Governance issues in private equity: the changing role of nominee directors
It is common for private equity sponsors to obtain board nomination rights that are commensurate with their level of investment in a given business. Board nomination rights provide the nominating shareholder with an ability to effectively monitor and, in some cases, control their investment by nominating directors whom they believe represent their interests. There are, however, limits on the extent to which nominee directors can be used by nominating shareholders to achieve those ends, as nominee directors are, first and foremost, fiduciaries of the corporations on whose boards they serve.
This piece focuses on two topics that are central to the effectiveness of board nomination rights:
- the role of nominee directors in strategic transactions; and
- information sharing between the nominee and its nominating shareholder.
Managing conflicts of interest in strategic transactions
Under Canadian law, nominee directors must act honestly and in good faith with a view to the best interests of the investee corporation. This obligation is to the corporation and not to any one of its stakeholders, including the nominee director’s nominating shareholder. Directors must consider the interests of all stakeholders affected by a particular decision and, where some of those stakeholders’ interests are in conflict, use their business judgment to balance the conflicting interests in order to identify the path forward that is in the best interests of the corporation.
Where the interests of a nominating shareholder are not aligned with the best interests of an investee corporation, nominee directors need to tread carefully. In such cases, nominee directors might find themselves in an actual or potential conflict of interest. Decisions involving conflicted directors tend to involve higher levels of judicial scrutiny, including judicial consideration of the substance of the matter at hand.
The sale of an investee company can present conflict of interest challenges for nominee directors. This is especially true when the nominating shareholder holds preferred securities or other instruments that will return consideration (in form or amount) different from that to be received by the common shareholders, or where such a shareholder has a unique liquidity concern (e.g., the need to monetize holdings of a maturing fund).
The Delaware Court of Chancery recently heard a claim involving allegations of a breach of nominee directors’ fiduciary duties where both aspects were present. The claim was brought by the investee corporation’s former common shareholders, who assert that the nominee directors acted disloyally to the investee corporation in connection with a rushed sale transaction that resulted in most of the consideration being paid to the investee corporation’s preferred shareholders (the largest of which was the nominee directors’ nominating shareholders). The court’s decision is pending.
Nominee directors should be aware of actual or potential conflicts of interest in strategic transactions, especially those in which their nominating shareholder plays a special role or is to receive differential treatment relative to other shareholders or (as in the Delaware case) may use their position to push through a transaction especially beneficial to the nominating shareholder. In these circumstances, directors and their nominating shareholders are encouraged to seek counsel early in the transaction process. Nominee directors should consider abstaining from board deliberations and decisions as appropriate. Where conflicts arise, investee corporation boards should form independent committees comprised of unconflicted directors to steer the transaction.
Information sharing
A director’s duty of loyalty to an investee corporation includes a duty to maintain the confidentiality of the corporation’s information. Canadian courts have not ruled definitively on whether or to what extent a nominee director may share investee company information with its nominating shareholder. This sometimes comes as a surprise to nominating shareholders, as information sharing goes to the core of why board nomination rights are bargained for in the first place.
Delaware law permits the sharing of information with a director’s nominating shareholder so long as neither the director nor the nominating shareholder misuse the information. In Canada, information sharing is clearly permitted where the investee corporation consents.
As we have written elsewhere, while we would expect Canadian courts to be generous in implying consent to the disclosure of investee corporation information in some limited fashion, nominee directors should obtain explicit consent from the investee corporation for such disclosure other than in cases where it is abundantly clear that implied consent is present. This position does not reduce protection for the corporation, as the shareholder (like the director) would be restricted in how such information can be used. For public companies, it is consistent with securities law, which, through special rules for insiders, presumes a nominee shares information with the nominating shareholder.
Key takeaways
- Directors must act in the best interest of the investee corporation: The duty of all directors is to act in the best interest of the corporation on whose board they serve and not in the best interest of their nominator.
- Abstain from board deliberations: In the event of a conflict of interest, the corporation should leave the details of and decision on the conflicted transaction to independent directors.
- Nominee directors can share information with their nominating shareholder: Though Canadian courts have yet to weigh in on the extent to which a nominee director may share company information with their nominating shareholder, information sharing is permitted if/when the investee corporation consents.
- Seek counsel before a conflict of interest arises: Nominee directors and their nominating shareholder should be aware of cases where they might have a perceived conflict of interest and seek counsel early in the transaction process to avoid contention.