My client was an investment adviser who managed a hedge fund. The disclosure documents for the fund stated that the fund would invest in equity securities of a wide variety of companies, including private ones. The disclosure also stated that the fund might acquire control over smaller companies. In fact, the adviser had taken board positions in a number of companies to get an inside view of them and see whether he could help management achieve enhanced performance. If the adviser saw a strong opportunity, he might choose to invest in such a company. Since the adviser had most of his money invested in his own fund, his preference was to use the fund as the vehicle with which to buy shares in these companies. By doing so, the adviser would be aligning his personal interest with those of his investors. This strategy is fairly common. Funds run by activist managers are quite popular among investors.
The disclosure did not state that that the adviser viewed the companies on whose boards he sat as investment targets. The reason for this was that the adviser did not want his clients to be tempted to buy shares in these companies prematurely and thus put upward pressure on the price before the adviser could cut a deal for the fund. One such company was a private company that was listed on OTC Pink ®. To qualify for this market and still remain private, a company may not have more than 500 non-accredited (or 2,000 accredited) stockholders. (Were the company to exceed these thresholds, it would have to register as a public company under the Exchange Act.) Given the small stockholder base of a listed private company, any large trade can have a significant impact on the stock price.
After a few months of serving on the board, the adviser was approached by a venture capitalist who held convertible preferred stock in the company. The VC decided to sell his position at a loss. He was willing to settle for just one third of what he had originally paid. The adviser jumped at the opportunity, because not only would he hold stock that in the fund’s hands had a 3X liquidation preference, but he would also have effective control over the company.
Much to our surprise, the adviser received a letter from a state securities regulator. The regulator alleged that the purchase of the preferred stock by the adviser on behalf of the fund constituted a breach of fiduciary duties because some of the fund investors did not learn about the adviser’s board seat until the transaction was reported to them. Of course, the investors could exit the fund at any time, or the preferred stock could have been placed into a side pocket (an arrangement where an investment can be shared among a subgroup of investors without any impact on the other investors). But none of the investors wanted out. In fact, the upside potential of the transaction was so lucrative that the adviser shut the fund to new investors altogether.
A fiduciary is an agent who must act in the sole interest of and for the benefit of the principal. Fees and other forms of compensation that fiduciaries earn for this work must be disclosed so that principals can decide whether or not to engage the fiduciary as their agent. In addition, any actual and current conflict of interest must be disclosed. Directors of corporations have fiduciary duties to their stockholders. Investment advisers have fiduciary duties to their investor clients. When a fund manager serves on the board of a company and then buys stock in that company on behalf of the fund, the adviser might face a conflict in the future.
Courts have wrestled with the conflict directors face when reconciling the contractual rights of preferred stockholders and the board’s fiduciary duties towards the common stockholders. In all the cases of which I’m aware, the courts are concerned with the interests of the common stockholders, because the conflict inures completely and absolutely to the benefit of the preferred stockholders. A sale of the company for an amount up to and including the liquidation preference would wipe out the common stockholders. In addition, when the preferred stockholders have a controlling vote and their representatives (typically fund managers) hold a majority of the board seats (or can reconstitute the board to gain such a majority), it is only the fiduciary duties towards the common stockholders that limits the power of the preferred stockholder’s representative on the board. The cases where directors are admonished by courts involve a fire sale of the company to satisfy the liquidation preference of the preferred stockholders, or other egregious behavior.
The regulator turned the issue on its head. Their worry was that despite the liquidation preference, the voting control and the strong alignment of economic interests, somehow the adviser, acting as a director of the corporation, had betrayed or was going to betray the interests of the fund’s investors. These of course are the preferred stockholders that the court cases never address, because, presumably, they are protected contractually by their preferences. In our conversations with the regulator, we repeatedly asked how and why this betrayal occurred or would occur, but we never received an answer; they just kept threatening to bring an enforcement action. The regulator cited no cases where a court had wrestled with this issue, and after an exhaustive search, I didn’t find any either. Further, as we pointed out to the regulator, no one ever got rich off of board fees for issuers of penny stocks and, as mentioned above, the adviser had most of his wealth invested in the fund.
As things stand, neither my client nor I understand what my client did wrong and how he or others could avoid running afoul of the regulator’s enforcement actions in this area in the future. In the “consent” order that the adviser was forced to sign to avoid being charged, the regulator focused on an alleged deficiency in the fund’s disclosure. The regulator presumably took this approach because they couldn’t find a reason why the transaction itself was inappropriate. Doubling down, the regulator then took the position that disclosure in advance of the purchase of the preferred stock was required. What that advance disclosure might look like is anyone’s guess, because before being approached by the VC the adviser would have had no idea in what ways his fiduciary duties to the common stockholders might impact the management of the fund. Upon joining the board, the adviser would not know that he might later be able to purchase the preferred stock at a steep discount . In fact, the adviser would have no idea what sort of opportunities to invest in the company would come his way. Further, he would have found no legal guidance on what disclosure might look like concerning the many possibilities and the risks faced by a director in connection with each of these. All the adviser knew was that since his money was in the fund, his interests and those of his clients were aligned. Disclosure about a potential amorphous conflict under those circumstances would seem unnecessary and too attenuated to entertain.
Of course, should the regulator’s concerns be realized and an actual conflict arise, there would be plenty of ways for the adviser to handle it at that later date. For example, after having purchased preferred stock for the fund and having gained effective control of the company, the adviser could abstain from participating in board deliberations concerning a sale of the company. If a sale price under consideration by the board appeared too low and thus unfair to the interests of the common stockholders, the adviser could resign from the board. Because there are ways to handle conflicts once these arise, speculation in advance about the myriad of possible scenarios has never been required, nor is it the accepted standard of practice in drafting disclosure.
Further, the fact that the adviser served on the company’s board was disclosed in advance in quarterly newsletters to the investors, on calls with the investors and in the Form ADV that the adviser had filed with the regulator. The adviser did err by not sending his investors a copy of the Form ADV after it was amended to include his latest board appointment, but that is a Brochure Rule violation, and not a breach of fiduciary duties. Now a Brochure Rule violation can be a serious matter if potential new investors in the fund receive inadequate disclosure, but that wasn’t the case here. No new investors joined the fund after the Form ADV was amended. Further, as stated above, once the investors learned about the purchase of the preferred stock, they had every opportunity to ask to get out of the fund or ask that the investment in the company be placed in a side pocket. However, the investors across the board were enthused about the investment in the company and wanted to stay in it. It never occurred to the adviser that a regulator would second guess his decision to disclose immediately following the purchase of the preferred stock and instead insist that not disclosing the possibility of such an investment in advance was a breach of fiduciary duties subject to an enforcement action.
Why on earth was the regulator worried in the first place? The regulator hasn’t been charged with protecting the common stockholders of the company. Their job is to protect the investors of the fund. The fund’s investors saw the adviser’s board position as an asset that far exceeded any potential liabilies. That is what investing is all about.
In the Bramble Bush, Karl Llewellyn wrote that what judges, lawyers, regulators and law enforcement officers “do about disputes is, to my mind, the law itself.” And of course, he was correct. The fact that the law and precedent was with my client was of little significance unless he was willing to litigate, an expensive and risky process.
I wrote this post so that readers might appreciate what goes through a lawyer’s mind when you ask for legal advice. What will a regulator do if I enter into the proposed transaction, you might ask? Well, we can tell you what the law says, but, honestly, the real answer depends on whether the regulator assigns your matter to an obtuse, uncommunicative and misinformed staff member, whom the regulator then obstinately supports. As your lawyer, there is no way for me to know that in advance.
John A. Myer is a corporate and securities lawyer with Myer Law PLLC in Seattle, Washington. This posting does not constitute legal advice.