— Wizard of Oz
There is an issue in board governance about which there is a body of useless literature: “constituency directorships.” When a director is designated to represent a particular stockholder or group, how can that director meet the fiduciary obligation of loyalty to the company?
In many states, such as Delaware, that duty is said to be owed to stockholders; in other states, such as Massachusetts (particularly after the March Supreme Judicial Court decision in IBEW v. Tucci), that duty is owed to the corporate entity.
This issue is acute when a venture capital firm, private equity firm or group of preferred investors (“investor”) place a constituent director (“designee”) on a board in which they invest (“corporation”).
We do not address limited liability companies, where statutes and case law permit managers greater fiduciary latitude (although that dichotomy of results between corporations and LLCs is itself anomalous).
Investors often extract contractual protections for their investment and place one or more designees on the board for enforcement. The contractual protections can be in the corporate charter, bylaws or an agreement, and typically are largely negative in nature: The corporation cannot take significant action without affirmative vote of the designee, such as sale or merger of the entity, change in business, issuance of securities senior or equal to the investor’s class of securities, or incurring major debt.
The legal analysis
Corporate statutes do not distinguish between designee directors and other directors; they all owe the same duties of care and loyalty, whether to the shareholders or the entity itself. The distinction may matter in how rights are enforced, but it is the same duty.
Stripped of false complexity, the question is: How can a director designee, delegated to represent specific investors, fulfill the duty of loyalty owed to all stockholders?
Simple: It cannot be done.
Why, then, although some cases are indeed brought, are our courts not clogged with litigation by stockholders successfully suing designees whose vote reflected loyalty to the investor who appointed that director?
Here is the practical answer: Everyone knows that our economy depends on designee directors doing their job for the investor. Businesses need the investor; they need VCs and PEs and strategic partners. So the system must develop compromises in the enforcement of strict fiduciary loyalty in support of the realities of the marketplace.
There are two levels of analysis — human nature and common sense — that prove to us that designees really do lean in the direction of “the man behind the curtain.”
The most scholarly study of designees called upon to serve two masters, professors Gelter and Helleringer’s “Lift Not the Partial Veil: To Whom are Directors’ Duties Really Owed?” (which can be found in the Social Science Research Network at http://ssrn.com/abstract=2419591) is essential reading for anyone trying in vain to parse the two inconsistent roles that designees are supposed to fill. The authors dare to state the obvious: People appointed to represent the interests of someone do not want to fail or be fired, often enjoy personal or professional relationships with the appointers, sometimes are paid directly and often indirectly by the appointers, and this reality “impacts their behavior,” and further “such loyalty will distort behavior on the basis of psychological mechanisms.”
Why is this tolerated by the corporation, and why are the courts often slow to actually enforce the fiduciary standard? A matter of common sense: Corporations need the money, they know the money isn’t stupid and wants control over a logical range of corporate decisions, and directorship is the way in which major corporate decisions are reached. Designees exercise the power the investor wants, and the corporation trades the power for the investment.
Cannot the investor protect itself solely by contract, at least in the charter that is supposed to be the “Constitution” of governance of the entity? Then, if there is a key corporate decision the outcome of which is controlled by that Constitution, where let us assume that the investor’s economic interest dictates Path A while the interests of other equity holders (and the interests of employees and even society) dictate Path B, all the designees need to say in order safely to select Path A is, “Well, I’m voting for Path A because that path is compelled by the Constitution.”
This argument is an attractive solution facially, but it is unrealistic.
First, there are usually myriad decisional points setting the stage for the choice between the paths. Simple example: Budgets must be approved by the board, including the designee who, in reflecting the investor’s preference for a more rapid exit, influences a series of budgets that front-end-load profits, leading to an early liquidity event.
Second, giving up too much power to investors through board designees could of itself be void as against statutory law that vests control in the board itself with limitations against undue delegation; a broad enough set of detailed controls given designees might rise to the level of excessive delegation.
But third and most importantly, who is smart enough to fully protect the investor by specific contractual terms, short of placing the investor through its designees in complete categorical control of everything?
Negative controls requiring consent of the designee, and indeed negative covenants prohibiting actions absolutely, cannot granularly control the myriad decisions that boards make over time. Such total control is not market practice and, in any event, would be complex to the point of absurdity.
For example, assume a charter absolutely banning the sale of a business without designee consent. Boards would have the inherent right and fiduciary duty to discuss sale at any time. What would a workable covenant, instituted at time of investment, look like that would be acceptable and also would protect a designee under current law from following whatever the investor instructs in all circumstances?
An absolute right to veto, regardless of all facts, might breach the duty of loyalty under current law. But what if the charter had been amended, upon funding, to provide that: “The business will never be sold except after June 1, 2020, and then only for over ten times EBITDA but not less than $40 Million with not less than a 50% yield on all classes of stock.”
Neither the corporation nor the investor would accept that specificity — it is incomplete, rigid and unworkable.
United States law defines fiduciary duties vaguely in terms of principles because it must; it cannot contemplate all situations. This vagueness also is convenient for the designee in its dual role. The designee needs a flexible standard to protect its decision while serving its master, the investor.
Indeed, our corporate statutes have been forced to recognize the practicalities of the marketplace to some degree. For example, our statutes do not automatically void self-dealing transactions involving directors just by reason of the combination of the office of directorship coupled with self-interest. See, for example, DGCL sec. 144.
Many of us have struggled to protect our own M&A deals by, for example, making our Delaware acquisition bomb-proof under judicially sanctioned methods of ratification (independent directors, committees, independent shareholders) or by arguing for application of various fiduciary tests (business judgment, entire fairness, heightened scrutiny), all in recognition that capital is entitled to protect its self-interest, and some argument needs to be found that leads to such result.
Since state law allows directors to self-deal, does it follow that designees can self-deal for their investor? Current law seems not to have developed in that direction and, more often, to avoid claims of breach of duty, the designee simply does not do its voting job and takes recusal, allowing independent directors to control the vote; if there are no independents on the board, some are hired for the occasion.
A deep dive into case law and commentary is disquieting. Just looking at Delaware jurisprudence, one finds adequate concern for the ability of designees to represent their investors (see the Trados decision and its progeny), or to share information with their investors.
There is even case law suggesting that, in some instances, a director’s resignation can itself breach fiduciary duty (although admittedly in different contexts — so far), which result by the way would be a curious twist since so often designees “solve” their dilemma by recusing themselves.
We need to change our corporate statutes. With the rise of shareholder capitalism and the vital role of outside capital to support our expanding technology economy, we need to provide clear paths to permit investors to name designees who can deliver on their job of being loyal to the investor.
We should create a special class of designee directors to serve without liability in voting consistently with loyalty to a given investor without getting sued. Why create liability for exercising human nature and economic logic? We would not be legalizing evil by directors; we would be permitting fundamentals of business deals and rational economic behavior to find expression within our corporations.
“Who can be wise, amazed, temperate, and furious,/Loyal and neutral, in a moment? No man.”
— Macbeth (Act II)
Stephen M. Honig practices at Duane Morris in Boston.