Venture capital investors are increasingly opting out of being appointed as a nominee director on the board of the investee company and instead preferring the role as an observer to the board. This is not a one-off occurrence, but a growing trend that’s being noticed. We analyse this trend in greater detail in this short piece.

A nominee director’s duties are two-fold, i.e., they are duty bound (i) under Section 166 of the Act; and (ii) to the investor. However, a nominee director is not required to participate in the day-to-day operations of the company. They do not exercise any executive functions/duties with respect to the management of the company. This becomes vital when we evaluate the pros and cons of appointing a nominee director.

Under Section 150(12) of the Act, an independent or non-executive director can only be held liable for acts or omissions that occurred with the director’s knowledge, i.e., being attributable to the director’s participation in the board process, and this further includes any instances where this director failed to act diligently. Section 166 of the Act mentions that the duties of a director are as follows:

  • To act in accordance with the articles of association of the company;
  • To act in good faith and for the benefit of the members as a whole;
  • To exercise due and reasonable care, skill, diligence, and independent judgment;
  • To avoid conflict of interest;
  • To restrain from making undue advantage of gain for themselves or their relatives; and
  • Not to assign their office.

There have been a few instances where independent, non-executive directors have been held accountable for their actions. The most notable examples are the IL&FS case and the Nagarjuna Finance case involving the role of Minesh Campani. In these cases, the independent and non-executive directors were questioned for their failure to raise questions and objections to certain decisions taken by the board. In the IL&FS case, the directors were questioned about their ignorance of the crisis and their failure to fulfil their duties to the company and its members. These duties are cast on all directors, including nominee directors, because their duty is not to themselves or the persons that appointed them but rather to the company for which the board exists.

The penalty under Section 166 of the Act is a fine which is set to be not less than one lakh rupees and also not exceed five lakh rupees. However, the penal provisions under Section 166 of the Act do not apply to nominee directors due to the provisions under Section 149(12). The Delhi High Court has held that – “No vicarious liability can be fastened on the petitioner (a nominee director) in the absence of specific role being attributed to the petitioner”. It is pertinent to note that the exemption mentioned under Section 149(12) is only limited to the Act and does not bar liability under other statutes. More importantly, what worries directors the most is the legal hassle and process in the event the company is non-compliant or comes under investigation.

In lieu of the aforementioned observations, we must now consider the advantages and disadvantages of an investor appointed as an “Observer” to the board of the company as opposed to a director. An observer is an individual who derives a right through the investment agreement or contract to attend and receive certain communication/information provided to the board members but is not permitted to participate or vote in meetings of the board. The Act provides no definition for an observer and is silent on what duties and liabilities may be applicable to an observer.

Usually the observer can observe board proceedings and share comments on certain items being discussed by the board, without having any decision making powers. The observer has to ensure that they maintain the confidentiality of the information communicated to them by the board. As the observer is merely ‘observing’ proceedings of the board, no liability is usually attributable to the role of an observer

It is at this stage that the nuance of picking an observer and carefully negotiating the veto matters by the investor can be appreciated.

The appointment of an observer will allow the investor to protect their interests by having a presence (albeit non-voting) on the board and will also extend the benefit of not being concerned about the potential liabilities that follow from the appointment of a nominee director on the board. At the same time a standard set of veto matters will ensure that the investor is able to participate in the decision making process of the company and protect it’s economic interests. This has increasingly become a trend amongst venture capital investors as they seek to balance their decision making ability while looking to reduce liability arising from the company’s operational affairs.

This material and the information contained herein prepared by Algo Legal is intended to provide general information on a subject or subjects and is not an exhaustive treatment of such subject(s). Algo Legal is not, by means of this material, rendering professional advice or services. The information is not intended to be relied upon as the sole basis for any decision. Algo Legal shall not be responsible for any loss whatsoever sustained by any person who relies on this material.