Legal counsel representing private equity and venture capital funds (“Funds”) regularly find themselves forced to navigate the uncertain terrain that transpires when the companies they invest in (“Portfolio Companies”) enter periods of financial difficulty. In such critical times, insolvency often follows, which triggers unique conflictsof interestrepresenting a troubling cause for concern.[1] This occurs when Fund-appointed directors serve as fiduciaries to two distinct entities whose interests can be directly at odds – termed “dual fiduciaries.”[2] When this event manifests, these entities are the Fund for which they are employed, usually as senior or junior-level executives, and the Portfolio Company where they have been appointed to the board of directors.[3] Courts have held that dual fiduciaries will be held to the same exacting standard for all companies in which they hold board seats.[4]
Though these conflicts tend to remain dormant in times of financial prosperity (or even when returns are static), issue surfaces when companies are faced with decisions in which their interests are at odds. This typically occurs when tables turn on their financial condition. For example, Funds “tend to seek high returns over a short window of time and would sooner cut their losses on companies going sideways and direct their funds to more promising ventures than wait and see if the company can be turned around.”[5] A dual-fiduciary’s investing strategy is completely inconsistent with their duties of loyalty and good faith, which require that they make decisions which maximize the long-term value of Portfolio Companies.[6] What emerges from this dreaded scenario is a devastating loss for the parties on both sides: Portfolio Companies are desperately clinging on to the capital that remains while Funds are usually in a position where they would pull capital out in order to cut their losses. As a result, dual-fiduciaries can no longer effectively serve the interests of both parties and are thus vulnerable to derivative shareholder actions for breaching their fiduciary duties.
Often times, disgruntled shareholders mount legal challenges against key decisions made by the Portfolio Companies, such as selling businesses that they invested in.[7] And while a director’s decision is typically afforded deference under the “business judgement” standard,[8] having dual-fiduciaries on the board poses the risk that courts will rule against directors, thus requiring them to prove the more stringent “entire fairness” standard.[9] So, this all begs the question: what can Fund managers and counsel do to mitigate the risk that dual-fiduciaries pose?
The most obvious answer is to take a passive investment strategy that steers clear of appointing Fund directors to Portfolio companies, thereby avoiding the entire conundrum.[10] However, the reality is that though there has been a recent decline in their use, active investment strategies continue to account for a significant portion of Funds under management.[11] Another viable strategy is to prophylactically defend derivative challenges based on dual-fiduciaries’ conflicts. This can be done by: (1) having decisions ratified by a majority of the disinterested directors, and (2) instituting and maintaining a “well-functioning” committee made up of independent directors.[12] Moreover, Funds could limit their investment to Portfolio companies, which presently have independent committees, or condition their investment on the formation of an independent committee. Because dual-fiduciaries are usually considered to be interested in decisions involving both entities to which they are fiduciaries, they must recuse themselves from the board and abstain from voting in the underlying transaction.[13]
Nevertheless, the question of whether abstaining from voting is enough to avoid liability remains unresolved. The Delaware Court of Chancery stopped short of adopting the idea that abstention is not enough in cases where dual-fiduciaries had some involvement in processes leading up to the transaction.[14] Unfortunately, the question did not receive a definite answer, as the parties settled soon after the pleading stage.[15] Consequently, a possible solution to dual-fiduciaries now remains without judicial support. Because this opportune case could have provided guidance for Funds, who wish to avoid liability in this context, the issue remains a difficult one for those Funds that consider active investing a part of their DNA.
[1] The likelihood of this scenario varies depending on a firm’s acquisition strategy. While some Funds prioritize the ability to appoint their own directors to the boards of the companies in which they invest, many undertake passive investment strategies where board involvement is not bargained for.
[2] See generally, John K. Wells, Multiple Directorships: The Fiduciary Duties and Conflicts of Interest that Arise When One Individual Serves More Than One Corporation, 33 J. Marshall L. Rev. 561 (2000).
[3] Id.
[4] See Weinberger v. Uop, 457 A.2d 701, 710 (Del. 1983).
[5] Practical Law Corporate & Securities, Westlaw Practical Law, Chancery Court Describes Risks of Liability for Directors and Sponsors in Preferred Stock Redemptions 5 (2017).
[6] Though fiduciaries must have a long-term focus, they need not act to ensure a company’s perpetual existence. Frederick Hsu Living Tr. v. ODN Holding Corp., No. 12108-VCL, 2017 Del. Ch. LEXIS 67 (Apr. 14, 2017).
[7] Id.
[8] The business judgment rule creates a presumption respecting the autonomy of directors to make managerial decisions and places the burden of proof on the defendant to prove that it should not apply. See Gimbel v. Signal Cos., 316 A.2d 599, 608 (Del. Ch. 1974).
[9] In these cases, the defendant Funds must establish “to the court’s satisfaction that the transaction was the product of both fair dealing andfair price.” Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156, 1163 (Del. 1995)(quoting Weinberger 457 A.2d at 711.
[10] Passive Investing, Investopedia, https://www.investopedia.com/terms/p/passiveinvesting.asp, (last visited Feb. 16, 2019).
[11] Kenechukwu Anadu, Mathias Kruttli, Patrick McCabe, Emilio Osambela, Chae Shin, The Shift from Active to Passive Investing: Potential Risks to Financial Stability 1–3 (Fed. Reserve Bank of Bos., Working Paper No. 18-04, 2018).
[12] Kahn v. M&F Worldwide Corp., 88 A.3d 635, 645 (Del. 2014).
[13] Id.
[14] See generally, Frederick Hsu Living Tr., No. 12108-VCL, 2017 Del. Ch. LEXIS 67 (Ch. Apr. 14, 2017).
[15] See id.
