Holding shadow directors responsible: A UK legislative perspective

October 1st, 2021
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Picture source: Gallo Images/Getty

The definition of a ‘shadow director’ as well as its constituent elements and its application within factual scenarios has been the subject of extensive commentary and the number of high-profile cases in South Africa (SA) has increased. The question of whether shadow directors owe fiduciary duties has troubled academics and the courts for some time.

Section 250 of the United Kingdom (UK) Companies Act 2006 states that a ‘“director” includes any person occupying the position of director, by whatever name called’. If someone acts in the role of a director and performs the functions usually performed by a director, they will be subject to the same fiduciary duties as any other director.

These duties include –

  • acting in good faith;
  • acting for a proper purpose; and
  • acting in the company’s best interests.

If a director fails to comply with these duties, they will have to account for the losses suffered by the company.

‘Whether someone is identified as a shadow director depends on the type of decisions they make and how often they are involved in the management of the company. Also relevant is the extent to which their instructions are automatically followed by the Board of the company and the scope of their influence’ (Prof Rehana Cassim ‘South African law is failing to make sure that “shadow directors” are held accountable’ www.unisa.ac.za, accessed 9-9-2021).

‘The law imposes duties on those who exercise power or control, which affects third parties. Shadow directors, however, have proved something of an anomaly. Until relatively recently a shadow director could exercise power and control over the affairs of a company, without having the same duties and responsibilities as de jure or de facto directors’ (Alison Ozanne and Gregory Tee ‘Shadow directors – power and influence bring responsibility’ http://aohall.com, accessed 9-9-2021).

‘Section 217 of the Constitution enjoins organs of state in the national, provincial, or local sphere of government to contract for goods or services in accordance with a system that is fair, equitable, transparent, competitive, and cost effective. This requires the state to take positive steps to ensure transparency of all public procurement processes, including through the investigation of allegations of corruption or improper conduct in procurement processes’ (Corruption Watch ‘Corruption and the law in South Africa – A Quick Reference Guide’ www.corruptionwatch.org.za, accessed 9-9-2021).

It is undeniable that ‘South Africa [SA] has become notorious for corruption in many of its state-owned entities’ (Prof Cassim (op cit)). A shadow director cannot carry out these acts themselves as they have to act behind the scenes as there is a reason that they cannot be appointed formally. For example, a body corporate will not usually be regarded as a shadow director because of its subsidiaries but a ‘dominant individual’ at the parent company could be. Advice given in a professional capacity (for example by legal practitioners or accountants) is not sufficient to make a person a shadow director, but banks seeking to protect loans made to a company or a ‘company doctor’ working on a corporate recovery plan could potentially be shadow directors.

A claim of misfeasance or breach of duty cannot be brought against a shadow director (but it can be brought against a de facto director) under s 212 of the Companies Act but a claim of wrongful trading can be brought against shadow directors, as well as de facto directors (UK Insolvency Act 1986). A shadow director can also be disqualified under the UK Company Directors Disqualification Act 1986.

The UK Small Business, Enterprise and Employment Act 2015 will ensure that shadow directors have legal duties (as set out in ss 170 to 177 of the Companies Act) on the same basis as individual directors.

Shadow directors are not ‘properly identified as directors, which means that they are able to escape legal responsibility for their influence and control. Due to conflicting authorities and no clear court ruling on this issue, it’s unclear whether shadow directors are governed by the Companies Act.

Holding shadow directors accountable for influencing and controlling directors of a board would deter bad behaviour and improve corporate governance. It would go some way to addressing the issue of corruption and the abuse of state-owned entities for personal gain’ (Prof Cassim (op cit)).

‘An intriguing aspect about how decisions [are] made revolves around the role of their [respective] boards, and in particular what influence “shadow directors” [have] over decisions. It may be arguable that some of those responsible for state capture are shadow directors’ (Prof Cassim (op cit)).

Academics and writers argue that ‘one potential upshot of holding shadow directors liable for the same duties as ordinary directors is that they would have to account for the losses suffered by a company due to a breach of their duties.

For example, if a shadow director influenced a state-owned entity to award certain contracts to companies associated with them, they could be held responsible for losses suffered by the company due to their breach of the duties to act in good faith, for a proper purpose and in the company’s best interests.

Another upshot is that shadow directors could be held accountable for losses suffered by the company as a result of being a part of fraud committed by the company when the shadow director knew that the act was fraudulent. Where fraud is committed by the company, under the Companies Act a criminal action can be brought against those responsible, resulting in a fine or imprisonment of up to [ten] years’ (Prof Cassim (op cit)).

In Standish and Others v The Royal Bank of Scotland PLC and Another [2019] EWHC 3116 (Ch) the High Court held that a bank that has been a shadow director of its customer will not be liable for breach of fiduciary duty unless the breach is linked to a specific instruction or direction given by the bank.

The claimants were shareholders in a company named Bowlplex Ltd (the Company), which owned and operated sixteen bowling sites across the UK. The Royal Bank of Scotland PLC (the Bank) provided the Company with banking facilities.

‘The Company was referred in June 2010 to the Bank’s Global Restructuring Group … , following the Company’s breach of its [banking] covenants. As a result, the Company was introduced to West Register Number 2 Ltd (West Register), an indirect wholly owned subsidiary of the Bank, and West Register’s employee, Mr Sondhi. Mr Sondhi indicated … that West Register was interested in acquiring 80% of the equity of the Company in exchange for securing the continued support of the Bank.

The Company was subsequently restructured on two occasions. Under the first restructuring, West Register acquired 35% of the Company and the Bank agreed to a restructuring of certain of the Company’s indebtedness. It was a condition of the first restructure that West Register would be permitted to appoint an observer to attend the Company’s board meeting and a non-executive chairman.

West Register subsequently appointed a chairman with a background as a turnaround consultant. The Company then implemented a company voluntary arrangement under which the Bank wrote off £ 4,5 million of indebtedness and West Register increased its equity holding to 60%. Shortly thereafter, the chairman sacked the Company’s managing director and former majority shareholder.

Ultimately, the Company was sold, and West Register was paid £ 13,6 million in respect of its shares’ (Herbert Smith Freehills ‘High Court upholds strike out of claim based on allegation a financial institution breached fiduciary duties as a shadow director of its customer’ https://hsfnotes.com, accessed 10-9-2021).

The claimants alleged that the Bank and West Register conspired to obtain the claimants’ equity in the Company using unlawful means. The unlawful means said to be at the root of this claim were put in various ways.  In particular, that West Register and/or Mr Sondhi breached the fiduciary duties to the Company that they had assumed as shadow directors. In effect that they were acting in their own best interests and not in the interest of the Company, contrary to ss 172(1) and 175(1) Companies Act 2006.

It was not suggested that the Bank or Mr Sondhi were de facto directors. ‘A de facto director is a person who assumes to act as a director. He is held out as a director by the company, and claims and purports to be a director’ (Sean Tan Yang Wei ‘The De Facto Director’ www.thomasphilip.com, accessed 10-9-2021).

These claims had failed before Chief Master Marsh at first instance. He held that the claim had no prospect of success, and the proceedings were struck out. The main difficulty for the claimants was that the decisions taken by the directors were taken of their own free will. The directors were not instructed to take specific steps as claimed, by West Register or Mr Sondhi.

The appeal

The claimants sought to further amend their particulars of claim to argue that as shadow directors, West Register and Mr Sondhi assumed all the duties of a de jure director. The basis of this claim was s 170(5) of the Companies Act, which reads: ‘The general duties apply to shadow directors where, and to the extent that, the corresponding common law rules or equitable principles so apply’.

That would include the duty to act in the best interests of the Company. For the purposes of the appeal, the court was prepared to assume that West Register and Mr Sondhi were shadow directors.

Mr Justice Trower referred to the decision of David Richards J in McKillen v Misland (Cyprus) Investments Limited [2012] EWHC 521 (Ch). That decision noted that the duties owed by shadow directors are limited in extent. This was further illustrated by the fact that the status of shadow directorship can be acquired or imposed where the relevant instructions do not extend over all (or even most) of the company’s activities or affairs.

This approach was well established in the insolvency context before the enactment of the Companies Act. Reference was made to Morritt LJ’s judgment in Secretary of State for Trade and Industry v Deverell [2001] Ch 340 where it was said that it is not necessary for the shadow director’s influence to be exercised over the whole field of its corporate activities.

That being so, ‘section 170 of the 2006 Act cannot be read as imposing the full range of fiduciary duties owed by a de jure director on somebody merely because they have acquired the status of a shadow director. Put another way, because the status of shadow directorship can be acquired through the giving of instructions that are limited to only some part of a company’s activities or affairs, there can be commensurable limitations on the nature and extent of the duties that they will thereby owe’ (Standish at para 55). As a result the appeal was dismissed.

Conclusion

I for one agree with fellow colleagues that South Africa ‘needs to take urgent action to end the uncertainty about whether or not shadow directors are governed by the Companies Act. This will require amending the definition of a “director” in the Companies Act so that it unambiguously recognises shadow directors’ (Prof Cassim (op cit)).

Sipho Tumelo Mdhluli LLB (University of Limpopo) is an LLM candidate at Unisa and is a legal practitioner at Lekhu Pilson Attorneys in Mbombela.

This article was first published in De Rebus in 2021 (Oct) DR 20.

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