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Rethinking Board Observers: Balancing Innovation and Antitrust Scrutiny in the Tech Sector

Nizan Packin and Anat Alon-Beck

Rethinking Board Observers: Balancing Innovation and Antitrust Scrutiny in the Tech Sector
iStock.com/Ladislav Kubeš

Board observers, a relatively recent development in corporate governance, are rapidly gaining prominence. These non-voting participants are strategically positioned to access critical company information without the formal responsibilities and liabilities of board membership. Often appointed through agreements or side letters, board observers are particularly prevalent in sectors like technology, where innovation drives value and competition is fierce. This role offers investors a unique vantage point but also raises significant antitrust concerns. As scrutiny intensifies in the US and EU, particularly regarding Big Tech's use of board observers to gain competitive advantages, it becomes imperative for PE/VC lawyers to understand the implications of this evolving dynamic.

1. The Strategic Allure of Board Observers

For investors, particularly in the tech sector, board observers provide a strategic alternative to board memberships. They enable investors to gain access to key information, understand market trends, and influence corporate strategy without triggering the antitrust scrutiny typically associated with formal board seats. This tactic has become increasingly popular among major tech firms seeking to secure a foothold in innovative startups, as it provides insights into potentially disruptive technologies and business models.

However, this strategy is not without controversy. While board observers circumvent direct regulatory oversight by lacking voting power, they still have access to sensitive competitive information. Critics and regulators argue that this approach could be used to sidestep antitrust regulations, potentially leading to unfair competitive practices. Moreover, it is questionable how often the lack of voting rights truly limits a board observer's influence, especially in situations where consensus within the board is typically achieved without formal voting, rendering the observer’s position nearly as powerful as a full board member.

2. Unfair Advantages and Antitrust Concerns

The use of board observers by major technology firms raises significant antitrust concerns. By gaining access to sensitive and potentially competitive information without assuming the formal responsibilities and scrutiny of a board director, these firms can potentially exploit this position to stifle competition. For example, a large tech company could use information gleaned from a startup's board to preemptively neutralize emerging competitors or influence the startup’s strategic direction in ways that align with the larger firm’s interests. This practice can distort market competition and lead to unfair advantages, which has drawn the attention of regulators and prompted calls for stricter oversight.

The controversy lies in whether these roles serve as a loophole to avoid antitrust laws. While board observers do not have formal voting rights, their ability to influence corporate strategy raises questions about the fairness and legality of their involvement. Given the increasing regulatory focus on maintaining fair competition, particularly in the tech industry, it is crucial for legal practitioners to navigate these concerns carefully, balancing the benefits of board observers with the need to comply with antitrust regulations.

3. Regulatory Attention and Case Studies

The relationship between Microsoft and OpenAI serves as a prime example of these dynamics. After a significant investment, Microsoft secured an observer seat on OpenAI’s board, gaining valuable insights into artificial intelligence advancements. This arrangement has sparked regulatory investigations in both the US and the EU, with authorities questioning whether such practices could stifle competition. Responding to growing scrutiny, Microsoft announced on July 10, 2024, that it would relinquish its observer seat, despite its $13 billion investment. Similarly, Apple declined a comparable position, opting instead for periodic meetings to stay informed.

These decisions reflect a broader wave of regulatory attention. The Federal Trade Commission (FTC) and the Department of Justice (DOJ) are currently investigating how Big Tech companies use investments and partnerships to influence competitors. The role of board observers is expected to be a focal point in these investigations and should be a key topic of discussion at the upcoming American Bar Association national meeting.

4. Balancing Innovation with Fair Competition

As regulatory scrutiny intensifies, it is essential to recognize that a combination of existing laws, new guidelines, and updated FTC documents—including the Clayton Antitrust Act, the FTC Act, and recent FTC guidelines—are capable of addressing potential antitrust concerns associated with board observers. The issue, therefore, is not a lack of regulation but the challenges in effectively enforcing these laws in the context of rapidly evolving corporate governance practices.

Board observers, while valuable in corporate governance, must not serve as a loophole to circumvent antitrust laws. The true challenge lies in ensuring that these roles are utilized in a manner that does not lead to anticompetitive behavior. Legal practitioners must focus on mitigating liability risks for their clients, ensuring compliance with existing laws while navigating the complexities of innovation and competition. This requires a nuanced understanding of how board observers can influence corporate decisions and the potential for their actions to attract regulatory attention, even without formal voting rights.

5. Reassessing the Role of Observers in Corporate Governance

Current and future judicial developments may have a significant impact on the role of board observers. The decision in Obasi Investment Ltd. v. Tibet Pharmaceuticals Inc., 931 F.3d 179 (3rd Cir. 2019), remains a critical point of reference in understanding the liability of board observers. The Third Circuit held that a non-voting board observer is neither a director nor a person whose functions are similar to those of directors under Section 11 of the Securities Act of 1933. The Court emphasized that directorship is defined by the formal power to direct and manage a corporation, which board observers lack. Despite their potential influence, observers are not held to the same level of responsibility or accountability as directors. This ruling, although binding only within the Third Circuit, offers comfort to individuals and organizations appointing board observers, reinforcing the need for clear distinctions in the roles and responsibilities of observers versus directors.

6. Key Considerations for Legal Practitioners

To navigate these complexities, legal practitioners must:

  • Draft Clear Shareholder Agreements: Explicitly delineate the roles, rights, and limitations of board observers in shareholder agreements. This should include clear definitions of their access to information, participation in discussions, and any restrictions on their influence over corporate decisions.
  • Mitigate Potential Liabilities: Ensure that the scope of a board observer's influence is clearly defined to prevent them from being classified as de facto or shadow directors, which could expose them to fiduciary duties and associated liabilities.
  • Stay Informed on Regulatory Changes: Keep abreast of ongoing regulatory investigations and evolving antitrust laws, including the new guidelines and updated FTC documents, to ensure that your clients' practices are compliant with the latest legal standards.
  • Balance Innovation with Compliance: Help clients find a balance between leveraging the strategic advantages of board observers and maintaining strict compliance with antitrust regulations. This might involve exploring alternative governance mechanisms or adjusting existing practices to align with regulatory expectations.
  • Adapt to Evolving Legal Landscapes: Regularly revise agreements and strategies in response to new judicial interpretations and regulatory developments, ensuring that your clients' corporate governance practices remain robust and legally sound.

By focusing on these key areas, legal practitioners can ensure that the benefits of involving board observers in corporate governance do not come at the cost of increased legal and regulatory risks.

The emergence of board observers represents both an opportunity and a challenge for PE/VC lawyers. While this mechanism can provide strategic advantages and foster innovation, it also raises significant antitrust and governance concerns. Navigating this evolving landscape will require a careful balancing act—one that prioritizes compliance, fosters fair competition, and supports the dynamic growth of the tech sector. As regulatory scrutiny intensifies, PE/VC lawyers must be proactive, informed, and ready to adapt to the changes ahead.

For more on these issues, please see our new research paper: Board Observers. Feel free to contact us with any questions or comments.

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