Shadow and de facto directors - a reminder of the risks

Recent media coverage has focussed attention on the duties and responsibilities of company directors and their liabilities to the company, its shareholders, employees and creditors. But despite some high-profile corporate collapses, less has been written about the risks assumed by those who are not appointed as board directors but who involve themselves in directing the company's activities in such a way that they may find themselves treated by the law as if they were directors.

Such persons (who may be individuals or companies) are known as "shadow" and "de facto" directors. Although both are types of person who exercise influence over a company without being validly appointed as directors, the categories are separate and in most cases mutually exclusive. But generally speaking, both are treated by law exactly the same as normal directors. So, for example, they may be personally liable for breaches of duty to the company, for wrongful trading, or for the company's failure to comply with certain legislation.

What liabilities are imposed on shadow or de facto directors?

With a few exceptions, all the provisions of the Companies Act 1985 (the Act) and the Insolvency Act 1986 which relate to directors apply equally to shadow and de facto directors. They are also subject to the common law duties of directors to exercise due skill and care, and to fiduciary duties such as the duty to act in the company's best interests, to avoid conflicts of interest and not to make secret profits. Shadow and de facto directors can also be disqualified as directors.

In practice, individuals or companies are only likely to find themselves named by the courts as shadow or de facto directors where either (unusually) a minority shareholder is able to bring proceedings on behalf of the company or the company is investigated by the DTI or (more commonly) where a company has gone into insolvent liquidation, and the liquidator is seeking to recover funds for the creditors from those connected with it. At this point, the shadow or de facto director may find himself faced with a claim for wrongful trading (i.e. failing to take every step with a view to minimising the potential loss to creditors when he knew or ought to have known there was no reasonable prospect that it would avoid an insolvent liquidation), misfeasance or breach of duty to the company and/or other claims designed to force him personally to contribute to the company's assets or to compensate creditors. Some such claims may involve criminal sanctions.

Persons found to be shadow or de facto directors will almost certainly be in breach of sections of the Act, since they will not have complied with the necessary formalities or made the appropriate disclosures. For example, if a company has made a loan to someone who is later held to be a shadow director, the company will have breached section 330. As a result, the loan will be voidable by the company and the borrower will be liable to account to the company for any gain made and to indemnify it for any loss or damage suffered. For good measure, a person found to be a director could also be fined for breaches of the Act.

Who are shadow directors?

A shadow director is defined in law as being a person "in accordance with whose directions or instructions the directors of the company are accustomed to act." A shadow director may be an individual or a company, and could include a holding company or creditor. But a person is not to be treated as a shadow director where the directors act on advice given by him merely in a professional capacity.

There have been few cases where the nature of a shadow director have been considered, but in Secretary of State for Trade and Industry v Deverell & Another [2000] 2 All ER 365 the Court of Appeal stated clearly that the statutory definition should not be strictly construed, since the purpose of the legislation is to identify, and hold liable, those with real influence over a company's affairs, especially where they have failed to stop the company going into insolvent liquidation.

Traditionally it was thought that at least a majority of the Board must be "controlled" by the shadow director, but recent cases have suggested that this may not always be necessary (see the points below). In the Company Law White Paper it is proposed that controlling "one or more" directors should be enough.

It is usually thought that the phrase "accustomed to act" requires that the board must have followed the instructions of the shadow director on more than one occasion. However, it is not always safe to assume this: a court might consider that a decision taken on a single occasion was so material to the company's affairs that the instructing party should be deemed a shadow director.

In many instances the critical question will be whether something communicated by the alleged shadow director was in the nature of a direction or instruction to the directors, rather than, for example, a mere recommendation or advice. This is a question which will be objectively ascertained by the court in light of all the facts. Therefore, simply labelling a communication as "advice" will not be effective if the circumstances indicate that the board were in fact compelled to follow it.

It is not necessary to show that all of the company's corporate activities are "controlled" by the shadow director, or that the board has cast itself in a subservient role to the shadow director, surrendered all its discretion, or become the shadow director's "puppet". Nor is it necessary to show that any particular directions or instructions actually compelled the board to do anything: it is enough that the board is accustomed to act in accordance with them.

The alleged shadow director need not actually be "shadowy" or have a "Svengali or Rasputin" image - his presence could be openly acknowledged. In most cases, however, in contrast with a de facto director, the shadow director claims not to be a director, and is not held out by the company as one.

Where might a shadow directorship be found and how can it be avoided?

Holding companies - where the board of a subsidiary is accustomed to act in accordance with instructions of its holding company, the latter will be treated as a shadow director of the subsidiary for most purposes. This will not be the case if the holding company simply determines the business policy of the subsidiary. If more than the subsidiary's business policy is controlled, the directors of the holding company are not themselves deemed to be shadow directors of the subsidiary, and therefore personally liable, unless such directors give individual or personal instructions to the board of the subsidiary. A holding company director should therefore ensure that all instructions given to a subsidiary have been approved by the whole board, and that he acts as a mere conduit or representative of the holding company in handing them down.

However, if a holding company is treated as a shadow director of a subsidiary, it will not be regarded as a director for certain purposes, including the requirement to obtain shareholder approval for substantial property transactions and the prohibition on loans to directors.

Bank/Lender – There is a risk that where a company in financial difficulties has to follow the dictates of its bank, the bank may be deemed to be a shadow director. There is authority that a bank in this situation does not become a shadow director as long as the nature of the Bank's influence is limited to restrictions or conditions necessary for the bank to continue making facilities available, and the company is able to choose whether or not to comply with such restrictions. However, the more "hands-on" a bank's involvement (including by way of contractual rights and undertakings), the greater the risk of the bank being deemed to be a shadow director. In view of this, banks should be particularly careful in appointing nominee directors to the company's board if their nominees may be in a position to dominate the board's decision-making.

Private Equity Investors – Typically, private equity investors take an active interest in the performance of their investments. Usually, they appoint an "investor director" to monitor and advise the investee company. Where a company has funding from a private equity investor that has not appointed anyone actually to sit on the board, the investor may be deemed a shadow director if the board acts in accordance with its directions.

Advisers/Company doctors/Interim managers – Though the Act provides that a person is not to be treated as a shadow director where the directors act on advice given by him merely in a professional capacity, the courts have held that where advice is not given in a professional capacity (or goes beyond advice given in a professional capacity) and this has the effect of a direction or instruction upon which the board acts, such an adviser may be found to be a shadow director. Professional advisers should therefore ensure that all communication is clearly provided on the basis of mere advice or recommendations to the company, and that the choice of action is left to the client.

Who are de facto directors?

There are two categories of de facto directors. The first is those who have agreed to become a director but for some reason (eg a failure to satisfy a share qualification requirement in the Company's articles) their appointment is defective. The Act provides that the actions of such a "director" are valid notwithstanding any defect in their appointment (although the company and shareholders may have the right to stop them acting as a director).

The second category is of persons who are held out as directors by the company and who carry out actions which may, or should, only be carried out by a board director, not by lower management. This is essentially a question of fact, although the courts have identified factors that may indicate that someone is acting as a director:

• the person is referred to as a director or partner in dealings with third parties;
• there are no other validly appointed directors;
• the person was solely in charge of the company's trading, or responsible for starting and managing the business; and/or
• the actions of the person could not be ascribed to a different role, for example that of a sales manager, lower management or consultant.

Where might a de facto directorship be found and how can it be avoided?

Business or divisional managers – such managers may attend board meetings and/or meetings with funders, customers or suppliers as if they were directors, and may even use the title "director" in correspondence. In order to avoid the risk of being deemed a de facto director, such a person should not, in the first place, act like a full board director, either internally or in dealings with third parties. Furthermore, the extent of their authority should be clearly defined in writing and adhered to, and all third parties should be made aware of the scope of such manager's authority and that he is not a board director.

Managers of subsidiaries – where a subsidiary company's only directors are head office nominees, and the business of the subsidiary is managed on a day to day basis by a manager or other senior employee, in order to reduce the risk of the manager being deemed a "de facto" director, the scope of their authority should again be made clear to all parties. The holding company should also bear in mind that if the only board directors of the subsidiary are holding company nominees who follow the holding company's instructions, there is a significant risk of the holding company being deemed a shadow director of the subsidiary.

Company doctors or interim managers – if they become involved in the company's decision-making process, carry out management actions or deal with third parties on behalf of the company, they are likely to find themselves treated by the Courts as de facto directors.

Previous directors – the courts have found that where a director has resigned from his position on the board of a company but still in fact retains control over the company's affairs after his resignation, and continues to be held out by the company as a director, such person is treated as a current director. Where a director wishes to resign while remaining active in the company's affairs, he may do so as a consultant or adviser, although he must restrict himself to giving advice that the company is free to accept or reject. Should he remain in control of management decisions, the courts may see him as a de facto director.

Conclusions

Whether a person is at risk of being a shadow or de facto director is, ultimately, a question of fact. While the above factors can be identified from previous cases, those involved with a company, whether as manager, creditor or adviser, should note that the courts will take a purposive approach, and will seek to identify and hold liable those persons with "real influence" in the management of the company.

Companies should check whether the terms of any directors' and officers' liability insurance that they have in place (in the company's name) would cover liability imposed on any de facto or shadow directors.

Those persons managing a company other than as directors should make sure that the scope of their role is clearly defined and adhered to and, where possible, they should avoid taking decisions that would usually only be taken by board directors.

Banks and creditors should ensure that conditions and restrictions relating to credit do not cross the line into actually becoming positive directions to the company's board that the company has no option but to comply with. Advisers should also ensure professional advice is only given in the form of recommendations, and that they do not get too involved in the decision-making process.

For further information, please contact Niall McAlister at niall.mcalister@cms-cmck.com or on +44 (0)20 7367 2694 or Dipesh Santilale at dipesh.santilale@cms-cmck.com or on +44 (0)20 7367 2726.