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Brief Counsel

Shadow directors: can a trade creditor be at risk?

12 July 2010

New Zealand’s courts have only very recently acknowledged that banks could be liable as shadow directors in the right circumstances - see our previous analysis of the Krtolica case here.  Now the New South Wales Supreme Court has considered whether the same liability could apply to creditors of distressed companies where they exert pressure to recover outstanding debts.1  

On the facts, no liability arose in the Australian case but the judgment once again highlights the risks taken by third parties who become involved in the affairs of their debtors. 

The case

Apple Computer Australia Ltd (Apple) supplied computer products to Buzzle Operations Pty Limited (Buzzle) on credit.  Buzzle became insolvent but continued to incur debts.  When Apple became aware of Buzzle’s financial difficulties, it instructed Buzzle to explore various rescue options, such as a demerger or further capitalisation. 

The liquidators claimed that Apple placed pressure on Buzzle’s directors to continue to trade, required Buzzle to engage Deloitte to develop computerised accounting systems, suggested that Buzzle prioritise those creditors who supplied essential goods and services to Buzzle or who might seek a winding up order, and required Buzzle to allow Apple to monitor creditor payments.

By the time liquidation proceedings commenced, further debts had been incurred, around half of which were owed to Apple.  Buzzle’s liquidators sought compensation from Apple and its financial director for debts incurred while Buzzle was insolvent.  They relied on legislation very similar to New Zealand’s to claim that Apple was a shadow director. 

New Zealand law

Section 126 (1)(b)(i) and (ii) of the New Zealand Companies Act provides that a “director” includes persons in accordance with whose directions and instructions an appointed director may be required or accustomed to act.  Once a shadow director, the relevant person incurs, in many circumstances, the same level of personal liability as a duly appointed director.

The decision

It will be a relief to banks and trade creditors that the Court disagreed with the liquidators and held that Apple had not acted as a shadow director.

The Court acknowledged that Apple frequently instructed Buzzle to act in certain ways, for example, requiring the appointment of accountants to conduct due diligence and to provide Apple with copies of those reports.  The Court also agreed that Apple took a proactive role in helping Buzzle explore third party investment and de-merger possibilities, and that it encouraged trade while these possibilities were explored. 

The Court found, however, that while Apple may have expected its instructions to be followed, its requirements were “part of a commercial negotiation at arm’s length” and did not amount to instructions as to how Buzzle’s directors ought to act in managing the company’s affairs generally.

Further, the Court concluded that no instruction or wish was given on which the directors collectively acted and that Buzzle’s board certainly had not become ‘accustomed’ to acting on Apple’s instructions or wishes.  There must be a causal connection between the instructions of a shadow director and the acts taken by the directors, requiring proof of “habitual compliance over a period of time”.  (Liability may be more easily imposed under New Zealand legislation, however, as Section 126 (1)(b)(i) of the New Zealand Companies Act states that it is sufficient if just one director is accustomed to act in accordance with a shadow director’s instructions.) 

The Court accepted that the superior bargaining power of a commercial supplier may commonly mean that purchasers are left feeling they have no choice but to comply with the requirements being imposed.  Yet even if performance of requirements is insisted upon, third party creditors are not usually to be treated as shadow directors. 

Insisting on terms attaching to commercial trade relationship is not akin to instructing directors on how to exercise their powers.  “Unless something more intrudes, the directors are free and would be expected to exercise their own judgement as to whether it is in the interests of the company to comply with the terms upon which the third party insists”.

Apple had obtained a written acknowledgement from Buzzle’s board confirming the directors understood and accepted that Apple did not intend to affect the decision making process of the company.  The Judge held that the letter demonstrated that “it must have been clear to Buzzle’s executives…that Apple was not purporting to give any direction to Buzzle’s directors with which the directors were expected to comply.”

The Court concluded that Apple’s conduct fell far short of a shadow director, confirming that the threshold is significant before a creditor will be regarded as acting as a shadow director. 

Implications for creditors

Despite the clarity of the decision in the circumstances of this case, this area of law is still vague in New Zealand and by its nature, is likely to remain so.  We therefore recommend that creditors and financiers should exercise a great degree of caution when becoming involved in the affairs of their debtors.

  • Like banks, they are entitled to exert significant pressure on troubled companies with an expectation that their demands will be met.  Commercial pressure will not automatically lead to liability as a shadow director.  Normally, the courts will take the view that directors must decide whether to take or leave the conditions imposed.

  • Creditors are entitled to act to protect their positions and to exert legitimate commercial pressure, provided they negotiate at arm’s length.

  • There is a line.  Intruding into the general affairs of the debtor company will at some point obstruct directors from exercising their own judgement.  When directors become accustomed to following the directions of a third party, that person will be liable as a shadow director.

  • Creditors should be aware of the potential for a director deliberately to set out to make a creditor a shadow director by stating an intention to exercise powers consistent with the creditors’ directions on the basis that preserving the forbearance of that creditor is essential to the company’s survival.

  • A written acknowledgement that the creditor is not involved with the corporate decision making of a financially distressed debtor may not immunize a creditor from shadow director claims, but it should act as reminder to debtors that they must ultimately make their own business decisions.  Obtaining such an acknowledgement is a prudent step.

Our thanks to Sam Vivian for writing this Brief Counsel.  For further information, please contact the lawyers featured.

Footnote

  1. Buzzle Operations Pty Ltd (In Liq) v Apple Computer Australia Ltd [2010] NSWSC 233 (30 March 2010)

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