Thursday, September 8, 2011

Ambush in the Board Room - Give Some Thought to Notice Requirements

You invest in a company (or someone invests in your company).  The lawyers prepare a fleet of long agreements giving you complicated rights to name directors, approve major actions, and participate in sales and issuances of securities.  It’s painfully clear how the company’s governance is supposed to work.  But will reality match up?

Not always.  The problem, as usual, is bad faith.  If the business goes well and everyone’s honorable, there won’t be a problem.  But stress (and sometimes greed) has a way of skewing people’s thinking.  At some point, the other parties may stop treating those carefully negotiated provisions as the rules of the road and start treating them as inconvenient roadblocks.  At that point, they’ll bring in lawyers and instruct them, in essence, to find a plausible misinterpretation that lets them do what they want.

One particularly unpleasant tactic is what I call “ambush:”  Here’s the idea.  You want to do something, but someone else clearly has the right to stop you and probably will.  So you figure out a way to do it behind their back or with so little notice that they won’t have time to exercise their veto right.  You ambush them.

This tactic often results in litigation, but people who use it advisedly often decide they’d rather do what they want (or feel they need to do) and then defend it after the fact.  In one well known case, for example, a company’s founder was running it into the ground.  He had the right to name two board members and had named himself and another person he thought was loyal.  With bankruptcy near, however, his designee on the board ganged up with the principal investor (the third director) to plan a transaction that would dilute away his control and boot him out.  They ambushed him at a meeting he thought was about something else (he may not even have understood it would be a board meeting).  Before he could gather his thought (he could have removed the designee on the spot if he had thought of it), the transaction was proposed and approved (2-1).  He was out.  Years later, a court ruled in his favor.

Where agreements give other people the right to amend your agreements or waive your rights, or where they allow actions to proceed without prior notice, ambush is always an issue.

A recent decision of the federal Ninth Circuit Court of Appeals has got me thinking about this issue.  To summarize the allegations (there’s been no trial), the founders ganged up with two out of three VC investors to sell their shares and freeze out the third VC (WPP).  According to the founders, the other VCs not only waived the third VC’s rights under the right of first refusal and co-sale agreement, but also waived its right to get notice that the sales and the waiver were happening.

In this case, the agreement required the founders to give notice to each VC explaining how the requirements of the right of first refusal agreement had “been met or waived” before they could complete a sale.  The court rightly pointed out that this provision wouldn’t make much sense if the notice requirement could itself be waived and that the piece of paper the VCs signed didn’t clearly say that it was waiving notice rights.  But it was a close point and it really shouldn’t have been.

Standard venture investment documents often deal badly, if at all, with this issue.  The shareholders can usually act by majority written consent without any prior notice to the non-consenting shareholders.  Sometimes, the board can act by majority written consent, too.  Many of the key documents (certificate of incorporation, voting agreement, right of first refusal agreement, registration rights agreement) can be amended or waived by some percentage of the preferred stock, again, with no prior notice to the others and often no notice even after the fact.

The only way to defend against ambush is to be very careful about notice provisions.  For example, to deal with the problem in the WPP case, it would be enough to provide that, to be effective, an amendment or waiver required not only the consent of a majority of the preferred stock, but also prior notice to everyone.  To deal with board and shareholder actions, you need to require notice to everyone who has a right to vote before a meeting is held or an action by written consent becomes effective.

Bear in mind that it’s not enough to say “notice.”  You need to specify that only actions described in the notice can later be taken on the basis of the notice.  Otherwise, you’ll get notice of a board meeting, deliberately scheduled during your long-planned vacation.  Thinking the meeting will be routine, you’ll decide to skip it, only to find out when you get the minutes that you were removed from the board and your stock position has been diluted or otherwise compromised.

It’s worth noting that getting prior notice of an action can be valuable, even if you don’t have the votes to stop it.  First, people sometimes do stupid things they regret later.  So just having a chance to raise objections can make a difference.  Second, the majority’s ability to take an action is often arguable (e.g. if someone is self-dealing) and it’s much better to make the argument before anything has happened than long after the fact.  A court won’t automatically order a halt, but it might.  So that threat alone gives you leverage.  Likewise, courts are averse to unwinding complicated transactions after they’ve closed.  So your remedy after the fact may not be very satisfying.

The big tradeoff in protecting against ambush is decisionmaking efficiency.  There’s no getting around it.  If any board action requires five business days’ notice, the board will only be able to act quickly by unanimous consent and that may not be possible if one board member happens to be trekking in Nepal at the wrong moment.  That said, this problem isn’t as bad as people sometimes make it out to be.  The fact that you have a right to five business days’ notice doesn’t mean you’ll want to delay an important transaction for no reason.  You can always waive your right if speed is valuable and you can generally be counted on to do it when it’s in the company’s best interest.

So the only real problem is unavailability.  For better or worse, unavailability is becoming less and less of an issue these days, as the tentacles of telecommunications reach into more and more remote places.  And last minute requests for board or shareholder approval usually reflect disorganization and laziness on the part of the company and its lawyers, not real emergencies.

I tend to favor ambush protection over decisionmaking efficiency.  Other people have different preferences.  Whatever your preferences, make sure you consciously consider the ambush issue when you’re forming or investing in a company.  Don’t assume that it will magically turn out the way you want.