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In typical private equity/venture capital transactions, investors require visibility on the day-to-day functioning of an investee entity.
India Corporate/Commercial Law
In typical private equity/venture capital transactions, investors require visibility on the day-to-day functioning of an investee entity. For this purpose, the right to appoint observers and directors forms part of the plethora of rights investors seek from investee companies. However, at times, investors refrain from appointing any director to the board of directors because of the conflict of interest between the investor as a shareholder and the duties of an investor director towards the company.
As the name suggests, a board observer merely observes board meetings but does not vote or participate in discussions on the matters put forward before the board of directors. Therefore, a board observer does not automatically, on the face of it, become equivalent to a shadow director.
The expression "shadow director" is neither defined in the Companies Act, 2013 ("2013 Act") nor the Companies Act, 1956 ("1956 Act"). However, in general parlance, a "shadow director" is someone who may not be formally appointed as a director but who nevertheless exercises influence or control over the company's directors and its decision-making processes.
While the roles, responsibilities, duties, and corresponding liabilities of a director are spelt out in common law and the 2013 Act, the 2013 Act neither deals with the process of appointment of observers nor does it deal with the roles, responsibilities, and duties of observers.
The definition of a "director" in the Companies Act 1956 ("1956 Act") was an inclusive one, to mean any person who occupies the position of 'director' by whatever name called. This created an umbrella within which persons who may not be designated as directors but who exercise the powers of a director also got covered. Consequently, the 1956 Act presumed the existence of a de facto (i.e., in practice) director and a de jure (i.e., by law) director.
In contrast, the 2013 Act defines a director exhaustively to mean only a person appointed to a board of directors. This is a significant change in the principle of who can be treated as a director. Having said that, the 2013 Act, while defining specific terms of relevance, such as "officer in default" and "promoter" has roped a concept similar to that of a shadow director, viz. any person in accordance with whose advice, directions or instructions the Board of Directors of the company is accustomed to act, other than a person who gives advice to the board in a professional capacity.
The meaning of the words 'being accustomed to act in accordance with the advice, directions or instructions' becomes critical to understand whether a person would be a 'shadow director' and, if so, the implications of being one. Since this expression is neither defined in the 2013 Act nor the 1956 Act, judgments of English courts may be referred to for guidance, given this expression finds a place in both the Companies Act, 1985 (England) and Companies Act, 2006 (England).
In re Hydrodam (Corby) Ltd (1994), it has been clearly stated that to establish a person was acting as a shadow director of a company, it is necessary to prove the following:
It is pretty clear that to establish a person as a shadow director, it will have to be proven as to who are the de facto and de jure directors on the board and the fact that such person directed the de jure directors to act in a particular manner in relation to the company.
Per Standish v.The Royal Bank of Scotland plc & others [2019], even if the directors act independently, if an individual instructs a board of directors on some business matters, then that individual can be considered to be a shadow director in relation to those specific instructions and matters.
However, for a person to act as a shadow director, it will have to be proven that the directions/instructions given by such a person are regular in nature. For example, Unidare Plc. v. Cohen (2006) held that a single instruction on a specific day by a person would be different from directors being accustomed to acting on his directions.
While there is little statutory and legal guidance on board observers, few judgments give sufficient material to indicate that caution needs to be exercised while appointing board observers and their role on the board of directors. As a matter of fact, it can be said that there is enough guidance to indicate that a board observer should stick to the true sense of being an observer and only 'observe' the proceedings of the board meetings and not overreach, otherwise, a board observer could be held accountable for any breach of duty or wrongdoing committed by a company, just like formally appointed directors.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
