Alert 05.20.22
Alert
06.03.22
Pillsbury’s May 20 alert “VC Update—The Down Round Is Back” described how the recent decline in public company valuations has caused venture investors to slow their investment pace, with the result that many companies are only able to attract venture investments at valuations which are substantially diminished from their prior financing rounds. Such “down round” transactions can negatively, sometimes devastatingly, affect the equity positions of a startup’s existing investors, founders and employees, giving rise to concerns around breaches of the fiduciary duties of directors (including the duties of due care, loyalty and candor), fiduciary duties to creditors, and controlling shareholder liability. This alert highlights these potential liabilities and offers proactive strategies to address them.
Duty of Due Care
The corporate law of most states imposes a duty of care upon directors, requiring them to inform themselves of all material information reasonably available in order to make informed decisions while acting in good faith. To fulfil this duty, a board should be informed about the business, strategy, business plan and results of operations of a company, and should be involved in the evaluation and approval of all significant matters. The board’s duty of care cannot be delegated to other decision-makers, but the board is permitted to rely on information provided by reasonably qualified experts and advisors. Generally, the board’s fulfilment of its fiduciary duties will be evaluated using the business judgement rule, which presumes that directors have acted on an informed basis, in good faith, and to serve the corporation’s best interests. However, in a conflicted or rushed situation, a plaintiff may be able to rebut this presumption, whether by highlighting one or more directors’ split loyalties or by demonstrating that the directors failed to exercise due care in evaluating the options of the corporation. In such instances, the board’s actions will be reviewed under a heightened “entire fairness” standard which is much more difficult to meet.
In the context of a down round, where liquidity concerns may bring a sense of urgency to the decision-making process, the board should take care to avoid making quick decisions and should be vigilant about fulfilling its duty of care. Similarly, it is imperative that the board build a supportive record documenting the steps taken. The corporate minutes should reflect that the directors were engaged in the decision-making process by attending meetings and asking questions, and that the board considered all reasonable financing alternatives and other opportunities to maximize value for its shareholders, including through a partial or full sale of the company or a liquidation. Additionally, because directors may rely in good faith on the advice of experts in fulfilling their duty of care, boards may consider hiring financial advisors or other experts to aid in the valuation of the company or in the consideration of other opportunities. This may be particularly useful when the round is led by existing stockholders or corporate insiders due to potential conflict of interest concerns.
Duty of Loyalty
The duty of loyalty requires directors to act in the best interest of the corporation and stockholders, rather than out of self-interest. Breaches of the duty of loyalty result in heightened scrutiny in court and greater potential liability for directors because certain statutory limitations of liability are not available where conflicts of interest are present.
In the down round context, conflicts of interest may arise where certain directors are affiliated with venture capital funds participating in the round, and thus may be deemed to be interested in the transaction. The corporate law of most states provides certain safe harbors for transactions with one or more interested directors. These statutes provide that a transaction is not void or voidable solely because of a conflict, and companies should use these safe harbors when possible in a down round that includes interested directors. For companies incorporated in Delaware, the following four statutory safe harbors are provided:
Another way for directors to minimize the risks associated with interested director transactions in a down round is to implement a rights offering, giving all existing shareholders the option to participate in the round on the same terms and conditions as the lead investors. Because a rights offering equally includes non-insiders in the financing, a rights offering can help defend against duty of loyalty claims by showing a lack of self-dealing.
Duty of Candor
When seeking shareholder action, directors are required under Delaware law to disclose fully and fairly all material information that the board controls. Delaware courts have also applied the duty of candor when directors communicate publicly or directly with shareholders. In any case, all director communications with shareholders must be truthful and not be misleading partial disclosures.
In the down round context, Delaware law typically requires stockholder consent in order to establish the preferences, privileges and rights of any preferred stock to be issued in the down round. A down round may also trigger consent rights that existing investors obtained in prior rounds. When directors are financially interested in the down round, companies may pursue a disinterested stockholder vote. In seeking stockholder consent, directors should be sure to provide shareholders with all information that is material to a shareholders’ decision, such as the extent existing shareholders will be diluted and the nature and extent of insider benefits, to avoid breaching the duty of candor.
Duties Owed to Creditors
Directors may owe fiduciary duties to creditors in certain circumstances. For example, in Delaware, when a corporation becomes insolvent in fact – by being unable to pay its debts as they come due in the ordinary course or when its liabilities exceed the reasonable market value of its assets – derivative fiduciary duties to creditors are triggered even if the company has not declared bankruptcy. Creditors of a solvent corporation are generally not owed fiduciary duties and are instead protected by contractual agreements and other legal protections related to fraud, fair dealing, bankruptcy and general commercial law.
There are several steps that directors should take to limit claims for breach of fiduciary duty to creditors. First, directors should monitor the corporation’s solvency to determine whether it has become insolvent or entered the zone of insolvency. As discussed in the context of duties owed to shareholders, the board should maintain detailed minutes that show the steps taken to maximize corporate value for the benefit of shareholders and creditors alike. Such steps should include cutting unnecessary costs and avoiding corporate waste to ensure that creditors’ recovery will be maximized if the company enters bankruptcy. Further, directors and corporate insiders should avoid conflicts of interest or self-dealing—especially if they are also creditors of the company. And while many states allow companies to include exculpatory provisions in the certificate of incorporation that limit director liability for breaches of the duty of care, certain courts outside Delaware have found that such provisions do no insulate directors from claims brought by creditors.
Controlling Shareholder Liability
State corporate laws commonly provide that controlling shareholders—those with majority ownership or actual control over a corporation’s business affairs—have fiduciary duties to the corporation and minority shareholders. “Control” is not limited to a stockholder that owns more than 50% of a company’s stock. Courts have found control to exist in situations where stockholders hold significantly less than that, often due to board representation or other facts and circumstances that indicate one stockholder has actual control over corporate decisions. Consistent with their fiduciary duties, these controlling shareholders must exercise their control in a just, fair and equitable manner. Particularly troubling, control shareholder actions are commonly judged against an “entire fairness” standard, a fact-based inquiry which is usually incapable of swift disposition by summary judgment motion, thereby providing substantial leverage to plaintiffs who press these claims.
Controlling shareholders face unique liability risks in down round financings if they appear to be nefariously using their inside or control position, or the company’s financial woes, to dilute existing shareholders. Controlling shareholders may also be held liable for aiding and abetting a portfolio company board’s breach of fiduciary duty due to its control over the Company. Stockholders who may be deemed to possess “control” over the Company through board representation or large holdings, should be mindful of their potential liability in down round financings and should insist that the board take appropriate measures to minimize the liability risk.
Additional Protection for Directors
Although not specific to the down round context, there are several protections that directors may want to implement to limit their personal liability for damages for breaches of fiduciary duty. For example, most states allow a corporation’s certificate of incorporation to include provisions eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director. Prudent corporate directors will also ensure that market-standard director indemnification agreements have been entered into that provide contractual rights to indemnification and require the corporation to cover defense costs, provide directors access to separate counsel and maintain directors and officers insurance, before commencing their board service. Finally, corporate directors can further protect themselves by ensuring that their portfolio companies have adequate D&O insurance, a protection which becomes increasingly important as a portfolio company approaches insolvency and become less likely to be able to satisfy indemnification claims directly. A prudent review of applicable director protections is advised in the event a corporation is exploring a potential down round financing.
Conclusion
As venture-backed companies increasingly face the prospect of down rounds, it is essential for directors, management and controlling shareholders to understand the lurking liabilities and follow appropriate procedures. Pillsbury’s attorneys are experienced in structuring down round financings to minimize these liability risks. Should you have any questions respecting these matters, please contact the attorneys listed below or the other attorneys at the firm with whom you regularly work.