United States: Direct Investing: Considerations When Serving As A Family-Designated Director

A family office or family investment fund making a direct investment in a company often gets the ability to designate one or more directors to the company's board of directors. The family usually has the right to designate one or more directors by either owning enough voting control in the company to elect the director directly, or specifically negotiating the right as part of the family's investment. Important legal and practical considerations must be weighed by a family when choosing to have a family designee appointed to the board of directors. In this article, we identify some of the key fiduciary duties owed to a company and its shareholders by directors, and corresponding legal and practical issues regarding having a family-designated director.

Special considerations apply when designating a director to a publicly traded company, including the application and impact of the stock exchange rules and requirements, insider trading rules, and other disclosure obligations—which are outside the scope of this article.

Fiduciary Duties

A director owes fiduciary duties to a corporation and its shareholders. The director's fiduciary duties are generally divided into two main areas: (i) the duty of care and (ii) the duty of loyalty and good faith.

Duty of Care. The duty of care generally focuses on the ways in which directors make their decisions on behalf of the company. When making company decisions, the duty of care imposes on directors the obligation to fully inform themselves and to carefully consider their decisions. When making a decision, a director should get the relevant information, take time to understand and evaluate the information and decision, consider any relevant expert advice, ask questions and challenge management's assumptions. In each case, it is important to document the board's deliberation. During their tenure, directors should review and assess the company's operations and performance, including periodic updates from management. Directors should also review the company's financial statements and internal controls. Satisfying the duty of care takes time and effort and each director's conduct is subject to individual scrutiny to determine if the director has met their fiduciary duties.

A family designee to a board of directors must be prepared and able to spend the necessary time and effort required of a director, including maintaining availability to prepare for and participate in board meetings. In some instances, directors may be allowed to attend meetings remotely, participating by phone or video conference. The family designee must also be able to understand and evaluate the corporate matters and decisions brought before the board of directors. Depending on the nature of the operating business, specific industry or operational expertise may also be important in choosing a director. In fact, direct investing by families often occurs in industries or areas in which the family has particular history or expertise. In these cases, the company looks to the family designee to bring additional industry insight and experience to the board of directors.

Duty of Loyalty and Good Faith. The duty of loyalty requires directors to act in good faith and in the best interest of the company. The best interest of the company must take precedence over any interest of a director not otherwise generally shared by the shareholders. They may see themselves as the "eyes and ears" of the family on the board; however, in their capacity as a director, the family designee owes duties to all shareholders—not just to the family. Complicating matters, if they are an officer or director of the family investor or other family entities, the family designee will also owe fiduciary duties to those entities as well.

When acting in their capacity as a director, the family designee must have the practical ability to exercise their judgment freely. They should not be restricted by a voting agreement, contract or other arrangement with the family to vote in a particular way. Their compensation with the family investor or family office should not be tied to the individual acting or voting a certain way when acting as a director. There should not be any economic bonus or penalty attached to the director voting in a particular manner.

A director cannot give a proxy to another person to vote on their behalf as a director. By contrast, stockholders typically can give voting proxies; a director, though, must exercise their own judgment when voting in such a capacity.

Conflicts of Interest. Once on the board, a family designee must regularly evaluate to determine whether he or she has a conflict of interest in making corporate decisions, which inevitably make a director more susceptible to a breach of the duty of loyalty. Beyond the impact to the individual director, broader governance implications exist for the company and the board if a decision is not made by a majority of independent directors. Under the "business judgment rule" courts generally give deference to business decisions made by the board in a deliberate and informed manner. In a conflict situation, however, courts will not review the decision under the "business judgment rule" but will look to a stricter standard under the "entire fairness test."

Determining whether there is a conflict of interest is fact-specific. Some conflicts are easily identified; others are not. Close attention should be paid to the personal and economic relationships the director may have—directly or indirectly—with the parties involved in a decision before the board. Having an economic interest in the transaction or getting a financial benefit from the transaction are important factors determining whether a conflict exists. Personal and professional relationships can also create a conflict of interest, which can be particularly complicated for family designees.

Once a potential conflict is identified, the director and the board need to determine how the conflict will impact the director and the balance of the board's decision making on the issue giving rise to the conflict. The director will need to disclose and discuss the conflict with the board, and the board should tailor its response after careful review and consideration of the facts and circumstances creating the conflict. For example, the board may establish procedures to have the disinterested directors evaluate and approve the proposed company decision; the board may also consider establishing a committee to review potential conflicts of interest. Depending on the scope and severity of the conflict, the board and the director may choose to have the director abstain from voting on the matter or recuse themselves from the board's deliberation. If the conflict is severe enough and ongoing such that it could impact all of the director's decisions, the conflicted director may need to resign from the board and the family investor choose another designee.

Indemnification and Insurance. Due to the potential liability in serving as a director, companies typically offer indemnification to their directors. Indemnification protection for directors is generally described in the company's governing documents. In addition, directors may also enter into separate indemnification agreements with the company. The company may also have a directors and officers (D&O) insurance policy covering claims against the company's directors, subject to certain exclusions; however, indemnification protection may be limited by law for breaches of the duty of loyalty and good faith. In those cases, the family designee will not be able to rely on the indemnification provisions in the company's governing document, insurance policy or separate indemnification agreement.

When designating a director, the family investor and the family designee should closely review the indemnification provisions in the company's governing documents, the company's D&O insurance policies and consider whether to negotiate a separate indemnification agreement or otherwise enhance the indemnification protections.

Confidentiality. The interplay of various confidentiality obligations the family designee may owe presents another complicated area for family designees serving on a board. Regarding a corporation, its directors generally have a duty not to disclose confidential information of the corporation. As to the family and possibly complicating matters, the family designee may also owe multiple duties to maintain confidentiality to the family investor and other family entities that may be hard to satisfy simultaneously.

As a practical matter, the competing confidentiality obligations can put the family designee in a difficult position. On the company side, the family designee may need to disclose company information to the family investor. On the family side, however, the family designee may need to disclose to the company information about the family investor or other family relationships, in particular when disclosing and describing conflicts of interest to the board.

To help give guidance, a company may adopt disclosure policies or other processes for information sharing between a family designee and the family investor. The family investor and the company can also enter into an agreement allowing the family designee not to disclose any family investor information and to recuse themselves without explanation from any board discussion in which disclosure would otherwise be required.

Conclusion

Designating a director is an essential and common protection for family investors making direct investments. However, the legal and practical implications of serving as a family designated director are complicated and require careful review both at the time of appointing the family designee and throughout the family designee's tenure as a director and the family investor's direct investment.

Direct Investing: Considerations When Serving As A Family-Designated Director

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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