It is typical for a private equity firm or investment fund that invests in or buys a corporation or takes control of a corporate borrower (under a ``loan to own`` strategy) to designate and elect, or have elected, one or more members of the corporate board.
It is also typical for one or more representatives of such a firm, fund, or lender to serve as designated directors, or members of the board, to represent its interests as a shareholder. The skill, knowledge, and judgment of those designated — also known as representative directors — typically make their service beneficial to the designating shareholder as well as the corporation and its other shareholders as a whole.
There are some difficulties with this arrangement, however. It may pose certain conflicts of interest for the representative director, and the fiduciary duty of loyalty imposed on directors under Delaware or Texas law may impair the benefit of the representative director`s service to the designating shareholder. Additionally, in the context of publicly traded corporations, this arrangement may result in restrictions on the designating shareholder`s trading activities under federal securities laws.
Clearly, recognizing these difficulties and determining the best ways to address them up front is imperative and in the best interest of all parties involved.
Implications of the Duty of Loyalty
The primary fiduciary duties imposed on a corporate director under Delaware or Texas law are the duty of care and the duty of loyalty. Performance of the duty of loyalty can pose a special challenge for the representative director. In general, the duty of loyalty obligates the director to act in good faith and in the best interests of the corporation and its shareholders, without taint of any other interest or influence, including that of the designating shareholder.
The practical implications of the primacy of the duty of loyalty include that a representative director:
- May not share information that may be of interest or use to the designating shareholder unless doing so would be for the corporation`s benefit
- Must vote only in the interest of the corporation rather than in the interest of the designating shareholder
- May have to provide first to the corporation any business opportunities that may benefit the corporation before any opportunity is pursued by the designating shareholder.
Implications of Federal Securities Laws
For directors of publicly traded companies, the federal securities laws impose restrictions on trading activities that may also impact the designating shareholder. One restriction on trading stems from the ``insider-trading`` law developed under the SEC`s Rule 10b-5, the general anti-fraud regulation under the Securities Exchange Act of 1934 (Act). The law imposes liability on certain persons effecting purchases or sales of securities while in possession of material non-public information about the issuer of those securities, such as material corporate developments. The persons subject to such trading restrictions, who are typically referred to as ``insiders,`` include directors of the issuer.
Another restriction, imposed by Section 16 of the Act, generally imposes reporting requirements and prohibits ``short-swing`` trading (i.e., purchases and sales within six months) and certain short sales of the equity securities of most publicly traded corporations. Although Section 16 applies only to officers, directors, and 10-percent shareholders of an issuer, the restrictions and potential liability under that Section may be imposed on persons, like a designating shareholder, under a ``deputization`` theory when the facts dictate.
The practical implications of these two securities laws include:
- If the representative director communicates corporate information to the designating shareholder, even if authorized to do so by the corporation, the designating shareholder will be considered an ``insider`` for purposes of insider-trading laws. Further, the representative director`s mere possession of material non-public information, even if not communicated to the designating shareholder, may be attributed to the designating shareholder and thereby restrict the designating shareholder from buying or selling shares in the corporation.
- Only a few courts have subjected a designating shareholder to Section 16 under the deputization theory, but courts have indicated that the theory is applicable particularly when the representative director routinely influences the designating shareholder`s trading behavior. This would be an issue, for example, when the designating shareholder is a private equity firm or fund without separate or independent trading personnel.
Addressing the Implications
Certainly, these implications are not typically what a designating shareholder or a representative director desires or expects from the arrangement among the designating shareholder, the representative director, and the corporation.
What should these parties consider to address these implications? The possible approaches depend on the circumstances, but they include:
- Even though the designation of the representative director is known, because of the charter provisions or the contract affording the designating shareholder that right, the representative director should be careful to fully disclose his conflict or potential conflict of interest to the other directors when any such conflict or potential conflict arises.
Authorization protocols when conflicts are known
- Each of the Delaware and the Texas corporate statutes includes a provision with alternative procedures by which a corporation may effect a transaction in which a director is interested or has a conflict. The procedure most typically used is authorization of the transaction by disinterested or non-conflicted directors.
- Although neither statutory provision addresses a director`s duty of loyalty, a representative director should determine up front how he will address the conflict with the board. He may abstain from participating in the discussion or from voting, or both. If he does not abstain, he should disclose his interest and have the minutes reflect that disclosure and the nature of his participation.
``Fundamental`` shareholders` agreement or charter provision
- A unanimous shareholders` agreement (under the Texas, but not the Delaware, statute) may vary the normal pattern of corporate governance in many specified respects to address foreseeable conflicts or potential conflicts of interest involving a designating shareholder and representative director.
- The Delaware statute includes provisions that permit a corporation, in its certificate of incorporation, to renounce any interest in specified, or specified classes or categories of, business opportunities or to somewhat modify the normal statutory pattern of corporate governance. To the extent that conflicts in business opportunities are foreseeable and may be specified, this flexibility may be useful to a designating shareholder or a representative director.
Approved communication of corporate information
- The designating shareholder may wish to obtain separate rights to information from the corporation directly instead of relying on the representative director. Alternatively, the designating shareholder and representative director may wish to obtain specific authority from the corporation for the communication to, and the use by, the designating shareholder of corporate information.
Voting or consent as shareholder
- The designating shareholder may wish to obtain separate voting or consent rights as to certain corporate matters as a shareholder, instead of relying on its representative director`s vote or consent. In general, the designating shareholder is entitled to vote or consent as a shareholder in its own interest, without considering the interests of other shareholders.
Observer instead of representative director
- Because of a director`s primary duty of loyalty to the corporation, a shareholder may choose to obtain the contractual right to have an observer attend corporate board meetings and receive all information provided to the directors.
- The shareholder may wish also to obtain the right to receive and use the corporate information and vote or consent on certain corporate matters, as described above.
Follow insider-trading policy
- A designating shareholder should follow the corporation`s trading restrictions, and trade only during ``open trading windows`` permitted by the corporation`s insider-trading policy.
Be cognizant of possible Section 16 restrictions
- If there is any significant possibility that the designating shareholder may be affected by the deputization theory, it should not engage in short-swing trading or short selling prohibited by Section 16.
- A designating shareholder would typically file Section 16 reports only if its status as an ``insider`` was so clear that it should formally acknowledge it.
In light of a corporate director`s duty of loyalty, the prudent designating shareholder should consider one or more methods of achieving its interests without relying on the activities of one or more representative directors. Likewise, a prudent person who is requested to become, or is serving as, a representative director should be mindful of the obligations and restrictions on his service as a director that the duty of loyalty imposes. In addition, when the corporation`s equity securities are publicly traded, the prudent designating shareholder should be careful to observe, with the cooperation and communication of the representative director, the trading restrictions imposed by applicable federal securities laws.