Liability Shift: Impact of RBI’s Directive on PE/ VC Appointed Observers in the Board of NBFCs

According to the India Venture Capital Report 2025, private equity (“PE”) and venture capital (“VC”) investments have been on the rise, with funding rebounding to US$13.7 billion in 2024—1.4 times the 2023 levels. Onboarding an investor is a critical milestone for any company, and few would want to miss the opportunity to close a deal—even if it means ceding certain powers and granting some rights to such an investor. Investors typically seek such rights, which keeps them informed about key decisions. One such right is the right to appoint a non-voting observer (“Observer”) to the board of directors (“Board”) of the investee company.

Some of these contractual rights and protections in heavily regulated sectors are now under scrutiny by the respective regulatory authorities. The latest development on this front is the directive issued by the Reserve Bank of India (“RBI”) for non-banking financial companies (“NBFCs”). The directive to NBFCs requires these NBFCs to undertake necessary actions to remove the Observers from their Boards and, if needed, appoint such nominee Observers as nominee directors to their Board (“Directive”). 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 by the Company. Appointing an Observer instead of nominating a director makes it easier for the investors to circumvent any potential liabilities.

The Directive aligns with the recent amendments made by the Competition Commission of India (“CCI”) to its combination rules. Under the earlier CCI regime [Schedule I of the CCI (Procedure in regard to the transaction of Business relating to Combinations) Regulations, 2011], 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 included various contractual privileges such as director appointment rights, and information and inspection rights. Notably, the only special right explicitly recognized under the previous framework was the right to appoint a director. The amended combination rules now specifically include the ability to appoint a board Observer. 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.

While Observers do not have a right to vote in a Board meeting, they are entitled to other rights similar to those of a director. These include attending Board meetings, receiving all relevant information in advance, and having a right to discuss and add to the agenda of a Board meeting. However, unlike directors, Observers are not formally recognized under the Companies Act 2013 and are therefore not subject to the same statutory obligations. Nominating an Observer allows an investor to maintain strategic oversight while limiting their exposure to regulatory and statutory liability.

Notably, the RBI’s regulatory framework for NBFC requires that directors meet stringent ‘fit and proper’ criteria. These standards include signing an undertaking and a deed of covenants, which formally define directors' roles, responsibilities, and liabilities. Consequently, accepting a directorship in an NBFC comes with significant compliance obligations and legal risks other than the ones in addition to the obligations under the Indian Companies Act.

As these 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 its governance framework. The Directive seems to convey that an Observer, in RBI's view, functions much like directors— exercising influence over Board meetings and receiving privileged information, all the while flying under its regulatory radar. This concern is particularly acute in cases where governance lapses or mismanagement 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.

On a larger note, this evolving regulatory view (initially CCI and now RBI) regarding Observers calls for a deliberate, nuanced approach to Board representation and governance rights in future investment structures.

With increased exposure to risk for PE/ VC investors due to the Directive, NBFCs and PE/ VC investors may need to renegotiate their Board representation rights. Given the significant investments made in the NBFC space over the years and its potential, the RBI may consider altering its regulatory regime to recognize an 'Observer', albeit with certain limited (as compared to a director) oversight and obligations.

About the authors: Abhishresth Goswami is a Principal Associate and Parth Bindal is an Associate at Tatva Legal, Hyderabad.

Disclaimer: The opinions expressed in this article are those of the author(s). The opinions presented do not necessarily reflect the views of Bar & Bench.

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