This article and the companion article on board advisors both address a corporate governance arrangement under which the skill set of the formal board of directors is supplemented by individuals who are appointed to serve in an observational or advisory capacity. These individuals do not have the fiduciary duties of elected board members. Board observers are typically a phenomenon of venture capital backed companies and represent the interests of such investors. In contrast, the use of board advisors is increasingly becoming a feature of board of directors meetings across the spectrum, including closely-held family-controlled businesses, venture capital or private equity-backed companies, and public companies.
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Although board observer arrangements are not uncommon, there is little case law squarely addressing the rights, duties, and potential liabilities of board observers. Reference to basic principles of corporate law, however, should provide corporations and investors sufficient guidance in structuring board observer arrangements. These arrangements may offer several advantages over a traditional designated board seat. From the investor’s standpoint, the arrangement may provide insight into a corporation that operates in a business line in which the investor is currently active or in which it is seeking to expand. At the same time, the arrangement helps to avoid subjecting the investor’s designee to traditional fiduciary duties. From the corporation’s standpoint, the arrangement may give the corporation access to an investor designee who has knowledge of the corporation’s business, and it may serve to promote a relationship with a potential strategic partner. The arrangement might also represent a compromise by which the corporation grants greater access and information to the investor in exchange for assurances that the investor will not be able to exert undue influence over corporate decisions or, in the event of intra-corporate disputes, gain access to privileged information. To function as all parties intend, a board observer arrangement should be carefully documented. This article sets forth some of the key issues that parties documenting board observer arrangements should consider.
General – Fiduciary Duties
A board observer should not be considered a fiduciary of the corporation whose board he or she observes solely by virtue of his or her role as observer. The imposition of fiduciary duties on board observers would be largely inconsistent with the corporate law underpinnings of fiduciary duties. Corporate law fiduciary duties arise from trust law concepts – a party who manages an asset for the benefit of another party is held to standards of care and loyalty in managing the asset for the beneficiary. In the corporate law setting, the business and affairs of the corporation are managed by or under the direction of the board of directors, and the directors, in discharging their duties, owe fiduciary duties to the stockholders, as the residual beneficiaries of the corporation. Board observer arrangements generally do not confer upon the observer managerial discretion or control over the corporation’s assets, nor do they give rise to such discretion or control. Since board observers, as such, have no control over the corporation’s assets and business, they should not be bound by traditional fiduciary duties.
The board observer agreement should nevertheless specify the limitations on the observer’s role and functions. Such limitations will help to constrain the observer, and thereby protect against claims that the observer is serving in a fiduciary capacity. Specifically, the board observer agreement should expressly provide that the observer has no right to vote on matters brought before the board (or any committee), and that the observer’s presence will not be necessary to establish a quorum at any meeting. In addition, the board observer agreement should not grant the observer any veto rights over corporate matters, including with respect to the establishment of budgets, financing arrangements, investment decisions, or any other matter brought before the board. Any such rights, if granted, should be given to the investor in the form of charter-based protective provisions or negative covenants in a separate agreement between the corporation and the investor. Even if the board observer agreement precludes the observer from voting on corporate matters, the observer may offer his or her views for consideration by the board of directors. In fact, the directors may from time to time seek the observer’s input. The observer should not, however, participate in any formal vote of the board or in any “straw poll” on a matter brought before the board.
Board Observer Agreements
The corporation and the investor are the principal parties to the board observer agreement. Since the agreement will impose obligations upon the observer, however, the observer should be named as a party. The agreement should also provide that if the investor removes any board observer, no person may be designated as a replacement observer unless and until he or she shall have executed a counterpart to the agreement.
Information and Participation Rights
Unlike directors, board observers have no statutory or common law right to receive notice of meetings of the board, to receive any materials or other information provided to directors, or to inspect the corporation’s books and records. Any rights extended to the observer, therefore, must be provided contractually. The board observer agreement should specify, among other things, the meetings the observer will be entitled to attend and of which he or she will be given notice. For example, the agreement may provide that the board observer will be given notice of and may attend all meetings of the board, whether regular or special, or only a subset of such meetings (e.g., the regularly scheduled quarterly meetings of the board).
The agreement may also specify the observer’s rights with respect to meetings of committees of the board of directors. If the investor wants to secure rights for the observer to receive notice of and to attend committee meetings, it should ensure those rights are expressly granted in the agreement; in the absence of such rights, the corporation may be entitled to exclude the observer from committee meetings. The corporation, however, may resist any such request, or it may seek to limit the observer’s rights to specified committees. In all cases, the corporation should ensure that it retains the power to exclude the observer from meetings of committees established for the purpose of negotiating with the investor or negotiating transactions that could implicate or affect the investor’s rights.
The agreement should also provide that the observer is entitled to receive copies of all notices, minutes, reports, and other materials that the corporation provides to members of the board (or committee) when such documents and materials are provided to members or the board or committee. The investor should include within the list of materials the observer is entitled to receive every form of action by unanimous consent in lieu of a meeting of the board and of each committee that the observer is entitled to observe, together with the exhibits and annexes to any such consent.
The agreement should specify the manner and form in which notice of meetings will be provided to the observer. In many cases, the agreement will provide that the observer will be entitled to the same notice as is provided for regular or special meetings of the board or committee, as applicable, under the corporation’s bylaws.
Limitations on the Observer’s Rights
In addition to specifying the observer’s rights to participate in meetings and receive information and materials, the board observer agreement should set forth the express limitations on those rights. Typical limitations relate to the observer’s right to receive information and materials or to participate in meetings if the board determines in good faith that the provision of such information or materials to the observer or the observer’s participation in such meetings would result in a waiver or compromise of the attorney-client privilege. The investor may seek to require that the board, in making such determination, do so after consultation with outside counsel, or that the board’s determination be based on the advice of counsel.
The corporation may wish to seek limitations that extend beyond the attorney-client privilege, limitations that restrict the observer’s access to specified classes or categories of confidential or sensitive information or materials. In addition, the corporation may wish to specify that it will not be required to furnish to the observer information relating to transactions or potential transactions between the corporation and the investor, or information that implicates or would affect the investor’s rights and obligations vis-à-vis the corporation.
In all cases, the corporation should bear the burden of determining the information and materials from which the observer should be shielded and which meetings (or portions of meetings) from which the observer should be excluded. The board or a committee, acting in good faith, should make the determination on behalf of the corporation. Although the corporation would be responsible for making those determinations, the observer may nevertheless wish to disclaim the right to receive information or participate in a meeting (or portion thereof), even if not specifically requested to do so. For example, in a situation in which the investor is considering a bid to acquire the corporation or some or all of its assets, or is considering a recapitalization or similar proposal, the investor may wish to remain unburdened by confidential information. This will help to allay, for example, complications that may arise if the investor is imputed with constructive knowledge of material information regarding the corporation.
Given that the observer will have access to board meetings and sensitive corporate materials, the corporation will want to ensure that the board observer agreement makes clear that all materials and information furnished to the board observer remain the property of the corporation and imposes restrictions on the use and disclosure of such materials and information. The agreement should contain a detailed definition of what constitutes “confidential information” and should require the observer to keep those materials confidential, subject to customary exceptions (e.g., where the disclosure is required by law). The investor will want to ensure, however, that the confidentiality restrictions are not drafted so broadly as to prevent the observer from sharing information and materials with the investor. Where the observer is permitted to share information and materials with the investor, the agreement should impose on the investor restrictions on disclosure and use.
If the agreement permits the observer or investor to share confidential information and materials with their representatives, it should obligate the investor or observer to inform such representatives of the restrictions on the disclosure and use of such information and materials under the board observer agreement to instruct such representatives to comply with such provisions. The board observer agreement should also provide that the investor is responsible for any breach of the agreement by its or the observer’s representatives.
Indemnification and Advancement
Due to his or her participation in board meetings, and his or her access to materials furnished to the board, a board observer runs the risk of being named as a defendant in stockholder lawsuits and in other actions involving the corporation. The observer or investor may seek provisions obligating the corporation to indemnify and advance expenses to the observer in connection with actions, suits, or proceedings brought against the observer, or to which the observer is otherwise made a party or witness, by reason of the observer’s position. If such rights are extended, the board observer agreement should specify that the corporation is providing third-party indemnification rights, and is not providing rights to indemnification or advancement of expenses to the observer in his or her capacity as a director or officer of the corporation.
Governing Law and Consent to Jurisdiction or Arbitration
The board observer agreement should specify the law by which it is governed. In general, the parties should provide that the agreement will be governed by the law of the jurisdiction in which the corporation is incorporated or in which its principal place of business is located. The board observer agreement should also require all parties to agree that all disputes will be resolved in a specified jurisdiction and venue. The parties likely would want to select the courts of the jurisdiction in which the corporation is incorporated or in which its principal place of business is located. Given that any disputes are likely to be business disputes among sophisticated parties, the parties should waive the right to a jury trial. The parties may wish to provide instead that disputes arising under the agreement shall be submitted to binding arbitration. In that case, the board observer agreement should set forth with specificity the provisions that would govern the arbitration proceedings.
In light of the nature of the parties’ obligations under the board observer agreement, it is likely that any disputes between the parties would involve a request for equitable relief. Accordingly, the board observer agreement should include a standard specific performance clause in which each of the corporation, the investor, and the observer acknowledges and agrees that it, he, or she would be irreparably harmed in the event of a breach by any other party, that monetary damages would not be a sufficient remedy, and that each will be entitled to specific performance or injunctive relief. The parties may also consider including a fee shifting clause.
ConclusionBoard observer arrangements may be advantageous to both investors and corporations. The arrangement, however, is defined almost entirely by contract, with few statutory or common law rights or obligations granted to or imposed upon the corporation or the observer. For that reason, corporations and investors should ensure that the agreement governing the arrangement covers the key issues that are important to the parties and is drafted with precision.