DISQUALIFIED DIRECTORS AND THEIR SHADOWS

A Director (and indeed the Board of Directors) is appointed and empowered by the Shareholders of a Company to run the company as an agent of the said shareholders, (hence the agency principle). The power however is accompanied with a heavy responsibility to run the affairs of the company to a statutory and ethical standard.

In many instances when the Director(s) fail to carry out this duty in accordance with the said standards and the company suffers loss, either by way of Insolvency or otherwise, the Directors are usually held to account or indeed responsible for the losses. Note the distinction between the responsibility and accountability of Directors. A brief word on the distinction between the two- Responsibility is the functional duty to carry out an act, which may be delegated or shared, whilst accountability refers to the ultimate and singular burden of seeing that the act is carried out, this can neither be shared nor delegated- to put it in layman's terms- accountability is where the buck stops, as is well known, you can't pass the buck.In the event of Director's of a company carrying out an act that exposes the company to loss and/or Insolvency, there are a number of sanctions that they may face, examples being:

a. Criminal Sanctions: If the act amounts to Criminal conduct e.g Fraud, Manslaughter etc The Directors as well as the company may face charges;

b. Civil Sanctions: If the c onduct of the directors directly results in financial loss to the Shareholders, the directors may face civil action to recoup the losses so suffered. In the UK however, where the Company is deemed to have committed a criminal act for which it faces sanction of a fine as tends to be the case, civil action has never been brought based on the contractual principle "Ex turpi causa non oritur actio" which means in plain English that a claimant cannot bring civil action based on his own illegal act. This principle is however being currently tested in the UK Courts in the case of William Morrisons v Webster and Others. Where this supermarket chain brought action for damages against the Former Chairman on Safeway (which Morrisons bought in 2004) following criminal sanction against Morrisons based on cartel price-fixing of dairy products by the defendants, before the purchase by Morrisons, the case is currently on-going and indeed an application to strike out the Claim was refused by the Court.

c. Disqualification: Where a Director has carried out an act which is deemed to be of such a serious nature as to merit the person from being barred for a specified period from acting as a Director of a Company - in the public interest, a disqualification order can be made preventing the said person from so acting as a Director.

The mechanism for this is provided in the UK under the Company Directors Disqualification Act 1986, which provides for a procedure whereby an Order of Court is made on application for the person to be disqualified from:

i. Acting as a director of a company taking part, directly or indirectly, in the promotion, formation or management of a company;

ii. Being a liquidator or an administrator of a company;

iii.Being a receiver or manager of a company's property.

The five main circumstances, in which a Director may be disqualified being:

i. Upon conviction of an Indictable offence (An indictable offence is a serious criminal offence such as a Felony) Section 2;

ii. For persistent breaches of Companies Legislation- This refers to failure to file returns and documentation relating to the company on at least three occasions in the five years preceding the Order, also for conviction for an indictable offence related to failure to so file such documentation. Section 3

iii. If in the winding up of a company the person has been guilty of either fraudulent trading (whether convicted or not) or for fraud committed whilst an Officer, Receiver, Liquidator or administrative receiver of the company or in breach of such duties while so acting. Section 4

iv. On Summary Conviction for an offence (whether indictable or otherwise) related to the failure to file company documentation or otherwise comply with requirements of Companies legislation relating to the filing of such documents. This order may be made by the court trying the said offence. Section 5

Disqualification is an instrument used to regulate the actions of Directors who would otherwise be provided the protection of limited liability of a company. Limited Liability refers to the principle in Company Law limiting the liability of the Shareholder to the value of the shares. Also it acts to lift the corporate veil. The sense behind this being that a registered company can act in its own name and indeed be sued or charged for an offence in its own name, however in circumstances as have been detailed here, the Corporate "veil" can be lifted for direct action against the directing hands that did the act.

Who makes the Order:

The Order is made by a Court- on application, under the auspices of the Secretary of State for Business Innovation and Skills

The Procedure

In the event of the failure or liquidation/administration of a company, the Official Receiver (or Insolvency Professional in a voluntary liquidation, administrative receivership or administration) after reviewing the conduct of the Directors for the 3 years preceding liquidation, if any misconduct is found such as- allowing the company to continue to trade when it was unable to pay its debts;a failure to keep proper accounting records, failure to prepare and file accounts or make returns to Companies House, failure to submit tax returns or pay over to the Crown tax or other money due,failure to co-operate with the OR/IP, the information is passed to the Office of Secretary of State for Business, Innovation and Skills, where a decision is made as to whether it shall be in the public interest to seek a disqualification order, where the same is decided, the application is then made to the Court on the auspices of the Secretary of State.

An application has to be made within 2 years of the winding up of the company or voluntary liquidation/administration etc. The court may of course extend time for the application to be made beyond the 2-year time-limit.

Upon a decision to apply for disqualification being made, the Director is given notice of the same. Furthermore, the Official Receiver or Insolvency Professional prepares a report which is submitted to the Court.. The director is then given the opportunity to respond to any allegations raised against him, by way of filing an affidavit in Court, rebutting any issues of misconduct raised in the report. Accountants and other officers of the company may also give evidence of fact either in support or in opposition facts contained in the report. The court then hears the application and makes a decision after considering evidence from both sides. If a disqualification is decided, the court will then decide how long it should last for i.e. between 2- 15 years.

A new procedure was introduced in April 2001, whereby a Director could give an undertaking to comply with the restrictions ordinarily imposed by a disqualification order and is the same in effect; only that it avoids the need for Court proceedings. The undertaking would be made to the Secretary of State and would be enforced by an application to court for breach of undertaking.

The Effects of Disqualification:

The disqualification order is an almost total ban on any form of Executive activity by the banned director and for the avoidance of doubt, the person is absolutely barred from acting as: a. A director of a company; b. Receiver of a company's property;c. Directly or indirectly being concerned or taking part in the promotion, formation or management of a company; or Being a member of or being concerned or taking part in the promotion, formation or management of a limited liability partnership and; d. From acting as an insolvency practitioner.

The consequence of breach of a disqualification order is a fine, imprisonment or both. This is detailed in Section 13 of the act as thus- ” If a person acts in contravention of a disqualification order or of section 12(2), or is guilty of an offence under section 11, he is liable-(a) on conviction on indictment, to imprisonment for not more than 2 years or a fine, or both ; and; (b) on summary conviction, to imprisonment for not more than 6 months or a fine not exceeding the statutory maximum, or both.”.

The next part of this study is the nature of Shadow Directorship

Shadow Directors:

A Shadow Director is defined by in section section 251, Companies Act 2006 (formerly Section 741(2) of the Companies Act 1985) ; section 251, Insolvency Act 1986; section 22(5), Company Directors Disqualification Act 1986) (CDDA) as “a person in accordance with whose directions or instructions the directors of the company are accustomed to act (although a person is not deemed a shadow director by reason only that the directors act on advice given by him in a professional capacity).”

Guidance on the mechanics of the definition in the former Section 741(2) was provided by the High Court and reinforced by the Court of Appeal in Secretary of State for Trade and Industry v Deverell and another as thus:

a) Majority of the board must be accustomed to act in accordance with the directions or instructions of the alleged shadow director. The purpose of the legislation is to catch a person who effectively controls the running of the company by controlling the board. Therefore, a person is unlikely to be within the definition of a shadow director if only one or two directors on a board of several directors follow his instructions;

b) The directors must “do something in conformity with” such instructions. It is not sufficient for the alleged shadow director simply to give instructions to the directors; his instructions “must be translated into action by the board”;

c) The directors must act on the alleged shadow director’s directions as a regular course of conduct of the directors over a period of time.

Of great significance is the dictum in the lead judgement of Lord Justice Morritt: “(1) The definition of a shadow director is to be construed in the normal way to give effect to the parliamentary intention ascertainable from the mischief to be dealt with and the words used. In particular, as the purpose of the Act is the protection of the public and as the definition is used in other legislative contexts, it should not be strictly construed because it also has quasi-penal consequences in the context of the Company Directors Disqualification Act 1986. I agree with the statement to that effect of Sir Nicolas Browne-Wilkinson V-C in In re Lo-Line Electric Motors Ltd [1988] Ch 477, 489. (2) The purpose of the legislation is to identify those, other than professional advisers, with real influence in the corporate affairs of the company. But it is not necessary that such influence should be exercised over the whole field of its corporate activities. I agree with the statements to that effect of Finn J in Australian Securities Commission v AS Nominees Ltd, 133 ALR 1, 52-53 and Robert Walker LJ in In re Kaytech International plc [1999] BCC 390, 402. (3) Whether any particular communication from the alleged shadow director, whether by words or conduct, is to be classified as a direction or instruction must be objectively ascertained by the court in the light of all the evidence. In that connection I do not accept that it is necessary to prove the understanding or expectation of either giver or receiver. In many, if not most, cases it will suffice to prove the communication and its consequence. Evidence of such understanding or expectation may be relevant but it cannot be conclusive. Certainly the label attached by either or both parties then or thereafter cannot be more than a factor in considering whether the communication came within the statutory description of direction or instruction. (4) Non-professional advice may come within that statutory description. The proviso excepting advice given in a professional capacity appears to assume that advice generally is or may be included. Moreover the concepts of "direction" and "instruction" do not exclude the concept of "advice" for all three share the common feature of "guidance ". (5) It will, no doubt, be sufficient to show that in the face of "directions or instructions" from the alleged shadow director the properly appointed directors or some of them cast themselves in a subservient role or surrendered their respective discretions. But I do not consider that it is necessary to do so in all cases. Such a requirement would be to put a gloss on the statutory requirement that the board are "accustomed to act" "in accordance with" such directions or instructions. It appears to me that Judge Cooke, in looking for the additional ingredient of a subservient role or the surrender of discretion by the board imposed a qualification beyond that justified by the statutory language.”

The implications of this in summary being thus:

a. The definition of a Shadow Director should not be construed strictly or literally but should have regard to the facts of each individual case, because of the consequence of criminal sanction in the event of breach.;

b. The definition of Shadow Director is very likely to apply to any person who gives directions or instructions to the Directors of a company unless the same is by way of professional advice.

c. The purpose of the directions or instructions are less important than the fact that they were given (except where given for professional purposes);

d. The Directors who acted in compliance with the direction or direction of the Shadow Director, need not be shown to act in a subservient position but more importantly to have acted or be accustomed to act (i.e. there should be a course of conduct).

The co-relation between Shadow Directorship and Disqualification of Directors is statutorily expressed in Section 22(5) of the Company Directors Disqualification Act 1986) (CDDA), which repeats the definition above i.e. " Shadow director, in relation to a company, means a person in accordance with whose directions or instructions the directors of the company are accustomed to act (but so that person is not deemed a shadow director by reason only that the directors act on advice given by him in a professional capacity)”

This definition being important as per Morritt LJ, based on the penal sanction attendant on breach of the disqualification order, in that if a person were to act as the Shadow Director of a company whilst disqualified, the consequences are serious and are detailed as stated above in Section 13 of the CDDA as thus- If a person acts in contravention of a disqualification order or of section 12(2), or is guilty of an offence under section 11, he is liable-(a) on conviction on indictment, to imprisonment for not more than 2 years or a fine, or both ; and; (b) on summary conviction, to imprisonment for not more than 6 months or a fine not exceeding the statutory maximum, or both.

The simple fact being that it is extremely risky for a disqualified Director to seek to continue to run or manage a company in the Shadows (literally and figuratively), since the Court will examine in details the nature of communication with the Directors and if any instructions are given and acted upon by a majority of the Board, then a Shadow Directorship will be assumed, unless the instructions were given in professional capacity.

The professional advice route does not provide a trouble-free escape route however, because Section 1 very clearly disqualifies the person from being involved with the promotion, formation and management of a company. Thus, if the advice is given in the course of management of a company offering professional services, it would arguably be in clear breach of section 1(d) of the act.

The two elements being : i. Management and ii. Of a company.

We shall examine these hypothetically:

i. Management

Chambers Dictionary defines management as “management noun 1 - the skill or practice of controlling, directing or planning something, especially a commercial enterprise or activity. 2 the managers of a company, etc, as a group. 3 manner of directing, controlling or using something.”

Using this as a general guide, the key elements would be control, direction of the organisation, enterprise or activity, the next element being:


ii. Company

Guidance is provided in S. 22. (2) of the CDDA- “ The expression “company”— in section 11, includes an unregistered company and a company incorporated outside Great Britain which has an established place of business in Great Britain, and (b) elsewhere, includes any company which may be wound up under Part V of the Insolvency Act.”

Part V of the Insolvency Act and specifically S.220 defines an unregistered company as thus “Meaning of "unregistered company" (1) For the purposes of this Part, the expression "unregistered company" includes any trustee savings bank certified under the enactments relating to such banks, any association and any company, with the following exceptions –

(a) a railway company incorporated by Act of Parliament,

(b) a company registered in any part of the United Kingdom under the Joint Stock Companies Acts or under the legislation (past or present) relating to companies in Great Britain.

(2) On such day as the Treasury appoints by order under section 4(3) of the Trustee Savings Banks Act 1985, the words in subsection (1) from "any trustee" to "banks" cease to have effect and are hereby repealed.”

There is no mention of Partnerships or Sole Traderships, however for greater clarity, reference must be made to the Companies Act 2006 which defines a company in Section 1 as thus:

“(1) In the Companies Acts, unless the context otherwise requires— “company” means a company formed and registered under this Act, that is—
(a) a company so formed and registered after the commencement of this Part, or

(b) a company that immediately before the commencement of this Part—

(i) was formed and registered under the Companies Act 1985 (c. 6) or the Companies (Northern Ireland) Order 1986 (S.I. 1986/1032 (N.I. 6)), or (ii) was an existing company for the purposes of that Act or that Order, (which is to be treated on commencement as if formed and registered under this Act).

(2) Certain provisions of the Companies Acts apply to—

(a) companies registered, but not formed, under this Act (see Chapter 1 of Part 33), and;

(b) bodies incorporated in the United Kingdom but not registered under this Act (see Chapter 2 of that Part).

(3) For provisions applying to companies incorporated outside the United Kingdom, see Part 34 (overseas companies)”

As seen above, the contrary position is found in the provisions of Part V of the Insolvent Partnerships Order 1994, which provides for the winding up of Insolvent Partnerships as an Unregistered Company either on presentation of a petition against all members, where no petition is presented against any member, or indeed Insolvency proceedings not involving winding up. The operative fact being that there is provision for a Partnership to be deemed an unregistered company.

Once again, this definition does not clearly extend to a Partnership or indeed a Sole Trader and is subject to inference rather than clear prescription in the CDDA, thus it is arguable that to come under the definition of company under Section 22(5), the company would have to be one registered under the Companies Acts or be a Limited Liability Partnership or even a Limited Partnership, it is important to note that this principle has not been tested judicially.

Conclusion

In conclusion and for the sake of good order it is important to distinguish between a Shadow Director and a De facto Director

De Facto Directors:

In Secretary of State for Trade and Industry v. Deverell and Another, reference was had to the judgement in In re Hydrodam (Corby) Ltd [1994] 2 BCLC 180 applying the definition of Millett J: "A de facto director ... is one who claims to act and purports to act as a director, although not validly appointed as such”

The judgement also affirmed the definition given by Judge Cook in Deverell (at the High Court) in which he set out two categories of de facto directors (in addition to two categories i.e shadow and proper directors so called) i.e “De facto directors type 1, being those who assume to act, claim to be and are held out by the company as being directors”; (b)” De facto directors type 2, being those who directly assume the functions of the directors and act on a equal footing with those who are but without having any sort of label”

The essential characteristics of De facto Directors being that they either openly assume the duties and profile of Directors or they directly hold themselves out as Directors, even if they are not properly appointed as such.

The distinction between a de facto Director and a Shadow Director being that the latter does not hold himself out, rather preferring to give directions from the background.

Edward C.Keazor ©