Shadow Director: How a Lender Can Become One

A workout puts a lender closer to a borrower's decisions than at any other time. Cash is short, the bank's money keeps the business trading, and tired directors may want someone to tell them what to do. A lender that fills that space can take on the position of the people it is advising. Company law in all three markets looks past the register to who is actually in charge.

The consequences make it a lender's question. In the UK, directors' general duties apply to a shadow director where they are capable of applying, and the wrongful trading provisions, under which a court can order a director to contribute after an insolvent liquidation or an insolvent administration, expressly include one. In Australia, the definition of director brings the duty to prevent insolvent trading within reach. In New Zealand, the extended definition can carry directors' duties, including the duty not to trade recklessly. Reported findings against lenders are rare. The cost of defending a claim, and the leverage it hands a liquidator, are the more common harm.

Three parts recur. The first is a pattern: the directors must be accustomed to act on the person's instructions, a course of conduct over time rather than one occasion of going along. The second is whose conduct counts. English courts have looked at the board, or at least its governing majority; the New Zealand definition also reaches a person whose directions a single director follows, for some provisions. The third is the exception for advice.

The Australian words about a business relationship speak most directly to a lender, though they protect advice, not instructions. New Zealand's definition has no such words, which some commentators read as leaving a bank less protected there, and its 'may be required' reaches past habit to obligation. In every market, a lender's ordinary tools are safest used as conditions: a covenant, a reporting requirement, an adviser's report before more money is lent, a refusal to lend. English courts have accepted that a bank setting out the conditions on which it will keep lending, leaving the company free to decide, is not a shadow director. The lender has gone too far once it is making the company's choices.

A family-owned plastics moulder, constructed for this page like every figure in it, owes its bank US$5.4m: a term loan of US$3.8m and an overdraft drawn to its US$1.6m limit. A large customer has moved its work offshore and the business is losing about US$90,000 a month. The file moves to the bank's workout team.

The first letter is a lender's letter. The bank will hold the overdraft limit for ninety days; it wants a 13-week cash flow every Monday and a review of the business by an accountant from a list of three, engaged by the company; and it will not fund payments beyond the forecast. The board takes its own legal advice, minutes its decision and accepts. Each condition protects the bank and leaves the decision with the directors.

Over the next two months the file drifts. The workout manager joins the weekly management meeting, approves each payment run line by line, tells the finance director which suppliers to pay and which to hold, directs that the night shift be cut, and emails the chair a list of machines to sell with the price to accept. The directors do each of these things. Six months later the company is in liquidation.

The liquidator's letter argues that the bank was a shadow director and should contribute towards the US$0.7m run up while it was directing the company. Whether that claim succeeds turns on evidence the bank wrote itself: its emails, the meeting notes, the payment approvals. The same result for the bank could have been reached the first way. A cash limit stated in a letter, with the board choosing which suppliers to pay inside it, protects the money without taking the decisions.

The concept readers confuse it with is the de facto director. A shadow director stands behind the board and instructs it. A de facto director acts as one without being appointed: sits at the board table and takes decisions as a member. Both can carry a director's duties. For a lender the difference is where the risk enters: instructions from outside raise the shadow question; a bank officer or bank-installed executive who joins the board's deliberations raises the de facto one.

Both differ from a director the lender nominates and the company appoints: a nominee is a real director, whose duties run to the company, not to the lender. And all three differ from a receivership, the lawful way for a secured lender to take control, entered by enforcing the security rather than by steering the board.

DEFINED IN ONE PARAGRAPH → · PROBLEM LOANS AND WORKOUT → · THE INDEPENDENT BUSINESS REVIEW →

It decides how a workout is written down. Conditions go to the board in letters, and the board records its own decision, ideally with its own advice. A lender that wants a turnaround specialist offers names and leaves the engagement to the company. A bank officer at a management meeting attends as an observer, and payments are governed by a limit, not by approvals given line by line.

It also tells a lender when to stop asking and act. If the bank has to make the decisions for the business to survive, the board can probably no longer run it, and the choice is between lending on conditions and enforcing. The directors may decide first, by appointing an administrator, which in Australia and New Zealand starts the voluntary administration timetable.

WHEN YOUR LOAN GOES TO WORKOUT → · VOLUNTARY ADMINISTRATION → · VOIDABLE PREFERENCES →