High Court upholds strike out of claim based on allegation a financial institution breached fiduciary duties as a shadow director of its customer

In a recent decision the High Court has held that a financial institution which is alleged to have been a shadow director of its customer will not be liable for breach of fiduciary duty unless the breach is linked to an instruction or direction given by the institution: Standish & Ors v The Royal Bank of Scotland plc & Anor [2019] EWHC 3116 (Ch).

The decision will be of particular interest to financial institutions involved in turnarounds, restructurings and the exercise of control, management or similar rights arising upon default under facility agreements.

Generally speaking, financial institutions will wish to avoid giving directions or instructions to the directors of a borrower company to minimise the risk of being found to be shadow directors. However, because Standish arose in the context of an interim application for strike out, it was assumed that the financial institution would be shown to constitute a shadow director. The decision therefore considered what duties would be owed by the financial institution in those circumstances – would it owe all of the duties that are owed by de jure directors of the company or instead duties which are specific to the directions or instructions given by the financial institution?  The court held that the latter approach now reflects the settled legal position.

Background

The claimants were current and former shareholders in a company named Bowlplex Ltd (the “Company”), which owned and operated bowling sites across the UK. The Royal Bank of Scotland plc (the “Bank”) provided the Company with banking facilities from 2004.

The Company was referred in June 2010 to the Bank’s Global Restructuring Group (“GRG”), following the Company’s breach of financial covenants. As a result, the Company was introduced to West Register Number 2 Ltd (“West Register”), an indirect wholly owned subsidiary of the Bank, and West Register’s employee, Mr Sondhi. Mr Sondhi indicated to the Company that West Register was interested in acquiring 80% of the equity of the Company in exchange for securing the continued support of the Bank.

The Company was subsequently restructured on two occasions. Under the first restructure, West Register acquired 35% of the Company and the Bank agreed to a restructuring of certain of the Company’s indebtedness. It was a condition of the first restructure that West Register would be permitted to appoint an observer to attend the Company’s board meeting and a non-executive chairman.

West Register subsequently appointed a chairman with a background as a turnaround consultant. The Company then implemented a company voluntary arrangement under which the Bank wrote off £4.5 million of indebtedness and West Register increased its equity holding to 60%. Shortly thereafter, the chairman sacked the Company’s managing director and former majority shareholder.

Ultimately, the Company was sold and West Register was paid £13.6 million in respect of its shares.

First instance decision

The claimants contended that the Bank, West Register and the chairman were parties to a conspiracy to enable the Bank or West Register to acquire the Company’s equity at the expense of the claimants via the use of unlawful means. The claimants argued that they had suffered loss in the amount of approximately £18 million, being the value they would have realised for their shares had they not been transferred to West Register pursuant to the two restructurings.

The claimants had initially relied on broad range of allegedly unlawful means, including breaches of contract based on an implied term of good faith. These were struck out by Chief Master Marsh in July 2018: see our banking litigation blog post.

One of the unlawful means alleged by the claimants was that West Register (or alternatively Mr Sondhi) acted in breach of its fiduciary duties as a shadow director. In particular:

  • Mr Sondhi was said to have been a shadow director because he was a person in accordance with whose directions or instructions the directors of the Company were accustomed to act. He had intervened during board meetings, added items to agendas for board meetings, required the Company to instruct professional advisers of his choosing and appointed a turnaround consultant as chairman.
  • As a shadow director, Mr Sondhi was said to owe the Company the duties which are owed by a de jure director, including to act independently in the best interests of the Company without conflict of interest.
  • The claimants argued that, through Mr Sondhi, West Register was also a shadow director of the Company owing fiduciary duties and that, in any event, the Bank and/or West Register were vicariously liable for any breach of fiduciary duty by Mr Sondhi.
  • As an alleged shadow director, West Register was alleged to have breached its duties by refusing the Company’s reasonable proposals to allow the Company to trade through its difficulties and by promoting the restructurings by which it acquired a majority shareholding in the Company. West Register was also alleged to have made demands on management time which prevented management from pursuing alternative financing, leaving the Company no option but to enter into the restructurings.

Though Chief Master Marsh struck out the claim based on the shadow directorship allegation, the claimants were granted permission to appeal to a judge.

Decision of the High Court (on appeal)

On appeal to the High Court, the shadow directorship allegation was therefore the only unlawful means relied on by the claimants. If the allegation was struck out, the claimants’ conspiracy claim was bound to fail.

Trower J, a company and insolvency specialist in private practice before his recent appointment to the bench, dismissed the appeal.

As the appeal of a strike out application, the court was required to assume that the relevant parts of the claimants’ statements of case would ultimately be proven. It therefore assumed that Mr Sondhi and West Register had given directions or instructions to the board and that, in doing so, they had become shadow directors of the Company because the other directors were accustomed to act in accordance with their directions or instructions.

The main issue on appeal was which of a director’s duties, if any, Mr Sondhi and West Register owed as shadow directors. While the Companies Act 2006 (the “Act”) codified the duties owed by a de jure or de facto director of a company, the application of those duties to shadow directors was left to the common law and equity. The cases before the enactment of the Act had not definitively determined whether a person, once found to be a shadow director, then owes general duties to a company with the same content as the duties owed by a de jure director. The more common result in the few decisions after the Act’s enactment was that such a person would only owe duties in respect of the directions or instructions which had constituted it a shadow director.

The court followed the recent trend. It was “quite clear” based on both the wording of the Act and on the more recent authorities that the full range of fiduciary duties owed by a de jure director are not imposed on a person that qualifies as a shadow director. That is because a person can acquire the status of a shadow director by giving instructions or directions in relation to only part of a company’s business or affairs. For that reason, the shadow director’s duties must be limited to the aspects of the company’s business or affairs which were affected by his directions or instructions.

A shadow director does not, therefore, owe a general duty to act in the best interests of the company. For a shadow director to be in breach of fiduciary duty, it must be shown that the failure to act in the best interests of the company was linked to a matter on which the shadow director had given directions or instructions.

Anticipating this result, the claimants sought to argue that, in this case, the directions or instructions of Mr Sondhi and West Register were sufficiently linked to their alleged breaches. The court rejected that argument. The pleaded acts of Mr Sondhi and West Register were general in nature – they related, for example, to the conduct of board meetings and the promotion of the restructurings. However, the alleged breaches of duty on which the claimants relied related to the pursuit and implementation of the restructurings. The claimants did not allege that either Mr Sondhi or West Register had given any instruction or direction to implement the restructurings, so they could not be liable for a breach in relation to their pursuit or implementation.

The court also rejected an argument that the directions or instructions of Mr Sondhi and West Register had caused the appointment of a turnaround consultant as the Company’s chairman, and that his appointment had ultimately caused the Company then to enter into the restructurings. The claimants were unable to point to anything in their statements of case which alleged how the direction or instruction to the board of the Company to appoint a chairman was said to have caused the Company at some time later to enter into the restructurings. That was particularly so where the chairman had only been appointed after the first restructuring. While Mr Sondhi was alleged to have promoted the restructurings and to have refused to agree to alternatives to it, it was not pleaded that either of these events was caused by the instruction or direction to appoint the chairman.

The judge further held that the application of commercial pressure by Mr Sondhi and West Register so as to leave the Company with no choice but to carry out the acts which they promoted was not the same as Mr Sondhi or West Register giving an instruction or direction from which the status of shadow directorship could flow.

It followed that all of the unlawful means on which the claimants relied were struck out. Their claim in conspiracy could not, therefore, succeed.

Comment

The decision will provide useful guidance and some comfort to financial institutions. Even if they, or their subsidiaries, employees or representatives, are found to have given directions or instructions which constituted them shadow directors of a customer, that will not mean that the bank then automatically owes all of the duties of a de jure director, including a duty to act in the best interests of the customer and not the institution’s own interests.

Instead, the court will undertake a qualitative assessment of the specific directions or instructions given by the financial institution and the duties which ought to attach to them. While it is possible that the directions or instructions pervaded all aspects of a company’s business so that general duties of directorship will be owed, where the directions or instructions are specific to particular acts of the company or areas of its business, the duties of the financial institution will be limited accordingly.

The decision also clarifies that there must be a specific direction or instruction. The application of commercial pressure is not sufficient. Further, the direction or instruction must be directly linked to the act which is said to have been a breach of fiduciary duty. It is not enough that the direction set off a sequence of events which resulted in a breach of duty. That is particularly so where the directors of the Company are required by their own duties to take decisions in relation to those events as they unfold – the appointment of a turnaround consultant as chairman did not cause all of the events which followed.

Natasha Johnson
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High Court confirms potential liability of creditors for breaches of duty by administrators

The decision in Davey v Money & Anor [2018] EWHC 766 (Ch) serves as a useful reminder for secured creditors (such as banks) of the potentially broad-ranging scope of liabilities that they may be exposed to in the course of dealings with administrators. In addition to the usual sorts of claims for ‘accessory liability’ that might be raised in that context, in this case the court concluded that, in the same way as a mortgagee can be responsible for the actions of a receiver, it was possible for a secured creditor to be liable for breaches of duty by an administrator on the basis that it directed or interfered in the conduct of an administration.

In particular, it shows that secured creditors may be liable in circumstances beyond those which might give rise to liability for dishonest assistance, procuring a breach of duty or an unlawful means conspiracy. Secured creditors should therefore be mindful of seeking to control the conduct of an administration. As a practical measure, it may also be sensible to ensure that proper records of dealings are kept and that relevant communications are set out in writing.

Background

The claimant was the sole director and shareholder of Angel House Developments Ltd (“Angel“), a property development company in liquidation. The claimant was also the guarantor of Angel’s indebtedness to Dunbar Assets plc (“Dunbar“), which appointed Mr James Money and Mr Jim Stewart-Koster as administrators (the “Administrators“).

The claimant brought a claim under paragraph 75 of Schedule B1 to the Insolvency Act 1986, which empowers the courts to inquire into potential misfeasance by an administrator at the request of a creditor or contributory.

The claimant alleged that:

  • the Administrators conducted a “light-touch” administration in which they failed to exercise independent judgment and instead had excessive regard to the interests and wishes of Dunbar;
  • the Administrators failed to take steps to involve the claimant in the administration which, the claimant alleged, would have led to the rescue and survival of Angel;
  • the Administrators sold Angel’s main asset, a commercial property, at a significant undervalue in reliance on unsuitable agents (Alliance Property Asset Management Limited, “APAM“) who had conducted a flawed marketing campaign and whom Dunbar had in effect selected;
  • Dunbar directed or interfered in the conduct of the administration so as to make the Administrators its agents, and that it was therefore liable for their breaches of duty;
  • Dunbar procured the breaches of duty by the Administrators; and
  • Dunbar conspired with APAM to cause Angel and/or the claimant loss by unlawful means, namely by deliberately causing the Administrators to carry out a limited sale process for Angel so as to realise insufficient monies to enable the secured indebtedness to Dunbar to be repaid, leaving Angel liable for the balance and the claimant liable on the personal guarantee.

Decision

The court dismissed all of the claimant’s allegations. However, on the question of whether it was possible as a matter of law for a secured creditor to direct or interfere in the conduct of the administration so as to make an administrator its agent, the court concluded that it was difficult to see any convincing policy reason why there should be any difference between the position that applies if the sale of the property were to be conducted by a receiver (where the authorities hold that it could make such a disposal) or an administrator.

That being the case, the court went on to consider what level of involvement would be required in order to justify a finding that an agency relationship had been created between an administrator and a secured creditor or otherwise to justify the imposition of liability on a secured creditor. The court adopted the formulation from the receivership authorities, that the mortgagee might be liable if it “directed or interfered” in the conduct of the receivership. It found that, to establish such a liability, it would be necessary to show something going beyond the legitimate involvement that a secured creditor could expect to have in the administration process by reason of his legal status and rights. That was because the formulation of the “directed or interfered” standard indicated that the administrator should either have been compliant with directions given by the secured creditor, or have been unable to prevent some interference with his intended conduct of the administration:

So, for example, I do not think that an agency relationship would be established merely because the secured creditor gave its consent to a sale of charged property which had been organised by the administrator. Nor would that be the case simply because an administrator had consulted the secured creditor and taken account of its wishes, even on a regular basis. Nor would such a relationship be established merely because the secured creditor took a commercial decision in the exercise of its own rights which necessarily constrained the administrator’s freedom of action. But if, in contrast, the secured creditor gave directions which the administrator unquestioningly followed, or if (to adapt the example in Morgan v Lloyds Bank plc) the secured creditor misled the administrators or exerted sufficient pressure on them so as to defeat their free will, then I see no reason why the courts should not be able to hold the secured creditor liable if the property in question was sold negligently for a price that diminished or eliminated the value of the company’s equity of redemption.

The court then considered whether Dunbar had procured breaches of statutory duty by the Administrators and whether Dunbar had conspired with APAM to injure Angel or the claimant by unlawful means. The court dismissed both of these allegations on the facts. It also emphasised that a claim for accessory liability against Dunbar in respect of breaches of fiduciary duty on the part of an administrator would lie in a claim for dishonest assistance.

Comment

Although the claimant’s allegations failed on the facts, the court’s judgment highlights the range of liabilities which secured creditors may be exposed to if they ‘overstep the mark’ in the course of an administration.

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Alex Lerner
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UK Supreme Court clarifies the “balance-sheet” insolvency test

BNY Corporate Trustee Services Limited v Eurosail-UK 2007-3BL PLC [2013] UKSC 28

The Supreme Court has delivered a judgment providing welcome clarification on the construction and effect of section 123(2) of the Insolvency Act 1986 (the “balance-sheet” insolvency test) and its interaction with section 123(1)(e) of the Act (the “cash flow” insolvency test).The decision is relevant not just to creditors presenting winding-up petitions in respect of insolvent debtors but also to the wider banking industry, insofar as insolvency related events of default are commonly incorporated in finance documents (either by direct reference to the statutory provisions or by some other means).

Key findings

  • There is no clear indication as to how the two insolvency tests under the Insolvency Act 1986 are intended to interact. Section 123(1)(e) refers to debts “as they fall due” and section 123(2) makes a direct reference to a company’s assets and liabilities.
  • The “cash-flow” test is not simply concerned with presently-due debts owed by the company, but also with debts falling due from time to time in the reasonably near future.  What constitutes “the reasonably near future” depends on all the circumstances and, particular, the nature of the company’s business. Once the court has to move beyond the reasonably near future, any attempt to apply the cash-flow test becomes speculative and a balance sheet test becomes “the only sensible test“.
  • The “balance-sheet” test is not to be taken literally. There is no statutory provision linking section 123(2) of the 1986 Act to the detailed provisions of the Companies Act 2006 as to the form and contents of a company’s financial statements. The “balance-sheet” test concerns a comparison of present assets with present and future liabilities (discounted for contingencies and deferment). This is far from an exact test and will depend on all the circumstances of the company’s business. Crucially, however, the test does not concern a test as to whether the company has “reached the point of no return” as a result of an incurable deficit in its assets. The abandonment of this aspect of the test overturned the decision (but not the ultimate findings) of the Court of Appeal.
  • The “point of no return” test goes beyond the need for a petitioner (or any party seeking to assert balance-sheet insolvency) to satisfy the court that, on the balance of probabilities, a company has insufficient assets to be able to meet all of its liabilities, including prospective and contingent liabilities. The academic reference to a company “reaching the point of no return1 (as cited and relied on by the Court of Appeal) serves only to illustrate the purpose of section 123(2), but it does not purport to paraphrase it. The Supreme Court warned that the phrase should not pass into common usage as a paraphrase for the effect of section 123(2).

Key facts

The present case concerned the solvency of Eurosail, which was a single purpose entity set up by Lehman Brothers (as part of a securitisation transaction) to issue interest paying notes. The underlying portfolio comprised non-conforming mortgage loans secured on residential property in the United Kingdom.

The Court considered that there were three “imponderable” factors which determined Eurosail’s ability to meet its liabilities, the majority of which could be deferred until the final redemption date of the notes (which was scheduled for 2045). Those factors were currency movements, interest rates and the United Kingdom economy and housing market. These factors were outside the control of the company and, given the redemption date of 2045, were a matter of speculation. Eurosail was not engaged in normal business activities and there were no management decisions to be made as to how the company should be run.

Comment

The decision will be welcomed by holders of distressed debt in particular and participants in the financial markets generally. The “point of no return” test adopted by the Court of Appeal set a high hurdle for parties seeking to assert insolvency in complex commercial scenarios.

However, the problem of uncertainty remains. The “balance-sheet” test under section 123(2) is not simply concerned with a review of the company’s financial statements. This will be assessed on a case-by-case basis and the Court gave no general guidance as to which factors will be taken into account. Rather, it will take into account “all the relevant circumstances“. In the present case, the Supreme Court considered there were five salient features of the conditions (and the supporting documentation) to the securitisation transaction which meant that the majority of Eurosail’s payment obligations could be deferred to 2045:

  1. The obligation to pay interest on certain junior notes was deferred to the redemption date if insufficient funds were available at the time the obligation became due;
  2. Temporary shortages of income were provided for by a Liquidity Facility;
  3. The redemption of the notes was not due until 2045;
  4. If there was surplus income from portfolio’s assets, the ‘excess spread’ could be used to reduce or eliminate any deficiency on whatever was the highest-ranking class of principal notes with a deficiency; and
  5. The transaction incorporated a post-enforcement call option (a “PECO”). If there were insufficient funds to repay the entire principal in the event of enforcement of the security, a call option was triggered whereby the option holder (a company related to the issuer) had an option in respect of the benefit of all the notes for a nominal purchase price. The purpose of this mechanism was to achieve bankruptcy remoteness for the issuer by limiting, in practical terms, Eurosail’s susceptibility to winding-up proceedings.

Since the majority of the payment obligations would not fall due until 2045, and Eurosail’s performance in the intervening 30 years would depend on the three “imponderable” factors identified above, the Supreme Court was not satisfied, on the balance of probabilities, that Eurosail had insufficent assets to meet all of its liabilities. Eurosail could not therefore be said to be “balance sheet insolvent” at this time.

Although a highly fact-specific case, Eurosail illustrates the type of factors that the Court will take into account when determining balance-sheet insolvency. As is clear, the Court will not be required to assess whether the company can trade its way out of financial difficulty or has met the point of no return. Notwithstanding the Supreme Court’s curtailment of the test, it is apparent from the decision that neither the cash-flow test nor the balance-sheet test can be precisely characterised.

Therefore, in order to give maximum flexibility to contracting parties who may seek to assert insolvency Events of Default, it is prudent for draftsmen to ensure that both tests are incorporated into the contractual documentation (either by direct reference to the statute or by words to that effect). This is already seen in various types of standard form documentation. For example, section 5(a)(vii)(2) of the 2002 version of the ISDA Master Agreement states that Bankruptcy Events of Default will be triggered when a Party “becomes insolvent[the balance-sheet test] or is unable to pay its debts [the cash-flow test]”.

Sir Roy Goode, Principles of Corporate Insolvency Law, Third Edition (2005) para 4-06

Damien Byrne-Hill
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UK Supreme Court refuses to enforce US judgment made in insolvency proceedings against English resident defendants

In Rubin v Eurofinance SA [2012] UKSC 46, the Supreme Court (by a majority of 4 to 1) reversed the Court of Appeal’s unanimous decision and held that the English court would not enforce a judgment made by the New York court in insolvency proceedings to which the defendant did not submit. In doing so, the Supreme Court gave valuable guidance as to the inherent conflict between the principle of universalism in insolvency proceedings and the common law rule that a foreign judgment should not be enforced unless the defendant was present in the foreign jurisdiction or otherwise voluntarily submitted to the proceedings in its courts.

Though the Supreme Court’s decision is most relevant to the enforcement of judgments made in foreign insolvency proceedings, it may also affect the scope of the English court’s ability to assist foreign insolvency proceedings. Importantly, the decision allows English residents with English assets to continue to make their own decisions about whether to submit to a foreign jurisdiction outside the EU, regardless of whether or not their counterparty has entered a foreign insolvency proceeding.

For more information, please see our Litigation Notes blog.

Delay to implementation of Jackson reforms in insolvency cases

In a written ministerial statement to Parliament yesterday, 24 May, the government has announced that CFA success fees and ATE insurance premiums will continue to be recoverable in insolvency proceedings until April 2015. Recoverability in all other types of case is to be abolished from April 2013 on implementation of the relevant provisions of the Legal Aid, Sentencing and Punishment of Offenders Act 2012 (see post), subject to further exceptions for mesothelioma claims (pending a review) and insurance premiums for expert reports in clinical negligence cases.

For more information, please see our Litigation Notes blog.