ADVISORY BOARDS AND SHADOW DIRECTORS - WHAT ARE THE RISKS AND HOW CAN THESE BE MITIGATED?

There are many cases where advisory boards or professional advisors are called upon to assist companies to develop strategic direction and provide guidance.  Conversely, it is often advantageous for experienced individuals to offer their skills and provide constructive guidance to companies, without requiring the companies to commit to a formal directorship position.  Such roles are particularly prevalent in the case of start-ups and SMEs.

However, there is also an inherent risk that such advisors may unwittingly expose themselves to potential statutory liability by virtue of becoming a “deemed” or “shadow” director.

What is a shadow director?

The Companies Act 1993 (Act) reformed previous company law and created a new category of a “shadow” director under section 126, which extends the definition and responsibilities of a director to a wider range of persons potentially including advisors, advisory boards, and professional advisors who are not formally appointed as directors.  It is a serious issue to consider who can properly be categorised as a shadow director as being classified as such will mean the person is subject to all statutory directors’ duties and liabilities.  The notion of corporate governance and the specific duties of directors, who must take responsibility for decisions made by a company and its Board, are topical and serious.  The recent finance company collapses have demonstrated that directors, who do not understand the character of a business or remain abreast of what the business is doing, may be found liable in both civil and criminal jurisdictions.  The imposition of liability onto directors for actions taken by a company will also naturally extend to the category of shadow directors.

Section 126 of the Act deems people acting in certain capacities as directors for the purposes of the Act.  These include:
  1. Shadow directors
  2. Delegates of the board
  3. Ultimate controllers of shadow directors, board delegates or de-facto directors
  4. Shareholders (in some circumstances)
With respect to advisory board members, the real risk is being deemed a shadow director.  A shadow director is someone who has the power to direct the actions of an appointed director or the Board as a whole.  They are termed “shadow directors” because they exercise control behind the scenes.  It must be shown that the Board is accustomed or required to act in accordance with the shadow director’s directions. 

The key issue to be aware of as an adviser is that by advising a Board or individual directors, the advisor’s advice may be construed as a direction rather than a recommendation.  Furthermore, where there is a pattern of behaviour that suggests the Board or a director simply institutes the advice of an advisor or advisory board without challenging it, or making an objective assessment as to whether that advice should in fact be followed, a Court is likely to find that advisor or members of that advisory Board are themselves shadow directors. 

The Courts have made it clear that whether or not a person is a shadow director is entirely a question of fact.  Not every person whose advice is sought by the Board will be classed as a de facto or shadow director.  The facts must show that the shadow director has not only the ability to control the company but also has put that control into practice.  As Millett J has expressed it:

In each case, the shadow director is consciously the controlling mind of the company.  The appointed directors do as they are told, not because they choose to, but because that is their function.  The relationship is that of a puppet master and his puppets.[1]

Practical steps to avoid being cast as a shadow director

In light of the above, it is important that an advisor understands the parameters within which he or she can act without attracting unintended liability as a shadow director.  The following are some practical steps that can be taken to ensure that the function of an advisory board remains strictly as an advisory role. 

Advisory Board Terms of Reference
An advisory board should have written terms of reference or an agreement with the company which includes a clear direction that the advisory board does not have the power to make governance decisions, does not have voting authority, and that all recommendations made by the advisory board are merely recommendations that the board must review, analyse and approve before they are implemented (if at all).  The terms of reference should also address:
  1. Appointment and tenure of members;
  2. The relationship with, and access to, the board and management;
  3. The parameters of advice which is to be provided by the advisory board and whether any particular matters are excluded;
  4. Frequency, mode and conduct of meetings;
  5. Liability and insurance;
  6. Keeping of minutes; and
  7. Dealing with conflicts of interest. 
Not only can a clear Terms of Reference document or agreement assist in minimising risk for the members of an advisory board, it also focusses the role of the advisory board to ensure that it is advising on matters which are helpful to the business, and that add value. 

Keep clear minutes of all advisory board meetings
As with board meetings, the advisory board meetings should be minuted.  The minutes are the primary evidence of what was discussed at the meeting and the capacity in which that advice was given i.e.: that the advice was prepared as a recommendation, and not as a direction to the board. 

Hold meetings separate to the board
Advisory board meetings should be held separately to board meetings.  Members of the advisory board should not be board members, nor should they be included in the quorum for the purposes of board meetings.  The purpose of the advisory board is to provide a collective opinion on how particular issues could be approached and, accordingly, a company should not be required to justify its final decision to the advisory board. 

Separate meetings can provide the necessary separation of roles.  In the event that an advisory board member attends a board meeting, the minutes of that meeting should record their attendance as “an attendee” rather than “present”, and any advice given at that meeting should be cast as advice, or the presenting of a relevant recommendation, rather than a direction per se. 

Careful use of language
All language used by an advisory board (whether in oral or written communication) must reflect its advisory nature.  In particular, advice should be framed as an opinion rather than a direction to the board, and reference to the members of the advisory board should be to “advisors” and not “the board”.

Insurance policies
In addition to appropriate provisions in the Terms of Reference or similar agreement, advisory board members should consider whether the company they advise should include advisory board members in their director’s and officer’s liability insurance policies.  This insurance could then be relied on by advisory board members in the event they are required to defend their advice or opinions as a consequence of being deemed a director for the purposes of the Act.

Conclusion

While there is a risk of advisory board members being cast as shadow directors, that should not in and of itself deter those with appropriate skill sets from supporting businesses where there is a need for their skills and advice.  With a little awareness as to the line between “advice” and “direction” to the board, and some practical measures being put in place to ensure this division is enforced, the risk is one that can be readily managed.

Matthew Mallett      
Partner

DD +64 (4) 498 3646  MOB 0275 888 739
www.morrisonmallett.co.nz

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[1] Justice Millett, “Insolvency Practitioner”, Journal of the Society of Practitioners of Insolvency, January 1991.