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Managing conflicting interests: a guide for private equity directors on portfolio company boards06/08/2008. Source: Pepper Hamilton LLP. Amy S Carder
 Private equity funds typically invest in young companies (each a portfolio company) with the hope that these companies will increase in value with the assistance of the private equity funds’ management and resources. During the investment period, managers of the private equity fund usually sit on the board of directors of the portfolio company. These 'private equity directors' may, however, find themselves in a position of conflict because, as directors, they owe fiduciary duties to the portfolio company and all of its shareholders, but as fund managers they remain loyal to the private equity fund (in certain US states, the law regarding fiduciary duties focuses solely on the best interest of the company, and the interest of the shareholders is just one of many factors to consider in determining the best interest of the company, which may alleviate some of the conflicts faced by directors in these jurisdictions).
While on the board, PE Fund managers often face decisions that, although in the best interest of the portfolio company, may be detrimental to the interests of the PE Fund. For example, a PE Fund might not favor an investment by the portfolio company that reaps benefits only in the distant future because, on average, PE Funds have investment periods of fewer than five years. Private equity directors need to be wary when faced with conflicting interests so as to avoid putting themselves at risk of liability for failing to uphold the fiduciary duties owed to the portfolio company.
Private equity directors can take several steps to insulate themselves from liability:
Before Serving on the Board
- Ensure Liability Protection: A director should confirm that the company’s articles of incorporation and bylaws contain provisions that eliminate or limit the personal liability of directors, giving directors the greatest liability protection permitted under governing law. However, these provisions may not protect a director in cases of certain breaches of fiduciary duties or intentional misconduct. The company also should have a comprehensive director and officer liability insurance policy.
- Require Indemnification by the Company: A director should confirm that the company’s articles of incorporation and bylaws contain provisions that state that the company will indemnify its directors for actions taken on behalf of the company. Additionally, a director may insist that the company enter into an indemnification agreement with him that provides him with a contractual right to protections that may be even more extensive than the protections granted under the company’s charter documents and that cannot be rescinded without the director’s consent.
While Serving on the Board
- Fulfill Fiduciary Duties: A director must have a comprehensive understanding of the fiduciary obligations imposed upon the board by applicable law. These fiduciary duties typically include the duty of care and the duty of loyalty.
Duty of Care: The duty of care refers to the director’s responsibility to exercise diligence when making decisions for the company. To fulfill the duty of care, a director should devote time to his position and stay informed about management’s actions and the business of the company.
Duty of Loyalty: The duty of loyalty refers to the director’s responsibility to act in good faith and in the best interest of the company. To fulfill the duty of loyalty, a private equity director must be cognizant of any potential conflict of interest he or the PE Fund may have with the company’s interests.
- Follow Corporate Formalities: Courts tend to focus on the observance of corporate formalities when determining director liability. Courts are less likely to find a director liable for bad decisions if the director devoted adequate time and effort to making informed decisions. Directors should try to do the following:
- regularly attend and participate in board meetings
- ensure that the company keeps a clear, written record of decision-making processes
- encourage the board to seek several proposals on transactions and have transactions approved by disinterested directors
- consult with outside experts.
- Avoid Blurring the Line: It is essential that a private equity director make it clear through his actions and communications that as a director of the portfolio company he acts in the best interest of all the shareholders, not just the PE Fund. The director must keep in mind when he is in the role of PE Fund manager and when he is in the role of portfolio company director and conduct himself accordingly. The director should explain to private equity colleagues the need to maintain his independent judgment on the board and be sure that he is not simply acting on instructions from the PE Fund. A private equity director also may need to refrain from participating in board deliberations in situations where impartiality is impossible.
Directors should be especially cautious when dealing with the following situations:
Fundamental Transactions: The board is responsible for approving any merger, acquisition, or other fundamental transaction to ensure that it is in the best interest of the company and its shareholders. Such transactions present the most likely scenarios in which the interests of the company do not align with the interests of management and the interests of the PE Fund. When conflicting interests arise, a private equity director must make decisions in accordance with his fiduciary duties to the portfolio company. The director must either act in accordance with the best interest of the portfolio company (regardless of whether such decision also is in the best interest of the PE Fund) or refrain from participating in the board’s deliberations.
Determining Executive Compensation: When determining the compensation of senior executives, directors must be well-informed and make independent decisions. The board should review carefully the reports it receives from management, and if possible, it should obtain and study reports from outside specialists on executive compensation before rendering a decision.
Transactions with Public Companies: If the portfolio company is a public company or is engaging in a transaction with a public company, then a private equity director must be even more careful about controlling the information he passes on to the PE Fund. Regulation FD prohibits people with material, non-public information about a public company from selectively disclosing that information. Additionally, the rules for insider trading are especially technical and can easily trap an incautious director. Private equity directors must have policies in place to ensure that they and the PE Fund do not make decisions to buy or sell shares of a public company’s stock in reliance on material, non-public information.
With the expansion of the use of the limited liability company as the choice of entity in many acquisition transactions, more often PE Funds are acquiring portfolio companies that are LLCs rather than corporations. Although LLCs can provide more flexibility than corporations with respect to governance and traditional corporate formalities, courts have generally extended the fiduciary duties that directors owe to a corporation to managers of an LLC, particularly when the LLC’s operating agreement does not explicitly limit the applicability of such duties. Even if a portfolio company is structured as an LLC, its private equity managers are likely to face the same potential conflicts as private equity directors face with respect to corporate portfolio companies.
PE Fund managers often feel like they are juggling the interests of numerous parties when they serve as a director of a portfolio company. To achieve the sometimes tenuous balance, a private equity director must be aware of potential conflicts of interest, keep his roles separate, and act in such a way as to avoid violating the fiduciary duties owed to the portfolio company and its shareholders. As long as a private equity director puts in place a comprehensive plan to minimize exposure to liability and devotes substantial time and effort to his role as a director, he should be able to navigate successfully the risks often faced by private equity directors.
Ms. Carder was assisted in writing this article by Chaitra Gokul, a 2007 summer associate at Pepper Hamilton, and Shirley Kuhlmann, an associate with the firm.
The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.
Pepper Hamilton LLP is a multi-practice law firm with more than 500 lawyers in seven states and the District of Columbia. The firm provides corporate, litigation and regulatory legal services to leading businesses, governmental entities, nonprofit organizations and individuals throughout the nation and the world. For more information go to www.pepperlaw.com
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