Observer or shadow director? – Investors must make sure they know the difference.

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A board observer will not, on the face of it, be a director of the company. However, care should be exercised by any person that is appointed as an observer as, depending on the level of involvement that they have in the proceedings at directors’ meetings, they may be regarded as a shadow director at which point they incur duties and obligations.

It is common for an investor to have the right to appoint their own director to the board of the investee company. Despite being selected to sit on the board as an investor’s representative, such an investor director must comply with all the general duties of directors, including the duty to act in the way he considers to be most likely to promote the success of the company (Companies Act 2006 s.172) even if this conflicts with the best interests of the investor. Often venture capitalists separate the investment decisions for the funds invested in the companies, from the investor director’s decisions, in order to avoid conflicts of interests for the investor directors. This separation is typically done by having another investment executive representing the funds’ interests when dealing with the company with respect to investor consent matters.

Some investors will never appoint a director at all because of potential conflicts of interest and liability issues, and will instead require the right to appoint a board observer, who can attend all board meetings, but who will not participate in any board decisions. Although an observer will only have the right to receive notice of directors meetings and to attend them, rather than rights to vote at these meetings, an observer gives such an investor more immediate access to information on decisions taken at board level than he would otherwise have as a shareholder, without the responsibility associated with making day to day decisions. Observers are a creation of contract only, and the role doesn’t have any statutory powers or definition. The powers and entitlements of observers are only those which are given in the agreement through which the appointment right arises (usually the investment agreement).

An observer will not, on the face of it, be a director of the company. However, care should be exercised by any person that is appointed as an observer as, depending on the level of involvement that they have in the proceedings at directors’ meetings and in the management of the company, they may be regarded as either a shadow director or a de facto director of the company at which point they incur duties and obligations.

In order to qualify as a shadow director within the meaning of section 170 of the Companies Act 2006, a person has to be someone in accordance with whose directions or instructions the directors of that company are accustomed to act.  This seems to be quite a high bar, intended only to catch the “puppet-master” operating a company from behind the scenes through individuals with no real executive power of their own.  However the recent case of Standish v The Royal Bank of Scotland plc & others [2019 ] EWHC 3116  (Ch ) confirms a recent development in the law to the effect that, where an individual instructs a board in relation to certain business decisions, and the directors act in accordance with those instructions, he can be considered to be a shadow director in relation to those matters, even where the directors clearly act independently in respect of other business matters.

The consequences of a person being found to be a shadow director are wide ranging as the duties set out in the Companies Act 2006 will apply to such a person in the same manner as if he/she were a formally appointed director.  The Standish case (whilst a first instance decision only, on a successful application by the bank to strike out a disgruntled shareholder’s claims) limited these duties to those matters which could be shown to have a direct causal link to the instructions on which the board had been accustomed to act. However, even with that restriction, the possible liabilities for individuals giving such instructions could be significant and unexpected.

The judgment in the Standish case made a clear distinction between a board of directors acting on the instructions of an individual and the company finding itself having to act in a particular way as a consequence of the contractual rights, or commercial bargaining position, of a third party with whom that individual is in some way connected.  In that case, a restructuring involving, essentially, a debt for equity swap as a consequence of which the disgruntled shareholder/director’s economic rights were diluted was found to be entered into as a result of such a bargaining position and not (on the case as pleaded) in consequence of the matters upon which the relevant individual gave the instructions on which the claim was based. However, where a causal link could be argued to exist between such instructions and a resulting loss to the company or its shareholders, that could give rise to a claim being brought.

An investor representative acting as an observer should therefore make it clear when attending directors’ meetings that any comments he offers are purely for the directors to consider and then take such action as they deem appropriate, and are not intended as directions or instructions. If the investor itself is entitled to give a direction to the company on a matter pursuant to a particular power in the company’s constitutional documents, this should be done formally, in writing, by reference to that constitutional or other contractual power and not as an oral communication from the investor representative.

As the economy turns, and an increasing number of the private equity investments made over the last few years find themselves in a distressed or turnaround situation, these issues should be at the forefront of portfolio managers’ minds.