Letter from the Chair: Legal Updates for PE and VC Funds

Joseph W. Bartlett, Founder of VC

1. VC Appointed Directors

A recent decision in a case (in which I was personally involved) has been handed down by a bankruptcy judge in the Northern District of Illinois (Eastern Division) in Telesphere Liquidating Trust, vs. Galesi. The decision turned out to be a resounding victory for Galesi, who had been a director of Telesphere Communications, Inc., and was the defendant in the instant action on the theory that he was the "controlling shareholder" of Telesphere and, therefore, owed a fiduciary duty to various parties. To prove Galesi's control, the plaintiff argued that Galesi dominated the board. I had been counsel to Galesi when he invested in Telesphere and was appointed to the board of directors in connection with his investment pursuant to a contractual right he bargained for. To illustrate the point of this memo, I quote from two passages of the Judge's opinion:

"At the time he agreed to serve as a director of Telesphere, Bartlett required Galesi to enter into an agreement providing that in the event of an unresolved conflict between Bartlett's fiduciary duties to Telesphere and its shareholders on the one hand, and his fiduciary duty to Galesi on the other, Bartlett would resign from the board.

"… Joseph Bartlett's action in preparing an agreement to deal with any potential conflict between his roles as board member and attorney for Galesi reflects a clear understanding on his part that he was obligated as a board member to act independently, in the best interest of the corporation, and he was present to advise other board members of their duties."

I recommend the above-cited course of action as a precautionary move, whenever an individual is appointed to the board of a portfolio firm at the request of a VC fund investing in the same, whether or not the nominee is styled as a "independent director."

2. "Best Efforts:" Do You Really Know What it Means?

You invest in a company in the business of promoting products licensed from others, obligating itself to use "best efforts" or "commercially reasonable best efforts" to promote the licensed items in the market place. Your portfolio company starts to lose money on the sales of the licensed item; maybe its day has passed, like hula hoops. Can your portfolio company drop the item? After all, if sales are dropping off no matter what, why continue? Not so fast. In New York, the law is set out in Bloor v. Falstaff Brewing Corp., 601 F2d 609 (2d Cir., 1979). See, e.g., Judge Friendly's remarks: "The burden is on Falstaff [the licensee], which agreed to promote [Ballantine Ale] to prove there was nothing significant it could have done to promote sales that would not have been financially disastrous." 601 F2d at 614. (Emphasis added.)

The lesson. Be careful of 'best efforts' if your company is the one giving the promise. Any effort short of the absolute "best" may be, under the doctrine in Bloor, actionable.

3. Lead VC's Compensation For Special Efforts: The Simplest and Fairest Structure

Assume a venture capital fund leading a syndicate wishes compensation for performing the special functions typically the responsibility of the lead investor . locating the investment, engaging counsel, negotiating the structure of the transaction and taking the laboring oar on due diligence.

I have seen a variety of schemes for rewarding the lead investor for its special efforts in this context, including elaborate schemes for the payment of fees, the issuance of favorably priced warrants and the like. The best way, in my view, is surprisingly simple. If the price of the Series B preferred is $20 per share, aggregate proceeds to the company must be, of course, $20 times the number of shares . but that result can be arrived at by everybody paying the $20 per share or the lead investor paying $19 and all the other investors paying $21. There is no apparent tax issue involved in this system; and, it is easy to draft.