Liability Shift: The Impact of RBI’s Directive on PE/VC Appointed Observers in the Board of NBFCs
INTRODUCTION
Accordingto the India Venture Capital Report 2025, private equity (“PE”) andventure capital (“VC”) investments have been on the rise, with fundingrebounding to US$13.7 billion in 2024—1.4 times the 2023 levels[1]. Onboardingan investor is a critical milestone for any company, and few would want to missthe opportunity to close a deal—even if it means ceding certain powers andgranting some rights to such an investor. Investors typically seek such rights,which keeps them informed about key decisions. One such right is the right toappoint a non-voting observer (“Observer”) to the board of directors (“Board”)of the investee company.
REGULATORYSCRUTINY ON BOARD OBSERVERS
Someof these contractual rights and protections in heavily regulated sectors arenow under scrutiny by the respective regulatory authorities. The latestdevelopment on this front is the directive issued by the Reserve Bank of India(“RBI”) for non-banking financial companies (“NBFCs”). Thedirective to NBFCs requires these NBFCs to undertake necessary actions toremove the Observers from their Boards and, if needed, appoint such nomineeObservers as nominee directors to their Board (“Directive”)[2].The Directive pertains to the ongoing practice of investing entities appointing 'Observers' to the Board of the investee NBFCs instead of nominating directors. This allowed the investors access to attend and partake in Board meetings without assuming the statutory obligations of being a director. A director may be subject to potential civil or criminal liability in the event of fraud, financial diversion, or significant governance failures[3] by the Company. Appointing an Observer instead ofnominating a director makes it easier for the investors to circumvent anypotential liabilities.
RBI’SDIRECTIVE MIRRORS CCI’S AMENDMENT
The Directive aligns with the recent amendments made by the Competition Commissionof India (“CCI”) to its combination rules[4]. Under theearlier CCI regime[5], acquirers were not eligible for an exemption if they obtained special rights (i.e. rights not available to ordinary shareholders)in the target entity. These includedvarious contractual privilegessuch as director appointment rights, andinformation and inspection rights.Notably, the only special right explicitly recognized under the previousframework was the right to appoint a director. The amended combination rules now specifically include the ability to appoint a board Observer[6].This change reflects the CCI’s view that directors and Observers are equally effective modes for an acquirer to exert ‘material influence’ over the management and affairs of the Board of the target entity.
ANALYSIS
WhileObservers do not have a right to vote in a Board meeting, they are entitled toother rights similar to those of a director. These include attending Boardmeetings, receiving all relevant information in advance, and having a right todiscuss and add to the agenda of a Board meeting. However, unlike directors, Observersare not formally recognized under the Companies Act 2013 and are therefore notsubject to the same statutory obligations. Nominating an Observer allows aninvestor to maintain strategic oversight while limiting their exposure toregulatory and statutory liability.
Notably,RBI’s regulatory framework for NBFC requires that directors meet stringent ‘fitand proper’ criteria.[7] These standards include signing anundertaking and a deed of covenants, which formally define directors' roles,responsibilities, and liabilities. Consequently, accepting a directorship in anNBFC comes with significant compliance obligations and legal risks other thanthe ones in addition to the obligations under the Indian Companies Act.
Asthese additional requirements do not bind Observers, appointing one has become a safer alternative to nominating a director. However, this has raised concerns with the RBI, which sees the increasing use of Observer roles to circumvent itsgovernance framework. The Directive seems to convey that an Observer, in RBI's view, functions much like directors— exercising influence over Board meetingsand receiving privileged information, all the while flying under its regulatory radar. This concern is particularly acute in cases where governance lapses ormismanagement occur in a sector as critical as finance. Yet, an investor's Observer, despite being a key decision maker, could escape accountability as a result of its status.
PE/VC investors, while evaluating their investment strategy (specifically for NBFCs),will need to carefully assess the trade-off between exposing their nominee to heightened regulatory obligations and risks or limiting their access to decision-making processes within the Board of NBFCs.
Ona larger note, this evolving regulatory view (initially CCI and now RBI)regarding Observers calls for a deliberate, nuanced approach to Boardrepresentation and governance rights in future investment structures.
CONCLUSION
Withincreased exposure to risk for PE/VC investors due to the Directive, NBFCs andPE/VC investors may need to renegotiate their Board representation rights.Given the significant investments made in the NBFC space over the years[8] and its potential, RBI may consider altering its regulatory regime torecognize an 'Observer' albeit with certain limited (as compared to a director)oversight and obligations.
References
[1]Page 6 of the report, available at<<https://www.bain.com/globalassets/noindex/2025/bain_report_india_venture_capital_report_2025.pdf>>
[3]Duties of directors as listed out under section 166 of the Companies Act, 2013.
[4]The Competition (Criteria for Exemption of Combinations) Rules, 2024, availableat << https://www.cci.gov.in/combination/legal-framwork/notifications/details/23/0>>
[5]Schedule I of the CCI (Procedure in regard to the transaction of Businessrelating to Combinations) Regulations, 2011
[6]Schedule E of the Competition (Criteria for Exemption of Combinations) Rules,2024, available at << https://www.cci.gov.in/combination/legal-framwork/notifications/details/23/0>>
[7]Page no. 94 of the Master Direction – Reserve Bank of India (Non-BankingFinancial Company –
ScaleBased Regulation) Directions, 2023, available at<<https://fidcindia.org.in/wp-content/uploads/2023/10/RBI-MASTER-DIRECTION-NBFC-19-10-2023.pdf>>
[8]Page no. 5 of the Reserve Bank Innovation Hub report on PE/VC IN FinancialServices and Fintech