By: Lori Smith, Ryan Udell and Adam Chelminiak
A recent decision by the U.S. Court of Appeals for the Third Circuit offers an important reminder of the distinction between the roles (and exposure to liability) of corporate directors and board observers. In a precedential opinion on a matter that previously lacked judicial guidance, the appeals court held that as a matter of law the functions of the defendant nonvoting board observers were not “similar” to the functions of board directors for purposes of imposing liability under Section 11 of the Securities Act of 1933.
In Obasi Inv., Ltd. v. Tibet Pharmaceuticals, Inc. et al (Obasi), the Third Circuit evaluated potential liability of two board observers for material omissions of negative financial information about Tibet Pharmaceuticals, Inc. (Tibet) in connection with the corporation’s initial public offering (IPO). Hayden Zou was an early investor in Tibet and L. McCarthy Downs was the managing director of the investment bank that ultimately served as Tibet’s placement agent. Zou and Downs worked together to help Tibet go public and were listed as nonvoting board observers chosen by the placement agent in Tibet’s IPO registration statement. The registration statement, however, failed to disclose that Tibet had defaulted on a loan from the Chinese government several months before the effectiveness of the registration statement, instead simply referencing a “long-term loan” without acknowledgement of the default. The Chinese government froze and auctioned off Tibet’s assets shortly after the IPO closed, prompting the NASDAQ to halt trading and leading to a drastic decline in Tibet’s stock price. Zou and Downs were among a number of defendants sued on behalf of a class of investors who alleged, among other claims, that the defendants had violated Section 11.
Section 11 imposes near-strict liability on certain enumerated categories of defendants for untrue statements or omissions of material facts in a registration statement. Individuals subject to such liability include “every person who was a director of (or performing similar functions)” of the issuer.[1] The district court in Obasi denied the defendants’ motion for summary judgment, concluding that in their capacity as nonvoting board observers Zou and Downs performed “similar functions” to those of the directors and were therefore subject to Section 11 liability. That decision rested heavily on language in the registration statement advising that, despite their lack of formal powers or duties, the board observers “may nevertheless significantly influence the outcome of the matters submitted to the Board of Directors for approval.”
On appeal, however, the Third Circuit placed little import on the observers’ ability to influence board decisions. Instead, it established that the basic functions of directorship are “defined by their formal power to direct and manage a corporation[.]” In the Third Circuit’s view, three features distinguished the board observers from the fundamental powers and responsibilities that define corporate directorship: (1) the observers could not vote for board action; (2) their loyalties aligned with the placement agent rather than the shareholders; and (3) their tenure was not subject to shareholder vote. Accordingly, the role served by the board observers was, as a matter of law, not sufficiently “similar” to the core powers and responsibilities that constitute the function of directors to impose liability under Section 11, and the appeals court directed the entry of summary judgment in favor of the defendants. It is important to note that the factors cited by the court in making its decision are common to most, if not all, situations where an investor obtains the right to appoint a board observer in connection with its investment in a company.
The court’s decision was limited to liability to shareholders under Section 11 arising from omissions in a company’s registration statement. In a footnote, the court suggested that a more expansive understanding of who is a “director” might be appropriate in a different context, for example, in assessing insider trading liability under Section 16 of the Securities Act. Nevertheless, the decision offers welcome clarity for a broad class of board observers (and private equity and venture capital funds and other third parties who often designate people to serve in such positions) as to whether there is a meaningful distinction between directors and board observers for liability purposes.
[1] 15 U.S.C. §77k(a)(3).
