What Is the Director Dispatch Clause in an Investment Agreement?

When a venture company receives investment from a venture capital firm (VC) in Japan, the investment agreement may include a provision known as the Director Dispatch Clause.

You may have a vague understanding of what this clause entails, but the specific nature of the clause and its legal meaning may not be fully understood in some cases.

Therefore, this article will explain the Director Dispatch Clause in an investment agreement.

Definition of the Director Dispatch Clause

The Director Dispatch Clause refers to a provision where a VC or other investors dispatch their own personnel to serve as directors in a venture company, etc., for the purpose of supervision.

The Significance of the Director Dispatch Clause

What significance does the inclusion of the Director Dispatch Clause have in the agreement? The following two points are generally considered:

1. Monitoring and supervision of decision-making by the Board of Directors
2. Ability to Grasp the Company’s Internal Information

Monitoring and Supervision of Decision-making by the Board of Directors

Firstly, the significance of dispatching their own personnel as directors allows VCs or other investors to oversee and supervise whether the business operations of the venture company are being appropriately conducted. By having their associates participate as directors, VCs or other investors can ensure that the business operations are conducted in accordance with the business plan.

Legally speaking, a decision at the shareholders’ meeting is stipulated in Japan’s Companies Act (Article 309, Paragraph 1) as: “Resolutions of the shareholders’ meeting shall be adopted by the affirmative vote of a majority of the voting rights of shareholders present, unless otherwise provided in the articles of incorporation, and by the shareholders having one-half or more of the votes of shareholders entitled to exercise their voting rights.” If an insufficient number of directors are dispatched, the VCs or other related parties cannot legally control the decision-making of the venture company’s Board of Directors. However, the situation may arise where the influence and practical control of the board’s decisions are exerted by expressing opinions.

Additionally, if other directors ignore the statements of the dispatched director and make decisions that cause damage to the company, the risk of them being assessed as violating their duty of care and loyalty increases. As a result, proper decision-making can be expected.

Ability to Grasp the Company’s Internal Information

The second significance of the Director Dispatch Clause in an investment agreement is the ability to grasp the company’s internal information. By having their associates participate as directors, VCs or other investors can access internal information presented at board meetings. Also, as directors, they can demand information disclosure from other directors to perform their duties.
Since the dispatched director remains a director, other directors may find it difficult to refuse if requested by the VC’s dispatched director to disclose information for the purpose of performing their duties.

Dispatch as an Observer

Similar to dispatching their own associates as directors, VCs and other related parties, may also dispatch them as observers. While they do not participate as directors in the board meetings of the venture company, their involvement as observers creates similar effects to the Director Dispatch Clause. Being dispatched as an observer generally has less influence than participating as a director but allows the avoidance of risks such as bearing director responsibilities or being unable to resign as a director.

Considerations for Venture Companies Regarding the Director Dispatch Clause

The explanation above details the significance of the Director Dispatch Clause.
Below, we will explain considerations from the perspective of venture companies, regarding the Director Dispatch Clause in investment agreements.

Number of Directors to be Dispatched

As previously mentioned, resolutions at the shareholders’ meetings are conducted as follows: “Resolutions of the shareholders’ meetings shall be conducted by the presence of shareholders who have more than half of the voting rights, except as otherwise provided in the Articles of Incorporation, and shall be conducted by more than half of the voting rights of the attending shareholders” (Article 309, Paragraph 1 of Japan’s Companies Act). Thus, if venture companies accept many VC-related individuals as directors, they must be cautious as this can lead to the venture companies being deprived of control and management rights by the VCs.

Even if venture companies hold a majority, caution is needed if they just barely maintain the majority. This is because it is conceivable that directors of the venture companies, etc., may side with the VCs, losing the majority to them, or that, depending on the proposal, directors from the venture company side may be unable to participate in the resolution as interested parties (Article 369, Paragraph 2 of Japan’s Companies Act), and thus unable to satisfy the majority requirement.

Therefore, it is advisable for venture companies, to maintain the majority with some margin.

Character and Personality of the Dispatched Directors

The directors who are dispacthed have various personalities, ways of thinking, and human characteristics. If the dispatched directors do not match the venture company it can inhibit the company’s directors, leading to unconstructive discussions and difficulties in smooth decision-making.

Hence, for venture companies, etc., who accept director appointments, it is also vital to consider compatibility with the appointed directors and to establish a system to request the VCs to appoint other individuals as directors if compatibility is lacking.

Key Points for Director Appointment Clauses from the Perspective of VC Investors

What should be noted in the director appointment clause when viewed from the VC investor’s side?

Above, I have explained the key considerations for the director appointment clause from the perspective of venture companies, etc. Below, I will explain the key points from the investor’s perspective in the investment contract concerning the director appointment clause.

Responsibility as a Director

When a VC-related individual is appointed as a director to a venture company they naturally assume the responsibilities of a director. Therefore, it is necessary to appoint individuals who can perform their directorial duties without violating duties of loyalty and due care.

When VCs appoint directors, it may be considered desirable to have a limited liability contract for the appointed director and to have them join directors’ liability insurance, just in case.

Relations to Conflicts of Interest

The dispatched director is a VC-related person and a director of the venture company at the same time. Thus, situations might arise where actions are necessary for the company’s survival but may cause a decrease in stock value. In such cases, the appointed director must consider what actions or statements are appropriate and exercise careful judgment.

Holding Venture Company Directors Accountable

Once VC-related individuals are appointed as directors of a venture company, etc., and are involved in the board of directors, part of the responsibility is practically recognized on the VC’s side if problems arise. Therefore, holding other officers of the venture company accountable becomes practically difficult for the VCs.

Difficulty in Resigning as a Director

Situations might arise where it would be preferable for the appointed director to resign due to conflicts of interest or unlikelihood of investment recovery, among other reasons. However, Article 346, Paragraph 1 of Japan’s Companies Act stipulates, “If a director is missing or if the number of directors provided by law or the Articles of Incorporation is lacking, the retired director shall still have the rights and obligations of a director until a new director (including those performing the duties of a temporary director in the next paragraph) takes office.” This means that, practically, it is impossible to resign as a director until a new director is appointed. Furthermore, if multiple VCs are appointing directors, whether or not resignation is possible may be determined on a first-come-first-served basis due to the relationship between Article 346, Paragraph 1 and the number of directors.
Therefore, when VCs appoint directors, they must carefully consider factors such as the number of directors of the venture company and the number of directors appointed by other VCs before making the decision to appoint or not.

Disclosure of Information to Shareholders such as Venture Capitalists (VCs)

Directors dispatched by Venture Capitalists (VCs) are obliged to fulfill the duty of due care and attention, just as regular directors. Consequently, if a dispatched director, being merely a shareholder like any other VC, were to indiscriminately disclose information obtained in their capacity as a director to the VC, there may be a potential violation of the director’s duty of due care and attention. Therefore, it is vital for VCs to stipulate, within the investment contract, not only the clause for dispatching directors but also a clause permitting the dispatched directors to disclose information known to them as directors to the VCs.

Conclusion: Seek Legal Advice on the Dispatch of Investor Board Member Clause in Investment Contracts

We have explained the director dispatch clause in investment contracts above. When detailing this clause from the perspective of both venture companies and investors, it may appear as a provision that requires utmost caution. However, since there are many highly experienced and excellent individuals among VCs, venture companies can leverage this excellence to grow, while VCs can dispatch personnel to promote company growth, creating a win-win relationship. Achieving this relationship is the ultimate goal of the director dispatch clause. To fully realize this role, it is advisable to either have the investment contract drafted by a legal specialist, such as a Japanese attorney, or to receive advice from a Japanese attorney.