Corporate governance in Indian companies has come under scrutiny in the recent past, for various reasons. Several high-profile issues have come to light in the last couple of years- inaccurate financial reporting, allegations of fraud, and misconduct by the management in companies pursuing disproportionate growth. This has heightened the focus on how governance structures in companies are managed, particularly given the founders’ broad roles within their companies.
Investors, especially institutional investors (financial and strategic) are crucial in guiding companies towards better corporate governance. Seeking representation on the board is a key manner in which the investors seek to implement corporate governance measures, along with maintaining oversight on the company operations. However, this right is not always exercised due to significant liabilities that a director may be exposed to, especially in the early phases of a company when processes and compliances are still evolving. However, investors want insight into key matters that are typically discussed at the board level. This is usually achieved by investors appointing an “observer” to the board. An observer is entitled to attend board meetings, permitted to speak at such meetings, represent the investor’s interests, and access all the same information as a full board member. However, they do not have voting rights. Legally, observers are not considered board members, and as such, they are not bound by the fiduciary duties and liabilities that are associated with a director under the Companies Act, 2013[1].
The role of an observer is contractual, its primary purpose being to provide investors with visibility into the company’s operations and financial health without the full responsibilities or legal risks associated with being a director. The observer’s involvement in board discussions allows an investor to stay informed about key decisions and to offer advice where necessary, without becoming legally responsible for those decisions. In practice, this means that observers can participate in board meetings and discussions, but their influence is not legally recognized unless they are appointed as directors.
Until recently the observer model had been universally accepted without regulators seeming particularly concerned about its implications of the observer role. However, there are increasing concerns about the possibility of observers exercising influence over the decisions of the company. If founders are consistently acting on the advice or suggestions of an observer, questions may arise as to whether the observer, in effect, has the same influence as a director—without being subject to the same legal and fiduciary responsibilities.
Recently, the Reserve Bank of India (RBI) has expressed discomfort with investors in Non-Banking Financial Companies (NBFCs) appointing observers in regulated entities. While the RBI is yet to issue an official notification on this matter, such a move would bring investor nominees under the statutory liabilities outlined in the Companies Act, 2013, as well as in the Master Direction – Reserve Bank of India (Non-Banking Financial Company – Scale-Based Regulation) Directions, 2023 (“NBFC-SBR“). The RBI’s potential move aims to address concerns that an observer’s influence over company decisions could undermine the regulatory framework for NBFC governance.
In addition to the processes set out under the Companies Act, 2013 to appoint a director, the NBFC-SBR guidelines impose additional requirements for the appointment, removal, and responsibilities of directors in NBFCs. These include compliance with the Fair Practices Code and a “Fit and Proper” criteria, under which the RBI evaluates the qualifications and suitability of directors before they can be registered. These additional checks help to ensure that directors in NBFCs have the necessary technical skills and integrity to fulfil their duties and responsibilities.
Why the ‘Observer’ Controversy?
The main issue with the observer role revolves around the fact that, while directors are subject to fiduciary duties and need to satisfy certain criteria for appointment in case of regulated entities, observers are not. Directors are held to high legal standards, including obligations related to corporate governance, financial reporting, and decision-making. If a director is involved in any criminal activity or misconduct related to the company, they can be prosecuted, particularly if the offense occurred with their knowledge or consent[2]. This is not the case for observers. Despite their involvement in the company’s strategic discussions, observers are not liable for the decisions made by the board.
Some argue that this lack of accountability creates a grey area. If an observer’s advice is followed consistently by the board, it may be difficult to argue that they do not exert any influence over the company’s governance and strategic direction. In this light, there is growing concern about whether the current structure adequately protects shareholders and stakeholders from any undue influence. A similar view is also taken by the anti-trust regulator, Competition Commission of India, where anti-trust regulations consider an observer at par with a director in terms of exercising influence over the board.
At the same time, others argue that imposing legal obligations on observers would amount to over-regulation, especially when the observer role has been functioning without issue for many years. Overregulating contractual positions could stifle the dynamic nature of businesses, potentially hindering their growth.
While there is no question that corporate governance in companies could be improved, it is crucial that regulatory efforts do not overreach by codifying contractual arrangements that have existed for decades. Instead, the focus should be on fostering an environment that encourages self-regulation and innovation. Companies can still improve their governance structures by adopting measures that strengthen internal controls and transparency.
RBI’s potential move to regulate the observer role reflects its ongoing efforts to streamline governance in the financial sector, particularly for NBFCs. However, the investor community, especially institutional investors, need time to assess the impact of these changes on their governance strategies.
Until then, self-regulation remains the ideal balance between the absence of corporate governance and overbearing compliance requirements. By focusing on responsible growth and internal controls, companies can navigate the complex regulatory landscape while continuing to innovate.
[1] Section 166 of the Companies Act, 2013.
[2] Shantanu Rastogi and Ors. Vs. The State of Karnataka and Ors., Karnataka High Court, 21.01.2021.
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Authors
Poonam Sharma and Parag Srivastava
Contact:
poonam@bombaylawchambers.com; parag@bombaylawchambers.com
Disclaimer: The article is intended solely for general informational purposes only and does not constitute legal advice. It should not be acted upon without seeking specific professional counsel. No attorney-client relationship is created by reading this article.