United States: A Director’s Dozen: 12 Thoughts for Private Equity Partners Sitting on Portfolio Company Boards

By Stephen D. Poss, John R. LeClaire and Jeffrey C. Hadden

"When you’re wearing multiple hats, you need to remember at any point in time which hat you’re wearing, and you have to keep it on straight."

General partners and managing directors of private equity and venture capital firms frequently sit on boards of directors of the companies in which their firms have invested. Often the portfolio company requests that the private equity investor take a board seat. Often the investor wants to be in the boardroom in order to protect and nurture the firm’s investment and in the belief that he or she can add value to the portfolio company’s board. Private equity and venture capital professionals have a great deal to offer, in terms of experience, wisdom and skill, to the companies in which they invest. In today’s litigious environment, however, the public perception of business has been tainted by numerous high-profile scandals. In this environment, it is best to stop, look and listen before agreeing to take a board seat. If you are going to sit on a board, it is now more important than ever to learn and obey the new rules of the road. Here are some practical tips to consider.

1. Recognize that the World Has Changed. The legal environment for outside, independent members of boards of directors has changed dramatically in recent years. We live in a world whose perception has been shaped by Enron, Tyco and WorldCom. Experienced, capable and diligent directors are learning that they need to change the way they do things or face unacceptable risks of liability to themselves and to their companies. Under the old law generally applicable to corporate boards, unless a director suspected that there was something illegal going on at the company, or that management could not be trusted, the directors traditionally had no legal duty to implement procedures designed to discover wrongdoing which they had no reason to suspect existed.

The law has changed. The new rule of thumb requires directors proactively to assure themselves that the company’s information and reporting systems not only exist but are reasonably designed and effectively implemented. The systems must be designed to provide senior management and the board with timely and accurate information sufficient to enable them to make informed decisions concerning the company’s business performance and its compliance with laws and regulations. In other words, as a director you need to make sure that your company has policies in place that will detect and deter wrongdoing and will reasonably ensure accurate financial reporting and compliance with the laws. If you have worked as a director to assure that such policies and procedures are in place and effectively implemented, then you may well be legally protected from liability even if things go wrong at the company.

2. The Risk of Personal Liability Is Real. Many directors believe that, if something goes wrong at their company, they will automatically be fully indemnified by the corporation or covered by directors and officers liability insurance and therefore that they have no real risk of personal liability. This is not true; no director should assume that the company’s indemnity or insurance policy will apply in every circumstance. While the risk of personal liability for diligent, careful and conscientious outside directors remains quite small, it is real. Directors need to understand that there may be personal financial consequences for sitting on the board of a company.

In the recent well-publicized Disney case, the Delaware Chancery Court refused to grant a motion to dismiss a complaint against the directors, noting that the facts, as alleged, suggested that Disney’s directors "consciously and intentionally disregarded their responsibilities" and thus may have breached the duty of good faith. This, in turn, led the Disney court to conclude that if these allegations were proved at trial, the directors would lose the protection from personal monetary liability otherwise available under Disney’s charter and Section 102(b)(7) of the Delaware Corporations Law. Although the same court later ruled, after a three-month trial, that the Disney directors had not breached their fiduciary duties, it reaffirmed its earlier ruling that a director’s "[d]eliberate indifference and inaction" is a breach of the duties of loyalty and good faith. Damages for such breach are not indemnifiable under Section 102(b)(7) and may give rise to personal liability on the part of directors

3. Know Where Your Duties Lie. As a partner or managing director in your private equity firm, you typically will owe a fiduciary duty to your investors. As a member of the board of directors of a portfolio company, you will also owe a fiduciary duty to all of the shareholders of that portfolio company. It is most important to be aware of these duties and to avoid placing yourself in a situation where those duties can collide. You need to remember at all times whether you are wearing your investor hat or your director hat, and you need to keep those hats on straight. This means developing policies and procedures to avoid conflicts of interest whenever possible and to deal with the conflicts that inevitably arise. For example, the portfolio company should have the independent members of the board review and approve transactions which present a conflict of interest (such as a follow-on financing with existing investors).

4. Watch Out for Reg. FD. By now, most senior business people dealing with public companies understand that SEC Regulation FD prevents those with knowledge of material, non-public information concerning a public company from disclosing that information selectively, rather than to the public at large. This can become a tricky issue for private equity partners. If the portfolio company on whose board you sit is a public company, you may not be free to go back to your office after a board meeting and let your colleagues at your private equity firm know what happened at the meeting, or what is going on at the company, before it is publicly disclosed. While there are policies and procedures that can be put in place at your private equity firm to make these communications possible on an efficient and timely basis, it is best to develop those policies and procedures with knowledgeable securities counsel in order to avoid foot-faulting on Reg. FD. It is also a good idea to have a training session for your colleagues on Reg. FD and similar issues on an annual basis.

5. Watch Out for Insider Trading. Most people think that insider trading is something done by crooks or fools or both. In fact, the insider trading rules can be highly technical traps for the unwary or unlucky alike, and it is easy for even careful and well-intentioned directors to find themselves in situations where they are investigated for possible unlawful insider trading. Here again, as with Reg. FD, it is important that partners and employees of private equity firms have policies and procedures in place to make sure that they do not intentionally or even accidentally make decisions to buy or sell shares of a public portfolio company’s stock while in possession of material non-public information concerning that company.

6. Avoid Deputization Issues. If something goes wrong at the portfolio company and it faces a securities class action lawsuit, a derivative fiduciary duty lawsuit, an SEC investigation or other troubles, you want to make sure that those problems are contained at the portfolio company level and do not expand to involve your private equity firm. It is important, therefore, to make clear that you serve as a director of the portfolio company in the same role as any other outside director, looking out for the interests of all the shareholders, rather than serving on the board as a representative or "deputy" of your private equity firm. You may need to demonstrate after the fact that you were not doing the bidding of your firm or investors with respect to board matters, but rather were acting independently as an outside director.

Avoiding the appearance of deputization involves educating your colleagues on the kinds of communications they should and should not have with you concerning the portfolio companies on whose boards you sit. Be careful to avoid creating a paper or e-mail trail that might indicate that you, as a director, are taking your instructions or acting in the interests of the private equity fund or its investors rather than in the interests of all of the company’s shareholders. Various policies and procedures can be considered that reinforce your ability to act independently as a director and help to avoid missteps.

7. Watch Out for Mergers, Acquisitions and Other Fundamental Transactions. Any time you sit on the board of a company which is considering or undergoing a fundamental transaction such as a merger or acquisition, whether on the buy side or the sell side, you are entering one of the riskiest danger zones for corporate directors.

As a member of the board, you must consider and approve any mergers, acquisitions and other major decisions carefully and in the best interests of the company and its stockholders. At times, you may find that a decision that seems right for the company as a whole may not be in the best interests of your private equity firm. For example, wearing your investor hat may cause you to focus on short-term returns while wearing your hat as independent director of the portfolio company might cause you instead to focus on longer-term returns. While your private equity firm can pursue its own interests when acting as an investor, your actions as a director must meet a different standard. In these instances, it is important to consider your board duties carefully and to either vote in the best interests of the portfolio company or abstain from board deliberations and voting.

8. Watch Out for Risks of Insolvency. Duties of directors of both privately held and publicly traded companies can change dramatically if the company is in the "vicinity" of insolvency. This can cause your duties to run to the company’s creditors and, in retrospect, may subject you to detailed scrutiny from regulators and plaintiffs’ lawyers. Ordinarily routine, everyday corporate decisions – such as how the company’s funds are managed and which bills are paid or not paid when it appears that the company may not be able to meet its obligations – can require additional scrutiny when the cupboard is bare. Particularly if your private equity or venture capital fund is a creditor of the company on whose board you sit, you may be placed in a very difficult position.

9. Executive Compensation Is a Minefield. As the Disney case shows, decisions concerning hiring, firing and compensation of senior executives can be a legal minefield for directors. While directors who act in good faith tend to be protected by the business judgment rule, it is still important to act carefully and independently in making significant decisions such as those involving the compensation of senior executives. Keep in mind that your conduct as a director may well be judged individually, and therefore, no matter how careful or diligent your fellow directors are, if you have not attended key meetings, have not asked questions and reviewed pertinent information, or have relied unquestioningly on what you were told by management, then you may be at personal risk for failure to act with the appropriate level of due deliberation and independence. It may also be wise to insist that the board retain an outside expert on executive compensation rather than simply relying on the experience and judgment of the various directors.

10. Time and Effort Are Your Best Protection. New corporate governance norms expect an outside director to devote substantially more time to his or her board position. You need to make sure you have adequate time to do a good job before you accept a board seat. Some successful private equity investors simply do not have time for meaningful participation, particularly if they serve on multiple boards. Keep in mind that the first thing that will happen after a corporate train wreck is that you will be asked how many meetings you attended, how long the meetings were, how many questions you asked at the meetings, what materials you reviewed in advance and other questions seeking to learn how diligent you were.

As the courts do not like to evaluate the substance of business decisions, they often elevate form over substance and pay more attention to how much time you spent on your board duties than on the merits of the board decision itself. This is a frustrating concept for business people, who value efficiency above all, but you need to understand that the quantity of time you invest as a director may be of equal or even more significance in protecting you from legal liability than the quality of judgment you bring to the boardroom. In times of corporate crisis, such as considering a merger or acquisition or bankruptcy filing, you may need to attend numerous, even daily board meetings on short notice and be fully prepared for and an active participant at each of those meetings. Particularly for private equity investors serving on multiple boards, remember that in the event of a scandal involving one of your portfolio companies, you will be quizzed on whether it was reasonably possible for you to devote adequate time to that company’s board given your other obligations on other boards and at your private equity firm.

11. Board Minutes Are Important. Many directors do not pay much attention to the written minutes of their board and board committee meetings. Often the minutes are reviewed briefly at the next meeting and approved without much thought or consideration. In any given instance, it is a matter of judgment as to how much detail to place in the board minutes, but you should be comfortable that the board minutes adequately reflect careful consideration and due deliberation by the board on important issues. The minutes should demonstrate that the board spent more time on important, big ticket items than on less important items. In the recent Disney case, the court complained that it could not tell from the Disney board minutes whether the board had spent substantial time on key issues. While board minutes should not be filled with unnecessary issues and details, the minutes should make clear that the board took adequate time and acted carefully in making its decisions. As your fellow directors and even the company counsel may not be attuned to these issues, you should make it a point to consider carefully whether the board minutes you are approving are adequate to protect the company and you in case some legal Mondaymorning quarterback attempts to second-guess your decisions several years from now.

12. Process, Process, Process. The most important point is saved for last, as it relates to all of the other guidelines: Remember that as a director the legal system will judge you on the soundness of the process you undertook, which may be more important than whether the decisions your board made turned out to have good or bad consequences. As noted above, the courts tend to focus on formalistic issues of process such as whether independent outside directors approved a related-party transaction, how many meetings the board took to discuss an important issue (more meetings are better), how much time the board took to discuss certain issues (more time is better), what materials the board received (the more the better), whether the board received written materials adequately in advance of the meeting, and how many questions each director asked at pertinent board meetings about the decision in question (in case you haven’t guessed, more questions are better). When subject to a legal challenge, courts are more likely to find independent directors not liable for corporate decisions gone bad, or for scandals, fraud or other problems at the company, if the directors, in good faith and without any conflict of interest, devoted adequate time and effort to acting carefully, based on adequate information and expert advice. While these factors can be annoying to experienced private equity professionals who may have the ability to make wise and expert decisions quickly based on their own experience and industry knowledge, keep in mind that a few extra hours invested in a board meeting today may save you weeks or months of depositions and trial tomorrow.

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.