Private Capital, Constituency Directors, and Fiduciary Loyalty: Evidence from VC

The Rise of Private Capital

Private markets have grown significantly in recent years, with private equity, venture capital, and hedge funds supporting startups and mature private companies that tend to stay private longer (Ewens & Mensa, 2022). The increased importance of private markets has prompted legal scholars to investigate the underlying drivers, including regulation (e.g., Gözlügöl et al., 2023; Roe & Wang, 2023). One channel through which legal regimes affect capital inflows is by constraining investors’ ability to write and enforce complex contracts (Lerner & Schoar, 2005; Enriques et al., 2025a and 2025b).

Constituency Directors 

Private capital investors typically secure board representation through the right to appoint a number of so-called “constituency directors”, whose presence is tied to a specific constituency or sponsor (Gelter & Helleringer, 2015). Constituency directors enable sponsors to oversee and steer board decision-making in a favorable direction (Sepe, 2013, Bartlett, 2015). 

Their role is therefore just symmetric to the role of more “traditional” directors, who must contribute to decision-making to advance the interest of a predetermined beneficiary (Gelter & Helleringer, 2015)— depending on the applicable corporate law regime, the corporation as a whole, shareholders as a class, or a given class of shareholders (e.g., common shareholders).

Despite their function, constituency directors are subject to the same corporate fiduciary law regime as traditional directors (Gelter & Helleringer, 2015). This implies that, while appointed to advance the interest of their sponsors, they are legally required of serving the interest of another beneficiary. These “dual fiduciaries” (Alon-Beck, 2023), therefore, sit in an inherently conflicted position.

The ability of constituency directors to opt out of the standard fiduciary regime can significantly affect private capital investors’ ability to attract investments. Legal scholars have highlighted inefficiencies in a regime subjecting all directors to homogeneous fiduciary loyalty (Sepe, 2013; Bartlett, 2015; Gelter & Helleringer, 2015). Relevant empirical research has thus far been lacking. 

Constituency Directors in the VC World

Our paper provides evidence on how the 2013 Trados ruling changed the behavior of constituency directors, particularly those appointed by venture capitalists.  VC (venture capital) funds, with a limited lifespan of up to 12 years, face pressure to liquidate as the deadline approaches, often leading to fire sales of startups at discounts. As VCs hold preferred shares, they are less affected by disappointing outcomes than the entrepreneurial team holding common shares.

As an oft-cited piece of research explains, VC-backed firms’ directors have long operated under the “contingent control approach” to fiduciary duties. A VC-controlled board could make decisions that favor preferred shareholders at the expense of common shareholders as long as the board can plausibly defend these decisions as being in the best interest of the corporation (Fried & Ganor, 2006). This approach effectively allowed the board to exercise some discretion in pursuing strategies that may favor preferred shareholders. Trados concluded, instead, that VC-backed firms’ directors are under the duty to maximize common shareholder value, ultimately restricting boards’ discretion in advancing the interests of preferred shareholders. (See In Re Trados Inc. Shareholder Litigation, 2009 WL 2225958 (Del Ch. 2009); In re Trados Incorporated Shareholder Litigation, 73 A.3d 17 (Del. Ch. 2013.))

Trados significantly affected how constituency directors in VC-backed startups, and their sponsors, behave. By comparing the probability of trade sales by VCs nearing maturity versus VCs further away from maturity, both before and after Trados, we find that, consistent with the increase in common shareholder protection stemming from that landmark decision, VC funds now act more cautiously in exit decisions. Maturing VC funds, especially those under liquidity pressure, are, post-Trados, less likely to execute fire sales. The ruling mitigates much of the effect of liquidity pressure on exit probabilities in acquisition scenarios, where fire sales are most extreme. However, Trados still has a smaller mitigating effect when sales are less costly to common shareholders.  

The impact of Trados on VC-appointed or affiliated directors has also had an indirect effect on VC intermediaries’ ability to raise capital. Moving from a preferred- to a common-favoring regime limits VCs' ability to implement their business strategies, which may lead fund investors to reduce their allocations to VC funds. This effect is particularly significant for foreign limited partnerships (LPs). One of the primary reasons foreign LPs invest in the US is to take advantage of a legal environment that allows them to craft and enforce complex financial contracts. With Trados introducing new fiduciary standards that hinder the implementation of these contracts, we document a decrease in the size of US VC funds compared to non-US funds, suggesting a reduction in the availability of VC for US startups. Our analysis also shows a decline in capital raised by US-based startups in global VC deals.

Lessons for Private Capital Contracts?

While we cannot conduct a full welfare analysis, our findings suggest that Trados reduced VC’s fire sale propensity but also limited US-based startups' access to VC and reduced overall VC supply. A consequential inference is that shaping fiduciary loyalty in a manner that overlooks the unique role of constituency directors and, more broadly speaking, the specific characteristics of VC-backed firms can prove problematic. In other words, the VC business model requires a customized duty of loyalty owed by the portfolio company’s directors. This is key for VC, and by (any possible) extension for private capital investments at large, to flourish.

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Bo Bian is an Assistant Professor of Finance at UBC Sauder School of Business.

Yingxiang Li is an Assistant Professor of Finance at City University of Hong Kong.

Casimiro A Nigro is a Lecturer in Business Law at Leeds University, and an ECGI Academic Member.

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