含羞草社区

含羞草社区 private equity (PE) and venture capital (VC) landscape remains robust with an investment inflow of USD49.3 billion last year. As capital continues to flood into the economy, investors rely on various mechanisms to monitor and protect their investments in companies.

One such mechanism is the appointment of “board observers”, namely individuals permitted to attend board meetings on their behalf.

Board observers versus directors’ duties

These observers receive copies of all notices, minutes and other materials provided to the directors but differ from directors in two critical respects.

First, they are not entitled to vote on board resolutions. Second, the role and duties of an observer is not statutorily recognised under the Companies Act, 2013.

For instance, section 166 of the act requires directors to act in good faith to promote the company’s objects, exercise reasonable care, skill and diligence, apply independent judgement, avoid conflicts of interest, and refrain from securing undue gain for themselves or their relatives; with non-compliance resulting in the imposition of monetary penalties.

By contrast, an observer’s appointment, role, obligations and rights arise solely from inter-se agreements such as shareholders’ agreements, articles of association and/or investment agreements.

Consequently, an observer seat is an attractive alternative for investors who do not wish to appoint directors in every portfolio company, especially at early stage investments.

India scrutinises board observers

In recent years, however, recognising the influence observers may have over company decisions despite a lack of voting rights, regulatory scrutiny over observer appointments has grown. For example, the revised Competition (Criteria for Exemption of Combinations) Rules, 2024 now provide that acquisitions of less than 25% shares in an entity would not be exempt from notification if the acquirer obtains the right to have representation on the board of directors of the acquiree entity either as a director or an observer.

Similarly, in December 2024, the Reserve Bank of India (RBI) issued directions to non-banking financial companies (NBFCs) requiring them to ask their observers to resign and offer themselves for appointment as directors instead.

This direction comes in the wake of several measures designed to tighten prudential norms for NBFCs, reduce regulatory arbitrage and strengthen governance structures of NBFCs, particularly considering the surge in PE/VC investments in the financial sector.

RBI directive turns observers directors

The RBI’s rationale seems to be rooted in the view that investors often place observers in NBFCs to avoid the liabilities that board members face, while still enjoying the rights to participate in such meetings.

However, while the directive aligns accountability with board influence by requiring observers to resign and become board directors, it also creates significant challenges.

As the primary function of an observer is to protect and represent investor interests in board meetings, requiring an observer (appointed solely as an investor representative) to owe a fiduciary duty to the company and its stakeholders could give rise to certain challenges.

The directives’ implementation also creates practical difficulties, especially in cases where an investment is not significant enough to commercially justify the granting of a board seat or voting rights. Both the NBFCs and investors may be opposed to such forced restructuring of the board composition.

Investors replace observers with protections

With this shift, investors who can no longer rely on an observer must now ensure their investment agreements contain robust contractual rights to receive necessary information and updates from the company.

Furthermore, where directors are appointed in place of resigned observers, it will become increasingly important for investors to require investee companies to maintain adequate directors and officers’ insurance to protect nominee directors against personal liability in case of defaults under applicable law.

In conclusion, the era of using observers as a low-risk monitoring tool in NBFCs is coming to an end – with the regulatory environment now demanding that anyone with a seat at the board table, whether they vote or not, accepts the corresponding legal responsibilities.

Swathi Girimaji is a partner, practice lead, VC and growth stage investments, and Theertha Aiyappa is an associate at Bharucha & Partners