Should board members representing inside investors vote on the board resolutions authorizing the insider-led down round?

December 27, 2008

As a theoretical matter, entrusting disinterested directors to approve a down round or dilutive financing is an excellent way to protect the insider-affiliated directors against claims from stockholders.  In this situation, the board may establish a special committee comprised only of disinterested directors to negotiate and approve the financing.  In a perfect world, the insider-affiliated directors would not participate in any of the board discussions to approve the transaction.

However, establishing an independent committee of disinterested directors to approve the terms of an insider-led down round financing is often impractical.  Oftentimes, there aren’t any disinterested directors to approve the transaction. All of the directors affiliated with investors participating in the financing will not be disinterested.  In addition, directors that are also employees may not be considered disinterested because they have a vested interest in completing a financing in order to keep their jobs.

In many scenarios, the inside directors will have to vote in order to have a valid board action.  However, the board will not have the benefit of the business judgment rule unless a majority of the disinterested directors or disinterested shareholders approve the transaction.  In this situation, courts will apply the entire fairness doctrine as the standard of review of director actions, which presumes that the directors acted unfairly and places the burden of proof on the directors to show fair dealing and fair value for the company.