The Nominee-Director Dilemma

| 9 minutes

The COVID-19 pandemic forces businesses to make significant and, at times, difficult decisions. In the current context, businesses may need to incur additional indebtedness or seek further equity investments, which can create opportunities. Looking at the decision-making process of corporations through the lenses of an institutional or private equity investor, this bulletin serves as a refresher with respect to the duties, responsibilities and liabilities of nominee directors and investors, and highlights certain key considerations for the negotiation of governance rights given that in connection with investments of a certain size, it is common for investors to be represented on the board of directors of investee corporations.

Decision-Making

Directors manage, or supervise the management of, the business and affairs of a corporation;[1] subject to the provisions of any unanimous shareholders agreement which can restrict, in whole or in part, the powers of directors.[2]

At the time of making an investment or increasing one’s interest in a corporation, investors have options when it comes to governance rights: (a) seek the specific right for such investor to nominate one or more directors; (b) request the right to nominate an observer on the board of directors, who would ideally have access to all information submitted to directors; and/or (c) negotiate “veto rights”, namely a list of material or fundamental decisions that may require the positive consent of shareholders representing a certain minimum shareholder percentage. The practice is often a combination of the above, depending on whether the investor is taking a minority or majority stake in the corporation. Another option is for shareholders to restrict all of the powers of directors, which is most often used by a parent corporation for its wholly owned subsidiaries in order to streamline the decision-making process within a group.[3]

However, requiring that fundamental decisions be subject to shareholder approval can transfer the responsibilities and liabilities of directors to the shareholders,[4] which may or may not have been the intent of the parties. In addition, the duties and responsibilities of a nominee director towards the corporation can create friction with his or her nominating shareholder and the corporation.

Shift of Responsibilities and Liabilities to the Shareholders

In the event that a unanimous shareholders agreement restricts all powers of directors, shareholders will be considered de facto directors and will have assumed all duties, responsibilities and liabilities of directors, with the corollary that any actual directors will be released from such duties, responsibilities and liabilities.[5] Directors owe a fiduciary duty to the corporation, whereas shareholders do not. Conversely, as a result of a unanimous shareholders agreement that restricts powers of directors, shareholders must change their decisional paradigm and act in the interest of the corporation.[6]

In the more common scenario where only “vetoes” or fundamental decisions require shareholder approval, the unanimous shareholders agreement can result in the partial restriction of the powers of directors. The issue of the transfer of the duties, responsibilities and liabilities of directors to shareholders has not, however, been completely fleshed out by the case law. In order to minimize the risk of shareholders to be considered de facto directors, it is advisable for a unanimous shareholders agreement to clearly either: (a) confirm that the powers of directors are restricted only in part and only for such matters listed therein or (b) provide that the special approval rights for fundamental decisions are in addition to the decisions being taken at the board level and are subject to the requirements of applicable laws.

Nominee Directors

As previously stated, it is common for institutional and private equity investors to have representation on the board of directors of an investee corporation.

In Canada, all directors (including nominee directors) owe a fiduciary duty to the corporation and, in exercising such duty, they may take into account stakeholders. Directors can also decide to maximize shareholder value but only if it is in the interest of the corporation.[7] Accordingly, nominee directorships may cause serious governance challenges for a corporation, its directors and its shareholders.

Conflicts of Interest

“It may well be that the corporate life of a nominee director who votes against the interest of its “appointing” shareholder will neither be happy nor long.”[8]

When contemplating a minority investment, investors should question whether there is actually a need to have representation on the board of directors, and whether shareholder approval rights on certain fundamental decisions and/or the right to an observer would suffice.[9]

The nominee director can easily be in a situation of conflict of interest where the interests of his or her nominating shareholder diverge from those of the investee corporation. In the context of the recent global pandemic, there are many examples of where this may arise as businesses seek out alternative financing or other operational decisions that may not be in line with the investment thesis of the nominating shareholders.

The conflict of interest may arise from the identity of the director and/or from the relationship between the nominee director and the nominating shareholder. For example, the nominee director can be a director, officer or employee of the nominating shareholder. In this scenario, such director has conflicting duties of loyalty to the corporation and to the nominating shareholder, which can place him or her in a very difficult position in connection with board-level decision-making.

As a reminder, the nominee director must act in the interest of the investee corporation. In satisfying this duty, he or she must positively apply his or her mind to assess what the corporation’s interests are and exercise independent judgement.[10] For example, the nominee director cannot agree in advance to act under the instructions of the nominating shareholder and neither can the nominating shareholder have any rights of veto over the nominee director’s decisions.[11] Nevertheless, the nominee director can consult with his or her nominating shareholder about the conduct of the affairs of the investee corporation as long as he or she remains free and independent to decide in the interest of the corporation. In doing so, the obligation of the nominee director may include the duty to tell his or her nominating shareholder that its requested course of action is not – in the view of the nominee director – in the interest of the corporation.[12]

Another potential conflict of interest may arise when the personal interest of the director conflicts with the interest of the corporation. Faced with a conflict of interest, best practice dictates that the director should disclose the conflict or potential conflict of interest at a board meeting, have such disclosure recorded in the minutes of such meeting and, in exceptional circumstances, withdraw from voting at such meeting or withdraw from such meeting.[13]

Confidential Information

The minutes of board meetings and information provided by the corporation to its directors constitutes confidential information of the corporation that cannot be shared by the nominee director to his or her nominating shareholder. A shareholder which wishes to have access to the corporation’s confidential information must contractually request such information specifically in an agreement with the corporation, such as a unanimous shareholders agreement. A shareholder can also obtain such information from an observer it has the right to nominate if such observer has the contractual right to receive such confidential information and is not prevented by a confidentiality agreement from sharing such information with the shareholder.

Conclusion

One size does not fit all. Prior to negotiating governance rights, institutional and private equity investors should assess and determine their objectives and goals for the particular investment. In the event that nominee directors are appointed by a shareholder, it is important for all directors to remember their duties to act in the interest of the investee corporation and not of its nominating shareholders. Although this may be difficult at times, it is essential to avoid a claim to the effect that the nominee director did not fulfil his or her duties.

[1] Canada Business Corporations Act, R.S.C., 1985, c. C-44, s. 102(1).

[2] CBCA, supra note 1, s. 146(1).

[3] A declaration of the sole shareholder can also have shortcoming because the interest of the parent and the operating subsidiaries may not always converge. See also infra, note 6.

[4] CBCA, supra note 1, s. 146(5).

[5] CBCA, supra note 1, s. 146(5).

[6] This is particularly true if the shareholder in question holds a majority stake in the corporation. See Deluce Holdings c. Air Canada, [1992] 12 O.R. (3d) 131 (Gen. Div.).

[7] Peoples Department Stores Inc. (Trustee of) v. Wise, [2004] 3 S.C.R. 461, 2004 SCC 68; BCE Inc. v. 1976 Debentureholders, [2008] 3 S.C.R. 560, 2008 SCC 69.

[8] 820099 Ontario Inc. v. Harold E. Ballard Ltd., [1991] O.J. NO. 266.

[9] As long as such observer does not de facto acts likes a director.

[10] Boulting et al. v. Association of Cinematograph, Television and Allied Technicians, [1963] 2 Q.B. 606 (C.A) cited in Central Bank of Ecuador v. Conticorp SA, [2015] UKPC 11.

[11] Hawkes v. Cuddy, [2009] EWCA Civ 291.

[12] 820099 Ontario Inc. v. Harold E. Ballard Ltd., supra note 8; PWA Corp. c. Gemini Group Automated Distribution Systems Inc., (1993) 103 D.L.R. (4th) 609 (Ont. C.A.).

[13] See also, CBCA, supra note 1, s. 120.

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