Legal Case: Shadow director claims against creditor rejected.

May 2010 by Michael Quinlan, Partner, Chris Peadon, Senior Associate & Tom Levi, Law Graduate Allens Arthur Robinson (www.aar.com.au)

Case references cited in the original article have not been recorded in the details below. Should you be interested in the case laws and references you should refer to the original article – click here.

creditors involved in negotiations with a financially distressed debtor will not necessarily void security or expose them to liability for any insolvent trading by the debtor

In brief

This case gives comfort to creditors that involvement in negotiations concerning business operations and/or the exertion of commercial pressure on a financially distressed debtor will not necessarily void security they have taken or expose them to liability for any insolvent trading by the debtor.

It also illustrates the prudence of obtaining from a financially distressed debtor, with whom negotiations are being conducted, a written acknowledgement to the effect that the creditor is not involved in the debtor’s corporate decision-making.

Background

Buzzle Operations Pty Ltd was created in July 2000 as a merger of six retailers of Apple products. Buzzle held much of its stock on credit from Apple and granted it a charge over its assets. By November 2000, Buzzle was insolvent. It then incurred additional debts of $18 million to Apple and other creditors, and made $12 million in payments to Apple. After Apple appointed receivers in March 2001, the Buzzle liquidators brought proceedings against Apple.

The liquidators sought:

  • a declaration that the charge was void; and
  • an order that Apple pay compensation for the debts Buzzle had incurred while insolvent.

Relevantly, the liquidators argued that Apple was:

  • an officer of Buzzle because it made decisions for the company and could affect its financial standing; and
  • a shadow director of Buzzle because the directors were accustomed to act according to the instructions or wishes of Apple and its financial director.

Officer of the company charge over assets

The liquidators argued that because Apple enforced the charge within six months of it being made, without leave of the court, it should be declared void under section 267 of the Corporations Act 2001 (Cth). That section only applied if Apple were an officer of Buzzle or an associate of an officer of Buzzle.

The liquidators argued that Apple was an officer because it:

  • made decisions affecting the whole or a substantial part of Buzzle’s business; or
  • had the capacity to ‘affect significantly’ Buzzle’s financial standing.

Alternatively, they argued that Apple was associated with Buzzle’s company officers.

Decisions affecting the business

Apple was heavily involved in the merger of the six retailers that formed Buzzle. It gave advice on the structure of the merger, the financial accounting system, the due diligence reports required, the transfer of stocks from the retailers and the future cash flow.

Justice White said these were arm’s length commercial negotiations. His Honour stated that the fact that Buzzle needed Apple’s consent to merge and that Apple could have refused it did not mean that Apple participated in Buzzle’s decision-making processes. Apple could insist on any terms it chose. While Buzzle felt that it had no choice but to agree to them, this also did not mean that Apple participated in Buzzle’s decision-making.

Capacity to affect financial standing

Justice White also agreed that Apple had the capacity to ‘affect significantly’ Buzzle’s financial standing. However, his Honour held that this was insufficient to make Apple an officer of Buzzle. He stated that a de facto officer is someone who has the capacity to ‘affect significantly’ the corporation’s financial standing in his or her management of the affairs of the corporation. That might, for example, be the finance manager who is not a director. However, it does not refer to a person who has the capacity as a third party to affect a corporation’s financial standing, with no involvement in the management of the corporation’s affairs.

Association with the directors

Alternatively, the liquidators argued that Apple acted in concert with its directors. Justice White said that they both saw the merger as beneficial but did not have a common purpose. Apple sought to protect its own interests and Buzzle felt it had no choice but to comply. Accordingly, he held that Apple was not an associate of an officer of Buzzle.

In light of the above, Justice White held that s267 did not apply and there were no grounds for declaring the charge void.

Shadow directors insolvent trading

The liquidators contended that:

  • Apple and its financial director were ‘shadow directors’ of Buzzle;
  • they breached their duty as shadow directors to prevent Buzzle from incurring debt while insolvent; and
  • should compensate Buzzle for the debts incurred while it was insolvent.

A person is a ‘shadow director’ of a company if the company’s directors are accustomed to act according to the person’s instructions or wishes. It does not apply if the person is giving advice to the company’s directors:

  • in the proper performance of functions attaching to the person’s professional capacity; or
  • as part of the person’s business relationship with the company’s directors.

Apple often gave ‘instructions’ to Buzzle as mentioned above and these were usually complied with (eg debt repayments to Apple). Justice White considered they were part of a commercial negotiation at arm’s length.9 His Honour observed that it is usual for a supplier or buyer such as Apple to impose conditions on a purchaser (in this case, Buzzle) and, because of the supplier’s superior bargaining power, the purchaser’s directors might feel they had no choice but to comply with the conditions imposed.

Nevertheless, Justice White said that ‘[u]nless something more intrudes, the directors are free and would be expected to exercise their own judgment as to whether it is in the interests of the company to comply with the terms upon which the third party insists’. Relevantly, Apple prudently requested that Buzzle sign a letter stating that, while Apple agreed to provide Buzzle with advice, Buzzle acknowledged that Apple did not intend to be involved in any of Buzzle’s corporate decision-making. Apple simply put increasing pressure on Buzzle to protect its own interests. Justice White held that this was far removed from Apple’s being a shadow director.

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