Lenders and other third parties as shadow directors or officers - law clarified and explained

Practical Law UK Legal Update 6-502-2131 (Approx. 7 pages)

Lenders and other third parties as shadow directors or officers - law clarified and explained

by Michael Hughes, Minter Ellison

Background

In 2000, the owners of the top seven Apple resellers hatched a plan to merge their businesses and float the rolled up enterprise on the Stock Exchange. This needed Apple's support. Each of them had acquired stock from Apple on credit, which held a fixed and floating change over the assets of each business, and directors' guarantees. This stock had to be acquired by the new entity, which was incorporated for this purpose in July 2000, under the name Buzzle Operations Pty Ltd (Buzzle). Buzzle would need its own reseller agreement and, for the float to succeed, Apple would need to give up the right to terminate that agreement on the previously prevailing 30 days' notice. Apple consented to the merger, and granted a reseller agreement to Buzzle. The merger took effect on 13 and 14 September 2000. Buzzle granted a fixed and floating charge to Apple.

There is no doubt that Apple's employee – who was sued as well – was closely involved. At one point the employee had his own office at Buzzle's premises (paragraph [305]) and required one reseller take over the business of another before Apple would support the plan; but he was not involved in the plan's formulation which was only presented after agreement between the resellers and it was found that at all times, he was acting to protect Apple's interests.

Unfortunately the merged venture did not perform well. The new single management information system did not materialise, and the float did not proceed. In February 2001 Apple appointed investigating accountants. On 31 March 2001, they were appointed as receivers and managers. In another action, Apple successfully sued the directors under the personal guarantees it was given along with the charge.

The liquidators' case

The liquidator launched the action alleging that because of Apple's involvement, Apple was an "officer" of Buzzle, or "a person associated, in relation to the creation of the charge" with such a person, and so the charge could not have been enforced for a period of six months (section 267(1), Corporations Act 2001 (Cth)).

It was alleged that the charge was enforced when the investigating accountants were appointed. Claims were brought against the receivers for trespass and conversion. Secondly, the liquidator claimed that as Buzzle was insolvent from January 2001, Apple and its employee had become "shadow directors" of Buzzle, and so should be held liable for the debts incurred from that time – including those to Apple (section 588G). There were separate claims that some transactions and payments made to Apple should be set aside as uncommercial transactions and unfair preferences.

All the liquidators' claims failed.

Officers and directors – statutory definitions

A primary focus of the case was the meaning of "officer" and "director" as set out in section 9. The "officer" definition has two limbs; it is either a person who:

"(i) makes or participates in making decisions that affect the whole or a substantial part, of the business of the corporation, or (ii) ... has the capacity to affect significantly the corporation's financial standing".

A "director" is defined to include a person in accordance with whose "instructions or wishes", the directors "are accustomed to act". While not defined as such, such a person has come to be known as a "shadow director". This is separate to another limb which has a person as "director" simply because they "act in the position" even though they have not been validly appointed. Such a person is a "de facto director". (Paragraph [227]).

In relation to the argument about Apple's charge, it was said that it was associated with the directors' as "a person in concert with whom the primary person is acting, or proposes to act" (Section 15).

These concepts are important not just to questions of the validity of charges or insolvent trading. As an "officer" or "director" of a company the third party would be subject to all of the duties imposed on people who occupy such a position, including those set out in sections 180 and 181, which would in effect force them to subjugate their own interests to those of the corporation. All these consequences were referred to by White J as a reason why limits should be placed on the definitions, notwithstanding their apparently wide terms (paragraphs [126] and [247]).

Much of the directors' evidence about the extent of Apple's involvement and that of its employee was contested and resolved in Apple's favour. But in White J's carefully considered reasons for judgment, a number of legal principles emerge which provide clear guidance to the third parties.

Apple not an officer

As noted already, the "officer" definition has two limbs. On the first, the liquidator argued that Apple had participated in 12 separate decisions that affected the whole or a substantial part of Buzzle's business. White J analysed the evidence about each of these decisions, and concluded that Apple had not participated to the extent required. For example, it was not enough that after a decision was made by the resellers it was communicated to Apple. Nor was it enough for Apple to propose something which the directors felt they had "no choice" but to agree with. In a recurring theme in the judgment, White J considered a decision that Buzzle enter into a "payments deed" under which limits were placed on its ability to incur debts other than in the normal course of business:

"Mr Hartono deposed that he felt he had absolutely "no choice but to agree to the terms contained in the Payments Deed". This does not mean that Apple participated in Buzzle's decision-making. To the contrary, Mr Hartono said he had no choice but to agree to what Apple proposed. For a director of a company to acquiesce in a third party's demands does not mean that the third party participates in the company's decision-making. Given that officers of a company have a statutory duty to act in the best interests of the company, it would be an impossible position if a third party making demands on a company in its own interests become an officer of the company because its demands were acceded to." (Paragraph [118] (emphasis added).)

As to the second limb, the liquidator argued the definition should be applied literally, that Apple was an officer because (plainly) it "[had] the capacity to affect significantly the corporation's financial standing". After reviewing the definition's legislative history and placing the definition in the context of the duties imposed, White J concluded that the person must be an insider involved in the management of the company's affairs:

"[it] should be taken as referring to a person who, in his or her management of the affairs of the corporation, has the capacity to affect significantly the corporation's financial standing. It does not refer to a person who has that capacity as a third party but is not involved in the management of the corporation's affairs". (Paragraph [126].)

White J makes the point that if the liquidator was correct, there would and could be no real limit on the definition, with the "absurd" result that every government, bank, wealthy company or individual would be an "officer" because they have the capacity to affect the financial standing of every company (paragraph [124]).

In this case, Apple had no involvement at all in Buzzle's management prior to the charge being granted.

Apple not an associate

The liquidator's argument that Apple and the directors were "acting in concert", and so must be "associates", was also rejected. On this score, the liquidator could not point to any conduct falling within this description, it being well established that there must be something beyond the output of the parties' conduct which is attacked – in this case the entry into the charge. The liquidator argued that Apple had its "own reasons" for permitting the merger to proceed, including improving the prospects of recovering the debts that were due to it by the resellers before the merger proceeded.

"However, none of the purposes attributed to Apple in the taking of the charge was common to Buzzle. It was no part of Buzzle's purpose that Apple obtain better security for the repayment of the vendors' debts. The fact that both Apple and Buzzle saw the merger as potentially beneficial to each of them does not mean that they had a common purpose in relation to the merger, let alone that they had a common purpose in relation to the creation of the charge." (Paragraph [132].)

Apple's charge enforceable

Accordingly the liquidator's attack on the charge failed. Given this, White J deliberately left open the question of whether the investigating accountants' appointment was of itself a step in the enforcement of the charge. He does however refer favourably to an earlier decision of Palmer J, in which it was found that the appointment of a voluntary administrator by the secured creditor would not be sufficient (Australian Innovation Ltd v Dean-Willcox & Ors (2001) 40 ACSR 521), and on this basis expressed the view that Apple did not seek to enforce its security by appointing investigating accountants (paragraph [140]).

Apple not a shadow director

Apple argued that because it was a corporation, which by its nature cannot be appointed as a director of a company (section 201B), it could not therefore be a "person" within the shadow director definition. White J rejected this argument, noting that it had been "held more than once and assumed on many occasions that a company can be a shadow director" (paragraph [231]).

The second and perhaps most important point to emerge from the decision is that in White J's opinion, the formally appointed directors must be accustomed to act as directors of the company, in accordance with the shadow directors' instructions or wishes as to how they should act. Any control that Apple may be said to have exerted over the directors when they were conducting their business as resellers prior to the merger, and which meant they felt constrained to meet sales targets to obtain rebates needed to achieve realistic margins, was not enough because it was quite separate to their functions as directors of Buzzle.

Additionally:

"a person or company is not within the definition ... merely because that party imposes conditions on his or her commercial dealings with the company with which the directors feel obliged to comply. A lender who is entitled to demand repayment of a loan and appoint a receiver can say, for example, that it will stay its hand only if the borrowing company sells certain assets. A supplier or buyer might impose conditions and because of its superior bargaining power, the directors of the company with whom it deals might feel they have no choice but to comply with the conditions imposed. It has been uniformly held that this is not sufficient to make the third party who exercises such powers in his dealings with the company a shadow director, even though the directors of the company are accustomed to comply with its demands

....

In my view the reason that third parties having commercial dealings with a company who are able to insist on certain terms if their support for the company is to continue, and are successful in procuring the company's compliance with those terms over an extended period, are not thereby to be treated as shadow directors within the definition, is because to insist on such terms as a commercial dealing between a third party and the company is not ipso facto to give an instruction or express a wish as to how the directors are to exercise their powers. Unless something more intrudes, the directors are free and would be expected to exercise their own judgment as to whether it is in the interests of the company to comply with the terms upon which the third party insists, or to reject those terms. If, in the exercise of their own judgment, they habitually comply with the third party's terms, it does not follow that the third party has given instructions or expressed a wish as to how they should exercise their functions as directors." (Paragraphs [242] and [243] (emphasis added).)

The third point is that there needs to be a causal connection between the shadow director's "instructions or wishes", and what the directors actually do. In this case, the liquidator sought to rely on steps that were taken by the directors which they would have taken anyway. For example, it was alleged that Apple had instructed Buzzle employees to prepare financial reports, prepare a plan for debtor collections and devote resources to that activity. White J decided that no reliance could be placed on these matters because these were basic steps for the operation of the business and things that the directors were in any event attempting to do (Paragraph [244]).

"For the reasons I have already given, I do not accept that to establish that person is a shadow director, it must be shown that the directors of the company do not exercise any discretion of their own. Nonetheless, the authorities provide powerful support for the defendants' submission that there must be a causal connection between the instruction or wish of the shadow director and the act taken by the directors. There is good reason for this. If a person is a shadow director, he, she or it owes statutory duties to act in good faith in the best interests of the company, and with the reasonable care and diligence of a director of the company. A shadow director is also liable to statutory liabilities, such as the liability of a director for insolvent trading. When the definition is construed in the light of the purpose of subjecting a person who is not appointed, and does not (or might not) act as a director, to the statutory duties and liabilities of a director, it makes good sense that there must be a causal connection between the acts of the directors and the instructions of the putative shadow director for the definition to be satisfied. I accept the defendant's submissions that such a causal connection is necessary." (Paragraph [247].)

Finally, care must be taken to analyse precisely who is acting in accordance with the third party's instructions or wishes, and the capacity in which that person receives the relevant communication. First, the directors collectively must be accustomed to act on that person's instructions or wishes, in which regard it will be enough that the governing majority is so accustomed. However it is not sufficient that executives who are not directors may be accustomed to act on the person's instructions or wishes; there is still scope for the person to be a de facto director, but they are not a shadow director.

Next White J accepted the position adopted in the earlier decision in Harris v S ((1976) 2 ACLR 51 at 72) that instructions given or wishes expressed to a director in his or her capacity as a working executive, as distinct from an instruction or wish relating to the director's performance of his or her function as a director, is not relevant: there must be a "board of directors claiming and purporting to act as such" (paragraph [250]).

This became important to the case, because the communications from Apple on which reliance was placed were made to three board members, and Buzzle's CEO. Apple had little involvement with the other directors (paragraph [255]). It would have been sufficient if the instructions or wishes were passed on and acted on with sufficient frequency, but neither all nor a majority of the directors of Buzzle acted in accordance with the alleged instructions (paragraph [307]).

White J then analysed each of 17 instances of instructions said to have been given by Apple, going back to before Buzzle was incorporated to determine whether by 31 December 2000, Buzzle's directors were accustomed to act on the instructions or wishes of Apple or its employee. The following can be distilled from his treatment of this aspect:

Negotiations or a requirement expressed as a part of a commercial negotiation do not amount to instructions, where it remains open to the directors to accept or reject the proposed terms (paragraphs [280], [281] and [292]).
Trivial matters – in this case the drafting of the announcement of the proposed merger – can be disregarded (paragraph [291]).
A creditor cannot be a shadow director because it demands payment of debts due to it, and those debts are paid in whole or part (paragraph [297]).
Steps taken or which would have been taken irrespective of the third party's instructions or wishes are to be disregarded (paragraphs [296] and [301])

Significantly, in respect of the period after 1 January 2001, by which time Buzzle had become insolvent, it was contended that Apple should in some way be held liable for effectively allowing Buzzle to continue to trade by not appointing receivers before it did. There was evidence that from the start of 2001, Apple had taken a "proactive role" in exploring the possibility of attracting third party investors, and pursuing a proposal for a demerger, albeit no instructions or wishes were given which the directors acted on (paragraph [325]).

On 22 January 2001, Apple sent a carefully crafted letter to the CEO in which it disavowed any involvement in any corporate decision making, either at managerial or directorship level and said that if it is invited to attend any meetings at which corporate decisions are made, it will only do so as an observer or adviser (paragraph [326]). White J rejected the directors' evidence that Apple's employee said that unless he signed his acceptance of this letter, Apple would "pull the plug". He also said that the letter would not have helped Apple, if it had in fact crossed the line, but did make the point that this was a very clear statement that Apple was not purporting to give any directions to the directors with which they were expected to comply (paragraph [329]).

These comments are important in the context of a work out, as they suggest that a clear statement of the lenders' position, which is not contradicted by the lenders' conduct will go some distance to minimising risk. Finally in this context, Apple did not become a shadow director, simply because for its own reasons it did not act earlier:

"The [Liquidator] stressed that Apple perceived it to be in its interests for Buzzle to continue to trade whilst Apple worked out what it wanted to do with Buzzle. It did not want winding-up proceedings to be commenced against Buzzle. The reason for this was that Buzzle was by far the largest Reseller and accounted for perhaps 30 per cent of its revenues. Apple faced substantial losses if Buzzle went into administration or receivership from the loss of sales and damage to Apple's brand. But motive for Apple to give directions to Buzzle's board, does not establish that Buzzle's directors were accustomed to act in accordance with Apple's wishes." (Paragraph [331].)

It is unclear whether there will be an appeal from the Court's decision, but pending this we think this decision will provide important guidance for lenders and other third parties whose contribution to a company has become essential.

Lenders and other third parties as shadow directors or officers - law clarified and explained | Practical Law