Are Corporate Board Observers Liable Just Like Directors?

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 fiduciary duty to shareholders.

On the other hand, in some cases, this view might be offset 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 indemnification agreement from a company. As I have discussed elsewhere, indemnification agreements are important for directors to be able to protect themselves from litigation defense costs and financial settlements.

There is even, perhaps, an argument that board observers who obtain indemnification agreements are taking actions that are inconsistent with their observer status.

While not dispositive, an observer who obtains an indemnification 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 indemnification 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 influence over a board on behalf of a shadow director or 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.

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 “significantly influence 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:

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 flowed 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) significantly influence 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 differed 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 fixed 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 affairs, 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’ fiduciary 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 their 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 affiliated with a board observer sues the company and its directors and officers, 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”) firms 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 firm 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 indemnification 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 indemnification or insurance arrangements at all.

For those who are concerned, however, it is a straightforward process to request indemnification and coverage from the investor who negotiated for the board observer position and then asked an individual to serve in that position.