• VC and PE investors increasingly opt for observers rather than formally appointing directors to mitigate risks and liabilities associated with fiduciary duties.

• Such ‘observers’ may, practically, wield significant influence over a company’s board, directing decisions and actions.

• The thin line between observers and shadow directors may pose a challenge, as substantial influence on board decisions may still lead to perceived liabilities.

Directors are entrusted with a wide array of responsibilities and obligations towards their company and its shareholders. They may face personal liability, especially when the company violates or falls short of complying with its obligations. It is critical to understand who falls under the definition of a ‘director’ of a company. Identifying who qualifies as a ‘director’ goes beyond a simple examination of Ministry of Corporate Affairs records. This article aims to explore situations in which individuals not officially appointed as directors may still be deemed directors and, consequently, held liable for the responsibilities and obligations associated with directorship.

Unmasking Shadow Directors:

While the Companies Act, 2013 (the Act) defines the term “director”¹ to mean a director appointed to the board of a company, the term “shadow director” is not directly defined under the provisions of the Act. English Law² however defines “shadow director”, as a person in accordance with whose directions or instructions the directors of the company are accustomed to act.

Generally, a shadow director, refers to a person who may not be formally appointed as a director but exercises significant influence and control over the board of directors. In essence, a shadow director is someone whose instructions or directions the appointed directors are accustomed to following. Such a person is a “deemed director” even though they do not officially possess the title of director. It is essential to establish that the company’s directors adhered to the instructions of the said shadow director instead of exercising their discretion or judgment to confirm the existence of shadow directorship.

In the case of Re Hydrodan (Corby) Ltd.³, the conditions necessary to determine whether a person is a shadow director were established. It must be proven that the individual is not officially appointed as a director of the company but yet has provided instructions and directions to the appointed directors in matters of management of the company. It should be demonstrated that these instructions have been consistently given and intentionally adhered to on a regular basis.

Under English Law, directorship can be broadly categorised as De Jure, De Facto and Shadow Directorship. A De Jure director is one who is formally appointed to the Board under applicable law under various designations such as Executive Directors, Alternate Directors, Nominee Directors etc. On the other hand, a De Facto Director, while not officially appointed as a director, presents themselves in a manner that would reasonably lead a third party to perceive them as a director. Lastly, a Shadow Director is not formally appointed to the Board, but they exercise a substantial influence and control over the company’s affairs, as the Board is accustomed to act in accordance with their instructions and advice.

The Act provides a definition for the term “Officer”⁴ which inter alia includes any person in accordance with whose directions or instructions the Board of Directors or any one or more of the directors are accustomed to act. Additionally, the term “Officer in Default”⁵ states that an Officer of the company who is in default will incur liability in terms of imprisonment, penalties, fines or otherwise, regardless of their lack of an official position in the company. Consequently, a director is an “officer” of the company and responsible, individually and collectively as Board of Directors, for compliances of all the legislations applicable to such company and can exercise all powers that a company is able to exercise. Any default in compliances with the applicable legislations, such officer, along with the company, would be liable for fine, penalties and possibly imprisonment as well.

Under English law, shadow directors are held to the same standard of responsibilities and liabilities as formally appointed directors. Under the Act, directors are obligated to act in the best interests of the company, exercise due diligence, and avoid conflicts of interest. It may be argued that shadow directors are expected to adhere to these fundamental principles. If it is established that an individual is acting as a shadow director, they can be held liable for any breach of duties and obligations. Potential penalties for such breach may include fines, restrictions on serving as a director, or legal action to recover damages caused by their actions. In some cases, shadow directors may be held liable for losses incurred by the company due to negligence or misconduct on their part. Shadow directors may also face a personal liability if they fail to carry out their duties in accordance with company policy or act in the best interest of the company’s shareholders.  

Investor Nominee Directors and Observers:

Venture capital (VC) and Private Equity (PE) investors often negotiate for the right to nominate a board seat. Having a representative on the board enables them to actively engage in decision-making, contribute to the company’s direction and monitor progress to safeguard their investments. However, a recent trend reveals a reluctance among these investors to formally exercise their nomination rights and appoint a director due to the potential risks and liabilities associated linked to directorships, including fiduciary duties⁶, which establish vicarious liability provisions for a company’s directors and officers concerning the company’s acts and omissions.

Consequently, VC and PE investors are increasingly refraining from formally designating their representatives as ‘directors’ on the investee company’s board, even if they may, practically, act as such under the investment agreement. Instead, these investors often opt for the role of an “Observer to the Board” without voting power, as opposed to formally appointing a nominee director with voting powers. Investors also usually retain the option to nominate a director to the board in the future. This is done to mitigate the risks associated with potential liabilities, which could lead to unnecessary legal complications, reputational damage, as well as loss of time and resources. This strategy aims to safeguard investors’ economic interests in the company and ensure a proactive approach to corporate governance.

The case of Sahara India Real Estate Corporation Limited⁷ illustrates the regulatory stance on shadow directorship. Despite lacking formal positions (directorial or managerial), individuals with substantial influence, being the founder and a major shareholder in the Sahara Group, such as Mr. Subrata Roy Sahara, may be classified as “Officers in default” if the board habitually follows their directions.

Observer to the Board or a Shadow Director in disguise:

An individual designated as an Observer to the Board is appointed by VC and PE investors to attend and observe company board meetings. This role involves receiving specific communication and information from the board members; the observer is not authorized to participate or vote in board meetings. The Act does not provide a precise definition for an observer, nor does it delineate their roles, duties, and potential liabilities. An observer typically does not have the right to vote on board resolutions, but they can observe the decision-making processes and discussions. Such an observer may not hold an official title but may exert significant influence on the board’s decisions, akin to a shadow director.

While this trend of appointing observers has gained traction among investors seeking a balanced approach to decision-making and aiming to mitigate liability related to their representatives’ involvement in the company’s operational affairs, it is crucial to ascertain where the ultimate decision-making power lies. Questions arise about whether the observers appointed by investors are, behind the curtain, running the show indirectly. Although these observers are not formally appointed as directors, if they wield substantial influence or control over a company’s decisions, there is a possibility that they may be perceived as “Shadow Directors”. This characterization arises from their role in directing and influencing the company and its board without holding the formal title of a “director”.

In certain jurisdictions, individuals in such roles are deemed de facto directors, subjecting them to accountability for their impact on the company. Common law judgments guide the determination of duties, responsibilities and liabilities of shadow directors, placing emphasis on establishing that the person, despite not holding a formal director title, consistently issues instructions and directions to the Board. The Board, in turn, intentionally adheres to these directives on a regular basis.

While board observers may not equate to formal directors in every aspect, certain situations may arise where their influence on the Board and company management is deemed significant. This necessitates a careful examination of potential liabilities that extend beyond those associated with being a formal director. This shift in perspective could undermine the intended risk mitigation for venture capital investors, challenging the assumption that the liability of a formal director on the Board adequately addresses all potential risks.

Conclusion:

The evolving landscape of corporate governance requires a nuanced understanding of roles, responsibilities, and liabilities, especially concerning shadow directors and board observers, especially in the context of board representation by VC and PE investors. The emergence of board observers adds another layer of complexity, as investors seek a balance between active involvement and mitigating potential liabilities.

However, the line between a legitimate observer and a shadow director in disguise is thin and determining where decision-making power truly resides becomes critical. While board observers may not be equivalent to formal directors, their influence can be substantial, leading to potential liabilities that go beyond the protections sought by investors. This shift challenges the conventional wisdom that the liability of a formal director adequately covers all risks. In navigating this evolving landscape, investors must carefully assess the roles, responsibilities, and potential liabilities associated with various forms of directorship, ensuring that corporate governance remains robust and effective.

As corporate structures adapt to new paradigms, investors must proactively engage with the intricacies of directorial roles, considering the implications for accountability, compliance, and risk mitigation. Balancing the need for active investor participation with legal prudence will be crucial in fostering a corporate environment that is both dynamic and legally resilient.