, and the process by which board decisions were made.
4. Using independent directors and outside consultants, particularly in cases where there may be a perception of a conflict of interest.
Since a private equity director will usually also have a significant equity interest in the portfolio company through the private equity firm, the interests of the private equity director are generally aligned with the interests of the other equity holders and of management of the portfolio company, with a focus on growth, maximising shareholder value, and building value for the long term. A robust and engaged board is an advantage to a portfolio company in implementing strategy, and private equity directors are a valuable resource to the management team. However, private equity directors are typically appointed to the board as representatives of the private equity firm investor. This represents an inherent conflict of interest for the private equity director as he owes a fiduciary duty to all of the stockholders of the portfolio company, but that director also owes duties to the private equity firm as an employee/manager/general partner of the private equity firm.
The most obvious conflicts arise in related party transactions, class issues between various classes of stockholders, and short-term goals of the private equity firm weighed against the longer-term interests of the portfolio company and other investors.
This dual interest was the subject of a recent October 2012 Delaware Court of Chancery case, Shocking Technologies, Inc. v. Michael. The dissident shareholder, a representative of two classes of preferred stock, was found to have breached his fiduciary duties to the portfolio company by trying to dissuade a third-party investment in the company that would have provided much needed cash, and disclosing confidential information to that third party regarding the company’s financial condition. The dissident director claimed he was acting in good faith, and that his actions would in the long term address certain governance issues he had with some of the other directors. He believed that the holders of the preferred shares with which he was affiliated, deserved greater board representation. The court noted that stockholders and directors have a right to seek a change in corporate governance and board composition, but a stockholder-director has limits on the steps he may take to achieve these objectives. The court held that this director went too far in sharing confidential company information with a third party, and had breached his fiduciary duties to the company.
The lesson to be learned from this case is that a private equity director owes fiduciary duties to all stockholders, and not just to the particular stockholders who he or she is elected to represent. Private equity directors should consider taking the following steps to assist themselves in complying with their fiduciary obligations to the portfolio company:
1. Act according to your role as a director by focusing on the interests of the portfolio company as a whole, not the narrower interests of the private equity firm or its affiliates.
2. Be vigilant in identifying potential conflicts of interest. Notify other board members of any actual or potential conflicts, and recuse yourself from participation in board discussions of the matter.
3. Obtain the approval of disinterested directors or a special committee of the board, after full disclosure of all material information regarding the proposed transaction and the interests of the interested director. Also, have a record maintained of the considerations addressed and key terms addressed and negotiated by the disinterested board members or special committees.
4. Whenever possible, utilise veto rights only in the capacity of a stockholder, and not as a director of the company.
5. Obtain third party valuations and “market checks” of proposed deal terms for significant transactions such as debt or equity financings or M&A transactions.
By implementing the pro-active measures suggested herein, a private equity director can help safeguard himself or herself against claims of breach of fiduciary duty, and at the same time improve the overall corporate governance procedures for their portfolio companies.
Based in California, Vicki Dallas is a shareholder in the corporate practice group at law firm Buchalter Nemer.