Lenders and other constituencies will under certain circumstances request and be granted “board observer” rights pursuant to a loan agreement or other contract. The potential legal liability of board observers under various laws applicable to actual board members has not been well developed. A recent federal appellate court decision addressed the issue of whether board observers may face liability for misleading statements or omissions in registration statements under Section 11 of the Securities Act of 1933, as amended (the Securities Act). In Obasi Investment Ltd. v. Tibet Pharmaceuticals, Inc. et al., the United States Court of Appeals for the Third Circuit determined not to impose liability on board observers under Section 11 of the Securities Act, but such determination turned largely on the board observers’ authority and obligations as disclosed in the registration statement. Nevertheless, this decision provides guidance to board observers on how to avoid liability under the Securities Act.
The basic purpose of Section 11 under the Securities Act is to provide protection against misstatements and/or omissions made in registration statements to purchasers of registered securities. Designed to ensure compliance with the disclosure provision of the Securities Act, Section 11 effectively imposes liability on parties who play a direct role in a registered offering. However, given the strict imposition of such liability, application of Section 11 is limited to certain specified categories of potential defendants, including “every person who, with his consent, is named in the registration statement as being or about to become a director, person performing similar functions or partner.” Thus, whether a board observer will fall within the purview of Section 11 will turn on whether such individual’s functions are similar to those that board directors perform.
In Tibet Pharmaceuticals, the majority found the function of a board of directors to include the direction and management of company affairs by formal voting subject to duties of care and loyalty. Additionally, the majority noted the absolute ability of shareholders to remove such board members (for dissatisfaction related to management or for no reason at all). In determining not to impose liability on the board observers who in this case were nonvoting board observers without any formal powers or duties and were affiliated with and appointed by the issuer’s placement agent, the three factors the majority found to vitiate against imposition of liability were:
- The board observers could not vote for board actions.
- The board observers did not owe duties of care and loyalty to the company or its shareholders.
- The board observers could not be removed by shareholders.
Conversely, the dissenting judge found that Section 11 merely requires that an individual perform functions similar to, or of a like nature or kind to, board functions. Unlike the majority, the dissenting judge would impose Section 11 liability on board observers performing functions similar to a director regardless of an absence of any formal power to direct and manage the corporation or responsibilities and duties that accompany such powers. The dissenting judge noted that the following elements would weigh toward imposing liability under Section 11:
- The board observers could significantly influence the outcome of matters submitted for board approval.
- The board observers had access to inside information and to attend meetings of the board and to speak or otherwise share their opinions at such meetings.
- The board observers were entitled to the same remuneration as independent directors and were eligible for reimbursement for attending meetings of the board.
The court in Tibet Pharmaceuticals looked to the actual disclosure in the registration statement in evaluating whether the board observers were subject to liability under Section 11. Simply being named as a board observer would not create risk of such liability as the title itself does not indicate that such position performs functions similar to that of a director. However, in Tibet Pharmaceuticals the registration statement indicated that the board observers, although nonvoting and without any formal powers or duties, could significantly influence the outcome of matters submitted to the board. Further, the registration statement failed to (i) provide a clear delineation of the powers and responsibilities of the appointed board observers and (ii) disclose any limits on the matters the board observers could influence. These failures increased the risk of Section 11 liability because it could be inferred that such board observers could influence the outcome of all matters submitted to the board, including decisions related to disclosure in the registration statement.
To decrease risk of Section 11 liability, board observers should ensure that each of the above factors is addressed. When drafting a registration statement, the full scope (and limitations) of their roles (including the limitations on their participation in the preparation of and responsibility for the contents of documents filed with the Securities and Exchange Commission) should be disclosed. Further, board observers of a private company may consider retaining the power to terminate their role as a board observer upon public offering.