Supreme Court Sides with IRS in Stock Redemption Agreement Case

By: David J. Winkowski and Andrew J. Barron The U.S. Supreme Court issued a decision on June 6 with significant repercussions for business owners who use life insurance as part of their business succession planning. In an uncommon 9-0 ruling, the justices in Connelly v. United States held that for federal estate tax purposes, the value of life insurance proceeds payable to a company upon a shareholder’s death was included in the corporation’s federal estate tax value, and this value was not offset by the company’s obligation to redeem the deceased shareholder’s stock under a buy-sell agreement. The Stock Redemption Agreement at Issue Brothers Michael and Thomas Connelly were the sole shareholders of a building supply business. The brothers and the company entered into a stock redemption agreement that allowed the surviving brother to purchase the shares of the first brother to pass away. If the surviving brother declined to purchase the shares, the company would be obligated to purchase them. The company obtained $3.5 million of life insurance on each brother to finance the redemption. After Michael Connelly died, Thomas Connelly declined to purchase his shares, and pursuant to the stock redemption agreement, the company became obligated to redeem them. The agreement laid out a number of methods for setting the redemption value of the shares (e.g., periodically executing a certificate of agreed value or having multiple independent appraisers provide valuation reports). However, the brothers never performed any of the valuation mechanisms. Instead, Thomas Connelly (as executor of his brother’s estate) and Michael Connelly’s son (an estate beneficiary) privately agreed to value Michael Connelly’s shares at $3 million. The company paid $3 million to the estate, and the estate valued Michael Connelly’s shares at $3 million on the estate tax return. The Internal Revenue Service (IRS) audited the return and assessed additional federal estate tax on the basis that the value of Michael Connelly’s shares included a proportional share of the life insurance proceeds. Michael Connelly’s estate paid the tax and sued the IRS for a refund. The estate claimed that the company’s obligation to redeem Michael Connelly’s shares was a liability on the company’s balance sheet, which offset the life insurance proceeds dollar for dollar. In contrast, the government argued that a redemption obligation is not a liability in the traditional sense and that a hypothetical buyer of Connelly’s shares would not have treated this obligation as a factor in reducing the purchase price. Supreme Court Affirms Lower Court Decisions The U.S. District Court for the Eastern District of Missouri and the U.S. Court of Appeals for the Eighth Circuit both ruled in favor of the government and the Supreme Court agreed, affirming the lower court decisions. The Supreme Court considered what a willing arm’s-length buyer would reasonably pay for Michael Connelly’s shares as of the date of his death. In the court’s view, the stock redemption at fair market value had no economic impact on either shareholder. Therefore, a willing buyer would not consider the redemption obligation as a liability. The court was careful to limit its holding to the specific facts of the case. In a footnote, the court mentioned that it does “not hold that a redemption obligation can never decrease a corporation’s value” if the underlying facts differ. For instance, a redemption obligation could “require a corporation to liquidate operating assets to pay for the shares, thereby decreasing its future earning capacity.” However, the company’s obligation to purchase the shares from the deceased shareholder’s estate did not, on its own, offset the life insurance proceeds used to finance the purchase. The Supreme Court did not address Internal Revenue Code Section 2703(b) and its regulations, which allow shareholders to set the value of company shares for federal estate tax purposes by agreement if certain criteria are met. However, the lower court opinions made it clear that the Connelly brothers’ failure to follow the terms of their agreement caused Section 2703(b) to not apply and instead allowed the IRS to determine the fair market value of the shares without reference to the agreement. The value of a decedent’s property at death should reflect its fair market value, which is the price at which the property could change hands between a willing buyer and a willing seller. In Connelly, the court determined that the fair market value of the corporation was increased by the life insurance proceeds payable to the corporation. Going Forward While Connelly held that a stock redemption obligation is not a liability that offsets life insurance proceeds in an estate tax analysis, careful planning and the use of alternative buy-sell arrangements (e.g., cross-purchase agreements or life insurance LLCs) may significantly reduce estate tax exposure. Business owners with buy-sell agreements in place should consider meeting with their advisers to review current valuation and funding provisions to ensure that their business documents will meet their intended planning objectives.   Meet the Authors David J. Winkowski David Winkowski concentrates on taxation and estate planning for high-net-worth individuals, executives at publicly traded and privately held companies, and owners of closely held businesses and their families. David has extensive experience designing and implementing sophisticated estate plans, wills, inter vivos trusts, prenuptial agreements and family limited partnerships. In addition, he advises clients on a variety of asset-protection techniques. | 484.323.1347 Andrew J. Barron Andrew J. Barron is an experienced tax, trusts and estates lawyer representing executors, administrators, trustees and beneficiaries in all aspects of trust and estate administration. His clients depend on him to navigate complex family dynamics to efficiently and empathetically resolve conflict. Andrew routinely prepares and reviews income, estate, inheritance, and gift tax returns, as well as accountings, nonjudicial settlement agreements and receipt/release agreements. Andrew works closely with high-net-worth individuals to reach their personal and business planning goals. He drafts and reviews wills, trusts, power of attorney, healthcare directives and other estate and business planning documents. Andrew is proud to maintain an active pro bono caseload. | 215.564.8519

The Times for Private Equity and Venture Capital Transactions Are A-Changin’: 2024 Challenges

Partner Lori Smith has authored the first in a two-part series for Reuters Legal News exploring key items that should be on the radar of private equity and venture capital funds and their portfolio companies for 2024 and beyond. In this first installment, Lori focuses on novel reporting obligations for U.S. and foreign businesses and a continued increase in antitrust enforcement. Read the full article.

Tax-Free Equity Rollovers: A Powerful Tool for M&A Transactions

In acquisition transactions, consideration is often composed of a combination of cash and equity from the buyer. Equity consideration is attractive for a number of reasons, including aligning the interests of both buyer and seller post-closing and giving the seller some tax deferral and the potential for additional upside as the business continues to succeed. Structuring the transaction to include a partial tax-free equity component, or “rollover,” is a crucial element in facilitating these transactions, potentially offering substantial tax benefits to the seller. This strategic maneuver allows the seller to avoid triggering immediate federal income tax liabilities on receipt of the equity consideration, ensuring the seller retains a larger portion of its cash proceeds from the sale. In this post, we will discuss common federal income tax considerations for achieving a tax-free equity rollover applicable to U.S. buyers and sellers. Additional federal income tax considerations would apply to non-U.S. parties, which are beyond the scope of this discussion and will only be briefly highlighted at the end. Typically, a tax-free equity rollover – more accurately, a tax-deferred rollover – will be structured such that the buyer will purchase a portion of the property being sold, whether equity in a target company or assets, in exchange for cash and the remaining portion in exchange for equity of the buyer (or a parent entity of the buyer). In order for the latter part of the deal (i.e., the rollover) to be tax-free from a federal income tax perspective, it is typically structured as a contribution of the relevant property to the buyer or parent entity in exchange for equity of the buyer or parent entity (i.e., the Buyer Issuer). Accordingly, the ability to achieve a tax-free equity rollover for the seller and any challenges that must be overcome will primarily, but not exclusively, depend on the entity classification of the Buyer Issuer (e.g., partnership, C corporation, S corporation) for federal income tax purposes. Buyers Classified as PartnershipsTax-free equity rollovers are subject to relatively fewer restrictions if the Buyer Issuer is a partnership for federal income tax purposes. Contributions of property to a partnership are governed by Section 721 of the Internal Revenue Code of 1986 (IRC), as amended. Section 721 generally provides that no gain or loss is recognized for a contribution of property to a partnership in exchange for an interest in the partnership. These rules also apply to multimember limited liability companies (LLCs), which are by default classified as partnerships for federal income tax purposes (although LLCs can file tax elections to be classified differently). The exceptions to such tax-free equity rollovers under Section 721 generally cover more complicated and bespoke fact patterns that are less likely to be encountered in typical acquisition transactions. These include, but are not limited to, disguised sales, situations where the partnership is an investment company (as opposed to one that primarily holds business assets or real estate), and fact patterns involving related parties. Accordingly, while buyers and sellers should always consult with their tax advisors, it is relatively straightforward for a seller to transfer property, whether equity of an existing target company or assets, to a Buyer Issuer classified as a partnership in exchange for tax-deferred rollover equity. Buyers Classified as C Corporations Alternatively, if the seller desires to receive tax-deferred rollover equity in a Buyer Issuer classified as a C corporation for federal income tax purposes, any contribution to the Buyer Issuer in exchange for stock of the Buyer Issuer would be governed by Section 351 of the IRC. These rules have more requirements than those governing partnership contributions. The most common obstacle to a tax-free equity rollover into a C corporation is the requirement pursuant to Section 351 that any seller making a contribution to the C corporation must “control” the corporation immediately after such contribution (i.e., the Control Test). For this purpose, “control” means both ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock. In most transactions, it is unlikely that a seller would contribute property with sufficient value to become an 80 percent, or more, stockholder of the Buyer Issuer. Instead, achieving a tax-free equity rollover into a corporate Buyer Issuer would typically require the Buyer Issuer’s existing stockholder(s) to also make contributions to the Buyer Issuer that are contemporaneous with the seller’s rollover. For example, if the Buyer Issuer is a subsidiary corporation, its parent company can contribute cash to the Buyer Issuer in order to fund the cash portion of the purchase consideration. If done correctly, the Control Test would be measured based on the combined stock ownership of the seller and the Buyer Issuer’s other contributing stockholders immediately after the contributions. Apart from the Control Test, and similar to Section 721, there are further exceptions to tax-free equity rollover treatment under Section 351, including but not limited to: receipt by the seller of non-qualified preferred stock, situations where the corporation is an investment company, or whether property contributed to the corporation is encumbered by liabilities in excess of such property’s tax basis. Based on the foregoing, it is even more important for the parties to immediately consult their tax advisors to ensure that a tax-free equity rollover is possible when the buyer is classified as a C corporation; in particular, this would allow the tax advisors sufficient time to consider possible structures for the Control Test or other applicable rules under Section 351. Special Issues for S CorporationsFor federal income tax purposes, an S corporation is a type of corporation subject to special rules that allow it to be taxed as a flow-through entity in many respects, similar to a partnership. Most importantly, an S corporation generally is not subject to federal income tax at the entity level but instead allocates to its shareholders any income, gain, deduction or loss that is recognized by the S

The Importance of Separating Community Benefits From Market Needs

The search for value often requires turning over a lot of stones and thinking creatively about structures and capital. In the search, an entrepreneur or investor often comes across an array of tax-exempt entities and considers whether they might be untapped potential resources. Whether it’s a new business idea that might fill a social need or a valuable opportunity to associate with a trusted brand, the nonprofit sector can present appealing options, even while investors lack an understanding of the real limitations of these entities. But while the strictures on public charities and private foundations (the Internal Revenue Code Section 501(c)(3) class of entities) are fairly well known, other tax-exempt forms are less well understood. Specifically, the entities qualifying under Section 501(c)(4) have drawn a lot of attention as social welfare organizations – those civic leagues and organizations described as “operated exclusively for the promotion of social welfare” and for “the general welfare of the people of the community” under Treasury regulations. What attracts the attention of both for-profit and nonprofit (i.e., 501(c)(3)) organizations is the ability of 501(c)(4) organizations to engage in some practices that are prohibited for 501(c)(3) entities, such as conducting an unlimited amount of lobbying and engaging in political campaign activities. In both cases, the activity is permitted to 501(c)(4)s provided that it’s not the primary purpose of the organization. However, identifying the primary purpose of an organization’s activities remains an inquiry that is based on all the facts and circumstances, and popular perception often overlooks this requirement. Similar to the wider allowance of political and lobbying activity, the 501(c)(4) form has also historically had more flexibility in what qualified as a purpose that promoted social welfare and the good of the community. Once a qualifying community benefit is established, its exemption, for the most part, is not jeopardized by undertaking other activities as long as that social welfare purpose is the primary function of the organization. Much of this is predicated on the lack of a firm definition of “social welfare” and the broad explanation that these organizations provide for “common good and general welfare” and “civic betterments and social improvements” along the lines described in regulations. While the standard for tax-exempt status is to operate “exclusively” for the promotion of social welfare, the practice has been to define “exclusively” as being met when the organization is primarily engaged in activities that promote the common good and general welfare of people in the community. As a result, some organizations take a liberal interpretation of what is covered by the social welfare umbrella for purposes that would otherwise most likely fail to qualify as tax-exempt under Section 501(c)(3), and then they cobble together other activities that are generally beneficial but sometimes overly narrow in those they benefit. In fact, this broad construction approach needs to be closely examined if a component of a proposed or existing business relationship is based on a 501(c)(4) relationship where the benefit to the community resembles activities that would normally be the domain of non-tax-exempt (i.e., for-profit) businesses. One common example comes from organizations claiming a social welfare purpose because they serve the “promotion of health” by offering health care, pharmaceutical or health-related services outside an organization that otherwise qualifies as a 501(c)(3). Other examples might be the provision of services to members, even members that are nonprofits, and to individuals who resemble a customer base more closely than the community as a whole. A hypothetical example might include an entrepreneur who develops a database and tracking system to manage the maintenance and upkeep of real estate holdings. The entrepreneur decides to put the software services in a 501(c)(4), making it available to low- and moderate-income housing units, many of which are maintained and operated by nonprofit organizations. He or she reasons that the organization benefits the community because it makes it possible to improve the maintenance and upkeep of low-income housing. Maybe our entrepreneur also licenses the services to for-profit real estate managers for a higher fee, funneling the licensing profits back into the development of more features that benefit both nonprofit and for-profit housing managers. While the purpose of the organization may be meritorious, the facts, only slightly embellished here, mirror a revenue ruling explicitly determining that the organization did not qualify for 501(c)(4) status. Unlike in the for-profit sector, what makes a purpose or activity one that serves the community goes beyond just meeting a market need. The key principle is that the organization’s activities provide a benefit to the community at large, as opposed to a group of members or select individuals. As a result, many goods and services that provide a market benefit to those individuals whose needs are met by those things being provided will not meet the threshold set for a community benefit in the context of a tax-exempt organization. Recent tax determinations and court cases have rejected tax-exempt organizations when the benefit included providing health care coordination services, pharmaceuticals, management consulting and software services. In many of these cases, the IRS has increasingly taken the position that the “exclusive” requirement more closely resembles the standard applied to 501(c)(3) organizations than the more-malleable popular perception that 501(c)(4) organizations have gained. In the run-up to an election year, the usual focus for 501(c)(4) organizations is on the amount of political activity these organizations engage in. While these organizations’ political activities have recently drawn the attention of the House Committee on Ways and Means, business investors should also be aware that these organizations also crop up in conjunction with organizations and individuals interested in the seemingly greater capacity of these organizations to engage in activities that are tangential to or only loosely qualify as a social welfare purpose. This trend in recent denials and decisions against 501(c)(4) organizations because they represent typical business purposes may signal increased attention to the social welfare purposes of 501(c)(4)s. As always, business transactions that involve or relate to tax-exempt entities require both close scrutiny and assistance from counsel with

Data: The New Currency In Carve-Out Transactions

In the current market conditions, carve-out transactions are becoming increasingly common as companies look to divest noncore businesses and assets in order to restructure and focus on their core operations. This is due to many factors, including the need to improve profitability, reduce debt and focus on innovation. In these transactions, a portion of a company is sold to a buyer while the remaining portion continues to be held by the seller. One of the key considerations in carve-out transactions is data sharing. In many cases, the carved-out business will need to continue to have access to data that the seller currently holds. This data could include sensitive customer information, financial data or intellectual property. The sharing of data in a carve-out transaction can pose a number of risks, including: Data security risks: Buyers must ensure that any data received is secure and will not be misused. This includes taking steps to protect the data from unauthorized access, disclosure, modification or destruction. Compliance risks: Buyers must ensure compliance with all applicable data privacy and security laws and regulations. This includes laws and regulations in the countries where the data is located as well as laws and regulations in the countries where the buyer and seller are located.¹ This also includes an analysis of the seller’s own data privacy policies, including whether the seller reserved the right to disclose data in the event of the sale or transfer of a business. Litigation risks: Buyers may be exposed to liability if the data they receive is used in a way that violates the rights of third parties. This could include using the data to commit fraud, to violate the privacy of individuals or to receive the data in a manner that does not comply with contracts or other licensing agreements. Business disruption risks: If the data-sharing process is not properly managed and the data necessary to operate the carved-out business is not transferred or made available, it could disrupt the operations of both the seller and the buyer. This could impact the transaction and lead to lost revenue, increased costs and damage to the reputation of both companies. In Stradley Ronon’s experience handling carve-out transactions, we have developed a list of factors for parties to carefully consider in order to mitigate risk as a transaction progresses: The nature of the data that will be shared, including where it resides, the infrastructure it operates on and how it may be associated with other bundled information (such as user accounts). The purpose(s) for which the data will be used. The contracts and licensing agreements that apply to the data. The security measures that will be put in place to protect the data. The applicable data privacy and security laws and regulations. The potential risks of litigation. The impact on the operations of both the seller and the buyer. In previous carve-out transactions, we have also found it particularly important to carefully negotiate the terms of the data-sharing agreement, which should include provisions addressing the following issues: The scope of the data that will be shared. The scope of the data that will no longer be maintained by the seller. The purpose(s) for which the data can be used. The security measures that must be put in place to protect the data. The duration of the data-sharing agreement. The termination provisions. The dispute resolution process. The number of carve-out transactions is expected to continue to increase in the near term. As a result, it is important for businesses to be aware of the risks of data sharing in these transactions and to take steps to mitigate those risks. In addition to the factors mentioned above, there are several other considerations that should be taken into account in carve-out transactions involving data sharing. These include: The shared assets, systems and employees that may be used by the carved-out business. In some cases, the carved-out business may need to rely upon assets, systems and employees shared with the seller. This could pose a security risk, as the buyer may not have the same level of control over these aspects of the business, and post-closing transfer of data between buyer and seller may increase the likelihood of an inadvertent data breach. It is important to carefully consider the risks and benefits of such an arrangement before entering into an agreement. The tax implications of a data-sharing transaction. The data-sharing transaction could have tax implications for both the seller and the buyer. For example, the buyer may be required to pay taxes on the data it receives, or the seller may be required to withhold taxes on the data it shares. It is important to consult with a tax adviser to understand the tax implications of the transaction. The impact of data sharing on the competitive landscape. Data sharing could give the buyer an unfair advantage over its competitors. For example, if the buyer receives customer data from the seller, it could use this data to target its marketing campaigns more effectively. It is important to consider the impact of potential data sharing on the competitive landscape before agreeing to it. Over and above these points, it is also important to consider the specific circumstances of the transaction. Ultimately, the factors that are most important will vary depending on the nature of the data that is being shared, the purpose for which the data is being shared and the laws and regulations that apply. By approaching each carve-out transaction carefully, considering the risks of data sharing and taking steps to mitigate those risks, parties to a carve-out transaction can protect their interests and ensure a smooth and successful transaction. ¹ Of particular note, the European Union’s (EU) General Data Protection Regulation (GDPR) applies to any entity that processes the personal data of EU citizens or residents or offers services to people who are EU citizens or residents. The GDPR applies even if the entity is not located within the EU and may impose significant fines for noncompliance. In

Critical Importance of a Holistic Approach in the M&A of a Closely Held and Family Owned Business

Successful business succession planning for a closely held and family owned business requires a multidisciplinary approach, bringing together professionals in several areas, including financial/wealth advisory, accounting, trust and estate law and corporate law. National surveys over the past 15-plus years have shown that the two most popular succession events are a sale of the business to an unrelated third party (representing over 50% of such events), followed by a transition of the business to the next generation of family owners (representing around 20% to 25% of such events). In a number of instances when the business owner wants to exit via the sale of the business, they may initiate the sale process with an investment banker or directly with a potential buyer who has approached the owner; then, they must properly gather their succession planning team and consider their options. In these instances, if the sales process gets too far down the road, to where bid proposals are received by the owner or the owner’s representatives, the ability to do important trust and estate planning by moving some company equity (typically, nonvoting equity) out of the owner’s estate to a family trust will be compromised. In a recent experience, the principal owner of a closely held corporate client engaged a nationally known investment banker to sell his company. As the investment banking firm began to ramp up its sales activities with the year-end financials from the company’s outside accounting firm, we convened a call with the owner’s succession planning team, consisting of the accounting firm, one of Stradley Ronon’s trusts and estates lawyers, his wealth advisory firm, and me – as the lead corporate M&A lawyer for the client. In that call, we mapped out a plan. We were able to put the investment banker’s sale process on a temporary hold; to recapitalize the company by creating two classes of equity (voting and nonvoting); and to get a valuation of the business before any bid proposals were received, which also allowed utilizing discounts for lack of control and marketability. We also planned to establish a trust for his wife and children and to transfer via gift, using the newly issued nonvoting equity from the recap, a material portion of his equity, valued at approximately $5 million, to a family trust before the investment banker’s sale process resumed, offering a sufficient gap in time between the company valuation used for this gifted equity and the receipt of bid proposals from third parties. Based on the projections of the investment banking firm, there is the expectation that the valuation of the company in the sale process will be three to four times higher than the company valuation used for the gifting, which will be a significant win for the owner.   Meet the Author Steven A. Scolari Steve provides practical and strategic legal and business advice to executives and owners of both private and public businesses in connection with a variety of transactional matters, as well as business succession planning engagements, in a wide scope of industries. Those transactions include mergers and acquisitions (M&A), debt and equity financings, joint ventures and corporate restructurings. 610.640.8005

Debt Relief Assistance: A New Model for Employee Benefits

Debt relief assistance is an often-overlooked, relatively low-cost employee benefit available to any employer. A recent study found that employees were increasingly distracted from work due to debt stress, with 62% of respondents reporting that they would be more likely to stay with an employer that offered debt relief assistance. Employers seeking to include debt relief assistance in their benefit plan offerings will encounter a wide range of options. Examples include: Employers may provide up to $5,250 per year tax-free to assist each employee in repaying the employee’s student loan debt. To qualify as tax-free, the program must be in writing, cannot favor only highly compensated employees and must satisfy other IRS criteria for an educational assistance program. Healthcare-related debt benefits focus on both avoiding and managing the debt. Examples include salary-supported loans, emergency savings funds, conversion of unused paid time off to an emergency medical leave bank, varying the employee share of health insurance premium based on wage level, tailoring company health insurance plan offerings to the needs of the particular workforce and employer contributions toward tax-advantaged health accounts such as health savings accounts (HSA), health reimbursement accounts (HRA) and flexible spending accounts (FSA). Credit card and mortgage debt are often targeted through offering free access to financial planning resources and counseling, including referrals to debt consolidation services. Employers seeking to make debt relief assistance part of their benefit offerings should speak with their employee benefits advisor to explore the options that best fit their workforce. The benefits program also should include processes for employees to confidentially access a particular benefit and ask questions about its application to their specific debt situation. Meet the Author A. Nicole Stover Nicole Stover is a strategic business partner to corporate and non-profit clients in all areas of employment law, including mergers and acquisitions, discrimination and harassment, competition and trade secrets, and compensation and benefits. 856.321.2418

Board Observers: Relevant Considerations and Potential Pitfalls

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