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.