Use a light touch when directing

Shadow directors can carry significant weight within a company. Professional advisers, such as lawyers and accountants, are protected under statute but, says James Walton, lenders are not so fortunate The economic downturn has put pressure on companies to balance their books and meet any existing obligations owed to their creditors a major class of whom are lenders. That pressure has forced many lenders to make decisions or offer advice to their borrower clients that could be seen as influencing a company in such a way that the lender could be construed as being a “shadow director”. What is a shadow director? A shadow director was described by Millett J in Re Hydrodam (Corby) Ltd (in liquidation) [1994] 2 BCLC 180 as one who “lurks in the shadows, sheltering behind others who, he claims, are the only directors of the company to the exclusion of himself”. Who constitutes a shadow director is governed by statute, namely: section 251(1) of the Companies Act 2006; section 251 of the Insolvency Act 1986; and section 22(5) of the Company Directors Disqualification Act 1986. In essence, a shadow director is a person outside of a company who gives instructions to the directors of that company and in accordance with whose directions or instructions the directors are accustomed to act. A person is not deemed to be a shadow director if he is acting in a “professional capacity”. This exception is one of policy. It is aimed at protecting legal professionals and accountants who regularly advise companies, which then act on that advice. It is not so clear-cut for lenders, which, particularly with regard to insolvency situations where they may have a substantial interest, could be deemed as not acting in a professional capacity. Given the economic climate, most if not all lenders now have greater involvement in the business affairs of their borrowers than they had over the past few years. Not only are lenders seeking to protect their interests by advising on the strategic direction of struggling borrowers but, in an attempt either to keep their lenders on-side or to secure additional funding, borrowers are increasingly requiring their lenders to become involved in the company’s affairs. In either case, it is likely that the lender will have proffered advice that it could later be argued the directors had little choice but to act on; thereby potentially allowing a third party, perhaps another creditor, to point to the lender as a shadow director. The consequences of a lender being held to be a shadow director are wide-ranging and onerous. Once it is shown that a person has been acting as a shadow director, he will owe the company certain duties and could incur liability for breach of these. The duties are based on common law and equitable principles, which to some extent have been codified by the 2006 Act. Such duties include declaring an interest in a transaction and avoiding a conflict of interest. Perhaps of greater concern, wrongful trading under section 214 of the 1986 Act can give rise to civil liability for a shadow director. Under the section, where a director knew or ought to have concluded that there was no reasonable prospect of the company avoiding insolvent liquidation, that director is under a duty to ensure that he takes every possible step to minimise the potential loss to the company’s creditors. If the court finds that the director did not do so, the court can order him to contribute to the company’s assets. This is worrying for lenders. On the one hand, they will want to ensure the economic survival of their borrowers but, on the other, they will not want their actions to put them in a position whereby they will be unexpectedly liable for the debts of borrowers. Staying out of the shadows On a strict interpretation of the relevant statutes, it is easy to see how a lender could be designated a shadow director. Although this fear is justified, all is not lost. Where the question of the statutory definition of a shadow director has come before the courts, a wider interpretation has been taken. In Ultraframe (UK) Ltd v Fielding [2005] EWHC 1638 (Ch); [2007] WTLR 835, the High Court considered how the existence of a shadow director should be determined. It stated that a person at whose direction a “governing majority of the board” is “accustomed” to act is capable of being a shadow director; a person is unlikely to fall within the definition of a shadow director if only one or two directors on a board of several directors follow his instructions. To fall within the definition, therefore, a high degree of involvement is required. Further, the directors must “do something in conformity with” those instructions. In other words, those instructions must be translated into action by the board as a matter of regular practice in order for the person issuing such instructions to be considered a shadow director. Crucially for lenders, the court stated that in cases where the alleged shadow director was also a creditor of the company, he will be entitled to protect his interest as a creditor without necessarily becoming a shadow director. Lewison J went on to confirm that a lender is entitled to keep a close eye on what is being done with its money and to impose conditions on its support for a company without this meaning that the lender is running the company or is emasculating the powers of the directors. This applies even if (given their situation) the directors feel that they have little practical choice but to accede to the lender’s requests. Avoiding unexpected liabilities It is clearly within a lender’s interest not to be construed as a shadow director, thus avoiding the onerous duties and obligations that such a position entails. However, following the valuable guidance expounded in Ultraframe, lenders should not be deterred from becoming involved in the affairs of its borrowers, particularly where the lender is seeking to protect its own interests. That said, care is required; where possible, lenders should avoid continually instructing their borrowers to carry out certain acts and they should make it clear in all dealings with their borrowers that, ultimately, any decisions taken by that borrower lie with the board of directors. By exercising such caution, lenders should be able to avoid any unexpected liabilities. James Walton is a partner at Rosling King LLP