With startup companies, it is not unusual for there to be a person (or persons) designated to sit on the board of directors who is given the status of “board observer.” Venture capitalists and other types of investors commonly seek to have a person affiliated with their investment company placed on the board either as an actual voting member or as an observer.
In explaining the differences, the first task is to start with the similarities. For both, there is an expectation that the person will be an active participant in board meetings including being knowledgeable, informed, and involved in all discussions. Furthermore, each will be entitled to notice of meetings and expected to attend all meetings and all parts of the meetings including the general session and any closed-door executive sessions. In terms of differences, they include:
Full member of the board:
- The person has the right to vote with respect to issues brought for vote
- Loyalty is specifically to the corporation at issue
- Placement on the board is via vote of the shareholder
- Status as member of the board of directors can be revoked by shareholders (or the board) for violation of duties and misbehavior
- Term/length of service is set by corporation’s bylaws (or by statute)
- The person has no vote on decisions
- Loyalties are generally known to be elsewhere — such as loyalty to the venture capitalist or investor
- Placement on the board is commonly based on contractual agreement with the venture capitalist
- Status as board observer is based on the contract and is generally not revocable by the other shareholders and/or the board
- Term/length of service is set by contractual agreement
It is easy to understand why a venture capital investor might insist upon some sort of membership on the board. Being at the meetings provides information, can help protect the investment, and even a board member with “only” observer status can be influential in guiding voting outcomes.
The difference in voting status and loyalty also creates a difference in the fiduciary duties owed to shareholders and under federal and California securities laws. A good case example illustrating the point is a recent opinion issued by the federal Court of Appeals for the Third Circuit out on the east coast. See Obasi Investment, Ltd. v. Tibet Pharmaceuticals, Inc., Case No. 18-1849 (US 3rd Cir. July 23, 2019). In that case, there were two board observers who supposedly knew certain information about a large loan to the company that was withheld from the public prior to the company’s initial public offering. When the information became known, the stock price plummeted and eventually, the board members and the observers were sued for fraud under various federal and securities laws.
With respect to the observers, the trial court dismissed all claims by the shareholders holding that there are different fiduciary duties owed by observers. The Court of Appeals affirmed highlighting several factors:
- Observers had no vote on corporate decisions
- Observers were arranged to be on the board by non-shareholders
- Observers had obvious and self-evident loyalties to the firms that arranged their observer status
- Observers could not be removed by the board or the shareholders
- Observers’ length of service was agreed upon — one year — and was not subject to revision
Based on these factors, the court held that the observers were not “directors” as defined by the applicable law at issue. As such, the observers were not subject to the same fiduciary duties as full voting directors; case dismissed against the observers. Note, however, that a director cannot escape liability for breach of fiduciary duties by having him or herself designated as an “observer.” California has adopted the “de facto” director rule so the courts will look to the actual facts, not just the designation.
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For more information, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard can be reached at (858) 483-9200 or via email. Mr. Leonard has been named “Best of the Bar” for four years running by the San Diego Business Journal. Mr. Leonard provides a full panoply of legal services for businesses including formation of corporate entities of all types. Like us on Facebook.