Board Observers, keeping an eye on board direction

Rose Edwards, 29 September 2016

An observer – not a real outsider, nor a complete insider, but possibly a great asset to good corporate governance

Why have an observer?

In a recent blog on board composition Gudrun Timm said that a properly workable board should fit around the average kitchen table. That being the case, it is clear that a company should set an upper limit of board member numbers and stick to it. So what happens when a new investor, taking a minority shareholding in the company, wants some board representation and finds the board is already full? One possible option, which could be of benefit to the investor and investee company alike, is a board observer position.

What exactly is an observer?

A board observer’s role is defined by the fact that when it comes to board decisions she or he has no voting rights. Beyond this central tenet everything about the observer’s role can be can be laid down in the company’s own rules and tailored in an agreement with the observer and the body they represent. A carefully drafted confidentiality agreement will protect the company but also ensure that the observer is not prevented from sharing information with the investor.

Advantages for the minority investor

The voting rights of board directors also come with fiduciary duties and potential liabilities, responsibilities with which the board observer is not burdened. For this reason an investor might choose a board observer position even if given the option of a company directorship. This can be particularly true at the outset, especially if the representative is a relatively inexperienced investment manager. The observer can then report back on the running of the company, and in time, with positive reports, the investor may decide to take more equity and with this be offered and accept a full board seat. On the other hand an observer might detect and highlight problems within the board. So for the investor this can be gain without the pain, but for the company this can also work well.

Advantages for the company

From the company’s point of view an observer can be a way to prove to an investor that they are doing things right and attract more investment. Moreover, anything or anyone that causes a company board to keep a tighter rein on good corporate governance has got to be a good thing. Even with the best of intentions a board can acquire bad habits or inadvertently fail to keep abreast of proper risk management and correct procedure. A board observer can be an extra layer of vigilance whose outside knowledge might guide the board back to safer ground. Even the mere presence of an observer could be enough to make the board think twice before falling into the traps of poor corporate governance.

So beyond the benefits that a board observer can bring as a source of information/advice and point of contact, you could look at an observer as a sort of smoke alarm for corporate governance, one which might prevent a fire and save everyone from damaging consequences. As with all alarms, you may never need it, but reassuring to know that it is there.