[co-author: Anthony Cahill]
After years of ever increasing valuations and growing competition to win investment opportunities, it appears that the public and private markets are about to experience a period of extreme volatility and dislocation as a result of COVID-19. Many companies with strong balance sheets are already tightening spending and placing strategic investment activity on hold to preserve capital until the market demonstrates stabilizing conditions. Over time, however, many private company boards will be forced to consider third-party financing and potentially other strategic alternatives. In so doing, board members who hold their director seat by virtue of an investment by their sponsor employer, facing scenarios that may impair the sponsor’s investment, will be asking themselves this question: where does my duty as a fiduciary ultimately lie?
The investor-director, the so-called “dual fiduciary,” is forced to wear two hats: one as the strategic advisor to the company, and the other as the investment manager, monitoring and maximizing the sponsor’s investment. As a board member, the investor-director is bound under Delaware law to uphold the fiduciary duties of loyalty and care to the corporation. The fiduciary duties of loyalty and care require that directors act to maximize the enterprise of the corporation for the benefit of its common stockholders. No special duty of care is owed to any preferred stockholder or any class of preferred stock by virtue of its preference rights in the capital structure (i.e., senior liquidation preference). Instead, the terms of a preferred security are considered a series of contractual rights and Delaware law makes clear that a director’s fiduciary duty is owed exclusively to the common stockholders.
This does not, however, prevent an investor-director from proposing financing solutions or serving both roles. Section 144 of the Delaware General Corporation Law provides that a corporate transaction involving an interested director is not void solely because of self-interest, or because that director votes upon, or otherwise participates in, consideration of the transaction so long as (i) proper disclosure of the interest is provided, and (ii) the majority of disinterested board members (or stockholders, if by ratification), vote in good faith to approve the transaction.
While capital from opportunistic investors may be available in the current market, sponsors should expect an uptick in inside rounds as existing investors seek to preserve and maintain existing investments using dry powder reserved for follow-on investments in portfolio companies. So, how do investor-directors who find themselves in a dual-fiduciary position balance the competing interests of the common stockholder with that of the sponsor’s interest in maximizing returns and fortifying long term investment strategies?
In situations where the board is considering alternatives for the company (e.g., a sale, restructuring or debt or equity financing), the “dual-fiduciary” should:
- Ensure he or she is fully informed with reasonably adequate information to consider all alternatives for the company;
- Disclose any conflicts of interests to the other directors as soon as possible, including reminding the board that the director is affiliated with a preferred stockholder;
- If the investor-director’s employer is involved in a transaction with the company, consider recusing themselves from board meetings and/or consult with company counsel about forming and independent committee;
- Consider what is best for the company and its common stockholders;
- Consider all available alternatives, regardless of their impact on the preferred stockholders; and
- Avoid advocating for any action that would disproportionately benefit the preferred stockholders or any particular stockholder.
In sum, investor-directors face an inherent conflict in balancing their obligation to monitor their investment while seeking to maximize value for common stockholders. Ultimately, it is critical that any director in a “dual-fiduciary” position focus on the needs of the company and its common stockholders ahead of any others, especially if the alternatives on the table or under consideration involve existing investors.