Shadow Directorship in Indian Start - Ups

Introduction

The eagerness to start one’s own business has become a trend. Every other “social media influencer” has started their own business, be it makeup, healthcare, etc., which has resulted in a rise of new start-ups in the global diaspora. Looking keenly at the Indian market, one can see the evident rise in start-ups, which require funds to keep functioning. In this case “angel investors” come into play, or as they are formally called, Venture Capital Investors.

Venture Capitalists (“VC”) seek high-risk yet high return businesses, hence the start-ups. Since the start-ups are not well-established, and can go out of business with a single wrong move, VCs invest in them early on in the business and exit as the start-ups gain momentum. VCs, in return for their risky investment, gain an unofficial seat at the Board meetings and also get the use of the veto power. They even go as far as to control who to appoint as senior members.

The situation is quite similar with Private Equity (“PE”) Investors - they invest in matured companies, and become an unofficial, yet powerful, board member.

This has become a recent situation, as earlier, the investors, in order to have a control over the inner workings of the company, used to formally join the board; or, on the other hand, would stay passive in any such matter. However, today, these investors have started exerting de facto control over the company’s functioning, and control its decisions contractually without befalling any kind of statutory liability.

The recent years have seen a major rise in VCs and PEs, which has raised a concern with the Ministry of Corporate Affairs (“MCA”) regarding the functioning of the businesses, and begs the question: Can the investors be held liable as shadow directors?

Investor Control Without a Liability

Section 2(59) of the Companies Act, 2013, defines “officer” as:- “any director, manager or key managerial personnel or any person in accordance with whose directions or instructions the Board of Directors or any one or more of the directors is or are accustomed to act.”

Stressing on the excerpt “any person in accordance with whose directions (…) the Board of Directors (…) is accustomed to act,” it can be seen that the investors, on whose funds the company runs, can be seen as such a person. Investors, who can exit the business on their own whim, who buy more than 50% of a company’s shares, are bound to have an influence on the company’s decisions and functioning, unless they stay passive in the matter. However, if an investor is investing a large sum of money in a business, s/he is bound to want to control the inner workings of the company so that s/he does not end up losing the money due to poor management. However, merely because the investor has put in a large amount of money in the business does not legally give him/her the right or the liberty to run the business.

Further, stressing on the phrase “accustomed to act,” is deemed to mean that people are used to following the particular person’s orders, who in this case, is the investor. However, merely because the law, in a way, recognises the role of the investor in the businesses nowadays, it does not mean that they are legally in the right. When the businesses have a lawsuit on their hands, the liability falls on the Board of Directors, and not the investors, because they are legally not privy to the functioning of the company. Investors deny any interference in the functioning of the company and let the Board of Directors take the fall. These kinds of investors are called “Shadow Directors.”

To understand the full extent of shadow directorship, one must first understand the difference between de facto directors, professional advisors, and shadow directors. De facto directors, firstly, are those directors who are not formally recognised as directors, however they function in the full legal capacity of a director of the company and hence are held at the same legal status as those of the actual directors.

Professional advisors, on the other hand, are those who specialise in their field and offer their specialised knowledge and guidance to companies. They may be lawyers, giving out legal advice, accountants, giving out financial advice, and so on and so forth.

Shadow directors, as was already discussed, are those who control the functioning of the company from behind the curtain, or from the shadows, but do not have to suffer from any legal liability in case of a suit.

Official directors have managerial control over the company; they control the day-to-day functioning of the company, and take big decisions for it. Minority shareholders, on the other hand, have protective rights so as to safeguard their interest without being an overall decision-making authority.

Shadow directors take advantage of having the highest shares in the company and unofficially exercise both managerial control and protective rights. By adding clauses in their contracts such as “veto power,” “affirmative voting matters,” and “exit approvals,” the investors unofficially own the company and then have a direct hand in its functioning. The veto power exercised by an investor in an important company decision could result in the plan not moving forward. By approving exits, the investors also control the hiring process of the company, and end up deciding who to hire in key positions. They also control the Board’s decisions from behind the curtain, and exercise protective rights by denying any knowledge of the Board’s functioning if in case the company faces a lawsuit. Having both of these powers makes the investors immune to any legal proceedings against them.

This results in highly warped accountability for the founders of the company. Where they did not have any say in the Board meetings due to the overly domineering presence of investors, the founders, or rather, the Board of Directors, are forced to bear the brunt of any shortcoming that results in a lawsuit, or even in the social diaspora, where any shortcoming results in the public persecution of the Board of Directors. The investors, on the other hand, have nothing to fear, as they maintain their position of being a “passive” member, where all the while they are the ones who orchestrate the workings of the company, and let the Board of Directors bear the brunt of any fallout. Having such influential investors also results in unsaid threats of the investors exiting the company, which results in the Board of Directors letting the investors take the reins.

Such a phenomenon begs a response from the judiciary. However, the judiciary has already been dealing with such cases. Such as in the case of Narayani Sahakari Bank Ltd. vs. Chandrakant Bhaskar Naik, the Bombay High Court held a non-board member liable as he was exercising de facto control over the company. However, that is just one case, whereas this phenomenon has been going on for quite some time now. The judiciary must look at the nature of such investors rights, the frequency and the binding nature of such approvals, and also whether the Board of Directors usually gets influenced by the investor’s directions. The judiciary needs to lift the corporate veil in such scenarios and observe who is actually and practically running the company—the Board of Directors, or the investors who have more than 50% of the shares in the company.

The MCA has also been scrutinising and aptly identifying the right people in control of businesses, even when such control has been discreet. They have been doing so by tracking the corporate decision-making chain, critically analysing the shareholder agreements and side letters, and finally identifying the individuals who exercised influence over company affairs. Where there have been repeated approvals or compulsory investor-sign offs, the MCA finds hard to believe that the investors in that case were “passive,” and impose accountability on them.

Conclusion

Without such clear thresholds, shadow directorship will remain prevalent in the corporate world, and the Board of Directors will remain falsely implicated while the real orchestrators, the investors, would remain scot-free. This begs a change in the way the investors enter into contracts with the companies. Limiting the veto rights to extraordinary matters rather than routine functioning would drastically change the investors function in the company. Further, avoiding any such clauses that require investor approval for daily functioning of the company would also drastically reduce the occurrence of such a phenomenon. And finally, by clearly maintaining the independent discretion of the Board even where investor approval is sought will radically change the status of investors in the company and uphold the core principles of corporate governance.

Moreover, actions taken by the MCA would play a crucial role in ending this phenomenon. By issuing circulars, guidelines, or clarifications regarding the role of investors and Board of Directors in a company, it would reduce the occurrence of shadow directorship and also ensure that there continues to be a changing and better governance discipline in start-ups.

Author: Vaani Parashar, in case of any queries please contact/write back to us via email to chhavi@khuranaandkhurana.com or at  Khurana & Khurana, Advocates and IP Attorney.

References

1. Companies Act, 2013

2. Unveiling the Shadows: Legal Implications of “Accustomed to Act” with Relation to Shadow Directors.

3. Narayani Sahakari Bank Ltd. v. Chandrakant Bhaskar Naik, (2013) SCC OnLine Bom 12.