Shadow directors and their duties

10th February 2014

A shadow director is defined in section 251(1) of the Companies Act 2006 as a person in accordance with whose directions or instructions the directors of the company are accustomed to act. There are limited exceptions for those who act purely in a professional capacity when providing advice – such as lawyers. A de facto director on the other hand is a person who performs the functions of a director but who has not been formally appointed as a director.

Identifying a shadow and/or de facto director
A number of cases have been concerned with the identification of a shadow and/or de facto director. The High Court decision in Smithton Limited v Naggar [1] is the latest.

In this case, the claimant company (Hobart) claimed for loss suffered when two companies, Insureprofit and Mariona, defaulted on obligations under contracts entered into with Hobart. Insureprofit and Mariona were insolvent and the claim was brought against a Mr Naggar personally. Naggar was the director of a company called Dawnay Day, itself the majority shareholder of Hobart. Dawnay Day’s business model was to “incubate” new businesses and then spin them off in joint ventures should they prove successful. Directors were appointed to the new companies by Dawnay Day to protect its interests. Naggar directly and/or indirectly owned both Insureprofit and Mariona. The first part of the claim against Naggar was that he was a de facto or shadow director of Hobart and had breached his statutory duties to Hobart.

On the question of whether Naggar was a de facto or shadow director, the court’s approach was to identify what “hat” he was wearing in his dealings with Hobart. The description of Naggar’s role was of less importance. The facts did not support a finding that Naggar was a de facto or shadow director. His involvement in Hobart’s business did not extend beyond what one would expect of a major shareholder and client. There was no evidence that a majority of the board were accustomed to act in accordance with Naggar’s instructions.

Recent cases have highlighted the fact-specific nature of assessing whether someone is a shadow or de facto director and also that the two concepts, whilst distinct, often overlap. This case is in line with those authorities, although the focus on identifying the “hat” worn by the putative director is noteworthy. This will be relevant to lenders as well as majority shareholders. In the words of the judge: “This ‘hat identification’ issue does not only arise in relation to human directors of corporate directors. In Ultraframe (UK) Ltd v Fielding Lewison J considered the position of a lender alleged to be a shadow director of the debtor company. He held that where the alleged shadow director is also a creditor of the company, he is entitled to protect his own interests as creditor without necessarily becoming a shadow director”.

The duties of a shadow director
Because of its finding that Naggar was not a shadow director, the High Court did not need to venture into an analysis of the duties of a shadow director. There are some express requirements in the Companies Act 2006: shadow directors are liable, in largely the same way that a run of the mill director is, for issues such as wrongful trading, director disqualification, and they are expressly obliged by statute to declare their interests in an existing transaction. However, the extent to which shadow directors owe fiduciary duties has not always been clear: in Ultraframe UK Ltd v Fielding [2] the High Court stated that “the indirect influence exerted by a paradigm shadow director who does not directly deal with or claim the right to deal directly with the company’s assets will not usually… be enough to impose fiduciary duties upon him”.

In Vivendi SA v Richards [3] Centenary Holdings III Limited (the Company) had been sold by the Vivendi group to a company that was ultimately owned by one Mr Richards. Richards had not been formally appointed as a director of the Company although he had entered into a consultancy agreement with it. The Company went into liquidation and the liquidators assigned claims to Vivendi.

Vivendi argued that by procuring payments by the Company totalling £10 million over a two-year period, the Company’s sole director had breached the statutory duty of good faith owed by a director to his or her company. Vivendi further argued that Richards was a shadow director and, as such, also owed a duty of good faith, which he had breached. Vivendi also argued that Richards had acted dishonestly.

The court found that Richards was indeed a shadow director, the formally appointed director being no more than his “legman”.

The court then went on to tackle the extent to which a shadow director owes a duty of good faith to the company and concluded that a shadow director will typically owe this duty at least in relation to the directions or instructions he or she gives to the formally appointed directors. This includes the duty of good faith, as a shadow director could reasonably be expected to act in the company’s best interests rather than his or her own interests, when giving such instructions.

The court went on to find that Richards had breached the duty of good faith. Whilst the duty is ordinarily owed to shareholders, the interests of creditors must be taken into consideration when a company is in financial difficulties, as was the case here. The payments were not in the interests of the company or its creditors. Further, Richards had knowingly acted contrary to the interest of the Company’s creditors in making the payments and, accordingly, the court made a finding of dishonesty.

Cases on shadow and de facto directors come before the courts on a fairly consistent basis and in each case context is all-important. The emphasis on ‘hat identification’ is a good way of working out whether a shareholder or creditor is acting as a shadow director. If they are, then the lesson from the second case considered in this article, is that they owe a duty to act in good faith in what they consider to be the best interests of the company.

[1] [2013] EWHC 1961 (Ch)
[2] [2005] EWHC 1638 (Ch)
[3] [2013] EWHC 3006