De facto directors
The role of the Chief Executive Officer (or CEO) is universally understood as the pinnacle of a company’s decision-making power. It’s the CEO’s job to lead the company in the realisation of its vision in line with its business plan and to achieve its commercial, financial and other objectives.
The role requires the individual to lead the entire organisation by being visible and setting an example for all its employees while simultaneously selecting and working with those individuals that will lead across the key verticals of an organisation’s mission, such as:
strategy
finance
talent
product
sales
operations
The CEO is the top ‘chief’ who leads the management team and each of their direct reports at the top of each of these verticals will be a ‘chief’ of their respective vertical.
As a company progresses through the mid to later stages of its life cycle, some of the authority to make critical decisions for a company will come to rest in the hands of a few individuals; the board of directors.
Any founder who has gone through a funding round knows the emphasis placed on directorship appointment rights and board composition. Which individuals will form the board of directors is a critical question facing any founder, or group of founders, looking to source capital from third parties. Investors often require the right to appoint an individual to a company’s board as a pre-requisite before making any investment. What we observe, in advising many of our clients, is that there’s often a misalignment over what the different stakeholders consider the role of board members to be.
In the mind of the investor, the role of the board representative is to ensure the person appointing them has sufficient oversight of a company’s actions and also the right to prevent any act of the company which may directly and adversely impact the value of their investment. From the perspective of the company’s senior management team, the function of the board is to bring management wisdom and experience into the company’s governance and, above all, to add value to the company through their contribution.
Ultimately, the way a board functions is influenced by the maturity, experience, credibility, authority and personality of the CEO and other members of the C-suite. In the start-up world, the C-suite (including the CEO) is often viewed by more senior board members in a paternalistic way, requiring hand holding, mentoring and active guidance. In several cases we’ve seen, a founder may factually lack the experience, maturity and confidence to steward the company through its most intense challenges but may simultaneously be so confident as to treat their board as an inconvenient sounding board.
In all cases however, and especially in the start-up world, the phenomenon of boards that take an active role in management is not uncommon. Board members have determinative rights (such as veto rights in relation to board reserved matters) and will use these to keep a management team in check.
Often, an investor’s appointed board representative will act to further the interests of their appointor (the investor) while acting in their capacity as a director. This can lead to decisions which are not necessarily in the interests of the company as a whole and, for this reason, common law jurisdictions (such as the Abu Dhabi Global Market (ADGM), Dubai International Financial Centre (DIFC), British Virgin Islands, Cayman Islands, and Delaware) will impose fiduciary duties on all company directors.
Fiduciary duties could easily merit their own article, and many a real-life corporate drama has turned on adherence to them or lack of it. The general idea is that fiduciary duties oblige directors to ensure that any acts they take, in their capacity as directors, on behalf of the company are, as far as they are aware with the information available at the time, in the best interests of the company.
Failure to comply with these duties can result in directors:
being held personally liable for their actions
having all their decisions being brough into question
facing a host of other consequences.
Such consequences often not only irreparably damage the company but could result in significant fines, or even criminal liability, against the breaching director. In fact, investors have at times balked at the idea of appointing a director because of the significant liability they incur and the high risk of conflict where the interests of their LPs and company diverge.
You don’t need a formal title to be considered a director. If you’re heavily involved in management decisions, you could still be legally treated as one, bringing with it the same fiduciary responsibilities and potential liabilities.
Who qualifies as a director?
This then begs the question, who qualifies as a director? Naturally, if you are formally appointed as a director, there is no debate. However, in 2024, stewarding a company rarely happens at your quarterly board meeting. It happens in a WhatsApp group, over a coffee, on your morning run, or wherever else inspiration may strike.
Moreover, that WhatsApp group usually comprises not only the directors, but the major investors, professional advisers, colleagues, and others. If a fundamental decision for the company is made over a WhatsApp conversation, would each of the members of that WhatsApp group qualify as a director? And subsequently, would they all be obliged to comply with fiduciary duties and potentially exposed to personal liability? As an investor, for example, your interests may directly conflict with the interests of the company, particularly where there’s a risk of the company going insolvent.
As an investor, you may be more interested in extracting as much of your money from the company as possible when the best possible solution for the company would be for you to invest more. In such a circumstance, even if you aren't actually appointed to the board or formally represent the interests of the company, could the courts consider you a director, putting you in breach of the fiduciary duties owed to the company?
Unfortunately, the answer is ‘maybe’. Common law principles have established that there’s no single test to determine whether someone would qualify as what the courts have labelled a de facto or a shadow director, a director by fact rather than purely by law.
Courts will look at the circumstances as a whole and decide on a case-by-case basis. Narrowing the outcomes of various cases, courts will look at whether the relevant person was part of the corporate governance system of the company and whether he or she assumed the status and function of a director. They will focus on the key strategic decisions of the company and the relevant individual’s role in making them.
With that said, it's never cut and dry. Very early-stage companies will often not have any coherent system of corporate governance, or the corporate structure operates with a high degree of informality. Even in such circumstances, some courts have still taken a view of the existence of de facto directors as the individual being ‘one of the nerve centres from which the activities of the company radiated’.
Essentially, even if you aren’t a formally appointed director, but still take part in the management of a company on equal footing as the directors, you may still be deemed a director in the eyes of the law. Moreover, if for example you are an investor who, concerned about potential conflict of interest or liability issues, decided to appoint an observer, rather than a director, to the board of your portfolio company, you too are not quite out of the woods yet.
As an observer, if the directors become accustomed to acting in accordance with your directions as an investor, even if you are not a formally appointed director, you could also be treated as a director where your influence resulted in the company acting against its own interests. Even if you aren't in the WhatsApp group but hold enough influence that the directors regularly act on your instruction, then you could be obliged to comply with the company's fiduciary duties.
Conclusion
Generally, it’s recognised that founders and directors will source skilled opinions which inform and guide their decisions, but in doing so it should be clear that such opinions remain advice for the benefit of the director who ultimately makes the call. If there’s ever concern that an individual may be overstepping their role, or equally that a director is relying heavily on the advice of a single, or group, of non-directors, there are precautionary steps which can be taken.
Clarifying that any views expressed are in the capacity as a shareholder, a lender, or an investor, with a view of protecting those interests or making it clear that any commentary provided on a given matter is purely for the directors to consider and not intended as instructions, could go a long way in establishing the appropriate boundaries in what is otherwise a very subjective and varying area of legal interpretation.