Strategic Investor Rights, Shared Risks: Governance Requirements When Interests Diverge

In a recent Delaware Court of Chancery opinion¹, Vice Chancellor J. Travis Laster examined the limits of strategic investor rights, upholding pleading-stage claims against an investor and its board designee. The claims arose out of an alleged scheme to utilize contractual governance and veto rights to access a start-up's technology, force the start-up to effectively shut down, and obtain a competitive advantage by an investor. Zync reaffirms the propriety of strategic investor relationships, but serves as a cautionary tale for both sides, highlighting the limits of contractual governance rights and the risks absent an alignment of interests.

Background: the investment and breakdown in alignment

Zync Inc. was a Delaware corporation that provided cloud-based video streaming and on-demand content for in-vehicle entertainment. In 2020, the investment arm of an international automotive manufacturer (the “Investor”) made a strategic investment in the company, and agreed to invest $2.9 million in the form of a convertible note with proceeds to be advanced in five tranches. As part of the investment, the Investor also received 305,430 shares of Zync common stock (a 5% equity stake.)

In connection with the investment, Zync and the Investor also entered into a voting agreement, fixing the size of the Zync board of directors at three (one of whom was to be designated by the Investor so long as the Investor held at least 2% of Zync common stock), and an investor rights agreement which gave the Investor board designee veto rights on a range of board decisions (including, among others, issuing equity or convertible securities, issuing debt security, increasing or decreasing the board size and modifying officer compensation). The investor rights agreement also gave the Investor a right of first offer on future securities issuances. The Investor appointed one of its employees as its board designee, to serve along with Zync’s founder and CEO and one other director on the board.

The complaint asserted that, from early on, the Investor allegedly frustrated Zync’s efforts to obtain necessary liquidity and capital and allegedly delayed multiple note advances, requiring Zync to obtain a €350,000 bridge loan from a third party. Zync had entered into a strategic relationship with the Investor, despite interest from other automobile companies, in part because of the potential for a long-term business relationship. However, a year into the arrangement, the Investor decided not to use Zync’s product in its vehicles and instead to go with “another kind of concept.” As a result, Zync pursued business relationships with other automakers.

Zync alleged that, in need of capital to scale the business and to repay the bridge loan, the company entered into a term sheet with a venture capital fund that sought to lead a $10 million Series A financing round, at a $40 million pre-money valuation. Consistent with the veto rights in the investor rights agreement, the financing required the permission of the Investor board designee (who would not approve the deal without permission from his employer, the Investor). After months of discussions, the Investor board designee stated that he would vote against the financing, quashing the deal.

Around this time, and following improved prospects of several commercial agreements with other automakers, the Investor suggested that it could provide Zync a bridge loan to help with liquidity needs. Before agreeing to fund the loan, the Investor requested a copy of the draft commercial agreement and “highly confidential” internal data of the competitor automaker. After receiving the requested information, the Investor withdrew its initial offer. The Investor instead reduced the amount of the proposed loan and demanded another board seat and personal guarantee from the CEO, to which the CEO refused.

Another opportunity arose when a private equity firm offered to acquire the company for $50 million. Zync and the private equity firm entered into a term sheet, with the deal again contingent on the Investor board designee’s approval. After discussions with his employer, the Investor board designee stated that he would only approve the deal if the private equity firm agreed to indemnify the Investor and the board designee individually. The firm declined and the deal fell through.

The original bridge loan matured and when Zync could not repay, the Investor then decided to cut ties with the company, according to the opinion, and the Investor board designee resigned from the board. Zync was unable to revive the private equity deal allegedly in part because the private equity sponsor was concerned with a lack of cooperation from the Investor and its ongoing governance rights. By the end of 2022, Zync had effectively shut down.

Zync brought suit in Delaware’s Court of Chancery, asserting a range of claims, including (A) breach of fiduciary duty against the Investor board designee and aiding and abetting, (B) tortious interference, and (C) breach of the implied covenant of good faith and fair dealing against the Investor. In its complaint, Zync theorized that it had fallen victim to a “catch and kill” investment strategy, in which the Investor allegedly provides seed money to start-ups, gains access to proprietary technology, and then uses its investor rights to control and cause the start-up to shut down when it would be advantageous to the Investor.

The Court (Vice Chancellor J. Travis Laster) denied the Investor’s motion to dismiss, allowing all claims against the Investor and its board designee to proceed.

The court’s decision

Breach of fiduciary duty and aiding and abetting

In respect of the breach of fiduciary duty claim against the Investor board designee, the Court explained that it is permissible for a director to hold dual directorships or roles with other companies, so long as the entities’ interests are aligned. Where interests diverge, however, problems can arise because a director’s loyalties may be torn between the competing interests.

The Court rejected the argument that, as a Zync equity holder, the Investor’s interests and those of the company were inherently aligned. Although Delaware presumes investors will maximize the value of their investments, it was not clear to the Court that the Investor’s investment in Zync was material to it such that the presumption applied, and may be outweighed by other incentives, including obtaining a competitive advantage from accessing Zync’s technology while denying competitors access.

The Court also held that the complaint adequately alleged that the Investor board designee acted in bad faith, i.e., for a purpose other than in the best interests of the company. The Court found sufficient allegations to suggest the Investor board designee’s bad faith, including, as alleged, deferring to the Investor repeatedly, refusing to act without the Investor’s approval, and, after extracting confidential information, backtracking on the bridge loan. The Investor board designee’s “conscious inaction” in declining to vote for funding could constitute a breach of fiduciary duty.

To state a claim against the Investor for aiding and abetting, Zync had to allege the Investor’s “knowing participation” in its board designee’s fiduciary breaches. That required reasonably conceivable allegations that the Investor knew it and its board designee’s conduct was legally improper, and that the Investor’s assistance in the breaches was “substantial.” Given allegations that the board designee acted at the Investor’s explicit instruction, the Court found these elements satisfied. The Investor allegedly was aware that Zync was desperate for money and its board designee (and employee) would not approve the financings absent the Investor’s explicit direction. The Investor allegedly nonetheless instructed its board designee to vote against the financings to allegedly gain advantage over its competitors.

Tortious interference with the company’s economic advantage

The Court outlined the four elements of tortious interference: (1) a reasonable probability of a business opportunity; (2) intentional interference; (3) proximate cause; and (4) damages. The Court held that Zync adequately alleged that the Investor intentionally interfered with prospective venture capital and private equity financings by instructing its board designee to withhold his consent, meeting these elements.

The Court explained that, in evaluating the tort, any interference must be weighed against the defendant’s legitimate interest to compete in the market and protect its business interests in a fair and lawful manner. While the Investor argued it did not act wrongfully, because the investor rights agreement identified certain actions that expressly required the board designee’s approval, the Court noted that if the Investor caused its board designee to breach his duty of loyalty to Zync and its shareholders, as alleged, the Investor acted wrongfully.

The implied covenant of good faith and fair dealing

The Court further stated that Delaware’s implied covenant of good faith and fair dealing, among other applications, constrains a contractual counterparty’s exercise of discretion. A party must exercise contractual discretion “reasonably”—that is, consistent with the parties’ expectations at the time of contracting.

The Court found it reasonably conceivable that the Investor breached the implied covenant by wielding its board designee’s veto right maliciously and without a justification rationally grounded in the contractual relationship. According to the court, if the Investor, for example, thought the financings were too expensive, or harmful, it properly could have directed its board designee to exercise the veto right. But the Investor could not do so for the sole purpose of harming the company, which the Investor allegedly did to keep competitors from accessing promising technology. In the Court’s view, the Investor acted maliciously in instructing its employee to deny Zync critical funding, in violation of the implied covenant.²

Why Zync matters

• Strategic investor arrangements—including board designation and veto rights—remain permissible under Delaware law. Zync affirmed the general propriety of such arrangements, as long as interests remain aligned and veto rights are exercised for “rational” purposes. Recent amendments to the Delaware General Corporation Law, including to Section 122(18) allow for freedom of contract, including with respect to stockholder agreements and the Court confirmed that there is not an inherent problem with strategic investment arrangements nor with board designations or veto rights. Even when a director owes dual loyalties, there is “no conflict of interest” when interests are “aligned,” and, as a general matter, Delaware law presumes alignment (and that directors will act in a company’s best interests) when directors or their affiliates hold “material amounts” of a company’s common stock.
  Nor is there any inherent issue when an investor or its designee deploys contractual veto rights to prevent a company from undertaking certain major decisions or actions. Exercise of such rights may be permissible so long as it is not for an “irrational” purpose, including to prevent harm to the company or even the investor’s own interests. Absent disloyal or bad faith conduct, the existence of such contractual rights may serve as a defense against liability for deploying them.
• Narrow exception for disloyal and malicious conduct by the investor and/or its designee. Zync involved a set of allegations—namely, that the investor deployed what the complaint characterized as a “catch and kill” investment strategy, in which it intentionally utilizes designation and veto rights to procure proprietary technology and shutter a start-up for competitive advantage. The Court held that this alleged conduct—which it deemed “malicious”—exposed both designee and investor to potential liability, despite contractual governance rights.
  The exculpatory effect of contractual rights is not absolute and Delaware courts frequently take a fact-specific view and look beyond technicalities and formalities and will evaluate conduct based on “external indications.” A director designee cannot act disloyally and intentionally advance the interests of other parties, to the detriment of the corporation and its stockholders. An investor, likewise, cannot direct its designee to act disloyally, nor can it exercise (or direct its designee to exercise) veto rights “maliciously” to harm the company for ulterior purposes. While validating the general propriety of strategic investor relationships, the Court found that the specific conduct alleged—a scheme to access proprietary technology and use investor rights to shutter a start-up so competitors could not gain access—would be a step too far.
• Caution warranted on both sides. Zync highlights risks for both investors and companies in strategic investment relationships. For investors, contractual governance rights do not serve as absolute protection where disloyal or bad faith conduct is involved. Companies, in turn, may be left hamstrung and unable to function absent alignment with the investor. Investment arrangements that may appear attractive at the outset can turn destructive absent alignment. Caution, due diligence, and counsel are warranted for both sides.

Although the Court upheld claims at the pleading stage, it remains to be seen whether the allegations will ultimately be proven, and whether Zync will obtain recovery for its alleged losses.

References

1. Zync, Inc. v. Porsche Investments Management, S.A.

2. The Investor also argued that a limitation-of-liability provision in its voting rights agreement with Zync—providing that “[n]o Stockholder . . . shall have any liability as a result of designating a person for election as a director for any act or omission by such designated person in his or her capacity as a director of the Company”—insulated it from liability. The Court did not follow this argument at the pleadings stage, noting that the meaning and scope of the provision were ambiguous and, in any event, Delaware common law does not permit parties to “eliminate liability for intentional and bad faith acts.” Id.

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.