Authors: Josh Galante, Eric Porter, and Lori Smith
Angel investors, venture capital and private equity funds often seek to secure some presence, formal or informal, within the board meetings of the corporations in which they invest. Such representation and participation in corporate governance provide potential benefits to both the investor and the portfolio corporation. The corporation can benefit from having experienced investors participate and provide guidance in board meetings and beyond. While some corporations may be wary of offering such investors a formal seat on the board of directors, one option commonly employed is to grant investors or their representatives rights as “board observers.” Such persons may observe and even participate, usually in some limited fashion, in meetings of the board of directors. They generally get rights to attend meetings and obtain all materials provided to formal members of the board, but in a non-voting capacity. Granting such rights, however, introduces a number of unique issues and subtle potential pitfalls that both the corporation[1] and the investor should carefully assess.
Little caselaw or statutory guidance exists on the rights and obligations of board observers. Corporations and investors, each seeking to protect themselves, should therefore ensure that they expressly delineate those rights and obligations in advance via a detailed board observer agreement executed by both the corporation and the observer. Some of the key considerations to address in such an agreement, and related issues, are discussed below.
Fiduciary Duties
Corporate law generally does not impose fiduciary duties on board observers. Such fiduciary duties typically arise where one party manages an asset or group of assets for another, as a result of which the law will accordingly impose on the manager certain duties of loyalty and care with respect to the beneficiary. Directors, officers and managers of the corporation, having been charged with the duty to manage the assets of the corporation, are deemed fiduciaries with respect to the stockholders. But since board observers, by contrast, will typically have no formal responsibility for managing the corporation’s assets, they will typically not be deemed to owe the corporation any fiduciary duty.
From the corporation’s perspective, the lack of fiduciary duties can lead to conflicts of interest, especially with strategic investors who may be in the same industry or business as the corporation. Such conflicts would not be addressed by an overriding duty of loyalty or duty not to act in a self-interested manner. Where an investor designates a representative to sit on the board, either formally or informally, that director could be said to be wearing two hats, one as a representative of the investor and one as a fiduciary to the corporation. In fact, that representative may even owe fiduciary duties to the investor who designated such person to sit on the board. As a formal board member, the duty of loyalty would protect the corporation from such conflicts. Therefore, on the one hand, companies often attempt to include language in board observer agreements that requires the board observer to act as if it were subject to fiduciary duties. On the other hand, investors often want the opposite, to expressly state that the board observer is not a fiduciary of the corporation. In fact, often, an investor will prefer an observer seat specifically because they are concerned about conflicts of interest created by such fiduciary obligations. The investor is interested in access to information and a window into its investment but doesn’t necessarily feel the need for a formal board seat that would give it the power to direct the affairs of the corporation through a vote on the board.
Regardless of whether the board observer agreement expressly addresses fiduciary obligations, the agreement should both define the scope of the board observer’s rights to participation and access to information as well as seek to protect the corporation by imposing express limitations on such rights. For instance, the agreement should make clear that the observer is not entitled to vote at board meetings, may not veto any decision or action taken or being considered by management and may be excluded from receiving certain information or attending portions of meetings, as more fully discussed below. It may even subject the observer to additional restrictions on the use and disclosure of information that are not necessary for voting members of the board. The agreement may also specify the conditions upon which the board observer’s rights may sunset, for instance, if the investor who has the right to designate the observer does not continue to hold a specified amount of stock or by or before an identified end date.
Confidentiality and Privilege
As a non-member of the board and a representative of a third party, the board observer’s mere presence in the board meeting may compromise the confidentiality of information shared or discussed in the meeting. The observer’s presence may also destroy the privilege that attaches to a meeting between the corporation’s board and the corporation’s attorneys. Special care should accordingly be taken to address these issues in the board observer agreement.
Courts considering the issue have reached varying conclusions on whether the provision of confidential or privileged information to a board observer waives the attorney/client privilege with respect to such information. In Finjan, Inc. v. SonicWall, Inc., a decision issued by the United States District Court for the Northern District of California in 2020, the Court found that a corporation’s disclosure to a board observer of information otherwise protected by the attorney/client privilege constituted a waiver of the privilege with respect to that information. By contrast, the United States District Court for the Eastern District of North Carolina held the exact opposite in a 2005 case, PharmaNetics, Inc. v. Aventis Pharmaceuticals, Inc.
Corporations and investors should attempt to address this uncertainty upfront through their board observer agreement. The agreement should expressly define “Confidential Information” and impose unambiguous obligations on the observer to protect and maintain the confidentiality of such information and to not use the information for any purpose other than for monitoring the relevant investor’s investment in the corporation. In many situations, it should also contain appropriate limitations upon the sharing of competitively sensitive information. The agreement should also make clear that all such information is proprietary to the corporation and may contain trade secrets, the disclosure of which would harm the corporation. The restrictions imposed should apply broadly to all those parties with whom the observer is authorized to share information obtained from the corporation. The board observer agreement may also expressly provide the corporation the right to withhold certain proprietary information, especially if it could jeopardize trade secret protection for such information.
The board observer agreement should also give the corporation the tools necessary to protect the corporation’s attorney/client privilege by expressly stating the corporation’s right to exclude the observer from any meetings or discussions with counsel where the observer’s presence might constitute a waiver of privilege. The corporation’s right to exclude the observer should also extend to situations in which matters being discussed may give rise to a potential conflict of interest. Of course, even when an agreement allows the corporation to exclude the observer for privilege reasons, the corporation must remain vigilant and actually exercise such right at appropriate times, or the privilege could be inadvertently waived.
Conclusion
Though the presence of board observers is fairly common in privately held corporations, corporations should think twice before liberally agreeing to allow any investor to appoint an observer, as their access to information and participation in a corporation’s board meetings raises a number of potentially significant issues for both the corporation and the investor. Given the relative lack of statutory guidance or caselaw governing the rights and obligations of these observers, both sides should ensure that they protect themselves in advance through the careful drafting and execution of a comprehensive board observer agreement.
Stradley Ronon has a deep bench of experienced attorneys who regularly draft board observer agreements for a variety of corporate and investor clients. We are well-prepared to assist you with any legal needs you may have in this area or any related area, including those involving startup investments, compliance and governance.
[1] Though this article focuses on observer rights with respect to corporations, observer rights can also be granted in entities that use other forms if they have boards or functionally similar governing bodies.