Shadow directors and controlling shareholders: duties and liability

With all too many aggrieved parties crying 'foul' as they look to apportion blame as well as salvage some of their cash from venture-backed companies that have fallen heavily to earth, the role and responsibilities of venture capitalists who sat on the boards of these portfolio companies is receiving close scrutiny. Joe Bartlett, of counsel at Fish & Richardson, takes a closer look at what this all means.

The meltdown and the consequent disappointments have produced a wave (actual and threatened) of litigation, alleging the VCs, through the board seats of their appointees, were in 'control' of failed companies (dotcoms and others), and therefore obligated to exercise 'fiduciary' care over the fortunes of minority shareholders. And, the deep pocketed VCs have, of course, been taking evasive action. Their time-honored gambits are, first, to eschew a board seat and substitute instead 'observer' or 'visitation' rights … the right to sit in attendance at all board meetings and speak one's piece, but not vote. Given the muscle the VCs enjoy, by keeping their hand on the money spigot, this usually amounts to the same thing as a board seat. This is a practice known in the UK as shadow directors (see the shadow cabinet) and I am informed by my UK compadres that liability can attach as if the individual VC was, de jure as well as de facto, sitting on the board.

One step further removed is the assertion of rights through negative covenants. This takes advantage of the well recognized doctrine in U.S. law that a shareholder may behave in any way he, she or it sees fit in exercising shareholder's rights, in contrast to one's obligation as a director to respect and further the interests of all the shareholders.

Up to now the selfish shareholder has not been deemed to have created a cause of action. Nonetheless, as stated above, there is a companion doctrine in U.S. law that a 'controlling' shareholder has fiduciary duties to the minority; and it has recently been argued, in a case in which I am involved, that the negative covenants in favor of a shareholder, even a minority shareholder, create the necessary quantum of 'control' to get the plaintiffs past the preliminary motions stage … the equivalent of victory in most litigation.

The case I am citing involved a shareholder exercising veto rights over a salvage round of financing, one the company needed in order to survive. Through negative covenants in that shareholder's particular series of preferred stock, the shareholder in question was demanding special consideration, in this case cash, to surrender the veto right … even though the shareholder had no plans to participate (although invited) in the salvage round.

The company threatened the shareholder with litigation on the basis of its control which was de facto absolute under the constituent documents … an outright veto over any new preferred stock or debt financing. The company also threatened to allege violation of a Massachusetts statute, Chapter 93A of the General Laws, which is useful in the People's Republic of Massachusetts to correct just about any situation a court deems to be 'unfair' and 'unjust.' Some of the case law under 93A uses the word 'extortion' in situations resembling the instant case and that noun was thrown into the draft complaint.

The truculent shareholder caved in. The point of all this is that we are in an environment similar to the late 1980s, when a host of leveraged buyouts collapsed and the victims, unsecured creditors and minority shareholders, went after the lenders on the theory of some form or another of what Professor F. Hodge O'Neal calls 'oppression.' Courts in the 1990s have backed away from some of the more extreme opinions in the 1980s, holding the lenders liable well beyond the losses incurred when their loans went sour. But the cult of victimization these days (every victim necessarily implies a villain) seems to be creeping back in again to the landscape. All this means is that there is less certainty about the ability of VCs to escape responsibility for failed investments than there was prior to the NASDAQ nosedive.