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31 Mar 2010

How far can a creditor push a distressed company?

The law of "shadow directors" means that a person who effectively controls a board of a company, even though that person is not a director, may find himself being legally classified as a director of the company. That carries with it the threat of legal liability for the company's insolvent trading debts in the event that the company goes into liquidation.

Yesterday's Supreme Court of New South Wales decision of Justice White in Buzzle Operations Pty Limited (In liquidation) v Apple Computer Australia Pty Limited & Ors [2010] NSWSC 233 gives investigative accountants, creditors and financial institutions with insolvent corporate clients important guidelines on how far they can go in providing assistance and instructions with respect to the management of the business of a company.

Background

Buzzle Operations was a merger of a number of resellers of Apple. Because the resellers all had contracts with and had granted security in favour of Apple, Apple took part in discussions leading up to and after the merger. During these discussions and communications, Apple made clear to Buzzle its financial expectations and what it required them to do in order to maintain its co-operation.

Buzzle failed fairly soon after the merger. Its liquidator then claimed that Apple's negotiations and communications with Buzzle had made it a "shadow director" of Buzzle and that, as a result, Apple was liable for insolvent trading debts that Buzzle had incurred (in the order of $50m).

A person is a shadow director of a company if the company's directors "are accustomed to act in accordance with the person's instructions or wishes".

The Court rejected the liquidator's argument. In the course of doing so, it laid down some important rules for determining what constitutes a shadow director.

The rules

How many directors? In order to be a shadow director, do you have to control every single director, a majority or just a number of directors? The Court held that control of a "governing majority" is sufficient to make you a shadow director.

The whole business? Similarly, the Court held that a shadow director does not have to control every aspect of the board's decision-making: "there is no inconsistency with a person being a shadow director, and on the other hand the board exercising some discretion or judgment in areas on respect of which the shadow director does not give instructions or express a wish".

Cause and effect. The Court emphasised that a person is not a shadow director simply because he and the directors have the same ideas. If a creditor told a company that it should prepare financial reports and the directors ordered those reports, this wouldn't necessarily show that the creditor was a shadow director, since the preparation of financial reports is a normal part of business.

The directors' choice. This is probably the most important part of the judgement, because it deals with the perennial problem of whether applying commercial pressure to a board makes a creditor a shadow director. The Court's view is that the person applying the commercial pressure will not be a shadow director if, at the end of the day, the directors are free to decide whether to comply with that pressure:

"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."

Comment

Whilst this is not the last word on shadow directors, the decision is an extremely valuable resource in gathering the principles of shadow directorship and provides clear guidelines for both creditors and the directors of companies they deal with. This is particularly important in the current economic climate and when there are many calls for directors to be allowed to negotiate informal work-outs rather than putting their company into liquidation or administration. This decision will give creditors some assurance that their participation in negotiating such work-outs will not automatically lead to their being classified as shadow directors.

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Disclaimer

Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.