Shadow directors are people who have not been appointed as directors, yet who can wield significant influence over the day to day decisions made in running the company.
The definition under the Companies Act 2006 is “a person in accordance with whose directions or instructions the directors of a company are accustomed to act”. The definition, however, excludes professional advisors such as accountants and lawyers because “a person is not deemed a shadow director by reason only that the directors act on advice given by him in a professional capacity”. To be a shadow director means to control the whole board of directors, not simply to exert influence over one, or to provide advice that the board follows.
Legislation extends to shadow directors. They are bound by many of the same duties and obligations as board members. However, they may not be aware that they need to comply with the law, and therefore may not seek to protect themselves in certain situations, for example, by taking up liability insurance.
The consequences of being a shadow director are:
- creating a liability to contribute to the company’s assets if the company becomes insolvent
- possible disqualification from being a director following insolvency (of particular trouble if the person is a board member of another company)
- possible criminal charges for breaches of directors’ duties
- personal liability for breaches of directors’ duties
People become shadow directors both intentionally and unintentionally. Intentional reasons are usually to try to circumvent the law. For example, someone who has been bankrupt cannot be a director. The bankrupt might think that he can appoint a family member as a figurehead director in his place and continue to run the company. In fact, the bankrupt would be breaking the law and open to criminal charges because he would be a shadow director.
So how does this relate to start-ups?
The first thing to be aware of as a founder is that people who control decision making in your company may be shadow directors if they are not directors. This is the unintentional.
The following are examples:
A debt investor may not take up a directorship, but may decide to exert influence over how the company is run, especially if the release of further funding is related to achieving milestones that are not well defined.
The company becomes reliant on the work of one of the first employees (perhaps a website developer or a business development executive) and that person has significant say over how his or her part of the business is controlled. He or she starts making decisions about strategy, which are voted through by the board because of the need to keep the employee on-side.
A fellow founder is bought out by an investor but continues to come into the office and influence employees as to how things should be done. He or she knows a lot about the business, so no-one questions what he or she says.
How to avoid shadow directorships
The key to avoiding a situation where a shadow director exists is to have clear, written rules about how decisions are made by the board. These should be in your articles of association or perhaps in the shareholders agreement.
First of all, you need to know on what basis decisions are made, and which ones are for directors to approve only. Appropriate action must be taken when board-level decisions are made outside board meetings.
The second thing to do is to discuss the proposal for action within a meeting. If the directors are acting with due care, both the advantages and disadvantages of the consequences of a decision should be discussed in full.
Lastly, if someone seems to be acting as a shadow director, he or she should be told that he or she faces risks and that no longer acting in this way is beneficial to him or her as well as to the company. The most persuasive risk is that if the board make a wrong decision and the directors are sued, he or she might also be sued for something he or she was never aware of. Directors may be covered by liability insurance, but any non-director would not be.
Shadow directorships are not a reason why advisors should not advise, but rather why they should not direct the board.