Be Careful What You Wish For Considerations When Obtaining Board Representation

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1 Be Careful What You Wish For Considerations When Obtaining Board Representation Marc Weingarten, Partner, Business Transactions Neil P. Horne, Associate, Business Transactions Activist investors frequently negotiate, and failing a consensual resolution may wage a proxy contest, for the right to appoint members of the board of directors of companies in which they are acquiring an equity interest. Achieving this representation can enable an investor to keep a close eye on its investment and the strategic direction of the company. The designee will vote on the company's board-level decisions, and thus will participate in shaping its strategic direction and other significant actions. Both the investor and the company may view the investor designee's expertise and business contacts as important contributions to the company's efforts. However, there are also complex legal considerations that arise when investors have board designees, and investors must understand the complications of these considerations before seeking representation. 1 The issues described below generally are present where the designee is affiliated with or beholden to the investor or communicates information that comes to the designee in its capacity as a director i.e., where the designee represents the investor on the board. These issues generally may be avoided where the investor merely suggests or approves the appointment of a director who is completely independent of, and "walled-off" from, the investor. These distinctions require careful analysis and planning in particular cases. Fiduciary Duties Pursuant to Delaware law, 2 a director of a corporation (whether private or public) is required to oversee the business and affairs of the corporation and is subject to certain fiduciary duties to the corporation and its stockholders in fulfilling that obligation. Under the duty of care, directors are generally required to exercise "that amount of care which ordinarily careful and prudent men would use in similar circumstances." 3 Under the duty of loyalty, directors are generally obligated to act in good faith and without self-interest for the benefit of the corporation and its stockholders. A director s compliance with these fiduciary duties becomes significantly more complex when he or she is the designee of an investor. Since a director s fiduciary duties are generally owed to the company on whose board he or she sits and the company s stockholders, a director designated by a particular investor needs to ensure that his or her fulfillment of obligations (if any) to the investor that has appointed him or her to the directorship does not jeopardize the director s ability to act in the best interests of the company and its stockholders as a whole. According to a leading Delaware law treatise, the duty of designated directors is to the corporation and its stockholders, not to the particular designator. 4 While this principle is easy enough to recite, its application in practice can be far more challenging for a board designee who also may have responsibilities to the investor who has appointed him or her to the directorship. 5 Since a director could face personal liability and monetary damages if he or she breaches these fiduciary duties, 6 it is important for an investor and its potential board designee to understand and evaluate these duties prior to agreeing to fill such a board seat. Conflicts of Interest There frequently may be instances where the interests of the investor diverge from the interests of the company and its stockholders as a whole. Obvious examples are when the company and the investor are entering into a transaction between themselves or directly competing with each other. Other examples of potential conflicting interests arise in connection with the decision whether, when and under what terms and conditions to sell, merge or liquidate the company if the investor who appointed the board designee has different exit timing horizons or stands to obtain different consideration in the transaction (by virtue of holding debt or preferred stock or otherwise) than other stockholders of the company. When potential or actual conflicts of interest arise, there are several steps that may be taken to reduce the likelihood of breach of fiduciary duty claims being successfully brought. It is important for a director who has a potential conflict of interest to disclose the conflict fully to the board of directors of the company. In addition, in view of the provisions of Section 144 of the Delaware General Corporation Law (the "DGCL"), Delaware's safe continued on page 4 activist investing developments spring

2 Be Careful What You Wish For continued from page 3 harbor statute for certain interested director transactions, the company should consider seeking the approval of a majority of the disinterested directors or the approval of the company's stockholders. In some circumstances, it may be prudent for the board of directors to appoint a special committee of the board comprised entirely of disinterested and independent directors to consider and vote upon the matter, and/or obtain the approval of a majority of the disinterested stockholders. However, even if the conflict at issue involves the type of transaction covered by Section 144 (frequently not the case if the conflicting interest is that of the investor and not personally of the director appointed by the investor) and protective procedures are followed, the conflict at issue may still be subject to a breach of duty of loyalty claim the safe harbor addresses whether the transaction itself is voidable, not whether a breach of fiduciary duty has occurred. Consequently, a board designee should also seriously consider recusing himself or herself entirely from the board's deliberations relating to the transaction or decision at issue and abstaining from voting on the matter. 7 Another option likely to be an undesirable alternative for some investors unless there is a continuing conflict is for the board designee to resign from the board. If the investor has preferred stock of, and/or an investment agreement or stockholders agreement with, the company that provides the investor with specified information and voting or approval rights, 8 the investor may determine that it is preferable to avoid the potential conflicts of interest that arise from having its designee continuing to serve on the company's board. 9 Care should also be taken to document in the company s minutes (and to the extent appropriate, the investor s minutes) the deliberations that have occurred and the steps that have been taken to address the matter. Corporate Opportunities Board designees must also be careful not to breach their duty of loyalty by taking for themselves or the investors who have appointed them business opportunities belonging to the company on whose board they sit. Conversely, the board designee also will want to ensure that he or she is not improperly depriving the investor of a business opportunity to which it is entitled. Section 122(17) of the DGCL does permit corporations to "[r]enounce, in its certificate of incorporation or by action of its board of directors, any interest or expectancy of the corporation in, or in being offered an opportunity to participate in, specified business opportunities or specified classes or categories of business opportunities that are presented to the corporation or one or more of its officers, directors or stockholders." However, to the extent that the company has not availed itself of this statutory provision, or the business opportunity at issue is not covered by the action that has been taken under Section 122(17), board designees will need to be careful that they are not breaching their duty of loyalty in connection with business opportunities and exposing themselves to related liabilities. Confidentiality Obligations There may frequently be circumstances where a board designee receives (or potentially could receive) confidential information in his or her capacity as a member of the company's board of directors that should not be conveyed to the investor who appointed him or her. In those instances, careful consideration should be given as to whether the board designee should recuse himself or herself from the related discussions of the board entirely, and even if a decision is made against recusal, the board designee should be careful not to disclose to the investor confidential information to which it is not entitled. Conversely, when a board designee seeks to disclose a potential conflict of interest involving the investor to the company's board of directors, there may be confidential information relating to the investor's business strategies that may be inappropriate to disclose without the investor's consent. This restriction, in turn, may make it more challenging for the board designee to fulfill his or her obligation to make full disclosure of any conflict of interest to the company's board of directors, and may warrant his or her recusal from the board's deliberations after disclosing the related confidentiality obligations. Section 16 of the Securities Exchange Act of 1934 Directors and officers of a public company and beneficial owners of more than 10% ("insiders") of any class of any equity security of a public company which is registered pursuant to Section 12 of the Securities Exchange Act of 1934 (the "Exchange Act") are subject to the requirements of Section 16 of the Exchange Act. Under Section 16(b) of the Exchange Act, an insider generally must disgorge to the company any profits ("short-swing profits") the insider has earned from any matching purchase and sale or sale and purchase of any equity security of the company continued on page 5 4 Schulte Roth & Zabel LLP

3 Be Careful What You Wish For continued from page 4 within any period of less than six months. Section 16(c) of the Exchange Act generally prohibits an insider from selling short any equity security of the company or selling such securities "against the box." Also, Section 16 generally requires insiders to file with the Securities and Exchange Commission (the "SEC") an initial report (Form 3) disclosing the amount of all equity securities of the company of which he or she is the beneficial owner within 10 days after he or she becomes such beneficial owner, officer or director (or, in the case of an insider of a company that does not have a class of equity securities registered under Section 12, on the effective date of the company's registration under Section 12 of the Exchange Act). Subsequently, the insiders are required, in most cases, to file a transaction report (Form 4) by the end of the second business day following the day on which there has been any change in beneficial ownership of such securities, and certain insiders are required to file an annual report (Form 5) within 45 days after the end of the company's fiscal year. A designee to a public company's board of directors would be subject to the above described requirements. In addition, the designee will be liable for disgorging his or her pro rata share of any short-swing profits of the investor who has appointed him or her to the board (and to report such holdings and transactions to the extent required by Section 16) if the designee is deemed to have a direct or indirect pecuniary interest in the equity securities of the company held by the investor. For example, pursuant to Rule 16a-1(a)(2)(ii)(B) under the Exchange Act, if the investor is a general or limited partnership and the board designee is a general partner of the investor, the designee will be deemed to have an indirect pecuniary interest in his or her proportionate interest in the portfolio securities owned by the partnership equal to the greater of his or her share of the partnership's capital account or his or her share of the partnership's profits at the time of the transaction. While an investor who crosses the 10% beneficial ownership threshold is subject to the above described requirements, an investor who appoints a designee to a public company's board of directors also is likely subject to these requirements (even if the investor does not cross the 10% threshold) if the investor is deemed to have "deputized" its designee to serve as a member of the company's board on the investor's behalf. 10 According to a leading Section 16 treatise: To establish that a director in fact is a deputy, a plaintiff must show that either (i) the director regularly shared confidential information about the issuer with the alleged deputizer, (ii) the director had a relationship with the deputizer that allowed the deputizer to influence the director's decisions as a director, or (iii) the director had a relationship with the deputizer that allowed the director routinely to influence the deputizer's investment policy, or at least its investment policy regarding the issuer. Then, to establish that the deputizer "functioned as a director," the plaintiff must show that the director performed his or her duties on behalf of the issuer for the benefit of the deputizer rather than for the purpose of guiding or enhancing the issuer's business activities. 11 Although an investor's contractual right to appoint a member of a public company's board of directors is a factor that a court would consider in determining whether the investor is a director by deputization, that right, without other factors supporting a finding of deputization, would not necessarily be dispositive. 12 To the extent that there is any possibility under the particular circumstances that the investor may be deemed an insider for purposes of Section 16, the investor will need to determine whether it is required to make any filings under Section 16, understand any applicable exemptions and determine whether it is required to refrain from engaging in the types of transactions that are prohibited by Section 16. Insider Trading Prohibitions If the investor and/or its board designee trades securities of a public company while in the possession of material, nonpublic information, or improperly communicates that information to others, they may be exposed to severe penalties, both criminal and civil. The prohibitions against insider trading may significantly curtail an investor's ability to trade securities in a public company if it has a designee on the company's board. While it is important that the board designee of an investor refrain from trading securities of the public company on whose board he or she sits while in the possession of material, nonpublic information, it is equally important that the investor who obtains material, nonpublic information from its designee refrain from such trading. Even in circumstances where the designee has not actually disclosed material, nonpublic information which he or she possesses to the investor, there is a risk that the investor will be imputed with knowledge of such information. To help ensure that insider trading violations do not occur, the company may adopt an insider trading policy that, among other requirements, prohibits trades in its stock by the board designee (and the other directors of the company) and the investor (and any other stockholders of the company with designees on its board) without prior notification to, and clearance by, the company and during designated "blackout periods" when it is most likely that they would possess material, nonpublic information. 13 In addition, an investor may consider appointing a board designee that is independent of the investor and implementing formalized information barriers to help ensure that the investor is not provided access to material, nonpublic information relating to the company that the designee receives. see footnotes on page 7 activist investing developments spring

4 Be Careful What You Wish For continued from page 5 1 With the passage of the Sarbanes-Oxley Act of 2002 and related requirements, the responsibilities of outside directors in general have significantly expanded. An outline of those increased responsibilities, the other obligations of directors and investors in general and the potential securities law filing requirements to which a director or investor may become subject is beyond the scope of this discussion. 2 Our discussion herein addresses certain aspects of Delaware law. If a designee is to be appointed to the board of directors of a company incorporated in another state, the applicable corporate laws of such state must be evaluated. 3 Graham v. Allis-Chalmers Mfg. Co., 188 A.2d 125, 130 (Del. 1963). 4 1 R. Franklin Balotti & Jesse A. Finkelstein, The Delaware Law of Corporations & Business Organizations, 3d ed., 4.38(B). 5 See Cyril Moscow, Corporate Governance: The Representative Director Problem, Insights, at 12 (June 2002) (indicating that the dearth of case law and literature addressing the unique position of representative directors can result in the "unnecessary separation of legal doctrine from corporate activity that can create confusion, expense and possible liability"). 6 Although Section 102(b)(7) of the Delaware General Corporation Law permits a corporation to include in its certificate of incorporation a provision eliminating or limiting the personal liability of a director for breach of fiduciary duty, such Section also prohibits the elimination or limitation of personal liability for, among other things, breaches of the duty of loyalty and acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law. 7 See Balotti & Finkelstein, supra note 4, 4.38(B) ( designated directors faced with a corporate transaction involving a potential conflict between the corporation and the designator are best advised to disclose the conflict and to totally abstain from participating in the matter. Failure to do so may result in liability to the director and, if also a fiduciary, to the designator as well. ) (citing Weinberger v. UOP, Inc., 457 A.2d 701, (Del. 1983)). 8 Even if the investor has a board designee, it may be preferable for such voting and approval rights to be granted to the investor rather than to the investor s board designee to avoid creating related conflicts of interest for the designee in taking action. See Matthew P. Quilter, Austin Choi & Sayre E. Stevick, Duties of Directors: Venture Capitalist Board Representatives and Conflicts of Interest in Venture Capital 2002: Getting Financing in a Changing Environment, at 1134 (Practicing Law Institute Corporate Law and Practice Course Handbook Series, June 2002) (covenants requiring the approval of a board designee "can unnecessarily cause the director to be placed in a conflicted position down the road"). 9 See id. ("Although venture funds may be reluctant to cede a board seat given their interest in monitoring their sizeable investments in a portfolio company, they may very well consider opting for board observation rights in lieu of formal board representation in light of the potential for increased conflicts of interest, and the risks to the venture capitalist director such conflicts pose"); Andrew M. Herman & Joanne Cosiol, A Hot Seat at the Table?; For Venture Capitalists, Board Membership Entails Certain Legal Risks, Legal Times, May 9, 2005, at 31 (indicating that information, access and voting controls can provide investors "some of the power of a board seat but without the fiduciary obligations and potential liability of that position"). 10 See Peter J. Romeo & Alan L. Dye, Section 16 Treatise and Reporting Guide, 2d ed., 2.04(5)(a) (2004) (indicating that a director by deputization would likely be subject to all of the above described requirements). 11 See id. at 2.04(4)(a). 12 See id. ("The status of an entity as a director by deputization should not be affected by whether the entity's representative was elected to the board pursuant to a written agreement between the entity and the issuer allowing the entity to name a nominee to the issuer's board"). 13 Rule 10b5-1 under the Exchange Act provides an insider with an affirmative defense to insider trading liability where material nonpublic information was not a factor in a trading decision because a trade was carried out pursuant to a pre-existing contract, instruction or plan (the "Trading Plan"). The availability of this defense is expressly contingent on the good faith of the individual or entity in entering into the Trading Plan, is not available where the Trading Plan was entered into "as part of a plan or scheme to evade" Rule 10b5-1 and is subject to several other parameters. Each of the board designee and the investor who appointed him or her should carefully review the requirements of Rule 10b5-1 prior to any trades being made in reliance on such Rule. activist investing developments spring

5 authors Marc Weingarten is a partner in and chairman of the business transactions group. He specializes in mergers and acquisitions, leveraged buyouts, and investment partnerships [email protected] Howard O. Godnick is a partner in the litigation department and specializes in complex commercial, activist and creditors rights litigation [email protected] Mary K. Marks is special counsel in the business transactions group and specializes in HSR, premerger and competition counseling [email protected] Business Transactions Partners Stuart D. Freedman Robert Goldstein Peter J. Halasz Eleazer Klein Michael R. Littenberg Robert B. Loper Donald Mosher Benjamin M. Polk Richard A. Presutti David E. Rosewater Marc Weingarten André Weiss Investment Management Partners Stephanie R. Breslow David Efron Steven J. Fredman Kenneth S. Gerstein Christopher Hilditch Kelli L. Moll David Nissenbaum Terrance J. O Malley Paul N. Roth Phyllis A. Schwartz Daniel S. Shapiro George M. Silfen Business Transactions Special Counsel Mary K. Marks Christian H. Mittweg Edward Schauder Steven J. Spencer Investment Management Special Counsel Lawrence T. Eckert Philip A. Heimowitz Richard Thompson 919 Third Avenue, New York, NY RETURN SERVICE REQUESTED activist investing developments spring 2006