“Shadow” or ex-officio director roles are often  established between institutional investors and their investee companies, whether intentional or unintentional,  with these roles having the same fiduciary responsibilities as actual directors.  We explain how these roles are sometimes established and the implications for both investors and investee companies.

In a series of blogs in 2022 around the impact of boards on (private company) unicorn success, we looked at directors and whether being an “invested” but non-executive director was important in this incredible growth of the unlisted market. My thesis was that PE investors, through their directors, play a large role in the strategy of these companies. The ex-head of Private Equity at a large South African institution was discussing this story with me and had a rather different take on the responsibilities of these directors. He had in fact written a paper on the subject for a law course that he was taking at the time; so thank you Dave Stadler for the material!

This scenario is most likely to happen with institutional investors such as Venture Capital (VC), Private Equity (PE) or even corporate investors, who appoint one or more nominee directors to represent the institution’s investment on the board of their investee company.

For example, if the Head of Private Equity in an institution can and does appoint the nominee directors, any directors appointed by this Head could potentially be regarded as “puppet” directors, depending on the level of influence the Head has on the directors, possibly making  the head a de facto director.

Clearly the company strategies would be not only discussed internally within the PE team, but also sometimes instructed by the Head via the appointed board members. One presumes that the Head could also attend board meetings, making their presence even more notable.

In our world, technopreneurs often see the institutional investors as key to decision making, given not only the money invested but also their professed expertise in value creation. Therefore it is not uncommon that the influence of the broader PE team is higher than merely having one or more board members appointed.

Appointing board observers is a common practice when there are multiple VC investors in an early stage or growth company. It goes without saying that board observers would also be regarded as shadow directors, due to their influence at Boards even if they do not have voting power as a director. Again, if they represent an institution such as a VC, there may be other people within the VC, such as a Partner, who could also be regarded as an ex-officio/shadow director, depending on their level of influence.

So what are the implications of being seen as a shadow director?

It  means that shadow directors have the same fiduciary duty to the company as actual directors. In simple terms, if you are going to have influence on a company as if you are a director, you have to take on the fiduciary duty to the company as if you are a director.

The directors of a company have a fiduciary duty to the company in acting in their role as a director and in performing their functions in relation to the company. The fiduciary relationship requires directors to act in good faith towards the company, to exercise their powers for the benefit of the company and to avoid conflict between their own interests and those of the company.

There may be personal liability should a director not carry out their fiduciary duty, not act in the best interests of the company nor act with the appropriate degree of care, skill and diligence.

Going back to our example of the Head of Private Equity,  “leveraging its portfolio of investments”, for instance, by changing one or more strategies only slightly to take advantage of portfolio synergies, needs to also be in the best interests of the investee company.

Senior management as “officers” of the company also have the obligation to act in the interests of the company and NOT the shareholders. For instance, some investors may insist on having the right to appoint the Chief Strategy Officer (CSO). That is fine, but if that investor’s director or shadow director tries to influence the CSO to act in alignment with the investor’s goals, it  also needs to be in the best interests of the investee company.

Strategic/corporate investors invariably have an agenda when making an investment, and therefore alignment between shareholder and investee interests can often be tricky. One may need to look carefully at the chain of command within the corporate investor to find the shadow director(s), to ensure that they are acting with fiduciary duty to the investee company.

One can also think of a corporate group as an investor in a subsidiary,  where the same concept would apply, according to C. Stein & G Everingham: The New Companies Act Unlocked:

“A director owes no duty to any concept called ‘group’. Accordingly, a director of a subsidiary company may not be compelled by its holding company to perform his duties in the interests of the group. The director must apply himself to the best interests of such subsidiary alone and cannot be compelled to compromise that fiduciary relationship by the parent alone”.

It is quite normal to have roles within institutional investor organisations that  have an influence on the strategy of the investee company. People in these roles need to remember their fiduciary duty to the investee company as  shadow directors, and not act in the narrow interests of the investor. The technopreneur would be well served to be aware of these shadow directors and their influences.