The economic turbulence stirred up by our most recent credit crunch has thrown up a myriad of difficult legal questions for financiers everywhere. This anxious economic environment which has restrained the financial independence of many Irish companies from their financiers is fraught with legal conundrums.

On the one hand, companies in danger of insolvency are forced to comply with the terms of the workout their bank(s) has demanded of them. By doing so, the board may have to surrender some of its immediate plans for the company and simply submit to the workout terms imposed by the bank in order to continue to avail of the vital financial support the bank has to offer, albeit on their terms. On the other hand, if potentially insolvent companies do not comply with those terms, the imminent and real fear of winding up becomes an ever more poignant reality. Companies in financial difficulty inevitably must submit to one evil or another, be it to winding up or to the bank's terms. However, the banks customers can take some comfort from the arrangement in a twofold benefit, namely the continued survival of the company as well as the possibility of availing of shared liability with the bank for insolvent trading if the company can show the bank to be a "shadow director". The extent of the company's submission to the bank's control however is crucial in dictating whether or not later on down the road, the bank may be deemed a shadow director.

This article will look briefly at the types of situations that may trigger the necessity for a workout agreement between the bank and its customer. Situations where companies default on loans, repayments or pre-empt this scenario by requesting a modification to their financing arrangement trigger the need for workout agreements. Where it is proven to the bank that survival of the company is likely with a re-working of the company's repayments, the bank may offer the company a number of options to tide it over. Such options typically include the option for a holiday payment, extension of overdraft, reducing term loan repayments or substituting certain secured company assets in exchange for others. However, such workout agreements are normally given subject to a power of the bank to increase it's monitoring of the company accounts, to attend management meetings, to be informed of all material decisions made by the board and to extend absolute discretion to the bank to block a board decision. However, taking the power given to the bank under the workout agreement beyond the parameters of the agreement to the extent that the bank dominates the board of directors, is where the bank creeps into the muddied waters of shadow directorship.

Pursuant to section 176 (1) of the Companies Acts 1963, and unlike in other jurisdictions, a company in Ireland is prohibited from acting as a company director after 3 months has expired since incorporation. One would imagine that by virtue of this strict rule of law coming into play that banks, like other corporations are therefore incapable of being deemed a shadow director. Not so. Worldport Ireland Limited (in liquidation) concluded that the terms 'shadow director' and 'director' are mutually exclusive and although legislation prohibits companies acting as a director, it does not expressly prohibit companies acting as or being deemed to be shadow directors, potentially exposing banks to the same restrictions and penalties imposed on directors for offences of reckless trading, restriction or disqualification, etc. This is why banks should be cautious not to allow itself to be deemed a shadow director of its insolvent customers.

What makes a bank a shadow director?

• Where corporate borrowers go into liquidation and resentful creditors want a piece of the pie.
  
  
• Where a court finds a company liable for insolvent trading, directors including shadow directors may be made personally liable and ordered to make payments to aggrieved creditors.
  
  
• Crucially, the bank will not be deemed to be a shadow director if the company, even after receipt of advice from the bank, is allowed to make up its own mind about the company's affairs.

Section 27 (1) of the Companies Act 1990 defines shadow director as being "a person in accordance with whose directions or instructions the directors of a company are accustomed to act". Therefore, a bank agreeing with a customer a workout agreement on the basis of the customer's business plan or refinancing arrangement, and setting out terms and conditions to be complied with in order to gain the continued support of the bank are actions unlikely to fulfill the "accustomed to act" criteria of the statutory definition. Rather, such actions are likely to be looked at as once off arrangements instead of a continued domination of the whole board as would seem to be the required threshold.

In order for a bank to satisfy the criteria of shadow directorship, it would need to be proven that when the bank gives the company directions and instructions, that the board acts on such instructions and implements the direction without any independent reflection or decision of its own. The board essentially must become a mindless puppet of the bank. The bank in turn must know this and have made a conscious decision to be the mind and brains of the board and to impose decisions upon them from the shadows so that the board merely becomes a dead façade, mechanically propelled and driven by the bank.

The de jure directors may be in deeper waters if the existence of the bank as a shadow director is revealed by the court or pleaded by the directors as a defence. However their inaction constitutes a breach of their fiduciary duty to act in the best interest of the company as a whole and may face tougher penalties as result of their ambivalence or inaction.

The test to determine the existence of a shadow directorship was set out by Millet J, in Hydrodam (Corby) Limited [1994] B.C.C 16. The four phases of the test are as follows:

1. Establish who the directors of the company are. Are they de jure or de facto directors?
   
   
2. Did the purported shadow director give directions or instructions to these directors?
   
   
3. If yes, did the directors act exactly in accordance with those directions or instructions?
   
   
4. Are the directors accustomed to acting in accordance with those directions or instructions? A pattern of behaviour showing the board to act mechanically upon those directions and without bringing any of its own judgment, consideration or discretion on the matter to the table at all, must be shown.

Banks should be wary of the consequences of forging close relations with their customers and offering off-the-cuff advice which their customers subsequently act upon. Such advice could be construed as instruction and directions of the bank.

If the bank is a shadow director its security and receipts of interest may be at risk. At law, transactions between a company and its director (s) (which include a shadow director(s)) may be set aside in certain situations. For instance, section 29 of the Companies Act 1990 makes it unlawful for a company to enter into a "substantial property transaction" involving its director or a connected person.

Therefore, a bank who has offered a workout agreement to a company in the hope that it will gain more from the workout than from the company's insolvency will be hard pressed to disguise its own self interest in the transaction.

The bank in exercising its discretion in allowing the company to take, for example, extra holiday payments not provided for in the workout agreement may too be deemed to be an exhibition of the bank exercising its influence over the management of the business and controlling the company's affairs. In order to avoid such inferences being drawn upon it, the bank would be well advised to maintain an arms length approach to their customers and insist on the board of directors calling a special board meeting to decide on whether to take such a holiday payment and in all cases to document the board's independent deliberation and approval of the transaction in their board minutes.

To conclude, whilst a workout agreement can be a useful mechanism for banks to monitor their clients' affairs when their solvency is at peril, overstepping the mark by taking the role of a shadow director of the client's company will also impose upon them all the obligations and duties imposed at law upon a shadow directorship.

June 2008.

For further information please contact Tracy Gilvarry.