Published on March 6, 2014
Copenhagen | Frankfurt Shadow Directors and Equitable Subordinbation Michael Carsted Rosenberg Advokat & Solicitor (England & Wales) Carsted Rosenberg LLP Advokatfirma
Overview • The problem of shadow directorships and liability in private equity owned firms or where the senior lender exerts control over the borrower following an execution of a share pledge. • The implications of the finding of a shadow directorship in relation to a claim for equitable subordination by a junior lender.
Shadow Directors Definition: • a person in accordance with whose directions or instructions the directors of a company are accustomed to act. • not a director of record and does not openly participate in the company’s governance, but whose directions or instructions are routinely complied with by the directors or employees. • someone who effectively directs the board's important decisions should have some legal duties and liabilities alongside those of the actual directors.
Shadow Directors • acting as a shadow director not an offence in itself, unless undischarged bankrupt or disqualified from being a director. • slippery slope in management – difference between advising and directing the board. • importance of good corporate governance. • private equity, venture capital and portfolio companies. • significant shareholders and lenders • Existence is a risk indicator.
Shadow Directors • demarcation line between the board's functions and the active shareholder's legitimate role in decisionmaking as owner of the company. • directors’ obligation not to fetter discretion. • not to be regarded as a shadow director by reason only that the directors act on advice given by him. • shadow director is treated in many ways as a named director of the company concerned and bound by the same duties and obligations. • lack of formal appointment as a director will not necessarily prevent the courts from concluding that a shadow directorship is in existence.
Shadow Directors Potential Liabilities: • liability to contribute to the company’s assets following the company’s insolvency. • the liquidator can take the same action against a shadow director as can be taken against the directors of record. • disqualified from being a director following the company’s insolvency. • criminal sanctions for breaches of directors’ duties. • personal liability for breaches of directors’ duties. • may not be covered by the company’s directors’ liability insurance.
Shadow Directors • across much of Europe, company law evaluates decisions made by those in charge of private companies against fairly lenient standards. • active PE owners of companies cannot ignore the legal framework in which they operate, especially where a company's solvency is in doubt. • generally common law concepts that applies in the more extreme cases when the company is on the verge of insolvency. • many shadow directorships are only discovered after a problematic transaction is identified or in cases of fraudulent trading.
Shadow Directors The Danish Perspective: • the clear starting point when evaluating potential liability for losses incurred by a company is that it is the company alone that must bear that loss. • rare exception where the actions of the managing director or board members can be characterised as sufficiently culpable which permits the “piercing the corporate veil” to hold the person or persons in charge personally liable. • that same exception applies to persons who have exerted de facto control over the company without being registered as directors, and as such are responsible for the loss incurred.
Shadow Directors • established case law shows that the decisive factor is whether a person has exerted de facto control over the company, not whether or not that person was officially registered as a board member or director of record. • typically majority shareholders, creditors or family members of the official board members or directors who have exerted significant and long-term control. • the concept of shadow directorship is recognised under Danish law for the purposes of allocating liability of losses incurred by the company. However, it is generally an up-hill struggle to establish personal liability by piercing the corporate veil. • while the concept is recognised under Danish law, it is only applied as an exception to the overall principle of limited liability for companies.
Equitable Subordination • bankruptcy courts may have the power and authority to subordinate prior claims on the assets of a bankrupt debtor company to the claims of junior lenders based on principles of equity. • basis for subordination is usually the inequitable conduct of the senior lender with respect to junior lenders. • equitable subordination can be used to subordinate both secured and unsecured claims
Equitable Subordination • decision by a bankruptcy court to subordinate a controlling shareholder’s (or shadow director’s) senior secured debt owed by the company to claims of lowerranking bona fide third party lenders. • equitable subordination protects external lenders by giving them rights to senior secured company assets secured in favour of senior who are also shadow directors or significant shareholders of the company. • it permits a court to reorder lender distributions made by a borrower with effect on the waterfall and the lender priority. • super senior and front loading situations.
Equitable Subordination • common law concept of an action in equity not directly transferrable to the Danish civil law system. However, certain elements of Danish law do in some cases allow for similar approach. • Danish hardening rules and dealings between related and affiliated parties. • Danish Insolvency Act and registered security.
Equitable Subordination • Danish law is very clear on the subject of pledges and the rights and remedies of the pledgee. The possibility of subordination is available only if it has been agreed beforehand (intercreditor). • the concept of equitable subordination is not recognised under Danish law. Subordination therefore requires the prior contractual consent of the prior pledgee. • the application of the legal concepts do naturally depend on the factual circumstances, but generally (i) equitable subordination cannot be claimed by reference to Danish law and (ii) any liability for shadow directorship is most unlikely to apply by reference to Danish law.
Carsted Rosenberg LLP Advokatfirma Michael Carsted Rosenberg Advokat & Solicitor (England & Wales) Presentation London 2012
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