Shadow Directors – lenders and mortgagees cautioned about the pitfalls of working too closely with defaulting borrowers to achieve a return of capital and interest.

Given the post GFC economic climate, many creditors are pursuing recovery procedures outside the standard legal process after an event of default has arisen. So called “workouts” are one example, where creditors exercise considerable control over the debtor company in default. This gives rise to the possibility of the creditors involved in a “workout” or restructure of a defaulting company being held liable if the workout fails and the company is liquidated. The case of Buzzle Operations Pty Ltd (in liquidation) v Apple Computer Australia Pty Ltd [2011] NSWCA 109 dealt with this issue.

Facts

This was an appeal from White J’s decision arising from the insolvency and liquidation of Buzzle Operations Pty Ltd. The company formed through the merging of six resellers of Apple products. Buzzle and the resellers merged on 13-14 September 2000. Buzzle became insolvent from at least 6 November 2000, leading to Apple appointing receivers on 31 March 2001.

In order for the resellers to merge and transfer their stock to Buzzle, they had to receive permission from Apple. Apple held a charge over the unsold Apple stock the resellers were transferring. Apple entered into a reseller agreement with Buzzle, taking charge over Buzzle’s assets.

Merger Deeds

The Merger Deeds provided for repayment of the transferred assets by Buzzle to the resellers according to two time frames. Regarding the transfer of stock, Buzzle was required to pay by 31 October 2000. The remaining amount was to be paid according to Clause 6.5(b) of the Merger Deeds which provided that:

“Payment of the remaining Cash Component by Buzzle Operations to the Vendors will be deferred until the earlier of:

(i) the float of Buzzle on ASX; or

(ii) the directors of Buzzle forming the view on reasonable grounds that Buzzle Operations has adequate cash flows to pay amounts owing to all Vendors on a pro-rata basis or in accordance with the requirements of that Vendor to pay its creditors”

Buzzle made four payments from October to December 2000 to Apple on behalf of the resellers. The first two, in October, satisfied the debt owed to the resellers for the stock portion of the assets. The second two payments of $1,016,827.64 on 6 November and $108,623.55 on 8 December must therefore have been payment of amounts under clause 6.5(b) of the Merger Deed.

The First Ground of Appeal

The liquidator contended that all of the debts due and payable by Buzzle to vendors for non-Apple stock had been satisfied prior to the payment on 6 November. He therefore believed that the only outstanding debts which could have been satisfied by the November and December payments were for debts subject to clause 6.5(b) of the Merger Deeds.

Uncommercial transactions

The appellants argued that when these two payments were made Buzzle was insolvent and so the payments amounted to uncommercial transactions. To support this claim, reference was made to faulty software used by Buzzle. This made it difficult to make and receive payments.

The appellants argued that a reasonable person in Buzzle’s position would not have diverted funds to pay another person’s debts where at best there would be an offset of a contingent debt which might not ever be payable. Therefore, the Merger Deed clause could not have been in effect. Apple denied that these transactions were uncommercial.  This gave rise to the first ground of appeal. Namely, whether the two payments made in November and December to Apple were uncommercial transactions.

The court held that even if the payments were uncommercial, Apple was not liable to repay the monies. The reason being it acted in good faith and had no reasonable grounds for suspecting insolvency. Young JA stated that as a general rule, a creditor receiving payment of a genuine debt acts in good faith. This rule was not displaced by the appellants because Buzzle was primarily dealing with Apple products. Therefore a reasonable person might take the view that it was appropriate to make the payments to Apple.

The Second Ground of Appeal

When Buzzle encountered financial difficulties, the expertise of Mr Likidis (Apple’s financial director) was offered. He worked closely with Buzzle’s CEO and two of its directors. Further debt was incurred to creditors other than Apple.

Shadow dierctors

This was the subject of the second ground of appeal. Namely, that Mr Likidis and Apple acted as “shadow directors” of Buzzle. And should therefore be liable for the debts incurred by Buzzle.

The key issue was whether Mr Likidis and Apple were acting as “shadow directors” of Buzzle. And whether the liquidator could recover an amount equal to the loss or damage.

The appellants appealed on the grounds that:

1. the primary judge erred in not finding that Apple and Mr Likidis were shadow directors, and
2. in finding that the directors of Buzzle made no delegation of their powers to the representatives of Apple, and
3. in failing to find that Apple and/or Mr Likidis contravened s 588G(2) of the Corporations Act.

Definition of a director

Young JA considered the definition of “director” as per Corporations Law in 2000 (the same definition as found in Corporations Act 2001). A director is:

1. A person who:
   1. Is appointed to the position of a director; or
2. Unless the contrary intention appears, a person who is not validly appointed as a director if:
   1. They act in the position of a director;
   2. The directors of the company or body are accustomed to act in accordance with the person’s instructions or wishes.

A person who fits in to the category of paragraph b(ii) can be termed a “shadow director”.

In accordance with Millett J’s comments in Re Hyrdofoam (Corby) Ltd, in order to establish a defendant as a shadow director of a company it is necessary to prove:

1. Who the directors of the company are, de facto or de jure;
2. That the defendant directed those directors how to act in relation to the company, or that he was one of the persons who did so;
3. That those directors acted in accordance with such directions; and
4. That they were accustomed to act in accordance with the directions.

The Court findings

Many of the things about which Apple or Mr Likidis gave instructions were things which the directors of Buzzle said they would have done in any event. For instance, the plaintiffs alleged that Apple instructed the directors to arrange for Buzzle’s employees to prepare financial reports, prepare a plan for collection of Buzzle’s accounts receivable, and employ resources for debt collection. Young JA agreed with the primary judge to the extent that these activities were for the basic operation of any business.

However, Young JA also considered whether the directors of Buzzle had delegated decision-making powers to Apple and Mr Likidis. The directors were scattered. And each was in charge of his own discrete business unit prior to the merger. And one particular director had control over a large number of the managerial functions. Therefore Young JA found no reason to deem Apple and Mr Likidis to be shadow directors of Buzzle, stating:

“There is a significant difference between a board assigning responsibility for the day to day running of certain activities, and formally delegating its collective responsibility for decision making in those areas. The facts in the present case have the matter in the former category.

Accordingly, the appeal was dismissed with costs.

Implications

The key principles to remember regarding the shadow director doctrine:

1. Not every person whose advice is followed by the board is to be classed as a shadow director.
2. If a person has a genuine interest of their own in giving advice to the board, such as a bank or mortgagee, the mere fact that the board may tend to take that advice to delay enforcement action by the mortgagee will not make the mortgagee a shadow director.
3. The key factor is that the ‘shadow director’ has the potential to control to entity. The fact that he or she may not use their power to control every facet of the company, or that from time to time the board disregards the advice, is not the issue.
4. Whilst there are problems in situations where the board of the company splits into a majority and minority faction, so long as the influence of the ‘outsider’ controls the real decision makers, the outsider exerting the influence is likely to be a shadow director.

This publication is provided for your information and interest only. It is not intended to be comprehensive, and does not constitute and must not be relied on as legal advice. You must seek specific advice tailored to your circumstances.