United States: Fiduciary Duties and the Venture Capital Director

Co-written by Edward Schauder. Elisabeth Neuberg, a 3L intern assisted in the preparation of this article

Originally published in New York Law Journal, December 3, 2001

Over the last eighteen or so months, the business environment has placed increased pressure on venture capitalists that serve on the boards of their privately held portfolio companies. Not only have directors had to assume a more active role, but stockholders are more closely watching the actions that directors take.

Venture capitalist directors have the same fiduciary duties as other directors of privately held companies. However, they are more likely to be conflicted than other directors given their dual role as directors and portfolio managers. In addition, practically speaking, venture capitalist directors are the most likely target of breach of fiduciary duty claims. Market terms for follow-on rounds have become more onerous, in some cases washing out earlier rounds of financing. In addition, as a result of the liquidation preference that venture investors receive, other stockholder constituencies may receive little or nothing upon a sale or wind-down of the company. In these instances, most of the ire of other stockholders is reserved for the venture capitalists. Furthermore, the venture capitalist directors often are perceived as having the deepest pockets, both personally and as a result of supplemental directors' and officers' liability insurance maintained by their fund to cover claims at the portfolio company level.

Corporate directors, including venture capitalist directors, owe two fiduciary duties to the corporation and its stockholders: a duty of care and a duty of loyalty. A director's fiduciary duties are determined by the laws of the state of incorporation, and the scope of these duties varies from state to state. Since the vast majority of venture-backed companies are incorporated in Delaware, for purposes of this article, we will focus on Delaware law.

In Delaware, like in most other states, there are no "bright-line" definitions of the duty of care and the duty of loyalty. The standards have evolved from case law under circumstances that are highly fact specific. To further complicate matters, cases sometimes can be hard to reconcile with each other.

Duty of Care

Under Delaware law, directors are required to exercise "that amount of care which ordinarily careful and prudent men would use in similar circumstances."¹ The duty of care is comprised of two components: (i) care in the decision-making process; and (ii) care in overseeing the conduct of employees and advisors.

Decision-Making. This component of the duty of care has evolved in various cases over the years. Perhaps the most well-known decision in this area is Smith v. Van Gorkom.² In Van Gorkom, the court held that the duty of care mandates that directors make an informed decision based on all material information reasonably available to them and that they critically assess information. In Van Gorkom, the court concluded that in this regard the board members were grossly negligent and had thus breached their duty of care. Van Gorkom, the chairman of Trans Union Corporation, had unilaterally negotiated the sale of Trans Union and presented the proposal to the board in a 20-minute presentation. Thereafter, the board deliberated for only 90 minutes before approving the plan. During this process, the board did not consult with outside counsel and the only evaluation of the purchase price was made at the last minute by an internal officer of the company. The court concluded that the directors were personally liable for their actions, although the case was settled before damages were determined.

Consistent with the principles set forth in Van Gorkom, other Delaware cases have raised issue with hastily-called meetings.³ An "aura of inevitability" to a board meeting also has been held to run counter to Van Gorkom.⁴

In reaching a decision, directors are not required to do all the leg work. Section 141(e) of the Delaware General Corporation Law⁵ that a director will be fully protected in relying in good faith upon the records of the corporation and information, opinions, reports or statements presented by officers and employees of the corporation, a committee of the board or other persons as to matters that the board member reasonably believes are within such other person's professional or expert competence, so long as such other person was selected with reasonable care by or on behalf of the corporation.

Oversight. Directors also are permitted to delegate to and rely on corporate officers and experts in other contexts, including the implementation of board decisions. The board must however oversee and investigate the conduct of corporate employees and advisors and exercise reasonable care to see that management fulfils its responsibilities in compliance with law. The duty of oversight does not require directors to seek out misconduct absent specific warning signs, although it does require them to conduct adequate and necessary inquiries where suspicions of misconduct should be, or are, aroused.⁶

Limiting Director Liability. Ordinarily, directors are personally liable for breaches of the duty of care. Section 102(b)(7) of the DGCL⁷ permits Delaware companies, in their charter, to limit or eliminate the personal financial liability of the directors for breaches of fiduciary duty, except in circumstances involving: (1) a breach of the duty of loyalty; (2) acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; (3) liability under Section 174 of the DGCL, which pertains to liability of directors for unlawful payments of dividends or unlawful stock purchases or redemptions; or (4) any transaction from which the director derived an improper personal benefit. Typical market practice in charters of venture-backed companies is to eliminate, rather than limit, this liability to the fullest extent possible.

Section 102(b)(7) of the DGCL does not, however, obviate the need to properly discharge the duty of care. A stockholder still can seek an injunction or rescission of a transaction involving a violation of the duty of care. Therefore, even though a director may not have personal liability for a breach of the duty of care, the breach can nevertheless have significant consequences.

Business Judgment Rule. The business judgment rule provides an additional level of protection for directors, even if a decision turns out to be poor in hindsight. The rule establishes a presumption in favor of directors that they have acted properly in their decision making process and a plaintiff challenging a business decision bears the difficult burden of rebutting the presumption.⁸

The board must satisfy several criteria to be protected by the business judgment rule. First, the decision cannot be tainted by a conflict of interest. Second, the directors must have acted or made a deliberate decision not to act. Third, the directors must have considered all material information reasonably available to them. Finally, the directors' decision must be based on a good faith belief that it is in the best interests of the corporation. If the requirements of the business judgment rule are not satisfied, it typically is incumbent upon the directors to show that the transaction passes muster under the "entire fairness" doctrine, which is discussed below.

Duty of Loyalty

The duty of loyalty is implicated when a director stands on both sides of a transaction, commits a fraud or personally benefits from a transaction. Because the corporate charter often exculpates directors from personal liability for breaches of the duty of care, claims against directors often also allege a breach of the duty of loyalty.

For venture capitalist directors, navigating the duty of loyalty can be especially tricky. For example, board approval may be sought for a follow-on round which the venture capitalist director's fund will lead. Approval also may be sought to merge a struggling portfolio company with another company in the venture capitalist's portfolio, or to enter into a significant commercial relationship with another portfolio company.

However, a venture capitalist director is not ordinarily an interested director for purposes of a proposed transaction unless the director has an interest that is material beyond that of a stockholder. Thus, a venture capitalist director does not become an interested director merely because his or her fund owns preferred stock of a corporation on whose board he or she sits.

Section 144 of the DGCL⁹ provides a safe harbor for interested director transactions. If the safe harbor is satisfied, stockholders cannot seek to void the transaction. In order to invoke this safe harbor, any of three requirements must be satisfied: (1) the material facts as to the director's interest, and of the transaction generally, are disclosed to the board, and the transaction is approved in good faith by the disinterested members of the board; (2) the material facts as to the director's interest and of the transaction are disclosed to the corporation's stockholders and such transaction is approved by the stockholders in good faith; or (3) the transaction is fair to the corporation as of the time it is authorized, approved or ratified, by the board, a committee or the stockholders. The first approach is most commonly taken in transactions where a venture capitalist is an interested director.

Satisfying the safe harbor of Section 144 does not necessarily insulate a venture capitalist director from liability; it only means that courts will not void the transaction. The transaction still must pass muster under the "entire fairness" doctrine. The entire fairness doctrine has two elements: (1) fair dealing; and (2) fair price. The fair dealing component focuses on when the transaction was timed, how it was initiated, structured, negotiated, disclosed to directors and how the approvals of directors and stockholders were obtained. Elements of fair price include the economic and financial considerations of the proposed transaction, including assets, market value, earnings, future prospects and any other elements that affect the intrinsic or inherent value of a company's stock.¹⁰

If the safe harbor of Section 144 is satisfied, for the directors to have liability for a breach of the duty of loyalty, the plaintiff stockholders typically must show that the transaction does not pass muster under the entire fairness doctrine. If the requirements of Section 144 are not satisfied, the burden of proof generally shifts to the directors to demonstrate the entire fairness of the transaction.

Fiduciary Duties and M&A Transactions

In the context of a sale of control or a break-up of the corporation, the fiduciary duty analysis is somewhat different. Rather than applying the business judgment rule, Delaware courts instead apply enhanced judicial scrutiny to the transaction. The directors are obligated to seek the transaction offering the highest value reasonably available to the stockholders.¹¹ However, directors have substantial latitude over the sale process and do not necessarily have to accept the transaction with the highest nominal price. Instead, the directors must show that, in reaching their decision, they were in good faith, adequately informed and acted.¹² In addition, the directors must show that their decision was based on a "body of reliable evidence."¹³

Venture Capital Cases

Although rare, there have been a few highly publicized cases involving alleged fiduciary duty breaches by venture capitalist directors. In Orban v. Field, ¹⁴ a 1997 Delaware Chancery Court case, common stockholders of Office Mart Holdings Corp. objected to a stock-for-stock merger with Staples in which they would receive no consideration. Prior to the merger, Office Mart's board, which was controlled by its venture capital investors, approved and completed a recapitalization in which debt owed to Office Mart's venture capital investors was cancelled in exchange for the issuance to them of additional preferred stock and common stock. The board, also facilitated the exercise of additional warrants held by the venture capitalists. These two steps substantially diluted the ownership of Orban, Office Mart's founder and largest stockholder, effectively preventing him from blocking the merger, which required approval of the holders of over 90% of the common stock.

Orban alleged that since the venture capitalists controlled the board, their director designees had breached their duty of loyalty by taking actions to dilute his common stock interest. The court ruled against Orban. In Orban, the merger consideration was insufficient to satisfy the preferred stockholders' liquidation preference. This placed the board in the position of deciding whether it would support Orban's effort to extract value from the preferred stockholders' position or whether it would seek to consummate the merger, which it believed to be the transaction at the highest available price. The court noted that the burden was on the defendant directors "to show that their conduct was taken in good faith pursuit of valid ends and was reasonable in the circumstances." ¹⁵ The court held for the defendants; concluding that the board's conduct was "measured and appropriate in the circumstances."¹⁶

The other widely quoted breach of fiduciary duty case in the venture capital context is what is commonly referred to as Alantec. Although a California case, rather than a Delaware case, it deserves mention here because of the frequency with which it is cited. In 1994, Kalasian v. Advent VI L.P. ¹⁷ was filed in Santa Clara, California. Among other things, a claim alleging breach of the duty of loyalty was brought by the founders of Alantec Corporation against the board representatives of Alantec's venture capital investors. The suit arose out of a down-round financing and the issuance of common stock to new corporate officers that substantially diluted the founders. Although Alantec was near bankruptcy at the time of the share issuances, it recovered and was sold in 1996 to FORE Systems for $770 million. The value of the founders' equity at the time of the acquisition was worth only $600,000, and they asserted that, but for the dilutive issuances, their stock would have been worth over $40 million. After an 18-day trial, the case was reportedly settled for $15 million, so a decision on the merits of the case was never reached.

Fiduciary Duties to Creditors

One final aspect of fiduciary duty law that is increasingly being faced by venture capitalist directors bears mentioning. When a company is insolvent or nearing insolvency, directors owe their primary duty to creditors rather than to stockholders and are charged with preserving asset value for eventual distribution to the creditors. A debtor is "insolvent" when its liabilities exceed its assets at a fair evaluation ¹⁸ or if it lacks sufficient property to pay its existing debts as they mature.¹⁹ Directors' actions are judged by a trustee standard after insolvency ensues, rather than by the business judgment rule and directors may be subject to personal liability for harm to creditors resulting from mere negligence. Under the trustee standard, directors are required "to exercise such care and skill as a man of ordinary prudence would exercise in dealing with his own property."²⁰

Accordingly, as a portfolio company's financial situation deteriorates, venture capitalist directors must be even more sensitive to the discharge of their fiduciary duties. The risk of breach of fiduciary duty claims by creditors of venture-backed companies has increased over the last few years as the dollar magnitude of outsourcing and consulting arrangements and capital commitments entered into by these companies has increased.

1. Graham v. Allis-Chalmers Mfg. Co., 188 A.2d 125, 130 (Del. 1963).

2 Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).

3. See, e.g., Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983).

4. EAC Indus., Inc. v. Frantz Mfg. Co., C.A. No. 8003 (Del. Ch. 1985), slip op. at 20-21.

5. Del. Code Ann. tit. 8, § 141(e) (2001).

6. In re Caremark Int'l Inc. , 698 A. 2d. 959 (Del. Ch. 1996).

7. Del. Code Ann. tit. 8, § 102(b)(7) (2001).

8. Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1985).

9. Del. Code Ann. tit. 8, § 144(a)(1)-(3) (2001).

10. Weinberger, 457 A. 2d at 711.

11. See, e.g., Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A. 2d 173, 182 (Del. 1985); Mills Acquisition Co. v. Macmillan, Inc., 559 A. 2d 1261, 1288 (Del. 1989).

12. Paramount Comm. Inc. v. QVC Network Inc., 637 A. 2d 34, 43-44 (Del. 1994).

13. Mills, 559 A. 2d and 1286 (citing Barkan v. Amsted Indus. , 567 A. 2d 1279 (Del. 1989)).

14. Orban v. Field, 1997 Del. Ch. Lexis 48.

15. Id. at *29.

16. Id. at *32.

17 Case No. CV739278 (Sup. Ct. Santa Clara Co., Cal. Filed March 23, 1994)

18. 11 U.S.C. § 101(32).

19. Tcherepnin v. Franz, 457 F. Supp. 832 (N.D. Ill. 1978).

20. Scott, The Laws of Trusts, 174, at 466 (4th ed. 1987).

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© 2001 Schulte Roth & Zabel LLP