Allens

Insolvency & Restructuring

Focus: Good news for lenders – shadow directorship risks clarified

12 May 2011

In brief: Recent guidance from the New South Wales Court of Appeal on the hotly debated elements of shadow directorship is good news for secured lenders in workout situations who wish to impose conditions on their continued support for their borrowers. While there is still a fine line between permissible conduct and shadow directorship, the case suggests that conditions on loans and/or forbearance do not a shadow director make. Partner Michael Quinlan and Lawyer Amy Spira report.

How does it affect you?

  • The decision1 has potentially wide-ranging implications for secured lenders who wish to make forbearance or further loans to their borrowers conditional on exercising a degree of influence or oversight over their trading activities.
  • In particular, it suggests that:
    • where a secured lender acting in its own interests exercises influence on the directors of a borrower, it will not generally become a shadow director; and
    • this is especially so if the lender's exercise of influence is supported by contractual rights and/or the directors of the borrower exercise independent judgment regarding whether to accede to the lender's influence.

Background

In July 2000, six retailers of Apple products merged to create a company called Buzzle. Buzzle held much of its stock on credit from Apple and granted Apple a charge over its assets to secure its debt.

By November 2000, Buzzle was insolvent but continued to trade, incurring additional debts of $18 million to Apple and other creditors. It also made roughly $12 million in early debt repayments to Apple.

Apple had been heavily involved in the merger of the six retailers that formed Buzzle. It gave advice on the structure of the merger, future cash flow, the financial accounting system to be used by the company and the necessary due diligence reports. When Apple got wind of Buzzle's cashflow difficulties, it installed one of its senior finance officers in Buzzle's office to advise Buzzle on its systems. Buzzle's directors generally heeded Apple and its financial officer's advice.

In March 2001, Apple appointed receivers over Buzzle's assets. Buzzle went into liquidation. The liquidators brought proceedings against Apple and its finance officer, attempting to:

  • avoid Apple's charge over Buzzle's assets;
  • have certain repayments that Buzzle made to Apple declared voidable uncommercial transactions; and
  • establish that Apple and its finance officer were shadow directors of Buzzle, and so liable for Buzzle's insolvent trading.

Please see our Focus for a summary of the first-instance decision.

The issues on appeal were:

  • whether Apple was liable for Buzzle's insolvent trading because Apple and its finance director were shadow directors of Buzzle at a time when Buzzle was insolvent and incurred debts; and
  • whether some of Buzzle's repayments to Apple were uncommercial transactions.

In the course of delivering its judgment, the court also examined certain defences to insolvent trading liability.

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The line between influence and shadow directorship

The starting point for the court's analysis of shadow directorship was the statutory definition of a company director:

director of a company or other body means...a person who is not validly appointed as a director if...the directors of the company or body are accustomed to act in accordance with the person's instructions or wishes.2

The Court of Appeal upheld Justice White's decision at first instance that, notwithstanding Apple's influence over Buzzle's business, Buzzle was not accustomed to act in accordance with the directions or wishes of Apple. As a result, Apple was not a shadow director and was not liable for Buzzle's insolvent trading. The court provided the following useful guidance:

  • A person is not a shadow director merely because they impose conditions on their commercial dealings with a company, even if the company feels that it has no choice but to comply with those conditions. Without more, such conditions do not amount to 'instructions or wishes' because the directors of the company are free (and expected) to exercise independent judgment as to whether it is in the company's interests to comply with the proposed terms.
  • This is particularly so if the person imposing the conditions is a secured creditor and the conditions are supported by the terms of the loan agreement between the parties.
  • Advice given in a non-professional capacity can amount to 'instructions or wishes', but not every person whose advice, instructions or wishes are heeded is a shadow director. The following additional elements are required for shadow directorship to arise:
    • causation: a causal connection between the alleged shadow director's 'instructions or wishes' and the company's actions. For example, if a company always intended to do certain things, such as prepare financial reports, the mere fact that it prepared them after the alleged shadow director expressed a wish that it do so would not necessarily give rise to shadow directorship;
    • majority of board habitually compliant: on the part of a governing majority of the board, a habit of deferring to the judgment of the alleged shadow director over a period of time. This requires an established pattern of compliant behaviour but does not mean that it has to be shown that the majority of directors exercised no discretion of their own on any board resolutions or that the alleged shadow director's instructions addressed the whole field of director decisions; and
    • instructions to directors in directorial capacity: the shadow director's instructions or wishes must be expressed to, and aimed at the conduct of, the directors in their capacity as directors. The outsider is not a shadow director if they gave instructions to board members in a different capacity (eg as shareholders or employees of the company).

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Uncommercial transactions

Justices Hodgson and Whealy (Justice Young dissenting) found that certain repayments that Buzzle made to Apple were uncommercial transactions. This is because, on a standard Corporations Act 2001 (Cth) section 588FB(1) analysis:

  • the evidence did not suggest any particular benefits to Buzzle in making the repayments;
  • the repayments caused a detriment to Buzzle by depriving it of liquidity – in particular, the ability to repay debts due to other companies. To this end, a relevant factor in determining detriment was that Buzzle had no obligation to make the relevant repayments at the time that it did; and
  • Apple benefited from the transaction because (a) its debts were satisfied; and (b) it did not need to pursue third parties for payment.

However, the court unanimously held that Apple was not liable because it was covered by the s588FG(2) defence, which prohibits the court from making orders adverse to Apple's interests if it entered into the uncommercial transaction in good faith, lacked reasonable grounds for suspecting that Buzzle was or would become insolvent, and had given valuable consideration for the transaction.

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Court may not need to order any payment for insolvent trading

The court's view was that even if it had held Apple liable in this case, it may nonetheless have had a general discretion not to order any relief. This is because liquidators (including the one who brought Buzzle's claim against Apple) are officers of the court and the court does not permit inequitable conduct by its officers. If the court had been of the view that relief would not have been equitable in the circumstances, it may have directed the liquidators not to enforce their legal rights to relief.

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Can insolvent trading claims be set-off?

Under s553C(1) of the Corporations Act, where there have been mutual credits, debts and/or dealings between an insolvent company that is being wound up and a person wishing to prove in the winding up, the debts and credits may be set-off against one another, leaving only the balance admissible to proof. There has been one case that considered whether an insolvent trading claim could be set-off: the Parker decision.3 That case found that a liquidator could set-off an insolvent trading claim against the company's parent company from a loan debt the company owed to its parent. Parker has been criticised because s553C(1) requires mutuality of debts and credits. Some argue this cannot exist where a liquidator brings an insolvent trading claim, because (a) the claim is that of the liquidator, not the company; and (b) the debt is not in existence at the date of liquidation. The court, however, said that it would have followed Parker, stating that had Apple been liable, set-off would have been available under s553C(1).

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Implications of the decision

For lenders

In the wake of the Buzzle decision, the line between permissible pressure by a third party to conform with its view on directorial decisions and shadow directorship remains a fine one. However, the case should give significant comfort to secured lenders wishing to exercise a degree of control or oversight over the activities of debtors in financial strife.

In particular, lenders can take comfort that:

  • where a secured lender acting in its own interests exercises influence on the directors of a debtor company, it will not necessarily become a shadow director; and
  • this is particularly so if the lender's exercise of influence is supported by contractual rights in its loan documents and/or the directors of the company are free to exercise independent judgment regarding whether to accede to the lender's influence.
For borrowers

Borrowers should heed the court's warning that the directors of a company experiencing cash-flow problems are still expected to give careful consideration to whether the terms of prospective finance agreements are in the interests of the company. In particular, the court acknowledges that finance agreements entered into by struggling companies may have the practical effect of fettering the company's discretion but, without more, the conditions of such agreements are unlikely to result in shadow directorship, leaving the company and its directors to shoulder the burden of insolvent trading claims alone.

For insolvency practitioners

Insolvency practitioners should also be mindful of the court's view (in obiter) that:

  • a liquidator may set-off insolvent trading claims against debts under s533C(1); and
  • the court may have a general discretion to withhold relief in cases brought by liquidators where granting relief would be inequitable in the circumstances.

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Looking forward

It remains to be seen whether the liquidator of Buzzle will apply for special leave to appeal this decision to the High Court. Given the importance of the issues raised in the case, and the implications for financiers and borrowers alike, we will be watching this space closely and will give updates on any significant developments.

Footnotes
  1. Buzzle Operations Pty Ltd (in liq) v Apple Computer Australia Pty Ltd [2011] NSWCA 109.
  2. Section 9 of the Corporations Act 2001 (Cth)
  3. Re Parker (1997) 80 FCR 1.

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