The directors of a corporation are critical to the company’s day-to-day operations. As a result, they owe the corporation certain fiduciary duties and are accountable to all stakeholders. These responsibilities have been established in India under Section 166 of the Companies Act of 2013. Acting in good faith, exercising reasonable care, skill, and diligence, exercising independent judgement, and avoiding undue gains are all examples of such responsibilities. As long as a firm is solvent, directors’ liability is primarily to its shareholders, as they are expected to make impartial judgments in their best interests. When a firm goes insolvent, however, directors’ focus must shift from “making profit for shareholder wealth maximisation” to “minimising loss to and defending the interests of creditors.” As a result, the Insolvency and Bankruptcy Code, 2016 (IBC,2016) was introduced, which aims to save the life of a firm in financial crisis.
Several countries’ bankruptcy legislation clearly mentions the liabilities that directors may incur during an impending insolvency. Liability for avoidance transactions (i.e., preferential deals, undervalued transactions, etc. ), improper dealing, fraudulent trading, misfeasance, and so on are among these liabilities. The aforementioned obligations may apply not only to nominally appointed directors, such as executive and independent directors, but also to non-appointed people referred to as “shadow directors.”
The purpose of this article is to clarify the meaning and concept of a shadow director, as well as his legal status in a corporation, and to examine his liabilities under insolvency law in depth.
Meaning of a Shadow Director:
The term “shadow director” was borrowed from English law. A shadow director is a person who, despite not being technically designated as a director, is accustomed to acting in accordance with the commands or instructions of the company’s directors. However, just because the directors act on his recommendations in a professional capacity does not make someone a shadow director.
To be designated as a “shadow director,” a person must have significant power to influence the entire or majority of a company’s Board of Directors (“Board”), make financial, commercial, and investment decisions that bind the company, and, in some cases, have full or partial management authority delegated to him by the company.
It could also include someone who was involved in the company’s establishment, promotion, or management. For example, a private company’s controlling shareholder who is not appointed as a director and does not actively participate in the company’s governance may offer directors or instructions that are routinely followed by staff or other directors. Special advisors, lenders, and bankers may also be considered shadow directors in specific instances.
As a result, if a person possesses the aforementioned powers, he may be deemed a shadow director regardless of the formal title accorded to him. He is a de facto director in the eyes of the law and is held equally responsible for the company’s tasks as the other de jure directors. It is critical to evaluate the specific person’s behaviour and the regularity with which it occurs in order to assess whether or not the influence is being used.
Legal position of a shadow director:
Although the word “shadow director” is not defined in the Companies Act of 2013, it is mentioned several times in the Act. The phrase “shadow director” is defined in Section 251(1) of the UK Companies Act, 2006 as “a person in accordance with whose commands or instructions the directors of the business are accustomed to act.”
In the following sections of the Companies Act of 2013, there is a similar definition to the one given above:
- Section 2(59) – “officer” means “any person in whose direction or instruction the Board of Directors or any one or more directors is or is accustomed to act.”
- Section 2(69)(c) – “promoter” means “a person whose advice, directives, or instructions the company’s Board of Directors is accustomed to act on.”
- Section 2(60)(v) – “officer who is in default” means “any person in whose advice, directions, or instructions the Board of Directors of the company is accustomed to act, other than a person who advises the Board in a professional capacity,” for any provision of this Act that enacts that an officer of the company who is in default shall be liable to any penalty or punishment by way of imprisonment, fine, or otherwise.”
As a result, the position of shadow director is unquestionably acknowledged and granted legal status under the Companies Act of 2013. This is vital to guarantee that they do not misuse the power that has been given to them and take advantage of the fact that they are not formally appointed in the organisation.
Liability of shadow directors for insolvency procedures
Directors’ responsibility under the IBC of 2016 can be punitive or disgorgement-based. Punitive liability arises when an element of mens rea is present, such as cheating creditors, concealing property, undervaluing transactions, or falsifying books of accounts, and the liability may be shown by a definite set of objective facts. Disgorgement responsibility, on the other hand, is imposed when wrongful trade or certain other unethical commercial activities occur, necessitating the restitution of ill-gotten gains.
The liability of directors and other persons is addressed under Section 66 of the IBC, 2016. Section 66(1) covers fraudulent trading, whereas Section 66(2) covers unlawful dealing. Any person, including ‘insiders’ and ‘outsiders’ such as workers, directors, including shadow directors, and any third parties, is liable for fraudulent trading. In the instance of improper trading, however, only insiders, such as corporate directors or partners, are liable. This section does not distinguish between executive, independent, or shadow directors, and it applies to all types of business directors. As a result, both fraudulent and unjust trading can be held against shadow directors.
Liability under the UK Insolvency Act, 1986
The regulations of India relating to fraudulent and unjust dealing are based on the UK Insolvency Act 1986. (UK Act, 1986). The provisions of the UK Act, 1986 seek to hold directors responsible not only for deceiving creditors, but also for reckless and negligent acts committed during a period of financial difficulty. Shadow directors are not exempt from the aforementioned liability, and the UK Act of 1986 tries to hold them liable for both fraudulent and wrongful trade.
Liability for fraudulent trading
On an application submitted by the liquidator, section 213 of the UK Act, 1986 allows the court to force any person to contribute to the company’s assets if they were knowingly party to fraudulent business trading with the intent to cheat creditors.
As a result, the corporation’s liability for fraudulent trading will not be decided until the company is liquidated. In such circumstances, the shadow director’s actions throughout the period leading up to liquidation must be considered. An purpose to cheat creditors can be inferred if a corporation conducts business and incurs debt when there is no reasonable possibility of repayment, to the knowledge of the party liable.
Only civil liability is covered under Section 213 of the UK Act, 1986, which allows liquidators to obtain compensation from anyone who knowingly assisted in the dishonest conduct of a company’s business. In the case of In Re Patrick and Lyon Ltd, a company director postponed liquidation for six months in order to prevent creditors from recovering their debts. The court decided that the court’s authority is limited to civil matters, and that the previous or present directors of the company, including shadow directors, are personally liable for all or any of the company’s debts as the court may designate.
Liability for wrongful trading
A shadow director is personally liable for contributing to the assets of a company that has gone into liquidation under Section 214 of the UK Act, 1986, if he continued to trade negligently and recklessly when he knew or should have known that the company had no chance of avoiding the liquidation process.
In the instance of Re Continental Assurance Company of London Plc, the company went bankrupt due to large losses caused by unexpectedly high travel insurance claims and the inability to make adequate provisions in the company’s reserves to cover these claims.
The liquidators filed a complaint under Section 214 of the aforementioned Act against the former managing director and several of the company’s former non-executives, alleging that the directors should have halted trading when the losses were first discovered.
The court, however, dismissed their argument, noting that the defendants acted properly in deciding that the company could continue trading while they sought a buyer for its business based on the information available at the time. Furthermore, they were actively involved in keeping the company’s financial status under constant scrutiny, and a fairly diligent person in their position could not have been expected to do any more.
As a result, a shadow director would be judged against the general knowledge, competence, and experience that a’reasonably diligent individual’ functioning in a similar role would possess.
Prioritising creditors’ interests
This section is responsible for shifting the focus of directors’ duties from shareholders to creditors during the ‘twilight zone’ (the period between the time when the director knew or should have known that there was no reasonable possibility of avoiding the commencement of CIRP and the time the company enters into such resolution), as it imposes personal liability on such directors to the extent of the potential loss incurred by creditors as a result of failure to comply with the resolution.
During this time, the director is given additional responsibilities, including prioritising the interests of the creditors over the interests of the shareholders and ensuring that the company’s affairs are properly managed and its assets are not abused to the detriment of such creditors. As a result, a shadow director must ensure that he acts in good faith and in the creditors’ best interests.
The confusing issue in this Section is establishing the exact moment when the twilight zone begins. Despite the ambiguity of this problem, a fair expectation of insolvency, along with knowledge that insolvency is imminent, will trigger a shift in directors’ interests from shareholders to creditors.
Ceasing of directors’ liability
During this time, the director is given additional responsibilities, such as prioritising the creditors’ interests over the owners’ interests and ensuring that the company’s affairs are properly managed and its assets are not abused to the detriment of such creditors. As a result, a shadow director must act in good faith and in the creditors’ best interests.
In this section, the confusing issue is defining when the twilight zone begins. Despite the ambiguity of the situation, a fair expectation of insolvency, along with information that insolvency is imminent, will force directors’ interests to shift from shareholders to creditors.
Punishment for transactions defrauding creditors
If the defaulting party is an executive of the firm, Section 69 of the IBC, 2016 recognises significant criminal consequences for cheating creditors. It entails a minimum sentence of one year, which may be extended to five years, or a fine of not less than Rupees 1 lakh but not more than Rupees 1 crore, or both.
Under Section 5(19) of the IBC, 2016, the term “officer” is defined as an officer who is in default as defined in Section 2(60)(v) of the Companies Act, 2013. As previously indicated, a shadow director is regarded an officer-in-default under the said clause and is thus subject to the required punishment.
Steps that can be taken to mitigate liability
The shadow director must guarantee that the company’s business value is protected while also avoiding personal culpability by taking suitable steps to minimise the likely loss to the company’s creditors. Even though the company is now solvent, it may be brought into CIRP due to temporary liquidity concerns. As a result, in order to avoid personal accountability, the shadow director must exercise caution. As a result, the following mitigation measures can be taken:
- Negotiate long-term loan contracts so that any default in payment allows the opposing party to commence CIRP only after giving the company a significant amount of time to consider all of the possibilities. As a result, he will have more time to consider all of his possibilities.
- Maintain suitable procedures to allow prompt consultation with the company’s auditors in order to obtain adequate financial information.
- Discuss and analyse the company’s cash flows on a regular basis, and keep a close eye on all actual and contingent claims against the company.
- Obtain director and officer liability insurance and examine it on a regular basis to ensure that it covers any responsibility that may arise as a result of improper trading.
- Ensure the employment of independent and reputable merchant bankers to formally opine on the viability and solvency of the business in the near future, especially if there are early indicators of difficulty.
- Obtain legal advice from reputable law firms to verify that actions made at the start of a possible CIRP meet the “due diligence” criteria laid out in Section 66(2) of the IBC, 2016.
Finally, if everything else fails, apply for CIRP as soon as possible if it appears that delay would result in a further drop in the value of assets to creditors.
Conclusion
Regardless of the challenges that come with making sound business decisions, when a firm is experiencing financial issues, immediate action is required. A financial slump frequently happens faster than many people believe. As a company’s financial situation worsens, the alternatives for finding a feasible solution become dwindling. The shadow directors are obligated to stay informed about the company’s financial situation. If they fail to take aggressive actions to recover a financially distressed company, the law should hold them accountable.
Section 66 of the IBC, 2016 aims to do this by not only making such directors’ culpability unlimited in cases of fraudulent trading, but also requiring them to contribute to the company’s assets in cases of negligence or recklessness. As a result, shadow directors, among others, should be aware of the company’s financial status and have access to all reasonably available information in order to do due diligence in order to address the company’s financial distress and satisfy creditors’ claims.
