Board Observer: A silent observer or a game changer?

-Pammy Jaiswal and Neha Malu | corplaw@vinodkothari.com

Background

Getting an investor for one’s business is a crucial stage for any company and so no company would want to lose the opportunity to crack a deal with the investor even if it has to give away certain rights and powers to the said investor. Looking at the Indian statistics, it has been observed that Private equity (PE) and venture capital (VC) investments have been on a growing trend and they stood at US$ 4.4 billion across 99 deals in December 2021. As the investors decide to put in funds, they look out for having such rights so that they are updated about every major decision being taken in the investee. Majority of the decisions affecting the day-to-day operations are usually taken at the board level. Therefore, it has been observed that generally to strengthen the investor’s confidence in the operations and decision making, a “Board Observer” is appointed by such investor pursuant to an agreement who carries certain rights and obligations.

The Board Observer is a representative of the investor who is expected to observe the board proceedings without being formally appointed as a director and has no voting rights in the board deliberations. Internationally, the said concept is much more popular and has also been a point of litigation to decide on the rights and obligations of such Board Observers.

In this write-up, we have tried to deal with the important aspects relating to the concept of Board Observer so as to determine whether he is just a “silent observer” on the board of the investee company or a “game changer” in the real sense.

Board Observer vs. Nominee Director

In a common parlance the Board Observer is considered  as a nominee of the investor on the board of the investee. However, after digging deep into the actual meaning of this term and that of a nominee director, the following points of distinction comes into light:

• Appointment and removal: The appointment and removal of a nominee director is governed by a set of provisions given under the law. On the other hand, there are no legal provisions provided for appointment and removal of the Board Observer and hence, the same is governed as per the agreement pursuant to which he is appointed.
• Voting rights: A nominee director being a director on the board of the company gets a right to vote in the board meetings. However, no such right is provided to a Board Observer for a simple reason that he is only an observer and not a director.
• Rights and obligations: The rights and obligations of a nominee director is as per the provisions of the statute. Whereas on the other hand, there are no set standards defining the level of participation, rights and obligations of the Board Observer and therefore, the same is decided by the parties based on the agreement.
• Liability towards the shareholders: A nominee director being a fiduciary to the shareholders of the company is liable for all the acts of the Company which has occurred with his knowledge and consent or where he has not acted diligently. However, in the case of Board Observer, there is absence of fiduciary duty towards the shareholders of the company.

Board Observer’s agreement

One of the major motivations behind appointing a Board Observer is the advantage of not having any liability towards the acts of the company. Having said that, such appointments are made strategically so as to ensure the favorable outcome to the investor because although there are no legal provisions in place to hold the Board Observer liable for the acts of the company, however, there is this concept of “de facto director”. De facto director means a director who is not actually appointed as a director but acts as a director and is held out by the company as such.

Section 2(59) of the Companies Act, 2013 (“the Act”) provides that “officer includes any director, manager or key managerial personnel or any person in accordance with whose directions or instructions the Board of Directors or any one or more of the directors is or are accustomed to act”. Further, as per section 2(60) of the Act, “officer who is in default” includes “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”. Therefore, the agreement pursuant to which the Board Observer is appointed should clearly identify his level of involvement in the Board deliberations so that his  extent of participation does not  make him a de facto director.

For drafting the Board Observer’s agreement, guidance may be taken from various such agreements^[1] entered into between the parties in more developed nations. Based on the guidance taken, some of the important clauses that should be included in the said agreement are as follows:

• Appointment and replacement: The agreement should specifically provide for the manner in which the Board Observer shall be appointed, his tenure as a Board Observer, if any, and circumstances that shall lead to his removal from such position.
• Rights of the board: The agreement should specify in details, all the rights that the Board Observer is bestowed with, so that there is no scope of conflicts in the future like it happened in the case of Braga Inv. & Advisory vs. Yenni Income Opportunities Fund I, L.P. where the main subject matter of the conflict was the interpretation of the term “board packages” which the Board Observer was entitled to receive.
• Liability of the Board Observer: The agreement should identify the liability of the Board Observer towards the appointing investor.
• Duties of the Board Observer: The agreement should define the duties and responsibilities of the observer towards the appointing investor and the investee company as to the compliance with the policies of the company. 
• Remuneration of the Board Observer, if any: The agreement should specify if the Board Observer will be entitled to any remuneration or not. In case the remuneration is required to be paid then it should also mention the party who shall be liable to pay.
• Reimbursement of expense: The agreement should provide whether the expenses incurred by the Board Observer for attending the meeting of the Board be reimbursed or not
• Indemnification: Although the absence of fiduciary duties excludes the Board Observer from the provisions of indemnification provided for other directors of the company. However, the same may be provided for if it is specifically mentioned in the agreement.
• Matters in which the Board Observer cannot participate: The agreement should specify the matters of conflict of interest or other sensitive matters during the discussion of which, the Board Observer should not participate. 
• Confidentiality: Confidentiality is one of the most sensitive clauses in the entire Board Observer’s agreement and its significance can also be understood through the case of Netologic INC. vs. Goldman Sachs Grp. INC. Therefore,it is utmost necessary to provide for the confidentiality clause in the agreement so as to bind the Board Observer from disclosing the information he acquires during the board meetings.
• Restriction to trade: It is very likely that the Board Observer because of his presence in the board meeting gets the unpublished price sensitive information and therefore, should be treated as a designated person under the SEBI (Prohibition of Insider Trading) Regulations, 2015. Hence, the restriction provided under the said regulation shall also be made applicable on the Board Observer and the agreement should capture it as well.

Capacities in which a Board Observer may be appointed

Having no legal provision to govern the role and responsibilities of the Board Observer, provides the appointing investor the liberty to determine the scope of services of the said observer so as to suit their requirements. Accordingly, a Board Observer may be appointed in any of the following capacities to the board of the investee company:

• Advisor to the board: In newly incorporated start-ups, its expert investors like angel investors, venture capitalists etc. may implant their observer to the board of the company to provide supplement for high growth and success of the company.
• Monitor of investor’s fund: The observer may be appointed to obtain the information through his presence in the board meetings which might not be otherwise available to the investor and hence help him in better monitoring of his invested funds.

Liability of the Board Observer

Since, a Board Observer is appointed pursuant to an investor’s agreement, there are no set of legal provisions governing his liability. However, having said that, in the historic Third Circuit decision of the US Court of Appeals, it was held that the Board Observer, unlike the other directors of the company, is not liable to the shareholders because of the following three major factors:

• Absence of voting rights in the board deliberations.
• Absence of fiduciary duty towards the company’s shareholders.
• The tenure of the Board Observer is determined pursuant to the investor’s agreement and the shareholders have no right to vote him out of the board.

Although the Board Observer is not liable to the shareholders for the acts of the company, an important fact that cannot be overlooked in this regard is that the Board Observer, because of his presence in the board meeting, gets access to the unpublished price sensitive information. And therefore, shall be liable as a designated person for any of the adverse acts so committed in violation of the provisions of the SEBI (Prohibition of Insider Trading) Regulation, 2015.

Conclusion

After having discussed the important aspects relating to the Board Observer, this fact becomes clear that such an appointment has both pros and cons. On one hand where the Board Observer enjoys the privilege of having the frontline view of the board proceedings without having any responsibility or liability towards the company at large, on the other hand, if the agreement does not provide for a significant “right to participate” in the meeting, he might end up being just a spectator on the board deliberations. Therefore, the most important factor in determining the real footing of the Board Observer on the board of the investee company is the rights that he is bestowed with. That shows that the “real champion” in the entire “narrative” of  Board Observer is the agreement pursuant to which he is appointed.

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^[1] https://www.sec.gov/Archives/edgar/data/1619762/000161976220000018/igt-123119xexhibitx215.htm

https://www.sec.gov/Archives/edgar/data/0000918541/000119312521089609/d162543dex102.htm

https://www.sec.gov/Archives/edgar/data/1456016/000145601615000045/gcear-exhibit101boardobser.htm