How VC-Backed Companies Can Mitigate #MeToo Risk

This article originally appeared in Law360 and is reprinted here with permission.

The #MeToo and Time's Up movements have placed boards of directors in the spotlight for how quickly and thoroughly they respond to allegations of sexual assault, sexual harassment and other improper behavior by founders, executives and employees.

While public companies have had their share of struggles responding to such allegations, venture capital-backed startups, especially in their early stages, face unique challenges in addressing such allegations.

For example, while well-established private or public companies have a succession plan and executives who can step in if a chief executive officer is placed on leave or resigns, early stage startups often do not. The founders are often central to the company’s survival and oftentimes are major stockholders as well. Consequently, allegations against them may threaten the existence of the company, making it harder for a board to remove the individual for improper behavior.

In light of this, there are proactive steps that venture capitalists can take to mitigate the risks posed by #MeToo-related allegations.

Bases for Liability

Victims of improper behavior and shareholders of companies where the behavior occurred can attempt to hold directors and officers, including venture capital representatives serving in such capacities, liable for #MeToo allegations under a variety of legal doctrines.

Failure to Supervise

In In re Caremark International Inc. Derivative Litigation, the Delaware Court of Chancery set forth the standard for liability when directors fail to adequately assess a risk.[1] Under Caremark, a plaintiff must demonstrate that directors “(a) utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.”[2]

Even though Caremark claims are routinely described as “possibly the most difficult theory in corporation law on which a plaintiff might hope to win a judgment,”[3] directors should not assume that #MeToo allegations cannot be sustained under Caremark as the #MeToo movement has already spawned Caremark claims against directors.

For example, in 2018, three Nike shareholders filed suit against, inter alia, Nike’s board of directors alleging that the board “facilitated, and knowingly ignored [a] hostile work environment that has now harmed, and threatens to further tarnish and impair, the Company’s financial position, as well as its reputation and goodwill ...”[4] The lawsuit asserts claims against Nike’s directors for breach of fiduciary duty and waste of corporate assets for awarding Trevor Edwards, Nike’s former President of the Nike Brand, $26 million between 2015 and 2018.[5]

Shareholders alleged that Nike’s directors failed in their oversight duties, allowing a toxic culture and hostile work environment to develop resulting in pay and promotion inequities on the basis of gender. Specifically, the shareholders alleged that Nike’s board “dragged [their] feet in addressing the issue of sexual harassment and gender discrimination” despite being “regularly apprised of the nature and volume of allegations,” which were reported to the Nike’s whistleblower line, called AlertLine.[6]

The shareholders claimed that “had the board made any reasonable inquiries — whether with members of the management knowledgeable on the issue of diversity and culture or with the company’s vendor retained to operate Nike’s AlertLine — the board would have discovered a huge gender disparity in the number of female employees within the executive ranks.”[7] The plaintiffs are seeking a $10 million reimbursement from Nike’s directors and an additional $10 million from Trevor Edwards himself.[8]

Breach of the Duty of Candor and Good Faith

Perhaps recognizing the difficultly in sustaining a Caremark claim, shareholders are also asserting other types of breach of fiduciary claims against directors. For example, a shareholder of Alphabet, Google’s parent company, filed a lawsuit against, inter alia, Alphabet and its board of directors alleging that they concealed sexual harassment allegations against former executives Andy Rubin and Amit Singhal.[9] The lawsuit alleges that the board allowed Rubin and Singhal to “quietly resign” with large severance packages, including a $90 million payout to Rubin, even “after an internal investigation found the allegations of sexual harassment against [them] to be credible.”[10]

The plaintiff explicitly stated that this “is not a failure to supervise case.” Rather, the plaintiff pointed to the board’s direct involvement and approval of the severance payments, which “breach[ed] its duties of candor and good faith.” [11] In addition, the plaintiff alleged that “the Directors’ wrongful conduct allowed the illegal conduct to proliferate and continue. As such, the plaintiff alleges members of Alphabet’s Board were knowing and direct enablers of the sexual harassment and discrimination.”[12]

Direct Liability for Sexual Harassment

Venture capital funds and their general partners should also be cognizant of sexual harassment claims that can be brought directly against them. California recently took steps to address the perceived unequal power dynamic that results from the fact that the venture capital industry is male-dominated and women founders receiving venture funding are still a rarity.[13]

For example, the California Fair Employment and Housing Act was recently amended to expand the universe of potential defendants to explicitly include “investors.” Now, a person will be liable for sexual harassment if the plaintiff can show that (1) “[t]here is a business, service, or professional relationship between the plaintiff and defendant, or the defendants holds himself or herself out as being able to help the plaintiff establish a business … Such a relationship may exist between a plaintiff and a person, including, [an] investor”; (2) “[t]he defendant has made sexual advances, solicitations, sexual requests, … or engaged in other verbal, visual, or physical conduct of a sexual nature … that were unwelcome and pervasive or severe”; and (3) “[t]he plaintiff has suffered or will suffer economic loss or disadvantage or personal injury … as a result of such conduct.”[14]

Practical Guidance

As evident from the above, victims of improper behavior and shareholders may seek to hold directors accountable for alleged failures to police and properly address sexual misconduct. In light of this, there are steps that venture capital funds and general partners should take to minimize their liability:

• Prevention Begins at Home: Venture capital funds should make sure that their general partners are properly trained not only to handle #MeToo-related allegations but also to ensure that they themselves do not run afoul of harassment laws. Early stage companies may lack in-house legal departments or have thinly staffed human resource departments. Consequently, complaints of improper behavior may be made directly to a general partner serving as a board member or board observer. Ensuring that they know what to do in response, and, as importantly, what not to do, can help ensure that the allegations are properly addressed.
• Exercise Due Diligence: Venture capital funds should seek in their due diligence to uncover potential #MeToo issues. The specific type of due diligence undertaken will depend, in part, on the stage of investment.
  
  For example, for an initial investment in a nascent company, the founders may not have an extensive business or employment history to investigate. “Social due diligence,” the examination of founders’ social media, can help uncover past allegations or troubling behavior. Criminal background checks and research into any past lawsuits should also be conducted.When investing in more developed companies, diligence should include asking pointed questions about the company’s culture, including an examination of the policies and procedures in place to address harassment and discrimination. Questions should also be asked regarding whether any allegations have been made in the past and the outcome of any investigation.
  
  Even when investing with a founder or team that is well-known and someone that the venture capital firm has backed before, the firm should not assume that diligence into #MeToo allegations is unnecessary and instead conduct the same level of diligence that would be done of an unknown player.
• Seek Representations in the Investment Documents: Venture capital funds should also seek to have #MeToo-related representations and warranties included in investment documents and/or employment agreements. Such clauses provide that the portfolio company is not aware of any allegations of sexual misconduct against an officer and that the company has not entered into any settlements of such allegations within some specified period of time.
  
  The purpose of these clauses is twofold. First, such representations supplement the venture capital fund’s due diligence by causing portfolio companies to make an affirmative statement concerning sexual misconduct claims. Second, in the event that previous sexual misconduct allegations are discovered, such representations may provide an avenue of recourse.
• Monitor Portfolio Companies: Even after making an investment, venture capital funds should continue to monitor the portfolio company. General partners serving as directors should make sure that the appropriate policies and procedures are not only in place but are being followed. Management should periodically report on the number of complaints received each year and the outcome of any investigations. As the company grows, care should be taken that the human resources department is given sufficient resources and authority to adequately address any allegations.
• Investigate, Investigate, Investigate: When #MeToo allegations occur, it is important to make sure that the investigation is handled properly. Early stage companies may not have a general counsel and instead use outside company counsel to perform a variety of legal services. Directors should not assume that company counsel should lead the investigation. Obtaining independent counsel to conduct the investigation can help to ensure that the investigation’s findings will be respected by victims, shareholders and courts.
  
  Proper measures should also be taken to shield the investigation process from the individuals being accused, even if they are the company’s founders. In addition, if remedial measures are necessary, companies, directors and their financial backers should recognize the difficulty in keeping the allegations from the public.[15]
• Get Insurance: General partners serving on portfolio company boards should seek to ensure that the company’s employment practice liability insurance and directors and officers insurance will provide sufficient coverage to address #MeToo allegations. This is by no means a solution to the problem, but insurance can provide a safety net in connection with the other steps identified above.

[1] In re Caremark International Inc. Derivative Litigation , 698 A.2d 959 (Del. Ch. 1996).

[2] Stone v. Ritter , 911 A.2d 362, 364 (Del. 2006) (adopting the standard set forth in Caremark, 698 A.2d 959 (Del. Ch. 1996) for oversight liability).

[3] Id. at 372 (quoting Caremark, 698 A.2d at 967).

[4] Stein, Sherman, and Udine, derivatively on behalf of Nike, Inc. v. Knight, et al. and Nike, Inc., No. 18CV38553, at 4 (Circuit Court of Oregon, Aug. 31, 2018).

[5] Id. at 16, 60-62.

[6] Id. at 29, 41, 57.

[7] Id. at 36.

[8] Id. The defendants have moved to dismiss on a variety of grounds, including that the breach of fiduciary duty claim failed as a matter of law. The motion to dismiss will be heard in March 2019.

[9] Martin v. Page, et al. and Alphabet Inc., No. 19CV00164 (Cal. Super. Ct., Jan. 10, 2019)

[10] Id. at 6.

[11] Id. at 9.

[12] Id. at 8-9.

[13] https://www.forbes.com/sites/carriekerpen/2018/04/09/how-women-entrepreneurs-are-closing-the-venture-capital-gap/#590ff3c61cf0; see also https://www.entrepreneur.com/article/324743 (“In 2017, women only got 2.2 percent of the total VC funding for the year, which was $85 billion.”).

[14] https://leginfo.legislature.ca.gov/faces/billNavClient.xhtml?bill_id=201720180SB224

[15] See California Senate Bill 820 (prohibits the inclusion of confidentiality provisions in settlement agreements executed after January 1, 2019 that would restrict the disclosure of factual information relating to claims of sexual assault, sexual harassment, or harassment or discrimination based on sex, unless the claimant requests a confidentiality provision).