Coming out from the shadows 04 October 2011 Although the new Companies Act is now five years

old, companies, their directors and their advisors are still getting to grips with the changes introduced. A shadow director is effectively a person who occupies the position of a director, regardless of whether he is officially named or identified as a director. The definition within the legislation is intended to be broad; and should not be strictly construed. The courts have historically considered that a person must exercise real influence over the companys affairs to satisfy the definition. There are clearly risks for senior members of management to be identified as shadow directors, but they are not the only people at risk of falling within the definition. In some circumstances, holding companies, major shareholders and even lenders may satisfy the relevant test. The Companies Act contains exceptions relating to professional advisors, but the exception can be lost if the individual goes too far in influencing the decisions of the company. There are numerous consequences for both the shadow director and the company in the event that a person is found to be a shadow director. In particular: 1. Shadow directors will have legal duties to the company. 2. A shadow director can be personally liable for the debts of the company in certain circumstances surrounding insolvency (such as wrongful and fraudulent trading) 3. Shadow directors can be subject to disqualification proceedings under the Directors Disqualification Act 1986. 4. Provisions within the Companies Act 2006 relating to declaration of interests and transactions with connected parties may apply to shadow directors. Bearing in mind the risks connected with being identified as a shadow director, companies are well advised to ensure that management structures are reviewed and documented to ensure that all individuals within the organisation are clear about reporting lines and how decisions are to be made. WHAT IS A SHADOW DIRECTOR? Under Section 250 of the Companies Act 2006 (2006 Act), a director includes any person occupying the position of director, regardless of whether he is officially named as one. The term director is seen as wider than simply including a person who has been validly appointed as a director and can also include de facto directors and shadow directors. A shadow director in relation to a company means a person in accordance with whose directions or instructions the directors of the company are accustomed to act (section 251(1), 2006 Act).

This definition is also followed in section 251 of the Insolvency Act 1986 (IA 1986) and section 22(5) of the Company Directors Disqualification Act 1986 (CDDA 1986). Guidance on the definition A recent case has given guidance on the definition based on CDDA 1986:

The definition of shadow director should not be strictly construed. The purpose of the legislation is to identify those, other than professional advisers, with real influence over an element of the companys business affairs. Evidence is needed to show that a communication was either a direction or instruction. Non-professional advice could fall within the definition. A person can still be a shadow director even though the board has not adopted a subservient role to him or has not surrendered its discretion. It is not necessary that a shadow director is someone who lurks in the shadows: a person can be a shadow director even if he is involved in the internal management of the company.

Other judicial consideration has concluded that:

In determining whether someone has become a shadow director, it is necessary to look at all the various matters as a whole. If only a minority of the companys board of directors are accustomed to act on a someones direction that is not enough to make the person a shadow director. The mere giving of instructions does not make someone a shadow director. It is only when they are translated into action by the board that the question can arise.

Who could be at risk of becoming a shadow director? To become a shadow director, a person must exercise a real influence over the companys affairs and direct the acts of the directors, such that the majority of the board act on those instructions, as a matter of practice, over a period of time. It is not a requirement that that person needs to have controlled all of the activities of the board. Those at risk of being shadow directors are:

A parent company that gives instructions to the directors of its subsidiaries, although in certain circumstances there is a specific exception under the 2006 Act. A shareholder in a joint venture company that gives instructions to the board of the joint venture company, or gives instructions to its nominated directors to direct the actions of the board of the joint venture company. An institutional or private equity investor who has a right under the investment agreement to appoint an observer or representative to a board. If the board acts on that observers or representatives instructions on a regular basis, there is a risk of him, or the investor, becoming a shadow director.

Risky actions Some examples of actions that could risk imposing shadow directorship include:

Imposing financial reporting requirements on the company, or taking control of the financial affairs of the company. Making, or substantially influencing, major strategic decisions of the company, or exercising any power of veto over the companys decisions. Negotiating with third parties on behalf of the rest of the board. Controlling the appointment of senior management of the company.

Ultimately, whether such actions can make a person liable as a shadow director will depend on the facts of each case. Exceptions There are certain exceptions to the definition of a shadow director, where circumstances may allow the person in question to fall outside of the scope of a shadow directorship.

Professional advisers, although this protection is lost if a professional adviser crosses the line so that he becomes the dominant influence on the directors. A parent company will not be considered to be a shadow director of any of its subsidiaries if it imposes a common policy that applies to all group companies without being in breach of its duties to the subsidiary. However, for the purposes of the CDDA 1986, there is no similar exception where the directors of a holding company who give directions to the directors of one or other of its subsidiaries can render themselves personally liable as shadow directors of the subsidiary.

Consequences Where a person is found to be a shadow director, there are various consequences that may arise under different statutes, which include the following:

Certain transactions involving the directors of a company that must be approved by the companys members also apply to a shadow director. A shadow director is required to declare the nature and extent of his interest in any transaction or arrangement that has been entered into by the company, in writing or generally. The general duties owed by directors in the 2006 Act apply to shadow directors where, and to the extent that, the corresponding common law rules or equitable principles apply. A member can bring a derivative claim against a shadow director for any act or omission involving negligence, default, breach of duty or breach of trust. A court can make a disqualification order against a shadow director. A liquidator can seek to bring an action against a shadow director of a company for fraud in anticipation of winding up, misconduct in course of winding up, material omissions from statements relating to companys affairs and false representation to creditors. In

addition, any director (including a shadow director) found liable of fraudulent or wrongful trading can be ordered to make such contribution to the companys assets as the court thinks proper. A shadow director is connected with the company. Certain transactions entered into by a company before the onset of insolvency proceedings can be challenged by a liquidator or administrator; for example, as a preference or a transaction at an undervalue. Where the transaction is with a connected party, the period within which such a challenge can be brought may be lengthened, or the burden of proof may be reversed, depending on the nature of the challenge brought. A shadow director is subject to the provisions of the Financial Services and Markets Act 2000 that apply to directors

Lenders: minimising the risks of shadow directorship To minimise the risk of a lender inadvertently becoming a shadow director and incurring the liabilities and duties associated with being a shadow director, it should:

Generally avoid giving directions or instructions to the board or any other action that could be construed as limiting the discretion of the board (for example, requiring the right to approve or veto the appointment of new board or management members). Present any conditions of continued support as contractual terms of credit that the company can then consider whether or not to accept. Make it clear to the board that any conditions on which the lender will agree to continue to support the company are conditions of that continued support and are relevant to the lenders position as lender only (and not as another stakeholder). It is then up to the board to consider whether it wishes to accept those conditions. If possible, suggest that the board should consider the lenders conditions and requirements with professional advisers and then respond formally to the lender. If attending board meetings, ensure that it is present as an observer, is not drawn into any discussions with the board during the meeting, and leaves before any decisions are taken. Never sign a document on behalf of the company or become a signatory to its bank account. Likewise, a lender should not negotiate on behalf of the company or hold itself out as acting for the company. In cases where it is likely to be heavily involved (for example, as agent, sole lender or coordinator) with the companys affairs, consider at the beginning of the process writing to the company, stating that the lender will be acting in its own interests, will not direct and should not be viewed as directing the company, and that all decisions and day-to-day management of the business remain with the board.

Who Is A Shadow Director? Section 251 of the UK Companies Act 2006 and Section 27 of the Irish Companies Act 1990 define a shadow director as a person in accordance with whose directions or instructions the directors of the company are accustomed to act.

Subsequent caselaw in both jurisdictions has expanded upon this definition, indicating that a corporate body can also be classified as a shadow director. Cases in which this issue has arisen include the UK case of In re PFTZM Limited [1995] BCC 280 and the Irish case of Worldport (Irl) Ltd (In Liquidation) and in the Matter of the Cos Acts 1963 - 2001 [2008] IESC 68 (2008). This approach is particularly interesting in Ireland where corporate company directors are prohibited. A shadow director is therefore a person or corporate body which, although not officially appointed to the Board of Directors, controls or influences the management of the Company. Those giving instructions or advice in a professional capacity however, as an accountant or as a lawyer for instance, are not deemed to be shadow directors as their advice tends to be limited to a particular aspect of the business. In contrast, in order to be considered a shadow director, the individual or corporate body must have the power to control a majority of the Board, or the Board in its entirety, over a period of time. Duties & Obligations Of Shadow Directors A shadow director is subject to the same duties and obligations as duly appointed directors of the Board. Interestingly, many shadow directorships are only discovered after a problem is identified, for instance, where the Company has entered into a substantial property transaction with the shadow director and the relevant shareholder approval was not obtained, or where the shadow director finds himself facing civil or criminal liability following a claim by the Office of the Director of Corporate Enforcement in Ireland that his actions amount to reckless or fraudulent trading. Companies, and those offering advice to Companies, must therefore be vigilant in identifying shadow directorships and ensuring that the relevant legal requirements are met. A shadow director will not be released from their duties and obligations simply because the shadow director, or their Company, was unaware of the existence of the shadow directorship. Conclusion Lack of formal appointment as a director will not necessarily prevent the courts in the UK and Ireland from concluding that a shadow directorship is in fact in existence. Significant legal duties and obligations are attributed to shadow directors with serious consequences arising when breaches occur. Companies and individuals must therefore be wary of inadvertently, or otherwise, assuming the role of shadow director and becoming subject to the related Company law requirements, as ignorance of the relevant legal principles will not be accepted as a defence if breaches occur.