Introduction
The Companies Act, 2013 (“CA 2013”) defines a director as a person who has been appointed to the Board of a company[1]. Directors typically have various duties and obligations towards the company, shareholders and all other stakeholders. They are also subject to civil and criminal liability under CA 2013, as well as under various other statutes, which have a standard vicarious liability clause for directors and officers of the company. In this context, another concept that emerges is of a “shadow director” or a “deemed director” who is a person not officially appointed to the Board but on whose instructions and directions the Board is accustomed to act upon. In this blog, we analyse the legal position surrounding “shadow directors” in India and the United Kingdom (“UK”).
Legal Position in India
Evolution of Law
The office of a “shadow director” was absent in the Indian Companies Act, 1913 (“CA 1913”) and was introduced by the Companies Act, 1956 (“CA 1956”), wherein it was embodied within the definition of an “officer” under Section 2(30) to mean any person in accordance with whose directions or instructions the Board is accustomed to act. Various sections of the 1956 Act, such as Section 295 dealing with loans to directors, Section 303 dealing with register of directors, Section 305 dealing with duty of directors to make disclosures, etc., explicitly refer to the prohibitions, restrictions, duties and liabilities that the law imposes on persons in accordance with whose directions or instructions the directors of a company were accustomed to act.
While the principle of law underlying “shadow directors” was carried forward in the 2013 Act, there are two major differences between the 1956 Act and 2013 Act: a) Unlike the 1956 Act, the latter Act does not impose any legal duty to file a form with the Registrar of Companies (“RoC”) declaring an individual as the “shadow director”. This requirement, seen under Section 303 of the 1956 Act, has been removed by the 2013 Act. b) In sharp contrast to Section 2(13) of the CA 1956, which defined director as any person occupying that position of a director, by whatever name called; the CA 2013 mandates a director to be appointed to the Board of the company.
In fact, the Report of the Expert Committee on Company Law in 2005 (Dr. J.J. Irani) also recognised how low-level employees or unexperienced relatives of shareholders found their way onto the Boards, with “shadow directors” pulling strings and acting as real decision makers. It was rather suggested that the law should discourage “shadow directors” who seek to operate from behind the scenes, and if the Board is accustomed to act on their instructions in any or all matters.
Therefore, under the CA 2013 regime, a “shadow director” does not fall within the ambit of a director, as under Section 2(34) of CA 2013, but is an officer as defined under Section 2(59) and the intention continues to be to use the test of “accustomed to act” to hold responsible persons who truly control the company and pull strings in a way they desire.
Current Law
According to Section 2(59) of CA 2013, an officer includes any director, manager or key managerial personnel or any person in accordance with whose directions or instructions the Board of Directors or any or more of the directors is or are more accustomed to act. Section 2(60) states that any person in accordance with whose advice, directions or instructions the Board of Directors of the company is accustomed to act, and is in default of provisions of CA 2013, shall be termed as an “officer who is in default” and shall be liable to any penalty or punishment by way of imprisonment, fine or otherwise.
In CA 2013, these “shadow directors” find references in multiple sections. Section 2(76) treat them as related parties of the company. Section 185, which allows advancing of loan to any body corporate where any director of the lending company is a “shadow director”, only after passing a special resolution and if the loans are utilised by the borrowing company for its principal business activities. Section 219 allows inspectors to conduct investigation into affairs of related companies, where the director of the related entity is accustomed to act basis the direction and instructions of the primary company. Section 339 allows penalising a “shadow director” for fraudulent conduct of business, in the course of winding up, and holds them personally responsible for all or any debts or other liabilities of the company as the Tribunal may direct.
The determination or test to determine whether a person falls within the ambit of “accustomed to act” under CA 2013 is a mixed question of law and fact, which leaves it open to interpretation. While Indian jurisprudence hasn’t laid down a brightline test to determine who a “shadow director” is, some parameters to identify one, as inspired from UK jurisprudence (and which is explained in detail below), are:
- Real influence is exercised over the affairs of the company and corporate activities.
- A “shadow director” isn’t necessarily an individual and can be a body corporate such as a holding company of a subsidiary.
- It must be proven that the directors of the company did not act on their own and acted in accordance with the directions or instructions of the “shadow director”.
Legal Position in the UK
In the UK, the concept of a “shadow director” can be traced back to as early as 1917. While the concept was not explicitly termed, it was included in Section 3 of the Companies (Particulars as to Directors) Act, 1917 (“English 1917 Act”). According to Section 3 of English 1917 Act, “…the expression “director” shall include any person who occupies the position of a director and any person in accordance with whose directions or instructions the directors of a company are accustomed to act.” Hence any individual who was not formally appointed as a director but whose directions or instructions were followed by the board of directors would also be covered under the expression “director”.
The concept of “shadow director” was first codified by the Companies Act, 1980, which was further amended and is now seen in its present version in Section 251 of the Companies Act, 2006 (“English 2006 Act”), which provides a comprehensive legal framework for company directors, including shadow directors. Section 251 of the English 2006 Act defines a shadow director as follows:
“251. Shadow director
(1) In the Companies Acts “shadow director”, in relation to a company, means a person in accordance with whose directions or instructions the directors of the company are accustomed to act.
(2) A person is not to be regarded as a shadow director by reason only that the directors act-
(a) on advice given by that person in a professional capacity;
(b) in accordance with instructions, a direction, guidance or advice given by that person in the exercise of a function conferred by or under an enactment;
(c) in accordance with guidance or advice given by that person in that person’s capacity as a Minister of the Crown (within the meaning of the Ministers of the Crown Act 1975)]
(3) A body corporate is not to be regarded as a shadow director of any of its subsidiary companies for the purposes of— Chapter 2 (general duties of directors), Chapter 4 (transactions requiring members’ approval), or Chapter 6 (contract with sole member who is also a director), by reason only that the directors of the subsidiary are accustomed to act in accordance with its directions or instructions.”
Any individual who has not been officially appointed as a “director” but who provides directions and instructions to the directors of a company shall classify as a “shadow director” if the directors are accustomed to act on his directions and instructions. In such a situation, even though no official position is held by such “shadow director”, he would be treated as an officer/director of the company and would be bound by the general duties and liabilities applicable to a director of a company. The purpose of introducing this concept was to subject individuals, who exercise real influence and control over the board without official appointment, to same degree of scrutiny as directors of a company. Even the English Insolvency Act, 1986 includes the concept of a “shadow director” within the definition of an “officer” making him liable for criminal offenses like fraud, misconduct, etc. while winding up of a company. However, certain exceptions are laid down in Section 251(2) and 251(3) of the English 2006 Act, wherein a person shall not be considered a “shadow director” if they are giving directions in a professional capacity or due to the exercise of a function under an enactment.
The essentials to determine an individual as a “shadow director” were analysed by the court in the landmark case of Re Hydrodam (Corby) Ltd[2], wherein it was held that an individual can qualify as a “shadow director” if he has directed the official directors of a company on how to act in relation to the company’s affairs and such directions and instructions were relied upon by the directors and the directors were accustomed to act in accordance with such directions. Additionally, there shall be an existence of a pattern to prove that the Board of Directors did not use their independent judgment and discretion, and merely relied on such instructions and directions; an isolated event of following instructions would not suffice to classify a person as a “shadow director”[3]. Merely giving instructions would not suffice to fulfil the requirements, but it is necessary that the majority of the directors relied and acted on such instructions[4]. If only a minority of the directors are accustomed to act on such directions, then it would not fulfil the test of a “shadow director[5]”. The Court of Appeal in the case of Secretary of State for Trade and Industry v. Deverell[6] stated that the true test to determine a “shadow director” was to ascertain if he actually has real influence in the corporate affairs of the company and if the directors regularly rely or act on his directions and instructions.
Conclusion
Section 166 of CA 2013 codifies duties of directors and explicitly provides that the directors shall exercise independent judgment in approving or disapproving any proposal before the Board. The unseen influence of a “shadow director” in decision making by the Board goes against this cardinal duty of the Board member, as the director on the Board is accustomed to act in accordance with the directions of the “shadow director”. In modern times, the problem is aggravated, as seen in the case of PE/VC investments, where increasingly, such investors opt for nominating observers rather than nominating directors on the Board to overcome potential liability issues. In practice, such observers do exercise significant influence over the Board deliberations and are effectively “shadow directors” as over time, members of the Board get accustomed to act in accordance with their directions. This practice belies good corporate governance by giving authority without accountability and it militates against the principle of collective responsibility of the Board.
While the CA 2013 has tried to impose liability on such “shadow directors” in few instances as outlined above, they continue to exert their authority over most large business conglomerates despite having no formal designations and wield significant influence and control over the decision-making process. It is, therefore, an opportune time for the Indian Parliament and the Securities and Exchange Board of India (“SEBI”) to bring about a more robust regulatory architecture as well as amend the vicarious liability provisions across statutes to impose criminal liability on such “shadow directors” and ensure that the Board of Directors are not constrained by such unseen influencers exercising significant power without any accountability. An explicit bar and imposition of significant liability on such persons exercising such power without a designation will go a long way in strengthening corporate governance.
[1] Section 2(34) of CA 2013
[2] [1994] 2 BCLC 180, 183
[3] Secretary of State for Trade and Industry v. Becker, [2003] 1 BCLC 555
[4] Ultraframe (UK) Ltd. V. Fielding, [2005] EWHC 1638 (Ch)
[5] Lord (Liquidator of Rosshill Properties Ltd) v. Sinai Securities Ltd, [2004] EWHC 1764 (Ch)
[6] [2001] Ch 340, CA