6.5 Steering the Ship of Fiduciary Duty in a Sea of Conflict

Last newsletter, we examined best practices and challenges associated with managing fiduciary duty. With a context for governance in place, let us move to scenarios, because there are pragmatic challenges in exercising fiduciary duty transparently in situations where conflicts abound.

The most common problem is when a company embarks on the next round of financing. If the company is performing well and there appears to be a healthy increase in the share price, everyone is happy and the nuances of fiduciary duty and transparency may not be critical.

However, if the venture capitalist (VC) is participating in the financing, then the VC Director’s interests as a VC and his fiduciary duty to the company are in conflict because they are on opposite sides of the table in the financing, whether or not the financing is favourable to all parties.

A more complicated problem occurs if the company is not performing well, and if the financing may be detrimental to the interests of existing investors (i.e. the infamous "down round"). In this case, the participating VC Directors are in conflict, and so are any Directors who hold shares that may be diluted by the contemplated financing. Founders and management Directors who hold management positions are also in conflict because they may perceive (often correctly) that their performance has contributed to the company’s need for a down round, and therefore their jobs, compensation and unvested equity may be at risk. The independent Directors may be the only ones without a conflict, but they may not have the interest or experience to navigate a contentious Board to a consensus on a difficult issue.

How does the Board operate in this stormy sea of conflicts?

In the case of only one or two Directors, if an actual or apparent conflict arises, the best action is for the conflicted Directors to voluntarily declare the conflict and withdraw themselves from any discussion on the topic and to abstain from a vote. Failing that, the Chairperson or another Director should identify the conflict to the Board and request the Board to rule. If a conflict is deemed to exist, the Board must request that the conflicted Directors recuse themselves. This should also be reflected in the minutes to make it transparent.

If a VC Director is in conflict, he or she can legitimately argue that with the most money at risk, they have a material interest in the issue in conflict. True, but there must be a clear distinction between the role of Director and investor. If a VC Director wishes to advance the interest of his investors, he should declare the conflict, and recuse themselves from the issue in question, in order to advance their interest as the investor to management and the Board. The VC Director would remain a Director to deliberate on other issues not in conflict. To make it even more transparent, the VC investor could appoint another VC principal to represent the VC investor’s interest, leaving the Director out of the discussion. Directors must still recuse themselves from both the discussion and the vote.

What if all Directors are in a real or apparent conflict, as noted above? They cannot all recuse themselves, since there would be no one left. In this case, pragmatism must prevail: the conflicts must be declared in the minutes, and there must be a Board decision to allow all the Directors to participate in the discussion and the vote. However, fiduciary duty must still be seen to prevail, and Directors must be careful to ensure that the company’s interest is paramount in all the discussions.

? added May, 2016: In cases where there is a sea of conflicts, such as the financing above, Directors can absolve themselves of the real and apparent conflicts by asking all of the shareholders of the company to sign a special shareholders resolution which clearly lists all of the Directors` and their funds` shareholdings, states the terms of the financing and how it will affect each class of shareholders, and asks the shareholders to acknowledge the conflict, approve the financing and to hold the conflicted Directors harmless.

In the case of a down round, investors should consider the value of the new investment in terms of the company’s ability to pursue its goals, and not by the impact on the current investors; management should similarly ignore the potential threat to their individual positions. Directors may want to write a justification for their recommendations and decisions based on the company’s interest so that they can verify that they acted in their fiduciary duty to the company.

The process improvements mentioned above are important. Strict and transparent adherence to the process of fiduciary duty encourages all Directors to act in the company’s best interest, and is critical to building trust and confidence in the Board.

In sum, improved performance of venture-stage technology companies demands transparent accountability. When in conflict, if possible, Directors must recuse themselves from discussion and votes related to the issue at hand. In all cases, the governance process must be transparent to ensure that best practices are observed.

 

This article first appeared in the Summer 2010 edition of The Hire Standard – the newsletter of Corporate Recruiters, British Columbia’s leading recruiters of high technology talent.