The directors of companies have roles, responsibilities and potential liabilities. But who can be held liable as a director? That was the question that the Third Circuit recently answered in an interesting ruling in which the appellate court determined that board observers could not be held liable as directors or director equivalents under Section 11 for alleged registration misstatement misrepresentations. The decision raises some interesting considerations when it comes to directors and their roles. The Third Circuit’s July 23, 2019 decision can be found here.



Tibet Pharmaceuticals is a holding company that through one of its subsidiaries sold traditional Tibetan medicine. Hayden Zou was an investor in Tibet. Zou told McCarthy Downs III, a managing director at the investment bank, Anderson & Strudwick (A&S), about Tibet. The two discussed the possibility of taking Tibet public.  A&S later agreed to serve as Tibet’s placement agent for the offering.


Zou and Downs were neither signatories to the registration statement nor named as directors. Instead they were listed as nonvoting board observers chosen by A&S. Though Zou and Downs had no formal powers or duties, the registration statement said “they may nevertheless significantly influence the outcome of matters submitted to the Board of Directors for approval.”


After Tibet went public, allegations emerged that prior to the offering the company’s subsidiary had defaulted on a loan from the Chinese government. The registration statement did not disclose the default nor that the prior to the effective date of the registration statement that the Chinese government had frozen all of the subsidiary’s assets.


A plaintiff shareholder filed a securities class action against Tibet, certain of its directors and officers, its offering underwriters, and Zou and Downs, alleging the defendants should be liable under Section 11 of the ’33 Act for material misrepresentations or omissions in the registration statement.


Zou and Downs filed motions for summary judgment on the grounds that as nonvoting board observers they were not among the groups of defendants that can be held liable under Section 11. The district court denied the summary judgment motion, ruling that it was for a jury to decide the question of whether or not the roles Zou and Downs played were sufficiently similar to the roles of directors that they were among the persons who could be held liable under Section 11. The district court judge then certified the issue for interlocutory appeal to the Third Circuit


Section 11(a)(3) of the ’33 Act lists as among those that can be held liable for registration statement misrepresentations as a “person who, with his consent, is named in the registration statement as being or about to become a director … or person performing similar functions.”


The July 23, 2019 Decision

In an opinion written by Judge Thomas Hardiman for a 2-1 majority (with Judge Robert Cowen dissenting), the Third Circuit reversed the lower court, holding that Zou’ sand Downs’s roles as nonvoting board observers was not sufficiently similar to the functions that board directors perform for them to be held liable as directors or director equivalents under Section11.


The appellate court looked at a wide variety of legal sources to identify the functions that typify directorship, determining that “at the most basic level, directors are thus defined by their formal power to direct and manage a corporation and the responsibilities and duties that accompany those power.”  But the question, the court said, is not whether Zou and Downs as observers were “similar” to directors “in some abstract sense” but whether they “possess at least some of the core powers and responsibilities that define corporate directorship under the law of corporations.”


The appellate court said further that in order to make this determination, the registration statement itself controls the issue, and that it is for courts, not juries, to make the determination. The court then said that there are three features that differentiate Zou and Downs from directors. First, they could not vote for board action. Second, they are aligned with the placement agent, A&S, not Tibet, and third, their tenures were to end automatically, without being voted out. That Zou and Downs might, as non-voting observers, influence board decisions is “not a grant of power at all.” The court said “simply put, the face of the registration statement confers no actual power on Zou or Downs.”


Because, the court said, Zou and Downs were not “named in the registration statement as being or about to become directors or persons performing similar functions, the appellate court reversed the district court’s denial of summary judgment.


In dissent, Judge Cowen said that the court majority failed to recognize the expansive scope of the word “similar” in the relevant statutory language and that the majority failed to take into account the broad remedial  purposes of the statute. He said that in his view Zou and Downs’ functions were sufficient for them to be proper Section 11 defendants.



It is probably worth emphasizing here that the appellate court’s analysis addresses only the question of who is a director for purposes of Section 11 liability. The court specifically noted in a footnote that the analysis might be different, for example, for purposes of determining who may be held liable under Section 16 for insider trading. The suggestion is that in other contexts, the question of who is a director or director equivalent might well be different.


It is probably also worth emphasizing that the appellate court also did not say that board observers could never be subject to Section 11 director liability; the court’s determination here is limited only to the potential liability of the two individuals based on the statements in the company’s registration statement about their role. Under different circumstances involving individuals in a different role, board observers theoretically could be held to be serving in a role sufficiently “similar” to that of a director that the observers could be subject to director liability under Section 11.


Setting aside the fact that the court was only addressing the issue with respect to Section 11’s liability provisions, the court’s determination that Zou and Downs were not liable as director equivalents raises some interesting questions. For example, if the non-voting board observers are not directors or director equivalents for Section 11 purposes, are they directors or director equivalents for purposes of D&O insurance coverage? To be sure, it may be that some companies may not want board observers as insureds under their policies, with a call on the policy proceeds. This is the kind of question that needs to be addressed up front at the time of policy placement; even if board observers may not be subject to liability under Section 11, they can (as Zou and Downs were here) be named as defendants in litigation with the attendant costs involved.


The question of whether or not a board observer appropriately should be named as additional insureds under a company’s D&O insurance policy raises a further question, which has to do with the capacity in which the observers act. Even if the observers are additional named insureds, there will still be the question of whether at the time of alleged misconduct they were acting in their roles with the company or in their roles as representatives of the actor on whose behalf they are observing.  In that regard, it is worth noting that one of the three reasons the appellate court gave why Zou and Downs were not acting in role similar to a director was that they were “aligned” with the placement agent and not with the company. That sounds a lot like saying they were not acting in an insured capacity.


Private equity, venture capital funds and other third parties often designate representatives to act as board observers at portfolio companies. The possibility that these individuals could get dragged into the companies’ litigation will raise questions of whether or not they are insured persons under the companies’ D&O insurance policies, and will in any event raise the question of whether or not they were acting in an insured capacity at the time of the alleged misconduct. These possibilities mean that these board observers must anticipate the possibility that they will have to look to the insurance of the firms they were representing. This in turn means that the insurance of the firm they are representing should take the possibility of this type of litigation into account, including not only with respect to terms and conditions, but also with respect to limits adequacy.  Among other things, these firms’ policies will need a broad Outside Directors’ Liability coverage grant to insure their representatives when they serve as board members, as advisors, and as observers.


My colleague Jonathan Legge published a recent guest post on this blog discussing in greater detail the considerations that should be taken into account by private equity firms and others when their representatives are serving in various roles at portfolio companies.