Directors appointed by strategic and corporate venture investors (CVC directors) face a unique set of challenges when attempting to resolve their fiduciary duties to the portfolio companies at which they serve as directors and their obligations to the corporate entities that employ them.
In connection with venture investments made by strategic and corporate venture investors (CVCs), CVC directors are often appointed to the boards of portfolio companies for oversight purposes and with the hope and expectation that the CVC directors will provide valuable insights and benefits to the companies. These benefits often include the CVC directors serving as connectors between key people at the portfolio companies and within the CVC’s parent entities. Parent entities to CVCs are often seen—whether correctly or not—as labyrinths that can be challenging to navigate without a guide, and the CVC director serving as this guide can provide significant value to portfolio companies in terms of building commercial and other relationships with the CVC parent entities. CVC directors can also offer unique advice and strategic intelligence to portfolio companies, typically insight that comes from expertise in the portfolio companies’ industries viewed through the lens of much larger organizations.
But maximizing these insights and benefits requires thoughtful attention to the dueling obligations that CVC directors must balance between the portfolio companies and their CVC parent entities. To strike an effective balance, CVC directors need to play a pivotal role in helping both their parent entities and their portfolio companies anticipate and navigate conflicts of interest.
Importantly, the failure to navigate these issues properly can lead to potential accusations of fiduciary duty breaches by the director(s) at issue (which can lead to personal liability for such director(s)) and potential claims against CVCs and/or their parent entities, such as if sensitive information of the portfolio companies are (or appear to have been) misused.
CVC directors are charged with fiduciary duties to protect the interests of the portfolio companies at which they are serving as directors. CVC directors—like all directors—are required to act in the best interests of the portfolio company and its stockholders. This cannon of corporate law is encapsulated in the twin fiduciary duties of “care” and “loyalty.” The duty of care mandates that directors—including CVC directors—be informed and make decisions based on all material information reasonably available to them. The duty of loyalty generally requires each director—including CVC directors—to act in the best interests of the portfolio company and its stockholders and not in such director’s interest (or in the interest of the stockholder who appointed such director) where those interests diverge from what is best for stockholders as a whole.
CVC directors also owe certain duties and obligations to their employers (i.e., to the CVCs and/or their parent entities that pay their salaries). The relationship between CVC directors and their employers is best encapsulated in the common-law fiduciary duties that agents owe to their principals, meaning, as employees, CVC directors are expected to act in the best interests of their employers in promoting their employers’ businesses.
Understanding “Conflicts of Interest” as CVC Directors
The phrase “conflicts of interest” generally refers to situations where the interest of an investor (and, thus, the director appointed by such investor) may conflict with, or at least differ from, the interest of the portfolio company.
In the context of discussions by a board of directors and decision-making for corporations, whether conflicts involving CVC directors exist with respect to a specific transaction or other discussion topic will depend on myriad factors, including:
- Does the investor who appointed the director have a line of business that competes with the portfolio company?
- Does the director-designee work for, or otherwise regularly connect with, the investor’s competing business line?
- Is the investor who appointed the director a counterparty in any transaction being discussed?
- Is a competitor of the investor a counterparty in the transaction at issue?
Conflicts can be particularly likely in situations where the parent entities of CVCs have lines of business that compete with their portfolio companies, and conflicts of interest issues are significantly heightened if CVC directors sit within the competitive business units of those entities.
In any competitive context, the following categories of discussions/decision points by boards of directors are at high risk of leading to conflicts of interest:
- Customer contracts and customer strategy
- Marketing/advertising strategy
- Product pricing and promotions
- Strategic plans
- Sales forecasts/projections
- Granular (by product, by region, or by customer) sales/cost/pricing data
- Sensitive R&D info
- Anything else that could be used to reduce competition between the parties
Conflicts also arise whenever boards of directors are discussing commercial, financing or acquisition transactions between portfolio companies and CVCs or their parent entities (or affiliates) or between portfolio companies and competitors of the parent entities of CVCs. Indeed, with the current health and economic crisis, transactions between portfolio companies and CVCs or their parent entities (or affiliates) require extra care and attention with respect to how conflicts are addressed. Down rounds, acquisition hiring (or “aqui-hires”) or distressed sales are already more likely to lead to stockholder litigation. As such transactions become more prevalent, the involvement of CVCs or their parent entities (or affiliates) in those transactions, where such CVCs are already investors in the portfolio companies at issue and where such CVCs have CVC directors serving on portfolio company boards of directors, further heighten the risk of stockholder litigation and put additional pressure on addressing conflict matters appropriately.
While it is important to understand how conflicts can manifest either generally or with respect to specific transactions or board-level discussion topics, CVC directors should also recognize that their dueling obligations (to their employers and the portfolio companies) create inherent conflicts, leaving CVC directors susceptible to claims that their loyalties were not properly aligned on a given issue.
Inherent conflicts may also exist “upstream” within the CVCs’ parent organizations. For example, if the CVC director reports to someone at their CVC parent entity who has visibility and/or managerial authority in a business line that could be considered a competitor of the portfolio company, then there could be an upstream conflict. Such upstream conflicts require different mitigation/remediation strategies to guard against claims that the CVC director and/or the CVC or its parent entities misused sensitive portfolio-company information, including information learned from board-level discussions.
Protective Actions to Address Conflicts of Interest
To address inherent conflicts, including upstream conflicts, CVCs should consider developing clear conflict of interest and confidentiality guidelines/policies that describe potential scenarios and decision matrices to address potential challenges and conflicts. Preparing educational programs on applicable fiduciary duties, conflicts of interest and confidentiality matters, together with the development of appropriate accountability mechanisms, can also be used by CVCs and their parent entities to further educate CVC directors and others within their organizations and help prevent even the appearance of impropriety. Guidelines/policies could include procedures to firewall the sharing of sensitive information of portfolio companies within the CVCs and their affiliates to limit potential misuse. CVCs could also implement policies that seek to appoint CVC directors who can be reasonably “walled-off” from any business lines or activities of CVC parent entities that may be deemed competitive with portfolio companies. Developing and implementing such policies (including evidencing compliance with those policies) requires a thoughtful consideration of what is feasible given the CVCs’ and their parent entities’ organizational structure and culture to ensure that the policies can be effective.
CVC directors should also be mindful to regularly: (1) identify or anticipate the possibility of conflicts; and (2) take steps to mitigate/remediate clear conflicts by properly and proactively recusing themselves from portions of meetings or from receiving certain information that might create liability risks to themselves or the CVCs that appoint them to boards of directors. To that end, in advance of each board meeting, CVC directors should review the proposed agenda and material distributed with an eye to whether potential conflict matters will be discussed. If no agenda or materials are provided ahead of meetings, CVC directors should request such information. In all cases, CVC directors should maintain an active and collaborative dialogue with a portfolio company’s CEO and with other board members to help identify and effectively manage potential conflicts of interest.
When potential conflicts arise and a specific course of action is not otherwise specified in advance, it is important to discuss the matter with the CVC’s in-house or outside legal counsel to determine a course of action. In certain situations, CVC directors may also need to seek the advice of their individual legal counsel. Appropriate courses of actions may include: (i) full disclosure as to the nature of the conflict of interest and the contract or transaction in question; (ii) recusals by the CVC director at issue from board discussions (or relevant portions thereof); (iii) creation of special committees of the board of directors made-up of disinterested directors and/or approval of matters in question by disinterested directors; (iv) approval by disinterested stockholders; (v) careful consideration of alternatives; and (vi) appropriate board meetings and recordation in board minutes. The process employed by boards of directors of portfolio companies to address specific conflicts is important, and may be critical, to establish that all of the directors—including CVC directors—satisfy their fiduciary duties to portfolio companies and their stockholders.
Identifying, mitigating and remediating actual or potential conflicts of interest present challenges for CVCs, their director-designees and the portfolio companies involved, especially given the dueling obligations and resulting inherent conflicts that these directors face. With some planning, vigilance and guidance as needed from counsel, potential conflicts can be assessed and addressed with the requisite rigor to ensure that CVCs and their CVC directors avoid potential claims while providing advice and strategic intelligence to portfolio companies and accessing strategic insights as part of investing in the portfolio companies.