Shifting Dynamics: RBI's New Mandate on Board Observers and Investor Accountability

Background

Recent regulatory developments have brought the role of board observers into sharper focus. A few months ago, the Competition Commission of India (“CCI”) revised its rules regarding exemptions from the notification requirements for certain combinations[1]. Under the previous regulations, acquirers could not acquire special rights in a target company—such as the ability to appoint a director — if they wished to qualify for an exemption. However, the revised exemption rules now explicitly include the right to appoint a board observer, signalling the CCI’s stance that directors and board observers should be treated similarly in terms of their potential to materially influence a company’s management and operations. Following in the footsteps of the CCI, the Reserve Bank of India (“RBI”) recently came out with a directive that non – banking financial companies (“NBFCs”) must now require their investor appointed observers to resign and be re-appointed as directors[2] (“RBI Directive”).

Such directives by the regulators may potentially transform the governance landscape of NBFCs and substantially impact PE/VC transactions; taking into account the standard practise of appointing board observers to ensure governance and protect the investment, without assuming the liability of appointing a director instead.

This article delves into the role of board observers, their significance in the PE/VC ecosystem and the proposed changes by regulators vis – a – vis board observers and impact thereof.

Significance of Appointing a Board Observer

Traditionally, the board observers have served as representatives for investors, offering insights into a company’s governance and exercising oversight over the investment, without possessing formal voting rights. In a practical sense, the rights bestowed upon directors and observers are not as distinct as they seem on paper, with the big exception of voting rights. The nature of rights given to a board observer are akin to that of an investor appointed director – they have the right to attend board meetings, participate in discussions and receive all information that a director would be entitled to prior to a board meeting. In the VC ecosystem, investors prefer going the Board observer route, as it is a comfortable mechanism to exert their oversight, even though an Observer does not have voting rights.

In addition (and probably in precedence to the above), one of the biggest motivators for an investor to appoint an observer, as opposed to a nominee director, is avoiding civil and criminal liability, which directors may have to face in the event of any default or fraudulent event happening in the Company.  

As per the Companies Act, 2013, directors have a certain fiduciary duty[1] requiring them to act in good faith and in the best interests of the company, its employees, shareholders, and the community. The directors must exercise due diligence, care, and skill while making decisions, avoid conflicts of interest, and disclose any personal interest in contracts with the company. They are also expected to attend board meetings regularly, stay informed about the company’s affairs, and ensure compliance with applicable laws and regulations. Failure to adhere to these duties may result in penalties and disqualification of being a director. In addition to the same, directors have liability under various tax laws and other statutes as well. Whereas, since board Observer is a contractual right and does not hold a fiduciary role under the Companies Act, the obligations, liabilities that a director is exposed to, is not applicable. In light of the same an investor, especially if the shareholding is not a big percentage on the capital table, may prefer to appoint an observer; without stepping into the regulatory spotlight.

 Regulatory Changes and Possible Impact

As noted in this article by the Economic Times, the RBI has stated that board observers essentially are permitted to act as directors – attend board meetings, share their views and convey opinions – without having the legal obligations of a director. However, there is no provision in law which allows for appointment of such individuals on the basis of contractual rights. With the recent regulatory developments and RBI scrutiny, board observers may be required to take on a newer (and stricter) level of accountability in investee companies.

The role of board observers also intersects with the concept of shadow directors, a critical issue under both Indian and English law. Under Indian law, the Companies Act, 2013 defines a "shadow director" under Sections 2(59) and 2(60). A shadow director is someone who, although not formally appointed as a director, provides directions or instructions to the board of directors, and whose advice is typically followed by the board. This concept is well-established in English law as well, particularly under Section 251 of the UK Companies Act, 2006, which also recognizes the legal status of shadow directors. In the case of Re Hydrodam (Corby) Ltd[2], the English court clarified that individuals who may not hold formal directorships but whose directions are followed by the board could be deemed shadow directors. In Ultraframe (UK) Ltd v Fielding and others[3], the English courts clarified that a person can only be considered a shadow director if the majority of the board is accustomed to acting on their instructions. This can extend to board observers who may exercise influence to such an extent that they effectively direct the board's actions. For example, if a board observer is consulted on routine decisions such as the company’s budget, hiring, or salary adjustments, their influence could cross the line from advisory to controlling, triggering potential liabilities under the law.

Therefore, it becomes crucial that the financing documents, such as shareholders agreement, to provide for only requisite controls, veto rights, reserved matter consents, in orders to prove that such rights are protective in nature and not ‘control’ in nature or playing an active role in management dt the Observer leading to be classified as “officers in default.”

Directors and Officers (D&O) insurance policy covers directors and officers of the company and seldom includes Observers. Good point to ponder if it is essential to include Observers as well.

Practical Challenges

The recent regulatory changes have highlighted the fine line between "control" and "protection" in the context of board observers, particularly in private equity and venture capital (PE/VC) investments. While investors often seek to protect their investments through oversight, the line begins to blur when they seek deeper involvement in the company’s operations. Veto rights are typically seen as a protective mechanism, ensuring that key decisions align with the investor's interests. However, when veto rights or other protective measures extend into operational matters, such as business expansion / business models, controlling founders' salaries or budgetary restrictions, they may start resembling control rather than protection. The same applies to detailed oversight over Management Information Systems (MIS), where the level of reporting may signal more influence over daily operations than intended.

The distinction becomes more apparent when investors request participation in monthly operations meetings. While initially positioned as a way to protect their investment, this type of involvement can easily cross into management territory, especially when it extends to dictating day-to-day operations. The challenge lies in determining where oversight for investment protection transitions into active control over the company's strategic direction. When investors specify the level of detail required in financial and operational reporting or demand control over decisions such as employee salaries and increments, it can shift the balance from protective rights to operational control, undermining the autonomy of the founding team.

Therefore, it becomes essential for both investors and founders to carefully distinguish between protective oversight and operational control. Investors, particularly those who appoint board observers, must be mindful that any influence they exert may inadvertently push them into shadow director territory. As regulatory scrutiny of board observers intensifies, especially in the wake of the RBI Directive, both parties must ensure that the role of observers is clearly defined to avoid such pitfalls.

Authors – Ms. Vanshika Kundra, Associate. With editorial inputs provided by Ms. Sharda Balaji, Founder.