Investors, whether angels, VCs or corporates, typically demand a seat on the board of directors of their target company in return for their investment.
However, it is important to remember that directors in Israeli companies have obligations as well as rights. They have a duty of care, a fiduciary duty and a duty of disclosure (and are not guaranteed remuneration). It is worth considering whether the burden of these duties is worth the privilege, particularly in cases where the investor does not control the board or can not veto decisions.
Duty of Care.
A director is required to act with the level of care which a reasonable director, in the same position, would have acted under the same circumstances. He must be proactive, not passive and use reasonable means to obtain pertinent information when making decisions. He must make himself familiar with the company’s affairs, reasonably monitor management and supervise any committee that the board has delegated authority to. A cursory review of the company’s financial reports is not sufficient; he must carefully examine the accountant’s notes and remarks. A director cannot be a “yes-man”.
Having said that, the recent trend in Israeli case law is to adopt a position similar to Delaware’s business judgment rule; i.e., the difficult-to-rebut presumption that a director has acted on an informed basis, in good faith and in the best interests of the company.
Also known as the Duty of Loyalty and Good Faith. A director must refrain from any conflict of interest with the company, including competing with or exploiting any business opportunity of the company for personal gain. He must act in the best interest of the company and all its shareholders, not merely his own interests as a shareholder. He must use his independent discretion when voting in the board and can not be party to a voting agreement.
The board may however approve certain “conflicts” if: (i) the director acted in good faith and the best interests of the company were not compromised; and (ii) the director disclosed the nature of his personal interest (including all material information) in advance.
Duty of Disclosure
A director is required to disclose to the board any personal interest that he may have, and all related material information, in connection with any existing or proposed transaction of the company.
A “personal interest” includes that of any entity in which he holds at least 5%, serves as a director or a CEO, or in which he has the right to appoint at least one director or the CEO. Moreover, if the transaction is an “extraordinary transaction” (i.e. not in the ordinary course of business, not on market terms or likely to have a material impact on the company’s profitability, assets or liabilities) a director is also required to disclose any personal interest of his spouse, sibling, parent, grandparent, descendant, spouse’s descendant, sibling, parent or the spouse of any of the foregoing.
Directors are also required to disclose whether they have been convicted of certain offences. Finally, an Israeli company is required to notify the Companies Register of the identity of its directors, and this becomes publicly available information. In other words, a director waives part of his right to privacy.
Indemnification and Insurance
There are of course means to mitigate a director’s liability. An investor can demand that as a condition to his investment, the target company agrees to (i) indemnify him in his capacity as a director and (ii) purchase and cover him under the target company’s directors and officers insurance policy (both of which need to be approved in principle in the company’s articles of association). However these protections are not absolute.
The Companies Law provides that a company may not exculpate, indemnify or insure a director with respect to any of the following (i) a breach by the director of his Fiduciary Duty – unless the director acted in good faith and had a reasonable basis to believe that his actions would not prejudice the company; (ii) a breach by the director of his duty of care if the breach was done intentionally or recklessly; (iii) any act or omission done with the intent to derive an illegal personal benefit; or (iv) any fine levied against the director.
In light of the above, perhaps investors, who are considering serving on the board of directors of their target company, may wish to ask for the right to appoint an observer instead. Such observer would be entitled to a non-voting seat at the table, to attend all meetings and to similar information rights (unless there is a conflict of interest or to protect attorney-client privilege). Accordingly, an observer would be kept well informed of the company’s activities and have the opportunity to express his opinion in an attempt to sway the board. This is not an insignificant tool in a small private company where board decisions are typically based on consensus, rather than a vote. In these circumstances an observer could exert as much influence as a director.
Although an observer does not have the power to vote, he is also not encumbered by statutory duties and obligations. Where the investor cannot direct or block the board the tradeoff may be worth it.