Fiduciary Duties and the Venture Capital Director

Co-written by Edward Schauder. Elisabeth Neuberg, a 3L intern assisted in the preparation of this article

Originally published in New York Law Journal, December 3, 2001

Over the last eighteen or so months, the business environment has placed increased pressure on venture capitalists that serve on the boards of their privately held portfolio companies. Not only have directors had to assume a more active role, but stockholders are more closely watching the actions that directors take.

Venture capitalist directors have the same fiduciary duties as other directors of privately held companies. However, they are more likely to be conflicted than other directors given their dual role as directors and portfolio managers. In addition, practically speaking, venture capitalist directors are the most likely target of breach of fiduciary duty claims. Market terms for follow-on rounds have become more onerous, in some cases washing out earlier rounds of financing. In addition, as a result of the liquidation preference that venture investors receive, other stockholder constituencies may receive little or nothing upon a sale or wind-down of the company. In these instances, most of the ire of other stockholders is reserved for the venture capitalists. Furthermore, the venture capitalist directors often are perceived as having the deepest pockets, both personally and as a result of supplemental directors' and officers' liability insurance maintained by their fund to cover claims at the portfolio company level.

Corporate directors, including venture capitalist directors, owe two fiduciary duties to the corporation and its stockholders: a duty of care and a duty of loyalty. A director's fiduciary duties are determined by the laws of the state of incorporation, and the scope of these duties varies from state to state. Since the vast majority of venture-backed companies are incorporated in Delaware, for purposes of this article, we will focus on Delaware law.

In Delaware, like in most other states, there are no "bright-line" definitions of the duty of care and the duty of loyalty. The standards have evolved from case law under circumstances that are highly fact specific. To further complicate matters, cases sometimes can be hard to reconcile with each other.

Duty of Care

Under Delaware law, directors are required to exercise "that amount of care which ordinarily careful and prudent men would use in similar circumstances."1 The duty of care is comprised of two components: (i) care in the decision-making process; and (ii) care in overseeing the conduct of employees and advisors.

Decision-Making. This component of the duty of care has evolved in various cases over the years. Perhaps the most well-known decision in this area is Smith v. Van Gorkom.2 In Van Gorkom, the court held that the duty of care mandates that directors make an informed decision based on all material information reasonably available to them and that they critically assess information. In Van Gorkom, the court concluded that in this regard the board members were grossly negligent and had thus breached their duty of care. Van Gorkom, the chairman of Trans Union Corporation, had unilaterally negotiated the sale of Trans Union and presented the proposal to the board in a 20-minute presentation. Thereafter, the board deliberated for only 90 minutes before approving the plan. During this process, the board did not consult with outside counsel and the only evaluation of the purchase price was made at the last minute by an internal officer of the company. The court concluded that the directors were personally liable for their actions, although the case was settled before damages were determined.

Consistent with the principles set forth in Van Gorkom, other Delaware cases have raised issue with hastily-called meetings.3 An "aura of inevitability" to a board meeting also has been held to run counter to Van Gorkom.4

In reaching a decision, directors are not required to do all the leg work. Section 141(e) of the Delaware General Corporation Law5 that a director will be fully protected in relying in good faith upon the...