Sitting in between two chairs or wearing two hats at the same time. Regardless of the expression used, being a nominee director can be a balancing act.
Nominee directors are a central feature of the private equity, venture capital and hedge fund landscapes: where an investor acquires a significant percentage of a company, it typically seeks representation on the company's board. And there is nothing intrinsically wrong with this, as courts in Canada and elsewhere have confirmed.
However, nominee directorships also carry the potential for conflicts of interest. Specifically, the risk of the loyalty of the nominee director being divided (or appearing to be divided) between, on the one hand, the company on whose board the director serves and, on the other hand, the nominating shareholder.
A recent series of Delaware decisions highlights this tension, and provides a reminder of the duties and potential liabilities of nominee directors. They also provide an opportunity for practical guidance regarding how to mitigate risks arising in the nominee director context, including amid M&A transactions. Finally, they highlight that Canada is not Delaware and that U.S. investors should appreciate the different playing field regarding fiduciary duties north of the border.
Fiduciary Duty Disputes Developing in Delaware
A notable aspect of the three recent Delaware decisions reviewed in this article is that they feature several common themes related to potential conflicts of interest in the nominee director context. These are:
- M&A decision-making alleged to be driven not by the best interest of the company but by the objectives of the nominating shareholder.
- Judicial concern that repeat nominee directorships may inherently give rise to conflicts of interest.
- Judicial concern with "dual fiduciaries", i.e., where the nominee director is a fiduciary both of the company and within the nominating shareholder's wider corporate group.
Altogether, these decisions evidence an incremental intensification of the scrutiny courts (at least in Delaware) are applying to nominee directors, to their relationship with their nominating shareholders, and/or to the business models (and routine tactics) of their nominating shareholders.
We are not yet aware of similar rulings in Canada, however, recent years have seen several noteworthy Canadian fiduciary duty disputes amid private equity and venture capital structures. For more insight on these disputes, please refer to our previous Capital Markets and Mergers & Acquisitions Bulletins:
- Fiduciary Duties in Private Equity: What Sponsors and LPs Should Know
- Derivative Actions in Private Equity? Recent Caselaw from BC and Ontario
- Fiduciary Duties and Private Equity LPAs: What Have Courts Said?
Manti Holdings v Carlyle Group: not so fast with that quick sale
Manti Holdings v Carlyle Group is a cautionary tale regarding a shareholder placing greater priority on accessing capital than on accumulating it where this creates misalignment between the shareholder's interests and those of the broader shareholder base, as well as the company's best interests. Specifically, in June 2022 the Delaware Court of Chancery upheld claims alleging a conflict of interest where the sale of a portfolio company appeared driven by the need to wind up the private equity fund that was the company's majority shareholder.
Evidence toward this end included one nominee director stating during sales negotiations that he was "under pressure to sell [the company] because it was one of the last investments still open in the applicable fund, and it was time for [the sponsor] to monetize and close that fund so the money could be returned to investors." Another nominee director, who was also the company's CEO, had allegedly stated during negotiations that he "worked for" the private equity sponsor and "had been told to sell the company."
The Court of Chancery upheld individual breach of loyalty claims against each of the three nominee directors appointed by the private equity sponsor. Notably, for two of these nominee directors a key consideration was that they were "dual fiduciaries", serving as directors of the portfolio company and also as officers of other entities within the private equity sponsor's larger corporate group. While this was not necessarily problematic on its own, conflict of interest arose from the terms of the sale and the differing interests of the private equity sponsor as compared to the company and its minority shareholders. The Court also indicated it would have expected the board to have formed a special committee to insulate the sales process from the nominee directors' influence. What occurred, however, was both the participation of the two directors throughout the sales process as well as them voting to approve the sale.
Goldstein v Denner: an activist's short-term "playbook" criticized by the court
Unlike in Manti Holdings, the dispute in Goldstein v Denner arose in the context of a publicly traded company that was the target of a single-bidder sales process. Similar to Manti Holdings, however, in May 2022 the Delaware Court of Chancery held that it may be a breach of the duty of loyalty for nominee directors to push for the sale of the company when motivated by the nominating shareholder's interest in redeploying capital. In particular, the Court indicated that a desire for liquidity may create a disabling conflict even if the investor doesn't have an "exigent need" for liquidity but simply wants to "redeploy" capital to a "different investment option".
The Court of Chancery also indicated that a nominee director acting in accordance with an activist hedge fund's short-term "playbook" could give rise to a disabling conflict of interest. In this case the "playbook" was alleged to consist of the director, first, pressuring the public company into appointing him to the board by threat of proxy contest, second, then recruiting allies onto the board in the form of the hedge fund's insiders or roster of nominee directors, and third, then forcing a near-term sale of the company in line with the hedge fund's short-term investment horizon. Once again, the focus here was on the investment preferences of the nominating shareholder driving the director's M&A decision-making rather than the best interests of the portfolio company.
Finally, the court indicated that nominee directors appointed by such "repeat players" as hedge funds may be inherently non-independent. Specifically, the court observed that they may be inappropriately influenced by the drive for "future opportunities" in the form of subsequent additional board seats. In so doing the Court referred favourably to recent academic thinking recommending that "courts move towards a more nuanced doctrine for analyzing independence which takes into account the ability of [venture capital and private equity firms] who are repeat players and who have a wide base of investments to influence nominally independent directors through rewards."
Delman v GigAcquisitions3: purposefully inadequate disclosure for greater deal certainty
At issue in Delman v GigAcquisitions3 was whether the directors of a special purpose acquisition company (SPAC) company breached their fiduciary duties by disloyally depriving the SPAC's public shareholders of information material to their decision on whether to redeem their shares in connection with the de-SPAC transaction or to invest in the merged entity. The alleged disclosure violations included the acceptance by the board of "an inflated valuation for [the target] built on unrealistic revenue and production projections", which "misinformation" was passed along to shareholders, without obtaining a fairness opinion or even an informal presentation on the fairness of the transaction. By doing so, the directors "could discourage redemptions and ensure greater deal certainty."
In January 2023 the Delaware Court of Chancery allowed the plaintiff's claims, and in so holding highlighted indications that the SPAC directors lacked independence from the sponsor, pointing to numerous affiliations between the directors and the sponsor such as employment with a sponsor-related entity and past or current directorships on other sponsor-related entities. On the latter point, the Court stated that it was "reasonably inferable that these directors would expect to be considered for directorships in companies – such as other SPACs – that [the sponsor] launches in the future." The Court summarized that the "totality of these relationships provides ample reason to doubt... that any of the [directors] qualify as independent of [the sponsor]."
Practical Takeaways and Best Practices – Part 2, Coming Soon
What are the key takeaways from Manti Holdings, Goldstein and Delman for private equity, venture capital and hedge fund investors and their nominee directors in Canada?
As mentioned above, the overall lesson is that Delaware courts may be inclined to apply increased scrutiny to nominee directors, to their broader relationship with their nominating shareholder, and/or to the business models (and routine tactics) of their nominating shareholders, including in the M&A context.
We are not yet aware of similar rulings in Canada, but as discussed in our previous bulletins (Fiduciary Duties in Private Equity: What Sponsors and LPs Should Know, Derivative Actions in Private Equity? Recent Caselaw from BC and Ontario and Fiduciary Duties and Private Equity LPAs: What Have Courts Said?), recent years have seen several noteworthy Canadian fiduciary duty disputes amid private equity and venture capital structures. Prudence may therefore be warranted in Canada, including as U.S. litigation trends have in the past proven capable of migrating north of the border.
Don't miss (subscribe) for the second part of this series, coming soon, where we pivot to the practical takeaways and best practices these Delaware decisions raise and that nominee directors and their nominating shareholders can employ to mitigate the risks of potential divided loyalties (or the appearance of potential divided loyalties) in the nominee director context. Also, for U.S. investors into Canada, we highlight how Canada differs from Delaware regarding fiduciary duties, both generally and as applies to nominee directors.
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.