INSIGHTS
Are Corporate Board Observers Liable Just Like Directors?
Priya Cherian Huskins, Esq.
Editor, Management Liability/D&O
NOVEMBER 13, 2019
MANAGEMENT LIABILITY/D&O
A board observer is someone who attends board meetings without actually being a board member. As
the name implies, board observers simply observe; they don’t have a vote.
Why would a board of directors allow someone to sit in on board meetings? Typically, the right to send
an observer into a boardroom is negotiated by a prospective investor as a condition of the investment.
Sometimes a company already has enough board members, so an observer position is a thoughtful
alternative.
In some cases, an investor might want to keep close tabs on an investment without taking on the
responsibility or liability of a board member. Board observers are much more common in private
company boardrooms than in those of public companies.
Given that board observers do not carry the responsibilities and liabilities of board members, do board
observers need to be covered by D&O insurance? The answer is no.
Nevertheless, board observers frequently ask to be named to a company’s D&O insurance policy. It’s a
bit of a puzzle that observers ask to be named to D&O insurance policies, especially given that the
whole point of being an observer—and giving up rights to vote as a director—might have been to avoid
the potential liability associated with being a director.
Asking to be named to a company’s D&O policy might seem to be at odds with the position that an
observer is not a party that owes any duciary duty to shareholders.
On the other hand, in some cases, this view might be oset by the concern that if an observer is faced
with even a completely frivolous lawsuit, the cost of defending oneself can be prohibitive.
Indeed, board observers typically would not have an indemnication agreement from a company. As I
have discussed elsewhere, indemnication agreements are important for directors to be able to
protect themselves from litigation defense costs and nancial settlements.
There is even, perhaps, an argument that board observers who obtain indemnication agreements are
taking actions that are inconsistent with their observer status.
While not dispositive, an observer who obtains an indemnication agreement is arguably providing
evidence for the idea that the observer was not really a mere observer. For this reason, board
observers might shy away from asking for indemnication agreements.
Note that being a board observer is not the same as being a shadow director. As the term is commonly
used, a shadow director is someone who is a large investor in a company and exerts control over a
company’s board, usually through the use of a puppet director.
A puppet director is someone who is elected or appointed to a board as a board member, but instead
of acting independently takes instructions from the shadow director.
To the extent that a board observer is exerting inuence over a board on behalf of a shadow director o
otherwise, the board observer is not really a mere observer. If a board observer acts like an observer
and not like a director, however, the observer should expect to be treated as an observer and not a
director.
Courts Weigh In
Supporting the contention that board observers who do not act as directors do not take on director
liability is the rare legal case about board observers, Obasi Investment Ltd. v. Tibet Pharmaceuticals, Inc.
et al. (http://www2.ca3.uscourts.gov/opinarch/181849p.pdf)
In a July 2019 case in the United States Court of Appeals for The Third Circuit, in a 2-to-1 decision a
three-judge panel overturned a district court’s original ruling in a Section 11 case.
Investors sued Tibet Pharmaceuticals for omissions in a registration statement for one of its
subsidiaries that was going public–Yunnan Shangri-La Tibetan Pharmaceutical Group Limited.
The case named, among others, two people mentioned in the registration statement as nonvoting
board observers who, according to Yunnan’s registration statement, may “signicantly inuence the
outcome of matters submitted to the Board of Directors for approval.”
While the two board observers could not vote on any matters brought before the board, they were
certainly important to the company and to the success of Yunnan’s IPO, as the court of appeals pointed
out in its decision (http://www2.ca3.uscourts.gov/opinarch/181849p.pdf):
Hayden Zou was an early investor in Tibet and the sole director of China Tibetan Pharmaceuticals
Limited, a wholly owned subsidiary of Tibet. Tibet’s ability to control Yunnan owed through China
Tibetan. In late 2009, Zou told L. McCarthy Downs, III, a managing director at the investment bank
Anderson & Strudwick, Inc. (A&S), about Tibet. The two discussed the prospect of a Tibet IPO, and
A&S later agreed to serve as Tibet’s placement agent. Zou and Downs then worked together to
bring Tibet public.
The issue presented to the Third Circuit was this: can defendants be potentially liable under Section 11
of the Securities Act of 1933, each as a “person performing similar functions” to a director, in light of
defendants’ role as board observers who could (but did not necessarily have to) signicantly inuence
the outcome of matters submitted to the board of directors for approval?
The court observed that whether someone is a director is a question of law, not fact. The court further
observed that Section 11 liability applied only to “limited and enumerated categories of defendants,”
and that among those defendants is “every person who, with his consent, is named in the registration
statement as being or about to become a director, person performing similar functions, or partner.”
Unlike the individual directors of Tibet, the two board observers were not signatories to the registration
statement.
The court also went on to consider the question of whether the two board observers were ultimately
performing similar functions as directors, and concluded that the answer was no.
The court found three ways that the observer role diered from that of a director, which is to say that
the observers were not persons “performing similar functions” as directors:
1. They were not able to vote for or against board action like board members.
2. Their interests were openly aligned with the deal placement agent instead of with Tibet as a board
member’s interest would be.
3. Their role as board observers was xed and ended automatically, unlike board members whose
terms of service are subject to the vote of the shareholders.
As the court noted:
Without the ability to manage the company’s aairs, Zou and Downs lack directors’ most basic
power. As agents of Tibet’s placement agent, their loyalties aren’t with Tibet’s shareholders—and
loyalty to shareholders is as vital to directorship as the power to manage. And unlike Tibet’s
directors, their tenure is not subject to shareholder vote. Add to that the registration statement’s
express provision for directors’ duciary duties, with no similar provision for Zou and Downs.
While this particular case was narrowly focused on the potential for Section 11 liability for board
observers, its reasoning and holding should be instructive for other situations as well.
Coverage for Board Observers
While this case makes for a nice example of how we might view board observers in the context of
liability, it also might prompt board observers to want some sort of insurance coverage “just in case”
they are in a position of having to defend themselves.
As mentioned earlier, it’s a bit odd for a board observer to obtain insurance coverage through the D&O
insurance of the company they are observing, especially since companies usually do not indemnify thei
board observers.
Moreover, there is a trap for the unwary for private companies when it comes to adding a board
observer to a company’s D&O insurance policy. For companies using the private company form of D&O
insurance, adding a board observer as an insured party means that you have added someone who can
trigger the “insured versus insured” policy exclusion.
This means that if the board observer or someone aliated with a board observer sues the company
and its directors and ocers, the D&O insurance policy will not respond.
The insured versus insured exclusion is not an issue for companies using the public company form of
D&O insurance, as I discussed here.
A better choice for a board observer looking for insurance would be the insurance of the investor who
negotiated for the board observer role. Private equity (“PE”) and venture capital (“VC”) rms usually
purchase general partner liability (“GPL”) insurance. To the extent that a board observer is representing
the interest of a covered fund, the observer is covered by the GPL policy.
This is also convenient since shareholders who might be suing a board observer will certainly also be
suing the PE or VC rm who named the board observer. The investor who named the board observer
would also be a natural party to provide the board observer with an indemnication agreement.
Notwithstanding these options, being a board observer carries with it a vanishingly small amount of
risk compared to serving as a duly elected or appointed member of a board of directors. For this
reason, many board observers do not bother with any indemnication or insurance arrangements at
all.
For those who are concerned, however, it is a straightforward process to request indemnication and
coverage from the investor who negotiated for the board observer position and then asked an
individual to serve in that position.
Shareholder class action trends, SEC enforcement actions, corporate governance, and the
issues impacting the personal liability of your directors and ocers. Priya Huskins
addresses it all in the D&O Notebook.
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All views expressed in this article are the author’s own and do not necessarily represent the position of Woodru-Sawyer & Co.
Priya Cherian Huskins
Senior Vice President, Management Liability
Editor, Management Liability/D&O
Priya is a recognized expert and frequent speaker on D&O liability
risk and its mitigation. In addition to consulting on D&O insurance,
she counsels clients on corporate governance matters, including
ways to reduce their exposure to shareholder lawsuits and
regulatory investigations. Priya serves on the board of an S&P 500
public company and a large private company and has an
impressive list of publications, speaking engagements, and awards
for her inuence and expertise in the industry.
phuskins@woodrusawyer.com | 415.402.6527 |
LinkedIn (https://www.linkedin.com/in/priyahuskins)
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