Corporate investors who wish to have more information about their investments have two choices: board member or board observer. The authority and duties of board members are created primarily by corporate law, but the rights and duties of board observers are created by contract. Many corporate investors choose to have a board observer rather than a board member to reduce the potential liability to the individual serving in the position as well as that of the investing company. Board observers may attend and participate in company board and committee meetings, but they are not formal members of the board and cannot vote on board matters.
Best Practice #1: Carefully Review Your Contractual Rights and Duties
Board observer rights agreement. The corporate investor must carefully consider the rights it wants prior to negotiating its board observer rights. The right to appoint a board observer may be contained in one of the main financing documents or in a separate document, often called a board observer side letter. A corporate investor should consider developing its own form of board observer side letter spelling out the rights it wants. If the corporate investor is not using its own form, it should carefully review the provisions in the proposed board observer letter in order to understand the scope of the rights being granted and the contractual obligations being imposed. The portfolio company’s standard board observer side letter may be inappropriate because it may have been drafted for use with traditional venture capital fund investors and may not be appropriate for corporate investors.
Areas to be covered in observer agreement: The board observer agreement should address the following key areas:
- • the right to attend board meetings;
- • the right to attend board committee meetings;
- • the right to receive information about the portfolio company; and
- • the scope of use of confidential information. (For more information on minimizing the risk of misuse of confidential information, please see our article in the September 2013 issue of Global Corporate Venturing).
Provisions that may be problematic: Corporate investors should be wary of three provisions that may be requested by the portfolio company:
- • the application of fiduciary duties to the board observer;
- • the limitation on the rights to obtain and use information; and
- • the limitation on the right to attend Board or committee meetings.
Carefully review duties imposed by board observer agreement. First, corporate investors should review any board observer agreement to make sure it does not attempt to impose fiduciary duties on the board observer. While board members have fiduciary duties of loyalty and care to the company under corporate law, board observers do not have fiduciary duties to the portfolio company unless they agree to such duties by contract. The corporate investor should reject the language imposing fiduciary duties on its board observer to avoid creating substantial additional risks to the corporate investor and the observer without the right to vote on issues which a board member would have.
Look for limits on portfolio company information to be provided to observer. Second, corporate investors should be careful about provisions that limit the board observer’s access to information. As a general rule, board observers should have access to all of the same notices, minutes and other written materials the portfolio company provides to its board members. Board observer agreements will generally provide that an observer may not receive certain sensitive materials, such as those relating to personnel matters and transactions with competitors, but such exclusions should be as limited as possible.
Make sure rights to attend meetings include appropriate board and committee meetings, with few limitations. Third, corporate investors should be careful about terms that limit the board observer’s rights to attend board meetings. The board observer’s attendance rights should include all meetings of the board and board committees. Board observer agreements will generally provide for exclusion of an observer from attendance at certain portions of the meetings. The most common exclusions are: (i) attendance could adversely affect the attorney-client privilege between the portfolio company and its legal counsel; (ii) discussion of the portfolio company’s relationship with the corporate investor; (iii) discussion of the portfolio company’s transactions with a competitor of the corporate investor; and (iv) discussion of a potential acquisition by a competitor of the corporate investor. These limitations should be carefully negotiated so as not to be overbroad.
Best Practice #2: Promptly Disclose Conflicts of Interest and Consider Recusal When They Arise
Be careful with confidential information of the portfolio company. A corporate investor should generally have the board observer come from its venture group and not its business unit. This approach reduces the risk of inappropriate use of confidential information. If the corporate investor determines the board observer will be from a business unit, the board observer should be from a division that is not directly competitive with the portfolio company. The board observer agreement may place limits on the ability of the observer to disclose information learned in his or her capacity as an observer, such as a prohibition on sharing such information with a corporate investor’s business unit that competes with the portfolio company. In any case, the corporate investor should have confidentiality procedures in place with respect to the use of the portfolio company’s information.
Consider disclosure and/or recusal from certain board discussions. A board observer should be sensitive to whether the topics being presented at a board meeting may create a conflict of interest with the corporate investor and the board observer should promptly disclose that potential conflict to the board. The board observer should also consider recusal from further discussions to limit the risk of learning confidential information that could create a problem for the corporate investor.
Best Practice #3: Keep in Mind the Role of a Board Observer
A board observer’s main roles are to monitor the portfolio company for the corporate investor and to provide guidance to the portfolio company. The board observer’s presence at board meetings and contributions to board discussions should be focused on strengthening the relationship between the portfolio company and the corporate investor. The board observer should be sensitive to the culture of the board and the degree to which the board observer should participate. Some boards welcome participation of board observers as if they were board members, but others boards have a culture in which only board members participate in the discussion during the meetings.
Although a board observer may participate in board discussions and generally assist the portfolio company with its strategy, he or she should always keep in mind that a board observer is not a formal board member and does not have a right to vote on official board matters. Note that, under corporate law, board members are not permitted to delegate their board votes to anyone else, not even to board observers or other board members.
Advice Box
Why Choose to Have a Board Observer Instead?
- • Reduced potential liability to the individual and the investing company (versus serving as a board member/director)
- • Observers may still attend and participate in board meetings
- • Observers may negotiate the right to receive the same information given to board members
Advice Box
Tips for Board Observers
- • Develop your own form of board observer agreement
- • Carefully review terms of board observer agreement if not your form
- • Avoid taking on fiduciary duties if an observer
- • Promptly disclose conflicts of interest
- • Consider recusing yourself from discussions involving a conflict
- • Remember observers are not voting board members