Insolvent Trading: Who´s Liable?

Australian directors have long lived in the shadow of insolvent trading. However, although directors' liability for insolvent trading is well-known, it's not so widely known that that liability can extend to people and organisations who have never been appointed to the board.

There are two categories of "third party" who can be made liable for a company's insolvent trading debts:

• holding companies

• shadow directors.

A holding company will most usually be a company that holds more than half of the voting shares in a company. However, actions against holding companies are rare, for obvious reasons: a solvent holding company would be reluctant to allow a subsidiary to go into an insolvent winding up, while an insolvent holding company provides an unattractive subject for a recovery action.

Shadow directors are, in some respects, similar to holding companies, in that they have a large degree of control over how a company operates. However, unlike holding companies, they do not have to have any formal connection with the company: a person is a shadow director if the "official" board is "accustomed to acting in accordance with that person's instructions or wishes" (Corporations Act, s 9).

To prevent shadow directors' escaping liability, the law treats them as directors for all legal intents and purposes. This includes insolvent trading.

In 1995, a NSW court held that a 42% shareholder was a shadow director of a company, and hence liable for the company's insolvent trading debts. The 42% shareholding was just one of a number of elements which combined to make the shareholder a shadow director:

• the other shares were widely dispersed (the next largest holding was 10%);

• the 42% shareholder imposed financial reporting requirements on the company, to make its financial reporting consistent with that of the shareholder's group of companies; and

• in their own decision making, the company's directors simply accepted the decisions which had effectively been made by the 42% shareholder.

In passing, the court noted that it is not uncommon for lenders to impose conditions on loans, including conditions as to the application of funds and disclosure of the borrower's affairs; and that it is even less uncommon for lenders to require security for a loan, and then to require the sale of property over which the security is given. In the court's view, these factors on their own would not make a lender a shadow director.

Notwithstanding these comments, the question of whether a lender is a shadow director was never squarely put to an Australian court, until it arose in the Supreme Court of Queensland case of Emanuel Management Pty Ltd & Ors v. Fosters Brewing Group Ltd & Ors [2003] QSC 205.

The Queensland Court was asked to rule that a lender's interaction with a client company was so extensive that the lender had effectively become a shadow director.

In fact, the Court found, the lender had only seldom issued "commands" to the company - and those commands had tended to be ignored in any event. There was no evidence that the company's directors had regularly deferred to the lender's instructions. Indeed, the Court pointed out that the company at one point had begun legal action against the lender - which was irreconcilable with the notion that the lender had been directing the company.

Although this was not a case in which a lender had been "running" the company, the Court took the opportunity to make a definitive statement about what a lender can legitimately do without becoming a shadow director.

It said that, in the ordinary course, a lender will not become a shadow director simply by insisting that the company act to protect the lender's interests.

What is that "ordinary course"? The Court cited the example of a corporate borrower that appears to be in financial difficulty. The lender may respond by:

• sending in an investigator

• demanding that the company's debt be reduced

• demanding security (or further security)

• calling for information such as valuations, accounts and budgets

• asking the company to put forward suggestions as to how the debt might be reduced; and

• advising the company on how to improve its financial position.¹

Doing any or all of these things would not make the lender a shadow director. The lender would be free to make it clear to the company that continued financial support depended upon meeting the lender's demands. But, as long as the final decision clearly rested with the company, the lender would not be a shadow director.

This did not, of course, mean that a lender could never be a shadow director. The Court appeared to suggest, for example, that a board which, over a period of time, repeatedly made management decisions in line with a lender's instructions might be said to be under that lender's control.

Although directors' duties are very wide, suing a director for a breach of duty may be a waste of time if the director has few personal assets.

Lenders, on the other hand, are often viewed as having deep pockets. That provides an incentive to argue that a lender to a failed company should face the same liabilities as its directors.

This decision limits that argument's chances of success. In doing so, it clarifies the legitimate rights of lenders. At the same time, however, it suggests that, when dealing with corporate clients, lenders should take care to spell out the fact that the company's business decisions are for the company alone to make.

1 The court quoted extensively from a 1991 speech about shadow directors by Millett J.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.