Understanding Potential Risks for Nominee Directors in India

Such directors should consider adopting adequate measures to safeguard the interests of private equity investors and avoid any undue liability on themselves...

Buoyed by a vibrant economy and high returns, the private equity (PE) and venture capital space in India was on a rising track to record an all-time high investment of more than $33 billion in 2018. With an over 35% year-on-year increase, it remained a landmark year for the sector.

Whether the foreign investor interest and PE investment tally of 2019 would outdo the highs of 2018 would not only depend on factors such as global economic trends, outcome of the upcoming national elections, but also on the increasing scope of liability and stringent national and international regulatory pressure imposed by various government authorities and international organizations.

Protecting Investments Through Affirmative Rights – 'Controlling Dilemma' For Nominee Directors

For any PE investor, appointment of nominee director(s) on the board of the investee company remains one of the paramount ways of participating in the management and governance of such companies. For protecting the investment made, certain key matters pertaining to the operations of a company are listed down as affirmative vote matters in the contractual arrangements, the passing or approval of which remains conditional to receipt of affirmative vote from such nominee director. However, such an appointment also exposes the nominee directors to risks and poses several challenges.

The aspect of exercising 'indirect control', notably in respect of the power to determine the outcomes of a board meeting or shareholders meeting, has been discussed at vast length in various judicial precedents. Taking reference from the case of Century Tokyo Leasing Corporation/Tata Capital Financial Services Limited, the Competition Commission of India had held that affirmative rights relating to certain items would be considered 'control' for the purposes of the Companies Act, 2013 ("Companies Act"). These items include annual budget; annual business plan; exit and entry into lines of business; appointment of management and determination of their remuneration; or strategic business decisions.

However, a different view with respect to associating of veto rights to exercising of control has been taken in various cases, like in the case of Subhkam Ventures India Private Ltd. v. SEBI, where it was held that veto rights in favor of certain shareholders to veto certain actions proposed to be undertaken by the company (affirmative voting rights in the shareholders agreements) does not amount to 'control' and that the shareholders having such affirmative rights need not make an open offer under the Takeover Regulations to the other public shareholders of the target company.

Potential Liability Under Various Laws In India

1. The duties of directors as codified under Section 166 of the Companies Act, 2013 do not distinguish between an executive and a non-executive director. And hence obligates a non-executive director almost on an equal footing as that of an executive director.

2. The term "officer in default" applies only to executive directors under the Companies Act, independent and non-executive directors (including nominee directors) can be held liable under Section 149(12) of the Act if acts or omissions by the investee company:

(i) occur with the knowledge of such independent and non-executive directors, "attributable through board processes", and with the consent or connivance of such independent and non-executive directors; or

(ii) where such independent and non-executive directors have "not acted diligently".

The affirmative voting rights provided to investor nominee directors under the provisions of an investment agreement and articles of association of an investee company can lead to a situation where non-executive directors would remain equally duty bound under Section 166 of the Companies Act, 2013 while protecting the interests of the PE investor. It can be further argued that though a non-executive director, who is not involved in everyday operations of the investee company, can face a potential risk where upon grant of affirmative voting rights, knowledge can be attributed through board processes and lack of diligence is seen to be exercised in the decision-making process.

3. Any non-diligent exercise of veto made available to the nominee director can lead to significant consequences, including facing of liabilities and serious implications for non-compliance, such as penalties, forfeiture and in certain cases, even arrest arising under various laws in India. Availability of such right and access to the information required in the process of decision-making to exercise such veto right may also negate defences otherwise available to nominee directors against noncompliance by investee company, they sit on the board of. In other words, the fact that a nominee director may not have any information or resources to be able to understand the business decisions, might not be enough to absolve him of the duties to understand the investee company's affairs and to apply his/her own mind to determine whether a particular transaction was in the investee company's interests.

4. PE investors also secure certain information rights under the investment agreements which binds an investee company to provide such investors with company-related information including financial statements, operations and management periodically. Most information rights also include the opportunity to visit the company's facilities, inspect the company's books and records, and discuss matters with company officers. As a practical matter, an investee company while adhering to such provisions, shares or is made to share all such information with the nominee director himself. These rights bring in another layer of obligation on nominee directors to remain diligent while examining the information/documents and taking into consideration such information while discharging duties as a director including exercising of veto rights, and any failure in exercising utmost diligence in reviewing the information can further outcast the shadow of liabilities under various laws in India.

5. Further with respect to other applicable laws, while it is difficult to provide any standard that would determine an individual's exposure to liability, it has generally been seen that 'only those persons are held liable for wrongdoing committed by a company, who were in charge of, and responsible for, the conduct of the business of the company at the time of commission of an offense'. Such liability may not always be foreseeable, and actions such as the violation of environment protection laws, dishonoring checks, offenses under the Income Tax Act of 1961 or Goods and Services Tax Act, 2016, violation of foreign exchange regulations, breach of securities regulations, non-payment of provident fund contributions, violation of the Shops and Establishments Act, or food adulteration, could result in liability that may not always be limited to the executive directors.

Conclusion

Securing affirmative voting and information rights in an investment agreement can be a double-edged sword for PE investors. Though it favorably provides an edge while securing the investment by guiding the operations in the desired manner, any inaccuracies in exercising such rights can also lead to risk of facing allegations and being charged for potential liabilities under various laws in India.

Increasing reliance on utilization of forensic auditing and investigation techniques combined with advanced data analytics has helped various companies and their investors in resolving unwarranted disputes in courts of law and other forums in India. Forensic techniques such as data analytics can be very useful in detecting, monitoring or investigating potentially improper transactions, events or patterns of behavior related to misconduct, fraud and noncompliance issues. By way of illustration, a Forensic Audit is a comprehensive and systematic process involving a series of activities and tasks undertaken for establishing the accuracy and authenticity of the transactions under review. Increasing reliance on conduct of forensic investigation coupled with legal health review, has helped various global private equity investors in collecting and preserving evidence, conducting interviews and preparing strategies for pursuing civil and criminal remedies while maintaining legal privilege.

In order to avoid and mitigate any liability on the nominee directors arising out of a non–compliance or breach by the investee company under various laws in India and any other legislation enacted outside India having an impact on conducting business in India, such directors should consider adopting adequate measures to safeguard the interests of private equity investors and avoid any undue liability on themselves.

Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature.