CLS Blue Sky Blog

Do Board Observers Improve Corporate Governance?

In the complex world of corporate governance, a novel mechanism has reemerged: board observers. Operating without the conventional voting rights of board members, these individuals have become pivotal in bridging the gap between ambitious startups and their venture capital (VC) backers, representing investor interests  without the formalities and direct liabilities of board membership.

Board observers have the privilege of attending board meetings without the liabilities associated with board membership. They participate in the meetings but do not have voting rights or the core responsibilities of directors. Typically appointed on behalf of a specific shareholder or group of shareholders, board observers represent the interests of those investors by monitoring the activities and decisions of the board.  While board observers can observe discussions, ask questions, and provide input during meetings, sharing their experience and expertise, they don’t have the authority to vote on resolutions or directly influence board decisions.

Being influential without holding a formal control or controlling position can be very effective and beneficial. With a keen interest in safeguarding their investments, investors use board observers partly because they seek a more intimate involvement in the affairs of portfolio companies without assuming the legal burdens of board membership. This role effectively fulfills these needs, offering a discreet yet influential way to guide company strategy and governance. Particularly valuable where VCs are involved with startups, board observers help maintain a balance between investor control and entrepreneurial freedom, which is especially important when every strategic insight can significantly impact the company’s trajectory.

Recent studies, such as the January 2024 survey conducted by the National Venture Capital Association (NVCA), highlight the widespread adoption of board observers by startups and tech companies. With 82 percent of the surveyed investing entities and VCs using this mechanism, board observers have helped enhance board transparency, mitigate litigation risks for companies, and navigate antitrust and regulatory considerations.

The role of board observers is unique in being defined contractually rather than through statutory board responsibilities. This arrangement allows board observers to circumvent the direct fiduciary duties typically associated with board membership, though it does not completely insulate them from potential conflicts of interest or scrutiny by regulatory bodies such as the Department of Justice and the Federal Trade Commission. This is particularly relevant in areas sensitive to antitrust laws and foreign investment regulations.

The partnership between OpenAI and Microsoft serves as a prime example of how board observers can facilitate strategic alignments while adhering to antitrust regulations. Microsoft’s decision to secure a non-voting observer seat on OpenAI’s board was a strategic move, allowing the tech giant to gain valuable insights into OpenAI’s governance without crossing the boundaries that a direct board position might have breached under antitrust laws. This arrangement highlights the board observer’s role as a strategic asset, enabling corporations to engage in partnerships and collaborative ventures while complying with antitrust law.

Moreover, board observers are crucial in managing compliance with regulations of the Committee on Foreign Investment in the United States (CFIUS). CFIUS scrutinizes foreign investments that may affect national security, and the board observer approach has helped ensure such investments proceed without compromising U.S. interests, by enabling foreign investors to appoint a board observer.  By allowing foreign investors to have observational but non-controlling insight into company operations, board observers could provide non-public information to the foreign investors and help balance the need for foreign capital and expertise with national security considerations. Realizing this, in recent years CFIUS has attempted to close this potential loophole, limiting the use of board observers in such situations.

In addition, board observers help ensure compliance with the Employee Retirement Income Security Act (ERISA), particularly for VC and private equity firms managing investments from pension plans. This oversight helps minimize the fiduciary liabilities that could arise under ERISA for direct board involvement. Board observers provide a layer of surveillance ensuring that investment decisions align with the stringent requirements of ERISA, protecting pension plan assets while enabling proactive management of those investments without crossing into the territory of direct fiduciary responsibility.

The U.S. appeals court decision in Obasi Inv. Ltd. v. Tibet Pharms. Inc, which focuses on securities regulation but is nonetheless relevant for the corporate governance aspects of board observers, exemplifies the protective benefits of board observers in litigation. The court held that board observers, due to their non-voting status and limited involvement, do not carry the same legal liabilities as traditional board members under securities laws. This ruling underscores how using the mechanism of board observers reduces legal risks for the observer and the business entities that appoint them. It also provides companies with the flexibility to engage with its investors on governance] without exposing them to the heightened liabilities associated with formal board positions.

As corporate governance evolves, and the role of board observers expands, there is an increasing need for a thorough examination of the ethical implications of board observers’ influence, potential conflicts of interest, and impact on corporate transparency and accountability. For example, in the OpenAI and Microsoft relationship, the board observer appointed by Microsoft is able to attend OpenAI’s meetings and pass that information to Microsoft. This can present challenging situations, especially because,  following the appointment of its board observer, Microsoft has also hired one of OpenAI’s competitors, Inflection’s chief scientist (Suleyman), and his team. The increasing reliance on board observers calls for more robust guidelines and regulatory frameworks to support their constructive engagement in governance and ensuring that their influence enhances rather than undermines the integrity of corporate governance.

The rise of board observers marks a paradigm shift in corporate governance, indicative of a deeper evolution in how investor influence and company oversight are managed. By blending strategic oversight with operational insight, board observers provide a nuanced perspective that reevaluates traditional governance models. As startups and venture capital navigate this changing landscape, board observers must begin to champion governance models that prioritize transparency, strategic alignment, and efficiency, heralding a new era of governance innovation.]

This post comes to us from Nizan Geslevich Packin, a professor of Law at Baruch College, CUNY and the University of Haifa Faculty of Law, and Anat Alon-Beck, an associate professor at Case Western University’s School of Law.  It is based on their recent article, “Board Observers,” forthcoming in the Illinois Law Review and available here.

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