The de facto director trap

When a business becomes insolvent, it's not only formally appointed directors who could be held legally responsible, writes Sam Pandya, an associate at law firm Matthew Arnold & Baldwin.

The downturn has seen a sharp rise in the number of companies going bust and directors being disqualified. In the last financial year, 1,145 directors were banned from doing business, up nine per cent from the previous 12 months, and the average length of disqualification increased to six and a half years.

From my experience as an insolvency examiner at the Insolvency Service, I believe that at least a third of directors disqualified are either shadow or de facto directors. This includes people who act as directors but are not formally appointed as such, for example, husbands, wives, partners, parents, ex-directors, consultants and even senior employees.

Before considering what might constitute de facto directorship, it’s worth looking at how disqualification works. When a company enters a formal insolvency process, the insolvency practitioner has a duty to file reports on the conduct of directors who have been in office in the three years prior to the insolvency. Adverse reports are passed to the Insolvency Service, which is well resourced and highly active in seeking disqualification (either by court order or negotiation) where directors’ conduct is found wanting. The consequences of disqualification are wide ranging – the prohibition extends to having any role in the management of a company unless very specific permission is given by the court.

Disqualification orders are not only based on conduct which falls within the scope of wrongful trading and challengeable transactions. The general test is whether or not the director is ‘unfit’ to act in the management of the company. A court will consider, at one end of the scale, the extent to which the director is responsible for the company’s demise and, at the other, whether the company’s books and records have been properly kept.

Directors can be disqualified for between two and 15 years. The recent increase in the number of years of disqualification would seem to suggest that a higher number of directors are being found unfit of more serious offences such as wrongful or fraudulent trading. The consequences of breaching a disqualification order or undertaking are very serious and include custodial sentences.

In all but name

So who might be considered a de facto or shadow director? The short answer is anyone who at some stage takes part in the formation, promotion or management of the company. Of course, merely exercising some control over cash at the bank or attending one management meeting would not in itself constitute directorship, but a combination of acts could.

I currently act for clients who are accused of offences during a period when they were not formally appointed directors. In more than one case, the signing of cheques has been an issue. Doing this occasionally is not indicative of acting as a de facto director. However, this together with signing off company correspondence as “director”, allowing customers, creditors, suppliers and employees to perceive you are a director or “decision maker” and making financial decisions about the company’s future with the company’s bankers and accountants may well cause further investigation of your role by the disqualification unit at the Insolvency Service or by the insolvency practitioner. In my experience such enquiries may include writing to all the company’s bankers, accountants, creditors, suppliers and employees and interviewing past or present directors to determine the roles of each individual they are investigating.

It is all too easy to allow non-directors to undertake functions properly conducted by directors. However, this may result in non-directors being at risk of falling into the de facto trap. I suggest the one question you ask yourself when considering whether you have fallen into the trap is “How do others perceive me?” If the answer is as a director or someone who makes the major decisions of the company, be careful, as this may lead to an investigation of your role within the company should it become insolvent. Hiding behind the formally appointed directors listed on Companies House will not be enough to avoid the de facto trap.

Nick Britton

Nick Britton

Nick was the Managing Editor for when it was owned by Vitesse Media, before moving on to become Head of Investment Group and Editor at What Investment and thence to Head of Intermediary...