I am a bit late getting this one out, but here it is. In addition to a regular board of directors required by law for a corporation, some companies also have a so-called “advisory board.” Advisory boards usually consist of individuals with special knowledge, expertise or connections useful to the company, or individuals who have a contractual right to attend board meetings as an observer. Advisory board members generally have significantly less responsibility than actual board members. Advisory board members are also thought to have less potential liability.

A July 2019 case in the Third Circuit Court of Appeals put this thinking to the test. In Obasi Investments Ltd. v. Tibet Pharmaceuticals, Inc., aggrieved investors sought to impose liability on two individuals who were identified as “board observers.” The case involved a claim by defrauded investors in an IPO that two board observers, who were identified as such in the IPO prospectus, were liable for the fraudulent prospectus under Section 11 of the 1933 Act, which permits an action against any person named in the registration statement as a director or “person performing similar functions.”

The District Court observed that Zou and Downs (the “Observers”) were named in the registration statement as about to become “board observers” appointed by the company’s placement agent.

Although our Placement Agent’s observers will not be able to vote, they may nevertheless significantly influence the outcome of matters submitted to the Board of Directors for approval.

The District Court focused on the statement that, while the Observers could not vote “they may nevertheless significantly influence the outcome of matters submitted to the Board of Directors for approval.” Arguably, the Observers had more influence than any individual board member, who could only cast a single vote. The District Court, therefore, denied summary judgment, finding there were material issues of fact about whether the Observers had been named as people “performing similar functions to a director.”

The Third Circuit reversed, holding that the Observers were not directors “as a matter of law,” and citing a number of important factors. The Observers were neither signatories to the registration statement nor named in it as directors of the company.

Three features differentiate Zou and Downs from directors. First, and most fundamentally, Zou and Downs cannot vote for board action. Second, they are aligned with the placement agent, A&S, not Tibet. And third, their tenures are set to end automatically, with no opportunity to vote them out. Without the ability to manage the company’s affairs, Zou and Downs lack directors’ most basic power. As agents of Tibet’s placement agent, their loyalties aren’t with Tibet’s shareholders—and loyalty to shareholders is as vital to directorship as the power to manage. And unlike Tibet’s directors, their tenure is not subject to a shareholder vote. Add to that the registration statement’s express provision for directors’ fiduciary duties, with no similar provision for the Zou and Downs.

Good news for the Observers, but a warning to all individuals serving as advisory board members or observers. Courts will examine an individual’s role carefully based on the particular facts of the case.

As noted in this blog post by our good friend Alan Dye (subscription required), “A person who has a contractual right to attend board meetings as an observer generally isn’t considered to be a director for purposes of Section 16, at least not by the observer or the issuer. The determination is usually based on whether the observer “functions” as a director, and the observer’s inability to vote on board resolutions, or in some cases even participate in discussions, usually drives the conclusion.”