Board of Directors: 6 Rules for VC Backed Directors of Portfolio Companies

Joseph W. Bartlett, Founder of VC

Directors of public and private companies organized under Delaware law are, in almost all instances, the beneficiaries of the exculpatory language in the charter authorized by Section 102(b)(7) of the Delaware Corporation Law. The language appears to exculpate directors ... meaning providing a basis for a Delaware Chancery Court to dismiss complaints, alleging board derelictions which do not involve conflicts with the director's personal financial interest and therefore, at least arguably, are limited to violations of the board's duty of care.

The First Rule

The first rule, now well known is: If the Corporation is Organized in Delaware, Make Sure the Certificate Adopts Section 102(b)(7).[1]

When Section 102(b)(7) first came out, being a legislative reaction to several Delaware rulings by activist judges which threatened to make Delaware a less comfortable home for board members (and therefore cut off a significant source of revenue for the state), some experienced observers expressed concern that Section 102(b)(7) wouldn't really change much; it would simply challenge plaintiffs counsel to be more creative in framing their complaints. Indeed, the decision of Chancellor Chandler in the Disney case appeared to confirm the cynic's forecast.[2]

Post Disney, it would seem that the wheel had come full circle and that the adoption of Section 102(b)(7) does not provide any real comfort to board members; partners in plaintiffs/law firms can count on a steady stream of spectacular income (despite the attempt to rein them in by both Congress and the Delaware legislature). They can get so rich they run for President (John Edwards) and/or buy a major league baseball team (Peter Angeles).

However, a more recent Delaware Chancery case involving Integrated Health Services appears to restore the road map function of the Delaware court system ... a series of decisions which lay out (if read carefully) what it is the board should do in order to protect itself against plaintiffs counsel invading the board members' personal assets or getting access to the D&O insurance.[3]

The lawsuit was brought against the members of the compensation committee, based on a series of loans, option grants, deferred compensation, loan forgiveness, bonuses and golden parachutes made available to the founder, president and chief executive, of Integrated Health Services. The court denied the motion to dismiss a number of the courts but granted the motions on several others. By contrasting the sets of facts and separating them into categories, the "road map" becomes more or less obvious.

The Second Rule

The second rule, and we have written in support of this rule the past,[4] is that (for better or worse) Any Controversial Matter May Require Consultation With An Independent Consultant ... the classic "second opinion." One of the most celebrated consultants in this area is Joe Bachelder; he was consulted (sometimes peripherally) in Integrated Health on several of the compensation committee actions and, in each case, the motion to dismiss was granted. Regarding those issues on which Bachelder was not brought in, the plaintiffs prevailed.

The Third Rule

The third rule, suggested by the Court's treatment (yea or nay) on the motion is: Do Not Act By Written Consent If You Can Avoid It. It appears that, whenever possible, a meeting should be held, even though the Delaware statute would indicate that written consent is the equivalent of a meeting. For Section 102(b)(7) purposes, it now appears that such is not guaranteed to be the case.

The Fourth Rule

The fourth rule, ratification appears to be more or less the equivalent of a written consent ... i.e., Ratification Is Not Very Effective. If a loan, grant or payment is made to an executive on Day One, the fact that it is ratified by the Committee on Day Ten does not appear to be of any particular moment in Delaware; the Committee should act in advance, rather than ex post facto.

The good news is that these rules appear to be reasonably explicit. If the committee or board action is likely to involve "fiduciary" duties or ignoring "red flags" (i.e., red meat for plaintiff's counsel). Run It Past A Consultant; Hold A Meeting; And Make Sure The Meeting Occurs In Advance Of The Benefits Winding Up In The Executive's Pocket Or The Issuance Of The Disclosure Statement.

It is tempting to question whether the road map in Delaware (or any other state) should not be set out by the legislature rather than the courts. But in the first place, the courts have been active in this area in Delaware for a lot of years ... filling in with helpful guidance until or unless the legislature acts, covering situations which appear not to have been appropriately contemplated in the Delaware G.C.L. Secondly, it appears obvious that the Delaware courts, like courts everywhere, are reacting to reported excesses of Ovitz/Grasso variety. In that connection by coincidence we were re-reading Lester Thurow's book, The Zero-Sum Solution. While everything Thurow forecasted didn't come about we note with interest following passage from his economic analysis, which seems prescient in light of today's events:

"American managers, for example, are fond of pointing out that if auto workers make $13 per hour in Japan and $20 per hour in the United States and if productivity is equal in the two countries, then America can only have a successful auto industry if American workers are willing to reduce their wages to $13 per hour. Management is right; American labor is going to have to learn to keep one eye on foreign wages and the other eye on raising productivity.

"American managers almost never mention, however, that they are paid almost three times as much as Japanese management. Whereas blue-collar wages must come down by one-third, managerial wages must come down by two-thirds if America is to be competitive. In a world of international competition only superior productivity can result in superior wages for either management or workers."[5]

Rule Five: Keep Complete Minutes

When I first started in this business, the conventional rule was ... keep minutes to a minimum, that way, the thought was, one could minimize the likelihood that an inadvertent phrase, or a conspicuous omission, might prove embarrassing. In today's environment, the basic rule has changed.[6] Some quotes from a recent article in Board Alert (Apr. 2005), p. 2.

"When it denied the Disney directors' motion to dismiss the case brought against them for approving Michael Orvitz's employment agreement, the Delaware Chancery Court cited, among other things, the minutes from the meeting where the directors approved that contract.

"'Less than one and one-half pages of the fifteen pages of the Old Board minutes were devoted to discussions of Orvitz's hiring as Disney's new president,' the court stated in its 2003 opinion. 'No questions were raised, as least so far as the minutes reflect.'

"More recently, following his initiation of an inquiry into the Procter & Gamble/Gillette merger's effects on Gillette's shareholders, Massachusetts secretary of state William Galvin questioned the adequacy of the minutes from the Gillette board meeting. He said the notes didn't provide evidence of extensive deliberation, and that he considered them too sparse in light of the size of the deal."

Rule Six

Upon Joining the Board as the VC's Nominee, Obtain Agreement on Your Role. An illustrative decision in a case (in which I was personally involved) was 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".[7]

[1] If the Company is organized in LLC or LPA format, see The Private Equity Bulletin, Dec. 2004. "The GP's Fiduciary Duty Can Be Now Eliminated in Delaware Limited Partnerships ... We Think?" The recent Delaware amendments to the LPA and LLC Acts provide exculpatory protection a good deal broader than Section 102(b)(7).

[2] In re Walt Disney Co., Derivative Litigation, 825 A.2d 275 (Del.Ch. May 28, 2003) appeared to validate the cynicism, Chancellor Chandler holding that the disinterested and independent directors nonetheless could be held "personally liable to the corporation for ... intentional lack of due care." The proposition seems to be an oxymoron; it is difficult to prove that anyone, indeed a director of a public company like Disney, intentionally decided to be negligent; but the language in Disney stated that the complaint, if construed (as one must on a motion to dismiss) in the light most favorable to the plaintiff, "belied any assertion ..." that the directors "exercised any business judgment or made any good faith effort to fulfill a fiduciary duties they owed to Disney and its shareholders."

[3] Official Committee of Unsecured Creditors of Integrated Health Services, Inc., v Elkins, 2004, Del. Ch. LEXIS 122 (Del. Ch. Aug. 24, 2004).

[4] See Bartlett & Auspitz, "Second Opinions" Buzz of the Week, 2/12/02).

"Assuming the stakes are high enough, the fuzzy areas are broad enough and the questions sufficiently difficult and/or subjective, this [the second opinion] is a system bearing similarities to the practice available to UK law firms, known as consulting the "Barrister." The Barristers are expert lawyers with offices physically inside the Inns of Court, who are consulted by the UK law firms on close and nice questions of law. The Barristers are independent; they do not solicit business (I believe they are paid a specified, fixed stipend), and their opinions are, therefore, as objective as one can imagine in a subjective world.

"Thus, my advice, if the company can afford it, is to ask a second firm of accountants, or an individual accounting expert, to review decisions on close questions arrived at by the company's regularly employed public accountants ... a system roughly akin to certifying specific questions to, say, an appellate court. It is not necessary for the firm or individual offering the second opinion to do any spade work and/or to duplicate the efforts of the current auditor. The facts may be stipulated; the sole issue presented to the consultant is the question of how those facts could be interpreted in light of current accounting conventions. As Jack Auspitz points out, a similar process was enthusiastically received by the court in the case of In re. Software Toolworks, 50 F.3d 615 (9th Cir. 1995). There, the Court approved the conduct of underwriters who, when confronted with an issue of revenue recognition, not only insisted that the company's regular accountants confirm their treatment of the issue in writing but went on to contact other accountants to verify the revenue recognition treatment of the first accounting firm. As the Court noted, the underwriters did not 'blindly rely' on the regular accountants but conducted a reasonable due diligence investigation."

[5] Thurow, The Zero-Sum Solution, Simon & Schuster, 1985, p. 138.

[6] "Fearing Law Suits, Boards Write More Defensive Minutes," Legal Issues, Board Alert, April 2005.

[7] "VC Appointed Directors," Letter From The Chair (Jul. 2003), a publication of Fish & Richardson P.C..