The Third Circuit recently issued an important decision for private fund advisors who serve on corporate boards.  In a precedential decision on a matter of first impression, the Third Circuit distinguished the role of nonvoting board observers from the function of formal corporate directors.  And while the decision was issued in the context of liability for alleged violations of the securities laws, the Third Circuit suggested the analysis may apply more broadly to other situations involving board observers.

The case, Obasi Investment Ltd. v. Tibet Pharmaceuticals, Inc. et al, began in New Jersey federal court as a class action lawsuit alleging Tibet Pharmaceuticals failed to disclose certain information about its financial health prior to its IPO.  Two of the defendants, Downs and Zou, claimed they were merely observers to Tibet’s board and therefore should not be found liable for any misconduct of the company board.  The trial court judge granted summary judgment in the duo’s favor on all counts except a violation of Section 11 of the 1933 Securities Act, stating that the question presented a novel issue ripe for an appellate court.

On appeal, the Third Circuit threw out the last remaining Section 11 claim against the two defendants stating that board observers are not the same as directors.  A claim under Section 11 can be brought against any person “named in the registration statement as being or about to become a director, person performing similar functions, or partner.”  The issue before the Third Circuit was whether the board observers were “person[s] performing similar functions” to directors.

As board observers, Downs and Zou were unable to vote on company matters but, according to the registration statement, “may nevertheless significantly influence the outcome of the matters submitted to the Board of Directors for approval.”  Nevertheless, the Third Circuit pointed to three features that distinguished the board observers from directors:

  1. The observers could not vote on board matters;
  2. The observers were loyal to the placement agent rather than the shareholders; and
  3. The tenure of the observers was not subject to shareholder vote.

In rejecting the plaintiffs’ primary argument, the Third Circuit held their interpretation of the word “similar” to be too narrow, determining that even if a person is named as performing similar functions to a director, that person still may not “possess the directors’ ‘formal power to direct and manage a corporation, and the responsibilities and duties that accompany those powers.’”  After comparing the responsibilities of Downs and Zou to those of a director, the Third Circuit held that the role of the board observers was not sufficiently “similar” to that of a director to find liability under Section 11.

The Third Circuit’s opinion provides some helpful guidance on the distinction between nonvoting board observers and formal corporate directors.  In connection with their investments in companies, private fund advisors often are given the right to hold one or more of the board of director seats or, alternatively, appoint a nonvoting board observer with informational rights.  There are several significant differences between the two.  For example, directors have voting – and sometimes veto – rights, but also owe certain fiduciary duties to the company and its shareholders and must be careful not to engage in activities that could be viewed as self-interested or not in the best interest of the company and its shareholders.  In addition, a member of the private fund advisor who also sits on the company’s board of directors must navigate potential conflicts of interest between their duties to the company and the private fund.  Board observers, on the other hand, have access to important and timely information, and while they do not have voting rights, board observers, unlike directors, do not owe fiduciary duties.  The Third Circuit’s decision – distinguishing board observers from formal directors for purposes of liability in at least some contexts – is another data point for private fund advisors to consider when weighing the pros and cons of appointing one of its members as a formal director or a nonvoting board observer.

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Photo of Hena M. Vora Hena M. Vora

Hena M. Vora is an associate in the Litigation Department and a member of the Asset Management Litigation practice and Products Liability group. Her practice encompasses a range of complex civil and commercial litigation matters, including securities litigation, partnership disputes, and consumer products.…

Hena M. Vora is an associate in the Litigation Department and a member of the Asset Management Litigation practice and Products Liability group. Her practice encompasses a range of complex civil and commercial litigation matters, including securities litigation, partnership disputes, and consumer products.

Hena has experience with various stages of litigation, including pitching clients, coordinating discovery, drafting dispositive motions and trial memoranda, and preparing witnesses for depositions and trial. She also has experience conducting highly sensitive and confidential internal investigations.

Hena maintains an active pro bono practice and has been awarded for creating a partnership between Proskauer’s Boston office and Minds Matter Boston, through which she helps high school students from low-income backgrounds achieve college readiness and success.

Hena earned her J.D. from Emory University School of Law, where she received the Pro Bono Publico honor and a Transactional Law Certificate. In addition, she was a national competitor on the Moot Court Society and served as president of Emory’s South Asian Law Students Association. While at Emory, Hena served as judicial intern for Judge Denny Chin at the U.S. Court of Appeals for the Second Circuit.

Photo of Michael R. Hackett Michael R. Hackett

Mike Hackett is a partner in the Litigation Department and Co-Head of the Asset Management Litigation practice. An experienced litigator and trial lawyer, Mike’s practice focuses on complex commercial litigation, with a particular emphasis on asset management, financial services, M&A, shareholder, and life…

Mike Hackett is a partner in the Litigation Department and Co-Head of the Asset Management Litigation practice. An experienced litigator and trial lawyer, Mike’s practice focuses on complex commercial litigation, with a particular emphasis on asset management, financial services, M&A, shareholder, and life sciences disputes.

A significant portion of Mike’s practice concerns disputes and regulation involving private funds, including private equity, venture capital, hedge, real estate and private credit funds, as well as their sponsors, partners, investors, portfolio companies, and officers and directors. Mike’s experience representing private fund clients runs the gamut, from control contests within advisers, to disputes between limited partners and general partners, to representation of investment advisers in connection with regulatory examinations, investigations and enforcement matters. Mike routinely represents funds, fund sponsors, portfolio companies, and their officers and directors, including in significant post-closing M&A disputes.

Mike also litigates high-stakes commercial disputes in the life sciences and financial services areas, including for established pharmaceutical and biotechnology companies, emerging and innovative start-ups, asset managers, and other private capital investors, in areas such as M&A, breach of contract, indemnification, fraud, contested earnouts and royalties, securities and capital markets, and corporate governance.

Mike has been recognized by Chambers USA and was named a “Rising Star” by Massachusetts Super Lawyers.

Photo of Timothy W. Mungovan Timothy W. Mungovan

Tim Mungovan is the Chair of Proskauer.  He is also the immediate past chair of the Firm’s Litigation Department and head of the Securities Litigation practice.

His practice is focused on securities, commercial litigation, governance, and bankruptcy-related matters. He has a national reputation…

Tim Mungovan is the Chair of Proskauer.  He is also the immediate past chair of the Firm’s Litigation Department and head of the Securities Litigation practice.

His practice is focused on securities, commercial litigation, governance, and bankruptcy-related matters. He has a national reputation for advising sponsors of private investment funds (hedge, private equity, private credit and venture capital) in a wide variety of matters, including litigation, governance, securities, fiduciary obligations, and regulatory enforcement.

Chambers USA describes Tim as “an extraordinary lawyer who is a fierce and very talented litigator. He is extremely knowledgeable, responsive and client-oriented.” Best Lawyers in America lauds Tim’s experience, integrity, work ethic, communications and courtroom skills. Tim has been listed in the “Top 100 Lawyers” in Massachusetts, and Benchmark Litigation has continually recognized Tim as a Litigation Star in Massachusetts.

Over the last six years, Tim has been the lead litigator representing the Financial Oversight and Management Board for Puerto Rico in the historic restructuring of Puerto Rico’s debts. The scale and complexity of this restructuring has resulted in one of the most active litigation dockets in the U.S. Almost every aspect of the litigation involved matters of first impression in part because the restructuring is governed by the Puerto Rico Oversight, Management, and Economic Stability Act, which was enacted for Puerto Rico in 2016.  The track record of success speaks for itself:  in the more than 150 lawsuits filed, Tim and the Proskauer team have prevailed in almost 95% of the cases.

Tim is recognized nationally for his experience in private fund litigation and disputes, having focused on the industry for more than 25 years.  As part of that focus, Tim created and is the lead editor of Proskauer’s blog on Private Equity litigation, The Capital Commitment.