January 05, 2023
The Unseen Influencers: Shadow Directors

  • 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 “director1 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 “Officer4 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 Default5 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.

 


Hetal Pandya, Maulin Salvi and Sahil Kanuga

You can direct your queries or comments to the author


1Section 2(34) of the Companies Act, 2013 - “director” means a director appointed to the Board of a company

2Section 251 of the Companies Act, 2006

3Re Hydrodan (Corby) Ltd (1994) 2 BCLC 180.

4Section 2(59) of the Companies Act, 2013 – “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

5Section 2(60) of the Companies Act, 2013 - "officer who is in default", for the purpose of any provision in this Act which enacts that an officer of the company who is in default shall be liable to any penalty or punishment by way of imprisonment, fine or otherwise, means any of the following officers of a company, namely:—

(i) whole-time director;

(ii) key managerial personnel;

(iii) where there is no key managerial personnel, such director or directors as specified by the Board in this behalf and who has or have given his or their consent in writing to the Board to such specification, or all the directors, if no director is so specified;

(iv) any person who, under the immediate authority of the Board or any key managerial personnel, is charged with any responsibility including maintenance, filing or distribution of accounts or records, authorises, actively participates in, knowingly permits, or knowingly fails to take active steps to prevent, any default;

(v) 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;

(vi) every director, in respect of a contravention of any of the provisions of this Act, who is aware of such contravention by virtue of the receipt by him of any proceedings of the Board or participation in such proceedings without objecting to the same, or where such contravention had taken place with his consent or connivance;

(vii) in respect of the issue or transfer of any shares of a company, the share transfer agents, registrars and merchant bankers to the issue or transfer;

6Outlined in Section 166 of the Companies Act, 2013, and other relevant Indian laws (such as labour, industry-specific, and environmental laws)

7In Re: Issuance of Optionally Fully Convertible Debentures by Sahara India Real Estate Corporation Limited and Ors., (2011) 5 CompLJ 470 (SAT)



Disclaimer

The contents of this hotline should not be construed as legal opinion. View detailed disclaimer.

This Hotline provides general information existing at the time of preparation. The Hotline is intended as a news update and Nishith Desai Associates neither assumes nor accepts any responsibility for any loss arising to any person acting or refraining from acting as a result of any material contained in this Hotline. It is recommended that professional advice be taken based on the specific facts and circumstances. This Hotline does not substitute the need to refer to the original pronouncements.

This is not a Spam mail. You have received this mail because you have either requested for it or someone must have suggested your name. Since India has no anti-spamming law, we refer to the US directive, which states that a mail cannot be considered Spam if it contains the sender's contact information, which this mail does. In case this mail doesn't concern you, please unsubscribe from mailing list.


January 05, 2023

The Unseen Influencers: Shadow Directors


  • 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 “director1 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 “Officer4 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 Default5 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.


Hetal Pandya, Maulin Salvi and Sahil Kanuga

You can direct your queries or comments to the author


1Section 2(34) of the Companies Act, 2013 - “director” means a director appointed to the Board of a company

2Section 251 of the Companies Act, 2006

3Re Hydrodan (Corby) Ltd (1994) 2 BCLC 180.

4Section 2(59) of the Companies Act, 2013 – “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

5Section 2(60) of the Companies Act, 2013 - "officer who is in default", for the purpose of any provision in this Act which enacts that an officer of the company who is in default shall be liable to any penalty or punishment by way of imprisonment, fine or otherwise, means any of the following officers of a company, namely:—

(i) whole-time director;

(ii) key managerial personnel;

(iii) where there is no key managerial personnel, such director or directors as specified by the Board in this behalf and who has or have given his or their consent in writing to the Board to such specification, or all the directors, if no director is so specified;

(iv) any person who, under the immediate authority of the Board or any key managerial personnel, is charged with any responsibility including maintenance, filing or distribution of accounts or records, authorises, actively participates in, knowingly permits, or knowingly fails to take active steps to prevent, any default;

(v) 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;

(vi) every director, in respect of a contravention of any of the provisions of this Act, who is aware of such contravention by virtue of the receipt by him of any proceedings of the Board or participation in such proceedings without objecting to the same, or where such contravention had taken place with his consent or connivance;

(vii) in respect of the issue or transfer of any shares of a company, the share transfer agents, registrars and merchant bankers to the issue or transfer;

6Outlined in Section 166 of the Companies Act, 2013, and other relevant Indian laws (such as labour, industry-specific, and environmental laws)

7In Re: Issuance of Optionally Fully Convertible Debentures by Sahara India Real Estate Corporation Limited and Ors., (2011) 5 CompLJ 470 (SAT)


Disclaimer

The contents of this hotline should not be construed as legal opinion. View detailed disclaimer.

This Hotline provides general information existing at the time of preparation. The Hotline is intended as a news update and Nishith Desai Associates neither assumes nor accepts any responsibility for any loss arising to any person acting or refraining from acting as a result of any material contained in this Hotline. It is recommended that professional advice be taken based on the specific facts and circumstances. This Hotline does not substitute the need to refer to the original pronouncements.

This is not a Spam mail. You have received this mail because you have either requested for it or someone must have suggested your name. Since India has no anti-spamming law, we refer to the US directive, which states that a mail cannot be considered Spam if it contains the sender's contact information, which this mail does. In case this mail doesn't concern you, please unsubscribe from mailing list.

 
 

 

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