Staying on the right side of Shadow Directorship

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Staying on the right side of Shadow Directorship

Staying on the right side of Shadow Directorship

You’re investing in a joint venture (or exiting management of a business you’ve built up but leaving your capital in) and keen to protect your investment.

Most often you'll do that via a joint venture, or shareholders agreement that contains investor controls – which are things that management cannot do without shareholder / investor consent. However, when does that put the investor at risk of becoming a shadow (or de-facto) director?

In the vast majority of cases investor consents will be the right side of that line. However, in a handful of cases I’ve dealt with, I’ve seen overzealous (and protective) investors stray across it. If all goes well with the business the consequences may not matter; but if it goes wrong – they can leave you on the wrong side of a misfeasance claim. The examples below demonstrate the importance of taking advice and thinking carefully about your shareholder / investor agreement (including controls) at the outset. What may appear to be a legitimate and clever idea at the outset can turn out to be very different. That’s where experienced advisors are worth their weight in gold, to prevent you from being in that handful.

A shadow director is someone in accordance with whose instructions the directors of a company are accustomed to acting on a regular basis, without exercising their own discretion (and someone who has real influence over the company’s affairs). Shadow directors are liable to the same sanctions as directors who breach their duty (save for some exceptions). So when might investor controls, and the exercise of them, cross that line?

The cases where I’ve seen it happen involved controls that went beyond those strictly necessary to protect the investor’s interests, and which stifled the directors’ ability to exercise their roles without consistently requiring instruction from the investors. Two I particularly remember:

  • The owner managing director ("MD") sold a 51% shareholding in a complex business to a junior administration employee who subsequently became the sole director. The shareholder agreement gave the retired MD investor controls including (most notably) a requirement for shareholder consent to: (i) Make any payments over £5,000 (when such payments were routinely required for trade); and (ii) the hiring and firing of sales and administration staff (as well as management) - some of whom included the retired MD’s family. The new director then authorised a series of dividend payments, at the retired MD’s request, that stripped the company of assets before it entered insolvency a couple of years later. The liquidators then pursued the retired MD for breach of duty as a shadow director.
  • The second example involved an individual venture capitalist taking shares in a fast growth tech company (with the seeming intention of squeezing the founders out). The investor agreement included controls that required the directors to obtain investor consent for virtually every corporate decision (including stationery supply agreements, internet supply contracts and all staff hires amongst other things). They were coupled with various swamping rights. Resentment, then disagreement, set it. A shareholder dispute followed before the company suffered financially from the management conflict and was wound up. The liquidators pursued the investor for breach of duty as a shadow director.

Both cases settled out of Court, but demonstrated the risks of overzealous investor consents. To a seasoned professional investor the controls used were clearly over the top. However, this demonstrates how an investor who is over eager, naive, inexperienced and / or to trying to be clever (or a mix of all) can end up in trouble.

For more information, please contact Frank Bouette, or give us a call on 0345 070 6000.