Beware Observers and Nominee Directors

Corporate & Commercial | Sep 2020 | Bharat Sharma

Authored by Bharat Sharma, Partner & Krishaal Morjaria, Associate

Shareholders and investors require visibility on the day to day management of a company in which they hold economic interest. The same holds good for lenders with respect to the affairs of the borrowing company. To ensure control and supervision, clauses providing for the appointment of observers and nominee directors on a company’s board are commonplace in transaction documents today. The observer is often a predecessor of the nominee director. Since the observer is appointed post-signing but before the consummation of a transaction, once the transaction is consummated, his role ends and the role of the nominee starts. It is thus important for both the nominator as well as the observer/nominee to understand the risks associated with his appointment.

Observers v nominee directors

As compared to observers who are appointed due to contractual obligations, while the genesis of their appointment may lie in a contract, nominee directors are appointed by following the provisions of the Companies Act, 2013 (Act). Section 149 read with Section 161(3) of the Act recognizes the appointment of nominee directors under various situations.

Ordinarily, though not independent, nominee directors are non-executive directors and thus, unlike executive directors, are not employed by the company on whose board they sit. Nominee directors may also be vested with powers to veto certain important actions proposed to be taken by the company. Such powers are not conferred statutorily but find mention in contractual arrangements which are then reproduced in the charter documents of the company. Observers are ordinarily appointed in a company to provide the appointer visibility on the actions by the company pending consummation of a transaction. As opposed to a nominee director who can participate in a board meeting, an observers role is limited to merely observing and reporting his observations to his appointor.  Thus, observers are not open to violation by a company of any statutory provisions as the observer’s appointment is not statutory but emanates from a contractual obligation.

However, an observer does not have complete blanket protection from violations. For instance, where he has been appointed as an observer to a listed company, he may be privy to unpublished price sensitive information being discussed at a board meeting, and towards this end come within the definition of a ‘connected person’. He thus needs to be mindful of the provisions of the Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 2015.

A nominee director, unlike an observer, is exposed to statutory violations – a few of which are set out below. Towards this end, the nominee may keep an eye open to take steps to mitigate risks.

  • Companies Act, 2013:

Section 166 of the Act makes it mandatory for a nominee director to avoid a conflict of interest situation as he needs to act in the best interest of the concerned company where he is a director. Accordingly, it could be possible that an action taken by him furthering the cause of his nominator, for instance by exercising a veto right, may be challenged on the basis that the decision (while it may have been in the interest of the nominator) is detrimental to the company. Thus, it would be beneficial for the nominee to not blindly follow the decisions of his nominator in cases where there is a direct conflict with the interest of the concerned company. Not all actions taken by a nominee are open to challenge, they would depend on the facts and circumstances peculiar to each case.

While it is important for a nominee to understand the repercussions of his actions, certain sections of the Act, besides penalizing the corporate entity, also penalizes ‘officers in default’. On the face of it, a nominee being a non-executive director does not fall within the ambit of the aforesaid definition unless he did not object or explicitly consented to a contravention under the Act, or consented to fall under the definition of ‘officer in default’.

It is further important for the nominee not to be appointed as key managerial personnel of the company as the statutory safeguard afforded to him by Section 149 (12) of the Act will wash away. In terms of the above section, a non-executive director, not being a promoter or a key managerial personnel cannot be made liable for acts pertaining to the company except in limited circumstances where such act had occurred with his knowledge, attributable through Board processes, and with his consent or connivance or where he had not acted diligently.

The aforesaid statutory safeguard has also been recognized in a recent circular issued by the Ministry of Corporate Affairs which has clarified that non-executive directors, not being whole-time directors who are involved in the day to day activities of a company must not be unnecessarily arrayed in any civil or criminal proceedings unless the criteria under Section 149(12) is met.

  • Other laws

Directors may be liable to prosecution under other laws, including the Negotiable Instruments Act, 1881, Factories Act, 1948 and other labor laws, Income Tax Act, 1961, foreign exchange regime, and securities laws. While the courts have generally been cautious in interpreting the applicable provisions of the above laws to ensure that prosecution can continue only against directors who were in charge of the day-to-day affairs of the company or those who had committed the impugned act. There are judicial decisions that have stated that non-executive directors cannot be said to oversee the day to day affairs of the company.  A nominee director, who is a non-executive director, will be exonerated if he is able to prove that the act was committed without his knowledge and had exercised all due diligence to prevent the exercise of such offence.

  • Resignation

While the above actions will help mitigate liability during the term of the nominee director, liability post-termination can also ensue. It is imperative that when he resigns from his office, he intimates the fact of his resignation to the company and the company does likewise to the statutory authorities. By doing this, the director, from the date of his resignation, may be protected from statutory violations where the cause of action has arisen post his resignation.

  • Indemnities and insurance

The nominee must consider obtaining an indemnity from the company for protecting such nominee for any liability arising out of default, negligence, malfeasance, etc. such director is accused of. The Act recognizes that every officer of the company may be indemnified out of the assets of the company against any liability incurred by him in defending any proceedings, whether civil or criminal, in which judgment is given in his favor or in which he is acquitted or in which relief is granted to him by the court or tribunal.

Similarly, the nominee may also insist the Company to take a Directors and Officers Liability Insurance which may provide cover for the personal liability of directors and officers arising due to wrongful acts in their managerial capacity. Such insurances may also provide defense costs payable in advance of final judgment.