Customary puppets: Meaning of Companies Act expression “accustomed to act”

Vinod Kothari and Pammy Jaiswal

corplaw@vinodkothari.com

The expression “accustomed to act” occurring with advice, directions or instructions of a person, is not at all new in corporate laws. Such expression was used in the 1956 Act, and has abundantly been used in the various global legislations like the UK Companies Act 1948, UK Act of 2006, Singapore Companies Act, 2006 as well as the Australian Corporation Act, 2001 to name a few other global jurisdictions. However, the provisions of section 185, restricting and regulating inter-corporate lending to directors’ entities, seems to be giving a new significance to this expression, as Explanation (c) below sec 185 (2) uses this term. Questions do arise as to when can it be presumed that the board of one company acts as per directions of another, or any other person? Who establishes this? Are there circumstances where there is presumption as to such customary adherence, or does it have to be purely left to circumstances?

This article explains the concept and seeks to provide a practical guidance as to the meaning of the expression.

Shadow directors:

The most important reason for the law referring to persons in accordance with whose directions the board of a company is accustomed to act, is to refer to “shadow directors”. Shadow directors are persons who are not formally anointed to the board, and yet, either because of their shareholding or their beneficial control over the company, are able to exercise absentee control over the board of the company. Despite such a person not holding the formal position of a director, such person is “deemed director”.

Sec 2 (13) of the 1956 Act sought to include shadow directors, as the definition included a person occupying the position of a director, by whatever name called. Rightly or wrongly, the 2013 Act makes a clear departure from this principle. Sec 2 (34) of the 2013 Act states that a director shall be regarded as such only where he is appointed as such to the Board. In other words, the functional position as a shadow director no more matters: for being regarded as a director, a person has to be appointed to the board.

At the same time, references to the word “officer” and “officer in default”, in sections 2 (59) and 2 (60) of the Act, continue to include references to shadow directors as well. In other words, responsibilities of the law fastening to “officers in default” may include shadow directors too, but the expression “director” cannot be deemed to include reference to a shadow director. The definition of “promoter” in sec. 2 (69), and “related party” in sec 2 (76) also include the reference to shadow directors.

Global position on accustomed to act

Under the UK law:

The UK Companies Act 2006[1] contains elaborate references to “shadow directors”. Sec 251 specifically defines the term as well. Of course, the definition goes no further than stating the most obvious: “In the Companies Act “shadow director”, in relation to a company, means a person in accordance with whose directions or instructions the directors of the company are accustomed to act.” Sub-section (2) makes an exception to following advice given in professional capacity. As is obvious, a shadow director may be either an individual or any other person.

The UK law also makes a specific exception to a holding company – a parent shall not be deemed to be a shadow director of the subsidiary, merely by reason of the board of directors of the parent acting as per the directions or advice of the parent. It is but natural that the board of a subsidiary will act as per the advice of the parent.

Under the Australian Law:

Even though the Australian Corporation Act, 2001[2] do not contain explicit mention of the term shadow director, however, the definition of the term director is clear enough to include and strongly indicate towards a person who even though is not validly appointed as a director but the directors of the company are accustomed to act as per the instruction or wishes of such person

Further, the definition also clarifies that such advice if made on a professional basis will not attract the provisions of a shadow director.

Under the Singaporean Law:

Similarly, the definition of director under the Singaporean Companies Act, 2006[3] contains like provisions as that under the Australian law.

Under the US Law:

The Jamaican Companies Act[4] also defines a shadow director and contains similar provisions as that under the UK law.

Judicial guidelines on identification of shadow directors:

There are several rulings on shadow directors, and in the era where institutional investors continue to exercise control on the strength of shareholders’ agreements, the phenomenon of absentee control on boards of companies continues to get stronger.

One of the classic authorities is Re Hydrodan (Corby) Ltd [1994] BCC 161. Millet J in this ruling gave several indicia of absentee directorship, and said that prima facie, the existence of such relationship has to be proved by the person alleging it. “What is needed is first, a board of directors claiming and purporting to act as such; and secondly, a pattern of behaviour in which the board did not exercise any discretion or judgment of its own, but acted in accordance with the directions of others”. One must stress the factual assertion that the board did not exercise any discretion or judgement of its own.

In Secretary of State for Trade and Industry v Deverell [2001] Ch 340, the scope of the expression “instructions” or “directions” was widened, even to include informal communication. Here, the court came to a finding that the so-called “guidance” given by Mr Deverell gave to his guidance the potency of a instructions or directions. He was listened to and followed. Hence, he was regarded as a shadow director.

Another ruling where the distinction between shadow director and de facto directors has been discussed, and disbanded, is Holland v The Commissioners for Her Majesty’s Revenue and Customs (Appellant) v Holland and another [2010] UKSC 51 .

Quite often, positive as well as negative control is exercised pursuant to commercial contracts or shareholders agreements. It may be interesting to argue whether such rights of positive or negative control would put the controlling party to the position of a shadow director. One such interesting case is Australian ruling in Buzzle Operations Pty Ltd (in liq) v Apple Computer Australia Pty Ltd [2010] NSWSC 233 and [2011] NSWCA 109. Here, the court laid several principles – first, that the directions or instructions by the alleged shadow director must be in relation to board matters, that is, matters requiring decision of board of directors. Second, referring to the test laid by Millet, J in Hydrodan, the court laid here that it is not necessary that the board of the controlled company must not exercise any discretion at all. It is still possible for the board of the controlled company to exercise discretion in matters where there is no direction from the shadow director. Third, there must be a clear causal link between the instructions given by the shadow director, and the actions on the part of the board of the controlled company. Mere commercial pressure is not sufficient. Finally, it is not necessary to ensure that the entire board of the controlled company acts as per directions of the shadow – it is sufficient if a functional majority does so.

Further, in the matter of Vivendi SA v Richards and Bloch[5], reliance was placed in the matter of Secretary of State for Trade and Industry v Deverell to conclude that Mr. Richard and Mr. Bloch have acted against their fiduciary duties and hence are liable under the law.

Who decides whether there is a shadow director:

It is imperative to note the provisions of section 166 (3) which states the following:

“A director of a company shall exercise his duties with due and reasonable care, skill and diligence and shall exercise independent judgment.”

The provisions of this section are explicit to clarify the position of directors and the judgement they are expected to exercise while delivering their obligations in the company. Being appointed by the member of the company, they are reposed with the faith and expectations of the members and thus, stand in a fiduciary capacity. In case, the actions of a director are influenced or instigated by the directions of a third party (not being an advise on a professional basis), the provision of section 166 (3) is said to be breached to call for prosecution on the accused director.

Clearly, it is purely a circumstantial issue as to whether the board of a controlled company is merely acting as a puppet in the hands of a shadow director. There is a basic presumption that a properly constituted board of directors of any company acts as per its own wisdom in the best interest of the company. Directors of every company are presumably aware of their duties, and liabilities in law, and therefore, the presumption to be made at the threshold is that every board is independent, and is not the alter-ego of another person or entity.

If someone alleges that the board is, in fact, accustomed to act as per instructions, the duty of discharging the onus is on the person making the allegation.

Can the holding company be said to be shadow-controlling the subsidiary:

As mentioned above, the UK Companies Act contains a specific exception in case of holding companies. However, the question is, had there been no such exception, is it likely that the board of the subsidiary company will be deemed controlled by the board of the holding company? The holding company’s control over the board of the subsidiary company is a de-jure control. On the face of it, the holding company is the parent, and hence, entitled to both shareholding control as well as management control. The sole purpose of shadow control is to detect and bring on board control which is latent, and not apparent. Surely the control of a holding company does not fall in this category.

Conclusion:

With plethora of duties and liabilities cast upon directors, the erstwhile practice of putting nominees on the board, by institutional investors or other stakeholders, may undergo a change. If control can be exercised without being on board, why be on the board at all? In such a situation, the deliberate deletion of the functional test of directorship in the 2013 Act may be undesirable. However, in application of restrictive provisions such as sec. 185 pertaining to loans to directors, whether a borrower or beneficiary company is shadow-controlled by the lending company or any director of the lending company, is a factual question that will continue to create confusion.

[1] http://www.legislation.gov.uk/ukpga/2006/46/pdfs/ukpga_20060046_en.pdf

[2] https://www.legislation.gov.au/Details/C2018C00031

[3] https://sso.agc.gov.sg/Act/CoA1967

[4] http://www.oas.org/juridico/english/mesicic3_jam_companies.pdf

[5] https://www.casemine.com/judgement/uk/5a8ff74260d03e7f57eaa801