Board Responsibilities in a “Down Round” Financing
Corporate & Finance Alert
May 5, 2009
Distressed situations can force additional burdens and responsibilities upon the directors of a business enterprise. A company seeking financing may have to undergo a “down round” financing, which refers to a round of venture capital financing which is based on a lower valuation for the company than the previous round. Existing owners, who are already unhappy with the declining value, and who will likely face further dilution in the down round, may try to recover some of their investment by alleging liability against the company’s directors based on a breach of fiduciary duties. Down round financings can create a perception of unfair dealing by the directors based on a number of factors, including the presence of interested directors on the board and the perceived leverage of the venture capital investors. Therefore, it is critical that board members understand their fiduciary duties in a down round and take steps to minimize any potential for director liability.
This Alert will address applicable fiduciary duties and best practices for directors of both corporations and unincorporated entities.
Fiduciary Duties of Corporate Directors
Corporate shareholders may bring a derivative claim against the corporation’s directors for a breach of their fiduciary duties to the corporation. Common law recognizes two main fiduciary duties: the duty of loyalty and the duty of care. The duty of loyalty imposes an obligation to refrain from conduct that is either harmful to the corporation and its shareholders or is solely in the directors’ own interests. The duty of good faith is a subsidiary element of the duty of loyalty and requires that directors act in a manner that they believe to be in the best interests of the corporation. The duty of care requires that directors act with the care an ordinarily prudent person would exercise under similar circumstances and includes a requirement that, prior to making a business decision, the directors inform themselves of all material information available to them, including reasonable alternative courses of action. In discharging the duties of loyalty and care, directors are entitled to rely on management and the advice of professional advisors who are experts in their fields, provided that the directors have no independent basis for not relying on such advice. Directors are entitled to a presumption that in making a business decision they have acted “on an informed basis, in good faith and in the honest belief that the action was taken in the best interests of the company.”1 This is the so-called “business judgment rule.” Under this rule, a director’s business judgment is respected and not second guessed by the courts.
Fiduciary Duties of Control Persons of Limited Liability Companies
Many business enterprises today are organized as limited liability companies (“LLCs”) with a corporate-like governing board of managers which may even be designated as a board of directors. State common law regarding the applicable duties of boards of control persons of LLCs is far less-developed than the law governing the fiduciary duties of corporate directors, with Delaware, frequently the jurisdiction of choice for professional investors, being a notable exception. In Delaware, it is well-settled that in the absence of provisions in an LLC operating agreement to the contrary, a board of an LLC would owe fiduciary duties to the company owners comparable to the duties owed by a corporate board of directors to corporation shareholders.
However, in Delaware and many other jurisdictions, in governance matters involving LLCs, maximum effect is given to freedom of contract. Since the structure and operation of an LLC may be designed by the owners in the operating agreement, the owners have wide latitude in describing the scope of the duties of a governing board, the manner in which such duties may be discharged and the liabilities of the governing board members if the duties are not discharged appropriately. Indeed, under the Delaware Limited Liability Company Act,2 fiduciary duties may be eliminated entirely. The sole statutory constraint is that the parties may not eliminate the implied contractual covenant of good faith and fair dealing, which has been described as requiring a party to the contract to refrain from arbitrary or unreasonable conduct having the effect of preventing the other party to a contract from receiving the fruits of the bargain.
Contractual freedom carries a burden. Courts which have addressed contractual provisions purporting to curb or eliminate the fiduciary duties of LLC boards have cautioned that the parties’ intent must be clear and unambiguous.
Best Practices in a Down Round
For corporate and LLC boards in which fiduciary duties have not been modified or eliminated, down rounds present special challenges. However, directors can avoid liability by making use of established safe harbors and applying the following best practices.
- The directors should take care to insure that they are fully informed, and to obtain all necessary information before acting. The failure to keep informed can lead to a loss of the protection of the business judgment rule. The board does not need to receive all the information which management receives, but it should work with management to determine what information is useful, and should periodically reassess this determination. The board should receive at least the same information that is available to owners or potential investors, such as press releases or analyst reports.
- The directors should make sure they are fully informed not only as to the down round, but more generally, as to the corporation’s overall strategic plan. The directors should have management frequently present on the long term strategic plan to the board, including any external influences on the plan such as trends or economic factors that will effect the corporation’s industry.
- Before approving a down round financing, the directors should carefully consider all other reasonable options available to the corporation for financing, such as bank or bridge lending. Moreover, the board of directors should consider other reasonable options to financing, such as a sale, merger or bankruptcy filing. Directors who act without considering other courses of action could be accused of not exercising their duty of care.
- Directors would be well advised to establish, document and follow a decision making process. The corporations’ professional advisors can help recommend such a process. The process will help insure that all reasonable options are considered in an informed manner prior to taking action.
- If the corporation can afford the expense, the directors should consider retaining financial advisors and other experts for help on the down round. The laws of most states recognize the right of directors to rely upon professional advisors. Outside professional advisors may be particularly valuable if there are one or more interested directors.
- Directors should assume that all of their actions will be scrutinized. While considering and approving a down round, directors should make sure that detailed meeting minutes are kept. The minutes will provide evidence that board members were fully informed and considered other reasonable options.
- The directors should attempt to confirm the corporation’s valuation and share price. Such confirmation can be obtained by encouraging or soliciting offers from multiple investors or potential buyers, or may be obtained by hiring an outside professional to provide its opinion of the valuation.
- The board should consider a rights offering, which means the company offers all existing owners the right to participate in the down round offering on the same terms as the lead investors. By giving minority owners the right to participate, the company may limit claims that the existing minority owners were treated unfairly or that the board did not otherwise exercise its duty to act in good faith.
- Directors contemplating a down round should continually monitor the financial health of the company to determine if or when the company may enter the zone of insolvency.3 Courts have held that when a corporation enters the zone of insolvency, the directors also owe fiduciary duties to the corporations’ creditors, as the beneficiaries of any residual value of the corporation. In the zone of insolvency, the duties of loyalty and care remain the same, however such duties are now owed to the larger group of corporate stakeholders (i.e., shareholders and creditors). Corporations often rapidly deteriorate. If the corporation may be in the zone of insolvency, the directors should try to maximize the value of the corporation for all stakeholders, should consider other options to the down round, should carefully limit the corporation’s expenses and should consult with outside professionals. Outside professions can assist in determining whether the corporation may be in the zone of insolvency, the directors fiduciary obligations and the legal implications on any down round.
- In advance of the down round, the company should make sure that the personal liability of its directors and officers is limited to the maximum extent permissible by law. The directors should ask for the indemnification provisions of the company’s charter documents to be reviewed. Typically, a director should be indemnified by the company for any liability incurred while acting as a director for the benefit of the company, unless he or she acted in bad faith or with willful misconduct. Furthermore, the company should acquire and maintain adequate D&O insurance to protect the directors from any loss due to liability for their acts on behalf of the company.
- The board should be conscious of the presence of any interested directors among its members and take steps to protect the board from any adverse impact in connection with such interested directors. Venture capitalists often demand the right to designate board members in conjunction with their investment in a company. Moreover, they will usually pick an employee, officer or director of the investment fund to serve as the fund’s designated director. In these cases, the board should take advantage of the safe harbor rules for an interested director. Under the safe harbor, an interested director shall not be found to be in breach of his or her duty of loyalty if: (i) a majority of the disinterested directors (or a majority of the disinterested members of a special committee charged with considering the transaction) approve the transaction after full disclosure of the conflict; (ii) a majority of the shareholders (ideally, of the disinterested shareholders) approve the transaction after full disclosure; or (iii) the transaction is determined to be fundamentally fair.
- Down rounds usually require shareholder approval. For example, shareholder approval may be required to issue new preferred shares in a corporation, to amend the corporation’s articles, to comply with the terms of an existing shareholders’ agreement, or to approve the down round in the presence of an interested board. When seeking shareholder approval, the directors’ fiduciary duties require that the directors provide the shareholders with all material information which a reasonable shareholder requires to make a decision. Therefore, the board should instruct management to fully inform the shareholders as to the materials terms of the down round, especially the dilution that existing shareholders will experience in connection with the issuance of new shares.
- Directors should keep all discussions and comments concerning the down round confidential. Any inquiry by the press or potential investors should be handled by management, or if necessary, by a single designated board representative. Any unauthorized disclosure by a director could lead to liability on such disclosing director for a breach of such director’s general duty of confidentiality to the corporation or for making misleading statements to the public.
- Despite the required care and scrutiny of stakeholders in a down round, directors should not be scared away from making any decision. If a board makes no decision, when some action was required, claimants may argue that the directors abdicated their fiduciary duties.
In the case of an LLC, the possibility of a down round of financing may be addressed as a matter of contract between the owners. There are a myriad of options. At one extreme, if the LLC agreement provides for a governance structure that is intended to resemble a corporation, most of the best practices described above would be applicable to the LLC board. At the other extreme, the LLC agreement could disclaim any duties of care, loyalty or good faith on the part of the board designees of the venture capital investor, and provide that such individuals have unfettered discretion to set the financial terms of a subsequent round of financing. The guiding principal is that the applicable contractual standards should be drafted carefully and unambiguously.
Directors need to act with heightened sensitivity to their fiduciary duties or, in the case of LLCs, applicable contractual standards of care, when their business enterprise is contemplating or undertaking a down round offering. Down round situations demand such increased attention because down rounds often take place in distressed situations or in the zone of insolvency, down rounds may involve interested directors, and down rounds may lead to unhappy and diluted owners. To protect themselves from liability, directors need to understand applicable corporate duties of care and loyalty, or such other applicable duties and processes as may have been established by contract in the case of an LLC, and should understand how to be faithful to such duties in a down round. Directors need to be fully informed about the down round, other opportunities and the marketplace. Directors should follow a documented and pre-planned decision making process with the help of management and outside advisors. Any when it comes time to make a decision, directors should use their reasonable business judgment to maximize the enterprise’s value.
1Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985).
26 Del. C.§§18-1101.
3There is no clear test for when a corporation enters the zone of insolvancy. Courts have recognized several different tests such as: (i) the inability to pay debts as they become due, (ii) the excess of balance sheet liabilities over assets, or (iii) inadequate capital to conduct business.