KIRKLAND M&A UPDATE
A recent Federal appellate court decision on
potential liability of board observers under the
securities laws is a useful reminder that the
legal status, rights and obligations of board
observers remain unsettled and therefore
attention should be paid to those issues at the
outset of an observer arrangement.
While shareholders in a company will often
negotiate to take board seats as a means to
monitor their investment, in many instances
investors will also or instead request the right
to appoint a board observer. While the details
may differ, observers do not have voting
rights but typically have the right to attend
board meetings, receive board materials and
participate in board discussions.
In the recent Third Circuit decision, a majority
of the court determined that board observers
did not have liability under Section 11 of
the Securities Act for misrepresentations
about the company’s condition ahead of
its IPO. Section 11 liability attaches to any
person “named in the registration statement
as being or about to become a director,
[or] person performing similar functions.”
Although the prospectus conceded that the
observers may “significantly influence the
outcome of matters submitted to the Board of
Directors,” the majority focused on three key
distinguishing factors in determining that the
observers were not covered by Section 11:
1. The observers did not have the right to
vote, which is the main mechanism by
which directors exercise their management
functions;
2. The inability of shareholders to vote the
observers out of the office since their
observer rights were under a contractual
agreement;
3. The absence of a duty of loyalty to the
company’s shareholders.
The dissenting opinion acknowledged these
distinctions, but felt that the admission in the
prospectus of “significant influence” implied a
more expansive director-like role that met the
test of “similar functions.”
Even after this decision, which was limited
to the narrow Section 11 question, there is
minimal statutory or common law guidance
on observers and the relationship is defined
almost entirely by the contractual agreement
granting the observer right. In entering into
such an agreement, parties may wish to
address some specific considerations that
arise out of the ambiguous legal standing:
» Fiduciary Duties and Litigation Exposure.
The predominant view among practitioners
is that observers are not subject to
the same fiduciary duties as directors.
Nonetheless and taking account of the
recent court decision, the parties may wish
to expressly define the role and function of
the observer in a manner that supports that
conclusion and reduces the risk that the
observer is determined to be a “de facto
director.” The rest of the board should
be cognizant of the observer’s different
status in this regard when the observer
participates in board deliberations.
14 August 2019
Lurking Questions for Board Observers
Attorney Advertising
A recent decision highlights
the fact that the legal status,
rights and obligations of
board observers remain
unsettled and should be
addressed by the parties at
the outset of an arrangement.
» Indemnification and Insurance. The
absence of fiduciary duties does not
prevent an observer from being named as
a defendant in litigation. Because they are
not directors, observers do not have the
benefit of the indemnification and expense
advancement offered to directors by
statute and the company’s organizational
documents and may not be covered by
the company’s D&O insurance. Any such
protection would need to be established in
an agreement between the company and
the observer.
» Confidentiality. In the absence of fiduciary
duties, an observer may not be subject
to a confidentiality obligation unless one
is included in the agreement. In addition,
companies should consider whether
observers should participate in certain
sensitive discussions given the absence of
fiduciary duties.
» Conflicts and Trading Restrictions. Unless
addressed in the agreement, observers may
not be covered by board policies relating
to conflicts of interest or trading black-out
periods.
KIRKLAND M&A UPDATE | 14 August 2019
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© 2019 KIRKLAND & ELLIS LLP. All rights reserved.
www.kirkland.com
If you have any questions about the matters addressed in this Kirkland M&A Update, please contact the
following Kirkland attorney or your regular Kirkland contact.
Daniel E. Wolf, P.C.
+1 212 446 4884
