Boardroom Dynamics: Observer vs. Director In India's Evolving PE/VC Landscape

I. The Governance Quandary

The Private Equity (PE) and Venture Capital (VC) market in India has experienced significant growth in the recent past, with investments reaching USD 43 billion in 2024. As investment activity within the PE/VC market increases, investors have become cautious in protecting their interests and money, ensuring better oversight over their investee companies. This foresighted approach has given rise to two key roles that an investor may like to have in investee companies: the Board Director or the Board Observer.

1. Board Director: A Board director is a member appointed to the Board of Directors of a company with voting rights, who directly influences the decisions and operations of a company.
2. Board Observer: Board observers are representatives of investors who may attend board meetings and receive information without being formally appointed by an investee company to its board, and they do not have voting rights.

Both are appointed on behalf of investors to monitor and protect their interests and money, yet they operate with distinct nuances and carry vastly different risk profiles.

With the rise in investment in the PE/VC space across various sectors, investors are gradually preferring board observer rights over board directorships, which may also depend on the type and extent of the stake an investor has in the company. This shift highlights not only a preference but also a calculated response to the liability framework under the Indian Companies Act, 2013 (Companies Act), and other special laws. Considering that, in some instances, investors might hold a minority or lesser stake, which may eventually lead them to opt for a board observer role.

Let's discuss a few examples, i.e. OYO and Paytm, which elucidate how liability concerns shape this shift from directorships to observer roles:

1. In 2020, Sequoia Capital's Managing Director resigned from OYO's board to become an observer. This was a careful and thoughtful choice to give up voting power in exchange for protection from liability.
2. In 2022, SoftBank's Vision Fund partner resigned from Paytm's Board while the RBI was looking into the company.

While it goes without saying that actions from the past might bite one even if one has become an observer, it might provide a safeguard in certain situations wherein control and steering are not in one's hands. The above-stated examples reflect a growing inclination among investors to balance their power without assuming all the legal responsibilities that come with being a formal board member.

The assumption that a Board Observer is completely immune from legal liability is a perilous misconstruction. The legal framework governing corporate governance in India, including the Companies Act, holds individuals accountable for their actual role and control in a company, not just their title or designation. This governance-related discussion becomes even more complex when considering the legal reality that observers can inadvertently become 'shadow directors'.

The law and courts employ a powerful 'accustomed to act' principle. If a person consistently influences the board to the extent that it becomes accustomed to following their directions, they risk being classified as a 'shadow director'. They can be held liable just like a formally appointed director.

There is a strategic question that an investor must ask themselves:

• Is it better to take a formal board seat with voting power and influence or opt for the observer role, which offers a position to persuade, albeit for the limited purpose of protecting investors' rights, but may provide a liability shield, both contractual and statutory?

Understanding this trade-off has now become more crucial for investor-friendly governance within the PE/VC space. To make a well-informed decision, an investor must not only consider the functional responsibilities or its stake in the company but also the legal and contractual obligations attached to the roles of Director and Observer.

Let's discuss how various elements influence investor choice, providing insights they may require to make the trade-off for balancing the risks and benefits associated with each role, i.e., an Observer or a Director.

II. Statute vs. Contract

A. Board Member (Director): Creation of Statute

A director is legally recognized as an "officer" of a company under the Companies Act, and in a large number of situations, an 'officer in default'. They are primarily responsible for the decisions regarding the management of a company and exercise influence over:

1. Key decisions
2. All the matters that might not cross the thresholds required for shareholders' approval
3. Financial management
4. Company's overall operations
5. Serves as a 'guiding force and brain' of a company

However, where there is power, there are liabilities to balance the position. The Companies Act, to balance the power, imposes liabilities/obligations on the powers of a director. Section 166 of the Companies Act lays down the fiduciary duties of directors, including:

1. Acting in good faith
2. Prioritizing the best interests of the company
3. Carrying out functions and responsibilities with due care, skill and diligence
4. Avoiding conflicts of interest
5. Avoiding undue gains

Breach of any of the above duties can attract;

1. Civil liabilities, including penalties under tax, insolvency, environmental, and other applicable laws.
2. Criminal liabilities under the Companies Act and other applicable laws.

Further, the resignation of a director under Section 168 of the Companies Act does not absolve them from liability for actions committed during their tenure. The proviso to Section 168(2) explicitly states that a director who has resigned shall remain liable, even after resignation, for the offences that occurred during their tenure. For instance, if a company has committed any offences under the Negotiable Instruments Act, 1881, or the Income Tax Act, 1961, a director can be held personally liable for the same if it is proved that such an offence was committed with the consent or connivance of that director or is attributable to any neglect on their part.

B. Board Observer: Creation of Contract

The position of a board observer is not statutorily recognized; it is currently only a creature of contract, such as Shareholders' Agreements (SHAs) or other similar arrangements, and the Articles of Association (AoA).

Board observers usually have the right to;

1. Attend meetings of the board and board committees
2. Inspect board materials such as agendas, resolutions, and financial reports
3. Receive MIS
4. Receive regular updates on company performance
5. Engage in strategic discussions

These rights come with aligned contractual liabilities:

1. Confidentiality and permitted use obligations
2. Non-interference covenants
3. Compliance with company policies
4. No misuse of information

Observers under the contractual framework represent the investor's interests in the investee company. Under India's corporate governance framework, they do have fiduciary duties, albeit not of the same nature as a director. Their obligations are primarily contractual and therefore narrower. With their primary interest aligned with that of the investor, the observer provides an unorthodox way to influence decisions through passive involvement, offering insights and monitoring investments without assuming the role of a formal director.

Interestingly, the idea of 'influence without formal accountability' presents a conundrum: can board observers truly influence company decisions without being formally accountable for those decisions? Ideally, this model allows observers to:

1. Engage in conversations with the board and management, providing insights without formally participating in decisions.
2. Ask targeted questions that help identify and flag potential issues or risks
3. Help companies decide on strategies by offering guidance and making value-added recommendations to the board, without directly engaging in decision-making.

The US Court of Appeals for the Third Circuit in Obasi Investment Ltd. v. Tibet Pharmaceuticals, Inc. (No. 18-1849, decided on July 23, 2019), while primarily breaking down the key distinctions between board observers and directors, sheds light on the broader issue of whether observers can influence decisions without bearing formal accountability. Focusing on the functions attached to both roles, the court observed that an observer:

1. Lacks voting rights: Unlike directors, board observers do not have voting rights on board decisions.
2. Has investor-aligned interests: The primary interest of board observers is aligned with those of the investor.
3. Has a fixed term: The term of board observers is governed by SHAs instead of the vote of shareholders.

The district court in Obasi Investment had initially found that the observers could significantly influence board decisions, even in the absence of voting rights. This finding was significant because it demonstrated that influence through informal channels could still pose risks of legal accountability, even if not formally recognized as decision-making.

While the Third Circuit reversed the district court's decision, affirming the legal differences between the observers and directors in that case, it did not dismiss the potential for observers to exert influence that could be interpreted as director-like control, especially if they are involved in decision-making.

With this, it can be seen that the Observer position is no longer an obscure term, but courts have started discussing about it. It is a matter of time before investors start evaluating the position of an observer through the lens of control and influence. Thus, understanding the legal differences between a director and a board observer on a case-by-case basis helps in taking the right strategic decisions that investors and companies require to balance liability, influence, and control. With legal frameworks in place, the next step is to examine how these distinctions impact the strategic motivations of both investor and company.

III. Strategic Motivations

Both the investor and the company are gradually preferring board observer roles over director roles, as the requirements that an investor may have can be fulfilled through the observer role in various situations. Ultimately, it is known to both the founder and the investor that the company will be run by the founders for the betterment and interest of the company. A regular oversight can be kept through the observer's role. For investors, it allows them to exert regular checks and influence over the company without incurring the liability of formal directorship, while allowing companies to reap the benefits from expert input without compromising control over the board. The table below outlines the key motivations for both parties in adopting this structure.

While investors and companies evaluate their strategic interests in a company's governance, they must also consider the legal risks associated with the roles they assume within the company. These risks directly affect their liability exposure, which varies significantly between board directors and observers.

IV. Liability Calculus

Different positions within a company are subject to varying degrees of liability under the Companies Act framework. The table below summarizes the same among executive directors, non-executive directors, and board observers.

While it may appear that the role of a board observer carries significantly less liability compared to a formal director, this perception is not entirely accurate in all scenarios. In reality, the line between an observer and a director becomes blurred when the observer has enough influence over the company's decisions to effectively control or direct the board's actions.

V. When Observers Become Directors

The designation of 'Board Observer' is not an impenetrable shield. The commercial intent behind appointing observers should remain the protection of the interests of investors, and must be reflected in conduct. However, when any of these roles turn into active control or regular influence over board decisions, an observer attracts liabilities similar to those of a director, irrespective of its observer title.

The Sahara case clearly reiterates that the law focuses on real influence and control, not just titles. In Re: Issuance of Optionally Fully Convertible Debentures by Sahara India Real Estate Corporation Limited and Ors., (decided on June 23, 2011), the Securities and Exchange Board of India ("SEBI") classified Subrata Roy Sahara as an "officer in default" despite not being a formal director, because the board habitually followed his directions. This test of conduct and ground reality established that persistent influence could break through the barrier of formal titles and hold people accountable.

By contrast, the Hon'ble Securities Appellate Tribunal ("SAT") in Subhkam Ventures (I) Pvt. Ltd. v. SEBI (decided on January 15, 2010) carved out the other side of the line. It clarified that not all investor rights or observer actions amount to control. The SAT, in this case, identified the lens to categorize two types of 'control', namely proactive and reactive control, and observed that protective rights, which enable investors to prevent certain actions, do not constitute control unless they permit the investor to direct the company's affairs. Simply having the power to stop the company from acting is not control; true control requires the ability to both guide and drive the company's decisions.

True control lies where the investor not only has the right to say "no" but also to say "go", controlling not just the brakes but also the accelerator and steering wheel of corporate strategy.

Thus, while the Sahara Case illustrates when an observer's influence crosses into shadow directorship and liability, the Subhkam Ventures Case provides the much-needed clarity, by confirming that mere veto or protective oversight, without the ability to direct operations, policy or management, does not amount to control.

Furthermore, in the case of Sayanti Sen vs. SEBI (decided on August 9, 2019), the SAT observed that a person not holding any office or designation in the company may be held liable if it is established that they are responsible for the actions of the company at the relevant time. These observations by SEBI and SAT elucidate the regulatory stance that observers may be held liable for the conduct of a company if they pass through the lens that they have carved out for control and influence.

A legal lens: a test of substance over form is required to determine whether an individual is truly an observer or, in fact, a shadow director. This test has two limbs: one relates to the observer's influence over decision-making, while the other concerns the legal and operational impact of observer rights.

This test has been most clearly articulated in the following landmark cases:

1. Re Hydrodam (Corby) Ltd, [1994] 2 BCLC 180, 183 (decided on December 17, 1993)
2. Secretary of State for Trade and Industry v. Deverell, [2001] Ch 340, CA (decided on December 21, 1999)

The UK Court in the above cases held that a person who is not formally appointed as a director may nevertheless be treated as one if it is established that:

1. They directed the board of the company on how to act in relation to the company's affairs.
2. The board routinely acted in accordance with such directions.

Fundamentally, it is not sufficient to show a single isolated instance of acting under the direction of a person; there must be:

1. A consistent pattern of reliance on such a person's directions indicating that the board relinquished their own independent judgment and discretion.
2. The influence of such a person must extend to a majority of the directors, and reliance by only a minority would not classify such a person as a shadow director.

The Deverell ruling further clarified that the actual test is whether the observer exercised real influence over the company's corporate affairs, such that the board regularly acted on their guidance.

What are the key differentiators:

1. Simply giving advice, especially in a professional capacity, does not constitute shadow directorship.
2. It is the consistent instructions and directions given by an observer, along with the accustomed compliance with such instructions/directions, that may bring them under the ambit of a shadow director.

Consider a practical scenario: a PE investor appoints its representative as an observer to a Company's board, only to monitor quarterly performance. However, as issues within the company's governance arise, the observer begins issuing detailed "recommendations" that the board routinely adopts, effectively shaping the company's outcomes without a formal vote in the board. In this scenario, what begins as protective oversight morphs into shadow direction, potentially exposing the observer to director-like liabilities.

VI. Regulatory Clampdown

In a scenario where the risk of observers crossing into shadow directorship increases, regulators have also begun to close the gap between influence and accountability, with the aim to ensure that individuals who actually control a company's decisions, even without formal titles, are held accountable.

In recent years, regulators have adopted a proactive approach to scrutinize the unaccountable influence exerted by observers on companies. For instance:

Apart from these recent regulatory developments, SEBI, for its part, has implemented indirect yet powerful safeguards within its regulatory framework to ensure that the role of board observers does not escape regulatory oversight, particularly with respect to listed companies. While there is no single provision or regulation dedicated solely to board observers, their conduct would be governed by various provisions. Amongst others, a few relevant ones include the following:

1. Insider Trading Compliance under SEBI (PIT) Regulations, 2015: Under SEBI PIT Regulations 2015, observers by virtue of their presence in a board meeting may necessarily be privy to Unpublished Price Sensitive Information ("UPSI"). This means that observers can be classified as insiders under the regulations and are required to comply with the provisions of the same. Any violations of provisions could lead to penalties, including fines and disgorgement of profits.
2. Approval and Disclosure of Special Rights under SEBI (LODR) Regulations, 2015: For listed companies, Regulation 31B of LODR provides that any special rights granted to shareholders, such as the right to appoint a director or observer, must be approved by a special resolution by existing shareholders once in every five years and must be intimated to the relevant stock exchanges.
3. Potential "Control" under SEBI (SAST) Regulations, 2011: "Control" under the SAST Regulations is defined broadly to include the right to appoint a majority of directors or the ability to influence management or policy decisions, whether directly or indirectly through shareholder agreements, or other similar arrangements. While the regulations also clarify that a director or officer is not deemed to be in control merely because of his position, in certain situations, board observer rights can be construed as "control" if such rights extend beyond passive attendance and information access to influencing strategic or operational decisions, thereby requiring obligations under the SAST framework.

VII. Closing Playbook: Navigate Power, Process, Paperwork, and Protection

As regulatory scrutiny across sectors increases, PE/VC investors must shape their governance strategies not only to remain compliant but also to align them with their own needs and interests. This evolution in regulatory expectations will directly shape the strategic decisions investors make, influencing their approach to governance across various stages and industries.

The following framework offers a systematic approach to navigating the complex trade-offs between influence, protection, and compliance across various investment scenarios.

A. The Investment Decision Matrix: Stake-Based Strategy

B. Company Life-Cycle Governance Evolution

Investment timing has a significant impact on governance complexity and market dynamics. Companies at different stages present varying risk profiles and governance needs:

BOTTOM LINE

The frameworks outlined above serve as a practical compass for PE/VC investors navigating the increasingly complex landscape between influence and liability. Rather than offering rigid prescriptions, these guidelines recognize that governance decisions must be tailored and augmented to the unique intersection of an investor's ownership stake, the company's development stage, and the regulatory environment in which it operates.

The key insight emerging from India's evolving PE/VC landscape is that effective governance is not about choosing between observer or director roles, but about building adaptive frameworks that can change with changing circumstances. Whether to choose the boardroom seat with its voting power and formal accountability, or the observer chair with its information access and contractual protections, an Investor's decision should be grounded in a clear-eyed assessment of stake, the company's needs, and the regulatory realities you face.

BIBLIOGRAPHY

Acts & Statutes

1. Companies Act, 2013, No. 18 of 2013.
2. Negotiable Instruments Act, 1881, No. 26 of 1881.
3. Income Tax Act, 1961, No. 43 of 1961.
4. Securities and Exchange Board of India Act, 1992, No. 15 of 1992.
5. Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 2015, 2015.
6. Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015, 2015.
7. Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011, 2011.
8. Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2009, 2009.
9. Competition (Criteria for Exemption of Combinations) Rules, 2024, 2024.

Indian Jurisdiction

1. Subhkam Ventures (I) Pvt. Ltd. v. SEBI, Appeal No. 8 of 2009 (Securities Appellate Tribunal Jan. 15, 2010).
2. In re Sahara India Real Estate Corp. Ltd., WTM/PS/42/IVD/June/2011 (Securities and Exchange Board of India June 23, 2011).
3. Sayanti Sen v. SEBI, Appeal No. 163 of 2018 (Securities Appellate Tribunal Aug. 9, 2019).

Foreign Jurisdiction

1. Re Hydrodam (Corby) Ltd., [1994] 2 BCLC 180 (Ch. Div. 1993).
2. Sec'y of State for Trade & Indus. v. Deverell, [2001] Ch 340 (C.A. 1999).
3. Obasi Inv. Ltd. v. Tibet Pharms., Inc., 931 F.3d 179 (3d Cir. 2019).

Report

1. Bain & Company. India Private Equity Report 2025. Bain & Company, 2025, https://www.bain.com/globalassets/noindex/2025/bain_report_india_private_equity_2025.pdf.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.