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Focus: Asia Finance - Governance of shadow directors in Hong Kong

4 June 2009

In brief: The Hong Kong Companies Ordinance imposes a number of liabilities and prohibitions on shadow directors. Banks need to be aware of what conduct, in a workout situation, could give rise to the accusation of being a shadow director of a distressed corporate borrower. Partner Matthew Barnard (view CV) and Foreign Lawyer Caroline Chan report on some cases that clarify the issue.

How does it affect you?

  • There is a trend in many jurisdictions for lenders to take more direct action in workouts.
  • Given the untested nature of the law of shadow directorship in Hong Kong, banks should still be cautious as to their actions in a workout situation.

Overview – what is a 'shadow director'?

Under the Companies Ordinance, a 'shadow director' is a person in accordance with whose directions or instructions the directors, or a majority of the directors of the company, are accustomed to act. There are statutory exceptions; for example, the fact that a majority of the directors of the company act on advice given by a person in a professional capacity does not make the adviser a shadow director. The rationale behind the concept of 'shadow director' is to prevent the evasion of liabilities by persons who control the company but choose to remain in the background (the 'shadow').

Case law indicates that some relevant factors are whether:

  • the person exercises real influence over the company's affairs.
  • the person directs the acts of the directors.
  • the directors act on the directions or instructions of the shadow director as a matter of regular practice over a period of time and as a regular course of conduct (i.e. not just on one-off occasions).

In looking at some cases, we can clarify this issue of control with a shadow directorship.

Each case where a shadow directorship has been claimed has turned on its own facts. In one case,1 a majority shareholder (Pioneer) was found to be a shadow director of its subsidiary (Giant) because:

  • Pioneer had effective control over Giant (it was by far the most significant shareholder);
  • Pioneer imposed financial reporting requirements on Giant;
  • the views of Pioneer delayed a takeover and an asset sale by Giant;
  • at the time when Giant was considering purchasing Pioneer's mineral assets, negotiations with third parties for finance to be provided to Giant for the purchase were conducted by Pioneer and not by Giant. The transaction was abandoned when the Pioneer board resolved that it was not in the best interests of either company to proceed; and
  • the decision to fund Giant and to take security over Giant's assets was effectively made by Pioneer and simply accepted by Giant.

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What are the consequences of being a 'shadow director'?

The Companies Ordinance imposes a number of prohibitions on shadow directors. Among other things, shadow directors:

  • cannot act as investment advisers for the purposes of section 49BA of the Companies Ordinance;
  • cannot take loans from the company and the relevant company cannot give a guarantee or security in connection with a loan to a shadow director. Standard exemptions to these rules do not apply to shadow directors;
  • are liable for the concealment of any debt due to, or from, the company if the company is wound up;
  • are liable for any debt or liability of the company arising when a company is deemed to be dormant; and
  • can be liable for the default, refusal or contravention of any provision of the Companies Ordinance (which he or she knowingly or wilfully authorises or permits).

In the United States, the United Kingdom and Europe, it is relatively common for companies in the process of restructuring to appoint a 'chief restructuring officer' to take the company through the restructuring process. However, this practice is uncommon in Hong Kong, primarily because of the concern held by banks and their receivers that a chief restructuring officer may be found to be a shadow director and the personal liabilities that follow would be considerable.

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Banks as shadow directors

The concept of shadow directorship has not been the subject of detailed judicial consideration in Hong Kong and there is no reported case where a claim has been made that a bank was a shadow director. However, in the current economic climate, the situation is ripe for a serious challenge to a bank if the facts support it. Cases from other jurisdictions are helpful in considering the potential liability of banks in the absence of statutory exemptions.

Court's reluctance to regard a bank as a shadow director

The English courts have held that it is possible for a bank to be a shadow director. In Re a Company (No. 005009 of 1987) ex parte Copp and another [1989] BCLC 13, the court refused to strike out the claim that a bank was a shadow director, where the bank had commissioned a financial report on the company containing recommendations (ie, grant of security) which the directors then implemented. However, in a subsequent hearing, the liquidator abandoned the claim against the bank.

An Australian court2 has approved the extrajudicial statements of Justice Millet3 in which he used a puppet master-puppet analogy to described the relationship between a shadow director and a company and expressed the view that the prospect of banks becoming shadow directors is remote.
Justice Millet stated that where a corporate customer of a bank appears to be in financial difficulty, the bank is likely to:

  • send in an investigating team;
  • demand reduction of its debt;
  • demand security or further security;
  • call for information such as accounts and valuations;
  • request the customer's proposals for the reduction of the debt; and
  • advise the company on how to improve its financial position.

The court in Emmanuel held that a lender could respond to a defaulting customer by taking any of these actions without becoming a shadow director.

Justice Millet considered that a bank could attach conditions to the continuation of its support (for example, the continuation of a loan facility) without being regarded as managing its customer's affairs. As long as the bank does not do anything that it would not normally do in telling its customers what it requires in order for banking facilities to be continued and leaves the decision to its customer whether it will comply or not, the bank is not a shadow director. Warning signs for a bank include the board of the corporate customer not giving careful consideration to matters and accepting the courses of action proposed by a bank as something inevitable or as a fait accompli.

Other examples of situations where the banks' control has not amounted to shadow directorship were:

  • where the borrower had agreed that the financier could attend the borrower's weekly management meetings, that all the borrower's revenue would be paid to the financier's account and that the financier's approval was required for all payments made by the borrower. Importantly, in that case the directors retained the power to take or leave the financier's offer4.
  • the Kuwait Asia Bank case5, where the court held that the power to appoint nominee directors does not make a bank a shadow director.
Behaviour of banks in a workout situation

As a guide, banks should avoid the following actions or situations in order to protect themselves against the risk of shadow directorship in a workout situation:

  • Participation in the daily business operations of a borrower.
  • Making or substantially influencing major strategic decisions concerning the business of a borrower.
  • Having or exercising the power of veto over the decisions of the borrower.
  • Control of the borrower's income or sales (as opposed to control over receipts).
  • Imposition of various restraints on the borrower company, such as requiring the lender's approval before making capital improvements or encumbering assets or making new financial commitments.
  • Control of the selection of the management or board of the borrower.
  • Negotiation on behalf of the borrower of an informal moratorium with the borrower's trade creditors.

The degree of risk that a bank faces in a workout situation will depend on the particular circumstances of the case and the number of these factors which apply.

Footnotes
  1. Standard Chartered Bank of Australia v Antico (1995) 13 ACLC 1381.
  2. Emmanuel Management Pty Ltd & Ors v Foster's Brewing Group Ltd & Ors [2003] QCS 205.
  3. Shadow Directorship – A Real or Imagine Threat to Banks (1991) Insolvency Practitioner 14.
  4. Re PFTZM Ltd (in liquidation) [1991] 2 BCLC 354.
  5. Kuwait Asia Bank E.C. v National Mutual Life Nominees Ltd [1991] 1 AC 187.

Published 4 June 2009

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