Court of Appeal Decision on De Facto and Shadow Directors
The recent Court of Appeal decision in Smithton Ltd (formerly Hobart Capital Markets Ltd) v Naggar and others  EWCA Civ 939 is a reminder about the points of general practical importance for identifying de facto and shadow directors.
The definitions of de facto director and shadow director have been determined by statute and case law. Without ever having been formally appointed as a director, a person may become a de facto director if they have performed the functions of a director, or become a shadow director if they are able to persuade the directors of a company to act in a certain way. The question which arose in this case, and which often arises in practice given the substantial duties (and potential liabilities) imposed on a company director, is whether a director of the holding company of a group of companies has become a director of its subsidiaries.
The appellant joint venture company (“Hobart”) brought proceedings against Mr Naggar (“N”), a director of its former holding company (“D”) and other group companies, to recoup losses which it incurred allegedly as a result of transactions with clients which were directly and/or indirectly owned by N and introduced to Hobart through N. The first part of the claim by Hobart was that whilst N was not a duly appointed director of Hobart, he was a director of D and a de facto or shadow director of Hobart and had breached his statutory duties.
The judge in the first instance, Rose J, approached the matter on the basis that N had a “hat” for each office he held and it was necessary to decide which “hat” he was wearing at any particular time by looking at what he actually did. Although important decisions were taken by N outside formal board meetings, N had not been formally appointed as a director, did not attend board meetings and did not hold himself out as a director. Further, Hobart did not hold N out as being a director of it. N was not appointed as a director under the joint venture agreement (the “JVA”), which set out the terms for the corporate governance of Hobart, and Hobart was authorised by the FCA but it had never reported to the FCA that N was one of its directors. Accordingly, Rose J held that N was not acting as a director of Hobart. His involvement did not extend beyond that of a major shareholder and client; in fact, he had been expressly excluded as a director under the JVA and in Hobart’s reporting to the FCA.
The Court of Appeal dismissed the appeal finding that there was no basis for interfering with Rose J’s findings of fact, and held that N was neither a de facto nor a shadow director of Hobart. Rose J focussed on the evidence for assessing in what capacity N had performed “directorial” acts and in doing so, had made no error of principle; the evidence suggested that N was acting as a director of D.
The Court of Appeal also offered guidance for future cases. Whilst there is no definitive test to determine whether a person is a de facto or shadow director, a court should consider whether the person forms part of the corporate governance of the company and has assumed the status and function of a director. In answering this question, a court should consider the factors in the leading case of HMRC v Holland  1 WLR 2793, including whether a person has assumed responsibility to act as a director irrespective of that person’s motivations and beliefs and whether the company holds a person out to be a director.
This decision sets out useful guidance on the test used to determine whether a person is acting as a de facto or shadow director, including the use of “hat identification” and highlights the importance the courts place on the context in which a person makes particular decisions. Groups of companies should consider the role that directors of the parent company play in the corporate governance of its subsidiaries.
The Importance of Being Clear
In the recent case of Heritage Oil and Gas Ltd & Anor v Tullow Uganda Ltd  EWCA Civ 1048, the Court of Appeal reinforced the importance of using clear language when drafting a provision that is intended to operate as a condition precedent.
The appellant, Heritage, argued that Tullow could not bring a claim under an indemnity because, amongst other things, it had failed to comply with the notice provisions requiring it to give Heritage 20 business days’ notice of any tax claim.
The Court of Appeal, in dismissing Heritage’s claim on this point, held that:
- While a condition precedent may provide clarity, it can also have the effect of depriving a contractual party of a right because of a trivial breach which has little or no prejudicial effect.
- The words “condition precedent” are often expressly used in notification of claims clauses, and indeed had been used in other clauses of the sale and purchase agreement. The parties in this case had not expressed that the right to the indemnity was dependent on compliance with the notice provisions.
- The use of the words “subject to” does not make the provisions following those words conditions.
This case highlights both the importance of the need for clear, consistent legal drafting and the reluctance of the Courts to hold that a condition precedent can be implied into a contract. If the parties intend a clause to operate as a condition precedent, they need to ensure that this is expressly stated and that the obligations on the parties are made clear from the outset.
Why It’s Not Always Good To Get A Promotion
We are often asked by companies wishing to raise money how they may do so lawfully. They may have entered into an agreement with a third party which agrees to procure finance for them. This is a heavily regulated area, with significant consequences for breaching the law. It is commonly referred to as the Financial Promotion Regime. Below, I summarise some of the key points which arise out of the regime and their consequences in an equity fund raising scenario. I do not address here any potentially overlapping issues arising from the Markets in Financial Instruments Directive.
Under section 19(1) of the Financial Services and Markets Act 2000 (“FSMA”), the most important starting point in relation to regulated activities, it provides:
“No person may carry on a regulated activity in the United Kingdom, or purport to do so, unless he is:
(a) An authorised person; or
(b) An exempt person.
A breach of the so-called “General Prohibition” set out above is a criminal offence under section 23(1) FSMA. Further, an agreement made by a person in the course of carrying on a regulated activity which is unenforceable against the other party under section 26(1) FSMA – the other party also being statutorily entitled to recover, under section 26(2) FSMA, any money or other property paid or transferred by him under the agreement and compensation for any loss sustained by him for having parted with it. Further applying this principle, section 27 FSMA provides that an agreement made by authorised persons as a consequences of anything said or done by a non-authorised party is unenforceable on the same basis. There are provisions in section 28 FSMA which entitle the Court to hold that an agreement is enforceable, or money or property be retained, in circumstances where it is just and equitable to do so.
What is a regulated activity? Section 22(1) FSMA provides:
“An activity is a regulated activity… if it is an activity of a specified kind which is carried on by way of business and –
(a) Relates to an investment of a specified kind; or
(b) In the case of an activity of a kind which is also specified for the purposes of this paragraph, is carried on in regard to property of any kind.”
The principal statutory instrument which applies is the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 – commonly known as the RAO. One of the regulated activities is “Arranging deals in investments” – Article 25 and Articles 25A-E). Article 25 provides:
1) Making arrangements for another person (whether as principal or agent) to buy, sell, subscribe for or underwrite a particular investment which is –
(a) A security,
(c) An investment of the kind specified by article 86, or article 89 so far as is relevant to that article,
is a specified kind of activity.
2) Making arrangements with a view to a person who participates in the arrangements buying, selling, subscribing for or underwriting investments falling within paragraph (1)(a), (b) or (c) (whether as principal or agent) is also a specified kind of activity.”
A “security” is widely construed and covers shares in a company and debt securities.
There is some judicial guidance on the application and extent of Article 25. In Re Inertia Partnership, Crow J found that merely introducing a potential issuer of shares to one of the so-called “boiler room” companies outside the UK was, “too nebulous and too remote to fall within the concept of “making arrangements” within RAO Art 25.” Further, “Such an introduction is not an “Introduction” in any meaningful sense for two reasons. First, because it does not result in anything further happening as between [the two parties introduced], let alone between any consumers and [the two parties]; and secondly because any further steps that might be taken following the introduction were not within [the introducer’s] power to effect or direct. As such, the introduction did not involve [the introducer] in any violation of the general prohibition under FSMA s.19.”
So far as “arranging” is concerned, Holroyde J in Watersheds v DaCosta and Gentleman found that an arm of an accountants’ practice which expressly marketed its services in helping company clients to obtain funding, for which it was separately remunerated by the client, was still not a breach of the General Prohibition. The services included assistance with the preparation of business plans, introducing the client to sources of funding and participating in discussions involving the client and potential funders. The Judge found that even if Watersheds were in breach of the General Prohibition, he would nevertheless exercise his discretion under section 28 to permit enforcement. However, the Judge still found that the introductions and activities did not amount to regulated activity under Article 25(2). He was helped in this decision by the contents of the FSA’s (as it then was) Perimeter Guidance Manual. The FCA is of the view that Article 25(2) RAO does include certain types of arrangements for making introductions. We believe there must be some doubt as to the judgment in this case as if introductions of this nature are outside the scope of the “arranging” activity then there would be no need for the specific exemptions contained in the RAO (Articles 33 and 33A) as to introducing activities.
Accordingly, companies wishing to raise finance, or which are offered advisory, arrangement and/or introduction services in the UK, must be sure to verify the legitimacy of the arrangements to ensure that they are not made in breach of the General Prohibition.
The Bearer of Bad News?
The Small Business, Enterprise and Employment Bill (the “Bill”) had its second reading in the House of Commons on 16 July 2014, and shall soon be timetabled to continue its march towards royal assent.
The rationale underpinning the Bill is the frequently resurrected (although seemingly never-ending) goal of cutting bureaucracy to stimulate enterprise, or, as it is more windily described in Research Paper 14/39, “[to] reduce regulatory burdens and facilitate the inception, financing and growth of business”.
The Bill’s scope includes addressing the transparency of company ownership, which has led to proposals for the abolition of the type of security known as ‘bearer shares’. As it is not easy to identify the owner of a bearer share, their existence has long been demonised as a dark corner of the UK’s otherwise bright and open regime of company ownership.
The conceptual difference between a bearer share and an ordinary share is a bit like the difference between money in a bank account and cash in hand. The proof of ownership of an ordinary share is the entry of the owner’s name in the publicly available register of members of the company which issued the shares, whereas the proof of ownership of a bearer share is in the possession (or the bearing) of the bearer certificate itself.
The identity of a holder of an ordinary share in a UK company must be entered into the company’s public register of members, whereas the identity of the holder of a bearer share need not be (only the existence of the bearer share must be entered). That means the owner of a bearer share is not readily identifiable.
There are significant advantages to being a holder of a bearer share. For example, a bearer share can be transferred freely without the need to amend the ownership details on the company’s register of members, which provides the holders with a great deal of flexibility. Also, the anonymity provided by bearer share ownership may insulate the identity of the owners of a company involved in controversial activities such as animal testing and research from the personal ire of those who disagree with the company’s aims.
The extent of bearer share ownership in UK companies, however, is miniscule. The number of companies to which the reforms relating to bearer shares will apply is remarkably small both in numerical and percentage terms. Approximately 900 out of 2.5 million companies trading in the UK have issued bearer shares, so their proposed abolition will affect merely 0.05% of active companies.
Despite the significant advantages accruing to a holder of bearer shares (and the extremely limited number of companies which have bearer shares) the Department for Business Innovation & Skills has opined that the potential for misuse open to those who retain anonymity “for the purpose of tax evasion or other criminal activity” outweighs those advantages, and that the recommendation of the Global Forum on Transparency and Exchange Information for Tax Purposes that the UK should “. . . eliminate such shares” should be adopted.
The Bill proposes to “eliminate such shares” initially in two ways. First, the Bill amends the Companies Act 2006 by preventing any further issues of bearer shares by companies. Secondly, the Bill establishes a statutory ‘surrender period’ during which every holder of a bearer share is required to surrender it for cancellation. Anyone surrendering bearer shares in this way shall benefit from a corresponding right to be issued with a new share certificate, and shall have their identity entered into the issuing company’s register of members. It is further proposed that a company will be required to undertake the expense of making a court application to effect the cancellation of any bearer shares which are not surrendered during the ‘surrender period’.
In order to ensure the implementation of the mechanisms outlined above, a number of statutory duties are to be imposed on companies and their officers. Should a company fail to comply with those statutory duties, an offence will be deemed to have been committed by every officer of the company who is in default.
For those reasons, any company that has issued bearer shares should seek early advice about the proposed statutory duties associated with their impending abolition.