Director Designation Rights are not Inviolable for PE Sponsors

Private equity sponsors received a warning earlier this summer from the Delaware Chancery Court that director designation rights are not inviolable, and that a company can impose reasonable conditions prior to seating a director designee—even where the agreement providing for such designation rights does not contemplate any conditions. While the facts in Partners Healthcare Solutions Holdings L.P. v. Universal American Corp. (Del Ch., June 17, 2015) are far from typical—a fraud suit brought by Universal American against Partners in connection with Universal American’s acquisition of a Partners portfolio company (a transaction that itself gave rise to Partners’ right to designate a director to Universal American’s board)—the Chancery Court’s holding is broadly applicable:

  • A stockholder’s contractual director designation rights remain enforceable, and claims may be brought against, and damages recovered from, a company for a breach of the underlying contract.
  • However, a company may impose reasonable conditions prior to seating the designee.
  • Specifically, a company may impose conditions on a director designee that are consistent with the company’s fiduciary duties, including conflict-of-interest and confidentiality conditions.
    • This was particularly necessary in Partners, where the director designated by Partners to Universal American’s board ostensibly represented a stockholder who was in current litigation with Universal American. Universal American required that Partners’ designee forgo representation by the same law firm that was representing Partners in the fraud suit, and that the designee sign a confidentiality agreement preventing him from sharing confidential information with such law firm.
    • Partners claimed that certain decisions made by the Universal American board during the period between the designation of its board representative and such individual’s actual seating on the board caused it harm, and it sued for breach of contract and sought damages (and attorney’s fees). The Chancery Court rejected Partners’ claims, holding that the imposition of the conditions was not a breach of the director designation agreement.
  • While the Chancery Court restricted its holding to the facts before it, commentators have noted that a court may uphold other reasonable conditions that are not contractually specified, including (i) conditions applicable to all directors and (ii) conditions for which the company has a strong legitimate need and that do not have a disabling effect on a stockholder’s contractually negotiated board designation rights.