Overview and Practical Key Takeaways
Nominee directors are central to private equity: significant investors in a portfolio company expect to have strategic input into the company's business.
But nominee directors can also face potential conflicts of interest in certain circumstances. The recent ruling of the Delaware Court of Chancery in Manti Holdings provides an example in the context of the sale of a portfolio company near the end of a private equity fund's term.1 We explore the ruling and highlight what nominee directors in Canadian portfolio companies should know.
Our key practical takeaways include:
- The ruling sets a high bar for when a fund seeking to liquidate its interest in a portfolio company to timely distribute funds to its investors might create a potential conflict of interest for a nominee director of the fund on the company's board.
- That the private equity business model incentivizes funds to timely liquidate their interest in portfolio companies to close a fund and pay investors on schedule is insufficient to demonstrate a potential conflict of interest. Specific evidence that meaningful pressure was exerted on a nominee director towards this end is needed.
- The fiduciary duties of nominee directors in Canada differ somewhat from those in Delaware. Nonetheless, the ruling and facts in Manti Holdings remain both insightful and instructive in the Canadian context.
Our detailed comments follow. For more Fasken M&A thought leadership, visit our Capital Markets and M&A Knowledge Centre and subscribe. See also Fasken's Private M&A in Canada: Transactions and Litigation (LexisNexis, 2024).
The Exit Sale
The portfolio company (PortCo) was in the business of fraud and counterfeiting prevention. Its product was innovative, but its performance was inconsistent due to a small client base (consisting principally of foreign governments) with volatile demand.
At the time of PortCo's sale in September 2017, the private equity fund (PE Fund) was its majority owner. The PE Fund also had two nominee directors on PortCo's board. The plaintiffs were a group of minority owners of PortCo, one of which also had a nominee director on PortCo's board.
PortCo's board initiated a sale process in 2016, and this led to the sale of PortCo in September 2017. PortCo faced several business challenges during this time, including the non-renewal of certain significant contracts by select counterparties.
The sale was approved by four of the five directors on PortCo's board, including the two nominees of the PE Fund. The fifth director – the nominee of one of the plaintiffs – abstained from the vote. His position was that the sale price undervalued PortCo and that the sales process should be deferred 12 months to allow its business to rebound.
The Plaintiffs' Claims
The plaintiffs brought two related claims, including that the two nominee directors of the PE Fund had breached their fiduciary duty to PortCo.2 Each of the two nominee directors were also officers or directors of the PE Fund. The key question for the court was whether the transaction gave rise to a conflict of interest on their parts.
The plaintiffs argued that such a conflict had arisen, and their basis was that the PE Fund's 10-year term was set to expire on September 30, 2017, i.e., shortly after the sale of PortCo closed on September 13, 2017. They argued that the sale of PortCo had not been driven by what was in the company's best interests, but what was in the best interests of the PE Fund; specifically, the desire for the PE Fund to liquidate its interest in PortCo to facilitate the timely distribution of proceeds to the PE Fund's investors.
As evidence, the plaintiffs highlighted that PortCo was the largest of the three remaining portfolio companies owned by the PE Fund at the time of its sale. The plaintiffs also highlighted evidence that one of the PE Fund's nominee directors had allegedly communicated to the abstaining nominee director that he (the PE Fund's nominee director) was under pressure to sell PortCo so that the PE Fund could monetize, close and distribute funds to its limited partners.
The Court's Ruling
The court did not agree that a conflict of interest had arisen, and its reasoning was twofold. First, it disagreed with the plaintiffs that the general business model of private equity was such that the PE Fund "thought it necessary to sell [PortCo] immediately, consequences (and price) be damned".3 Second, it underscored several elements of the particular circumstances of PortCo's sale that undercut the plaintiffs' argument that the PE Fund was motivated to conduct a "fire sale" of PortCo.4
The Business Model of Private Equity
In support of its argument that the general business model of private equity incentivized the PE Fund to prematurely sell PortCo, the plaintiffs presented expert evidence. The expert testified the "pressure" felt by the PE Fund to sell PortCo by September 2017 arose from the "well-understood expectations" of the fund's investors.5
The expert opined that, in private equity, "[l]imited partners always want to know where they stand vis-a-vis liquidity" and that "not returning funds on a timely basis... can be a black mark... to secure commitments for a new PE fund", while returning capital on a timely basis is "a five-star rating."6 The plaintiffs also relied on textbook commentary that a private equity firm's "ability to achieve timely and profitable exits reliably across multiple funds is a key measure of success applied by financial market players; it allows the PE firm... to approach... institutional investors again for future fundraising."7
The court was not persuaded. It held that a "standard ten-year fund life" only "indicates an intent to exit investments, profitably, on that general time-frame."8 This was "insufficient" to "demonstrate specifically" that the expectations of the PE Fund's investors were such that the PE Fund caused its nominee directors to "run a fire sale".9 More specific evidence of investor pressure was needed. The court elaborated:
To prove a liquidity-driven conflict... it is not enough to show a general interest in investors that a fund adhere to a timeline; a plaintiff must show sufficient evidence "of a cash need" that explains why "rational economic actors have chosen to short-change themselves." "[S]weeping characterizations" of the "industry writ large" are insufficient. And the private equity lifecycle "is not so formulaic and structured that the cycle itself [can] support an inference of a liquidity-based conflict."10
The court added that mere "investor requests for updates on fund performance and potential exit timing" did not amount to investor pressure to liquidate.11 It concluded that the PE Fund was a "bog-standard equity-fund investment vehicle, and there was no 'pressure' for a quick exit beyond that inherent in the business model itself."12
The Particular Circumstances of the Exit Sale
Nor did the particular circumstances of the sale of PortCo support the plaintiffs' contentions. While the court accepted that the facts demonstrated that the PE Fund wanted to sell PortCo, they did not demonstrate that the PE Fund needed to sell PortCo. The court highlighted five points.
- As PortCo's largest shareholder, the PE Fund had an "an inherent economic incentive to negotiate a transaction that would result in the largest return for all shareholders."13
- Nothing in the PE Fund's limited partnership agreement compelled the sale. The fund's ten-year term "did not impose a deadline for selling its portfolio of companies."14 Rather, the fund was entitled to continue to hold investments after termination (as the PE Fund had elsewhere done). The PE Fund could also extend the term to permit additional investment in portfolio companies (as the PE Fund had also elsewhere done).
- While PortCo was the largest portfolio company remaining in the PE Fund, two others also remained at the time. Moreover, extending the fund's term had been considered since August 2017 and prior to the sale of PortCo, and such an extension in fact occurred following PortCo's sale.
- The fact that the PE Fund's investment advisory committee, which was comprised of representatives of the majority of the fund's investors, approved the extension of the fund's ten-year term evidenced a lack of investor pressure to liquidate.
- The sale of PortCo was the culmination of a "comprehensive marketing and sales process" that had taken a "full year."15 A total of 127 potential buyers had been contacted. This outreach yielded 18 "fireside chats" with potential buyers. Six potential buyers submitted indications of interest.16 Two potential buyers submitted bids. There was no indication (a) of a failure to contact logical buyers, (b) that too few buyers had been contacted, or (c) of a refusal to work with any particular buyer.
The court viewed each of these as evidence against liquidity pressure. The aggregate result was that the "record demonstrate[d] that [the PE Fund] was interested in moving quickly because of the volatility of [PortCo's] business rather than due to liquidity pressure because of the fund life."17 The breach of fiduciary duty claims against the PE Fund's nominee directors were therefore dismissed.
Key Practical Takeaways for Nominee Directors in Canada
The ruling of the Delaware Court of Chancery in Manti Holdings sets a relatively high bar that will be welcomed by private equity nominee directors both north and south of the border. That said, it should be appreciated that the fiduciary duties of nominee directors in Canada differ somewhat from those in Delaware.18
- In Canada, directors owe fiduciary duties to the corporation and not to any other entity or person.
- Directors can take into account the interests of stakeholders in the corporation, such as shareholders, but should a conflict between the two arise, a director's duties in respect of the corporation are always owed solely to the corporation, and in this regard, the interests of the corporation must prevail.
- This standard does not change in the instance of a nominee director appointed by a shareholder with expectations of meaningful input into business strategy. Indeed, Canadian courts have expressly recognized that this can sometimes put nominee directors in a difficult position.19 Should a nominee director in Canada find themselves in a conflict of interest, they must declare the conflict and abstain from voting on (or other decision-making regarding) the matter.20
- A notable exception to the foregoing as relates to nominee directors is in Alberta, where s.122(4) of the Business Corporations Act provides: "In determining whether a particular transaction or course of action is in the best interests of the corporation, a director, if the director is elected or appointed by the holders of a class or series of shares or by employees or creditors or a class of employees or creditors, may give special, but not exclusive, consideration to the interests of those who elected or appointed the director."
- A common practice in Canada that mitigates the risks of a potential conflict of interest for nominee directors in a context similar to Manti Holdings is the provision of approval rights to the private equity fund regarding the sale of the portfolio company that are separate and distinct from the portfolio company's board approval. The private equity fund having such an approval right means that, even if a conflict (perceived or real) requires a nominee director to abstain from voting, the private equity fund maintains a veto. In other words, proper drafting and structuring can anticipate and mitigate the risk that manifest in Manti Holdings.
In total, as in Delaware, potential conflicts of interests are possible in Canada should the nominee director of a private equity fund face pressure from the fund or its investors to liquidate its interest in a portfolio company in advance of the fund's term where such a sale is arguably not in the company's best interests. Should such a situation arise, it should be navigated carefully with appreciation of the nuances of Canadian corporate law.
Footnotes
1. See [i]Manti Holdings, LLC v. Carlyle Group Inc.[/i], 2025 Del. Ch. LEXIS 3 [[i]Manti Holdings[/i]]
2. The second, related claim, was that the PE Fund, as a controlling shareholder, had breached its fiduciary duties to PortCo and its other shareholders. As Canadian corporate law does not include the same notion of a controlling shareholder as exists under Delaware corporate law, we do not discuss this aspect of the claim further.
3. [i]Manti Holdings[/i] at *31.
4. [i]Manti Holdings[/i] at *3 and *38.
5. [i]Manti Holdings[/i] at *43.
6. [i]Manti Holdings[/i] at *44.
7. [i]Manti Holdings[/i] at *44.
8. [i]Manti Holdings[/i] at *44.
9. [i]Manti Holdings[/i] at *44.
10. [i]Manti Holdings[/i] at *44-45.
11. [i]Manti Holdings[/i] at *41.
12. [i]Manti Holdings[/i] at *3.
13. [i]Manti Holdings[/i] at *39.
14. [i]Manti Holdings[/i] at *40.
15. [i]Manti Holdings[/i] at *45-46.
16. [i]Manti Holdings[/i] at *46.
17. [i]Manti Holdings[/i] at *46
18. For further discussion, see Fasken's recent article in [i]The M&A Lawyer[/i] entitled "Nominee Directors in Shareholder Activism, Private Equity and Venture Capital
19. See [i]820099 Ontario Inc. v Harold E. Ballard Ltd.[/i], [1991] O.J. No. 266 at para. 107: "It may well be that the corporate life of a nominee director who votes against the interest of his 'appointing' shareholder will be neither happy nor long.
20. This principle may also require the director to leave the meeting where the matter giving rise to the conflict of interest is being discussed, e.g., to avoid influencing the decision.
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.
