Financiers at risk of liability as shadow directors

As the recession bites, financiers, and in particular their internal recovery teams, are likely to become more involved in the businesses of clients under pressure as they seek to mitigate their losses from insolvency.  As a financier’s involvement increases, so does the danger that it may become exposed to liability as a shadow director. 

This Brief Counsel explores the case law in New Zealand, Australia and the United Kingdom and attempts to draw some guidelines regarding what is permissible involvement by a lender in a customer’s affairs.  It is a vague area of legal interpretation and one where the courts have not always reached consistent decisions.

A timely reminder

The most recent New Zealand case dealing with the issue of shadow directors is Krtolica v Westpac Banking Corporation (9 January 2008, unreported, Auckland High Court, Stevens J). In that case, the Court considered the issue of shadow directorships and revisited the question of whether it is possible for a bank to be liable as a shadow director under the relevant provisions of the Companies Act 1993.  The Court recognised that liability as a shadow director has never been imposed on a bank in New Zealand and, indeed, decided that Westpac was not liable. 

However, the Court expressly accepted for the first time that such liability could arise where the right facts were present.  The Court did not provide a detailed analysis of the circumstances which might amount to shadow directorship but we think it opportune now to re-examine the principles set out in the case law of the United Kingdom and Australia where similar provisions apply.  

Who is a shadow director?

Sections 126(1)(b)(i) and (ii) of the Companies Act 1993 define shadow directors as persons in accordance with whose directions and instructions an appointed director or the board of a company may be required or is accustomed to act.

In Re Hydrodam (Corby) Limited [1994] 2 BCLC 180, the English Court of Appeal stated:

“A shadow director… does not purport or claim to be a director.  On the contrary, he claims not to be a director.  He lurks in the shadows, sheltering behind others who, he claims, are the only directors of the company to the exclusion of himself.  He is not held out as a director by the company.”

In its most classic form, shadow directorship embodies the role of the puppet-master who pulls the strings and controls the company’s appointed directors.  However, the concept has the potential to apply more widely to persons who provide financial assistance to the company and/or assistance with the management of the company (such as where an investigating accountant is engaged).

Common interventions when insolvency appears likely

Typical responses by financiers when a corporate customer shows signs of insolvency are to:

  • Investigate the customer’s circumstances. The financier will often involve its internal investigating or asset management team in assessing the solvency of the company and the likelihood of a turnaround. The customer may be required to provide current financial information and/or report regularly to the financier. The financier might also require valuations of the customer’s fixed assets or a business plan setting out the customer’s proposed survival strategy.
  • Appoint a monitoring agent. The financier will often require a representative (either an employee or an external business expert such as an investigating accountant) to attend board meetings or be deployed into the company for the purposes of monitoring and/or providing advice to the financier.
  • Require a change to existing security arrangements and/or
  • Provide advice. Such advice might relate to the format of the customer’s management team, staff levels, restructuring options, the possibility of selling assets or the ongoing trading of the business. 

Unfortunately there is no clear code of acceptable conduct in the legislation that a financier can follow to avoid liability as a shadow director.  However, we have been able to extract some principles from case law in an attempt to define what may and may not be permissible involvement in a customer’s business.

The case law: some observations

There is a reasonably significant body of case law from New Zealand, the United Kingdom and Australia dealing with shadow directorship.  From those cases, it appears that:

  • Lenders are entitled to protect their interests. The Courts have recognised that at least to some degree, a lender may impose conditions on the provision of ongoing finance. In Standard Chartered Bank of Australia v Antico (1995) 131 ALR 1, the New South Wales Supreme Court thought that imposing conditions as to the application of the funds, requiring increased disclosure of company affairs, requiring new security to be provided and requiring the sale of some existing assets were all permissible conditions that would not of themselves have led to liability as a shadow director. There has also been some judicial recognition that a financier may expect that its demands will be met (because a customer has no option if it wants its facility continued) without this necessarily being construed as taking the role of a shadow director. In the English case of In re PFTZM Limited [1995] BCC 280, the Court expressly noted that the efforts of the bank were directed to protecting its position and that the directors were left with a decision whether to take or leave the bank’s conditions.
  • Lenders should allow directors to maintain independent judgement to the fullest extent possible. In the Krtolica case, in finding that Westpac had not taken a directive or instructing role, the Court was influenced by the fact that the director continued to exercise independent judgement in all areas of the business. In particular, the Court noted that the director continued to approach potential investors, had rejected an offer for sale of the business and had negotiated lease and supply agreements.
  • “Effective control” of a customer is not permitted. It will be a question of degree whether the financier has imposed so many conditions as to be effectively controlling the customer. In the Antico case, various major strategic decisions were made by the financier. These included the financier delaying a takeover, making the decision to abandon a planned acquisition and requiring the sale of a related company.
  • Involvement has a cumulative effect. The imposition of conditions might not amount to control when each condition is viewed in isolation but may when too many conditions are imposed together.  This was expressly recognised in the English case of Re Tasbian Limited (No. 3) [1992] BCC 358.
  • Some types of involvement are more controversial than others. The Antico case established that where a financier makes major strategic decisions for a client, it may be deemed to be acting as a director. The Tasbian case also casts doubt on the appropriateness of financiers vetoing payments. In that case, the Court noted that the person concerned decided which creditors were paid and in which order such that he was able to control the company’s affairs. On the other hand, the financiers in the PFTZM decision were entitled to veto payments without being held to have been acting as shadow directors.
  • An interest in the company and an ability to appoint directors will not automatically lead to a finding of shadow directorship. In the Antico case, the financier held a 40 per cent shareholding in the company and had the power to appoint a substantial proportion of the board. The Court expressly recognised that these factors alone did not create a shadow directorship even though the shareholding led to a situation of control as there were no other significant shareholders.
  • The professional capacity exception will not always protect financiers. Section 126(4) provides that the majority of section 126 (including the shadow directorship provisions) will not apply to a person “to the extent that the person acts only in a professional capacity”. The Krtolica case did not consider whether this exception could apply to financiers. However, in the case of Fatupaito v Bates [2001] 3 NZLR 386, the Court rejected an argument by a business adviser who later wrongfully purported to become a receiver that the exception applied to protect his position. The Court noted that the director had handed over his powers upon “receivership” and held that upon his “appointment” the adviser assumed control of the company. This suggests that it is not the nature of the work being undertaken which is important, but whether the person is “only” acting as a professional, or conversely, has assumed duties and responsibilities which are normally expected to be undertaken by directors. In the case of Mistmorn Pty Ltd (in liquidation) v Yasseen (1996) 14 ACLC 1387 the Court thought the difference between a consultant to and a director of a company was that the former is engaged to perform specific functions whereas the latter is engaged in the affairs of the company generally. This exception has not been tested, and until such time as judicial clarity is available, we would recommend that it not be relied upon by banks as a get-out-of-jail-free card.


It is noteworthy that many of the cases discussed above were decided in the early to mid 1990s following the last global recession.  We expect that more cases will arise due to the present credit crunch.

As this continues to be a vague area of the law, we would recommend that banks tread carefully and, wherever possible, err on the side of caution when becoming involved in their customers’ affairs.

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Related topics: Restructuring & insolvency; Finance; Directors

Finance; Corporate & commercial; Restructuring & insolvency

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