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1
DIRECTORS’ CREDITOR-REGARDING DUTIES IN RESPECT OF TRADING
DECSIONS TAKEN IN THE VICINITY OF INSOLVENCY
Paul Davies
1
I The scope of the paper
Although this paper began life under the title of ‘Directors’ Liability in the Vicinity of
Insolvency’, the scope of the paper is rather more limited, as the current title more
accurately reflects. In fact, the paper focuses, not on the whole range of directors’
potential liabilities in the vicinity of insolvency, but on directors’ duties and liabilities
in respect of their decisions to continue, terminate or restructure the company’s
trading or business activities in the vicinity of insolvency. Needless to say, I am
interested in such duties and liabilities in their creditor-regarding or protecting
aspects. Nor do I concentrate on the legitimacy of specific transactions that may occur
in the course of implementing these trading decisions, but rather on the legitimacy of
the strategic decision to continue trading (or not) in a particular form and to maintain
that decision subsequently. Thus, I leave on one side consideration of transactions
whereby the directors, with the aim or effect of creditor avoidance, shift assets out of
the company in the vicinity of insolvency, whether by way of distributions or
transactions with favoured third parties.
2
On the other hand, my paper discusses what
might be seen as a generalisation of the problem discussed by Prof Skeel in this
volume,
3
which is the potential liability of company controllers who decide to finance
the continued trading of the company by way of a loan to it.
The core question for this paper may be said to be this. Under what circumstances do
directors incur liability for trading decisions taken in the vicinity of insolvency which
lead to a deterioration in the company’s net asset position
4
compared with what it was
at the time the decision was taken? One can also ask, though this is less often done,
1
Cassel Professor of Commercial Law, London School of Economics and Political Science and
Fellow, European Corporate Governance Institute. I am grateful to the participants at the conference
held in Munich for their comments on a first draft of this paper, especially for the formal response of
Gerald Spindler who has also been most helpful in subsequent discussions, notably in relation to
French law. I am also grateful for input from John Armour (both at the conference and subsequently),
Vanessa Finch, Sir Roy Goode, Thomas Telfer and Peter Watts. The usual disclaimer applies.
2
These issues are pursued by Professor Baird in this volume at p. 000.
3
At p. 000.
4
Since the paper is concerned with creditor protection, net assets constitute the correct focus of
concern because that will determine the level of creditor recovery in insolvency.
2
whether there can be liability for a decision which leads to a less favourable asset
position for the company compared to some other decision which was available to the
directors. If one permits the second question to be asked, then a decision to cease
trading is no longer a guarantee of no liability for directors.
II Some theory
Companies with significant shareholder funds
The focus of this paper is on liabilities to creditors. Shareholder-regarding duties,
which exist at all stages of the company’s existence, are not of direct concern here.
Directors’ creditor-regarding duties, although much discussed in recent years, are
clearly of secondary significance in the overall legal regulation of the exercise of
directors’ discretions. Thus, one needs to explain both why creditor-regarding duties
are not pervasive but also why they occur at all. Accordingly, this section advances
two arguments to address these questions. With regard to the non-pervasiveness of
creditor regarding duties, it is argued that creditor-regarding duties are unnecessary so
long as the company’s financial statements reveal significant shareholder equity
5
or
shareholders’ funds, to use the accounting term. Where this is the case, the rule that
losses are borne by the shareholders first provides an incentive to company controllers
to take on only appropriately risky projects. In such a situation the risks of failure and
the rewards of success will bear most heavily on the (ordinary) shareholders because
the value of their equity in the company will directly reflect the profits earned or
losses incurred in the project. In this situation the argument that limited liability
protects shareholders against losses in excess of the amount that they have paid for
their shares misses the point. Where the company has significant net assets, the failure
of an excessively risky project threatens to deprive the shareholders not only of the
amount they paid for their shares (which may have been negligible) but also of their
interest in those assets.
6
Thus, the loss caused to the shareholders by the failure of a
5
By ‘equity’ I mean the company’s value after all its debts and liabilities have been allowed for, ie the
value of the shareholders’ economic interest in the company. This concept of ‘equity’ involves no
presumption that the shareholders have provided significant legal capital to the company. Thus,
shareholders in a British private company, whose shares have been issued for a nominal consideration,
nevertheless will have a substantial equity in the company if its business does in fact prosper and the
resulting profits are retained within the company.
6
The fact that those accumulated profits may be distributed does not fundamentally affect the
argument. The company may be reduced to the situation where the shareholders have no equity in the
company by unsuccessful trading or by distributions. The above argument in favour of imposing duties
on directors in the vicinity of insolvency does not turn on how the threat of insolvency was brought
3
risky project where the company is a profitable going concern with undistributed
profits may well exceed the price paid by the shareholder for the securities. In other
words, if I have bought a share for 1 and its market value is now 10 but the failure of
a risky project reduces its value to 0, my loss is 10, not 1.
7
As far as strategic business decisions are concerned, therefore, creditors are de facto
protected by the directors’ shareholder-regarding duties, so long as the company has
significant shareholder funds. It is true that imposing creditor-regarding duties on the
directors in such a situation might give the creditors an even higher level of
protection, but it is not necessarily in the public interest to do so. Rather, imposing
creditor-regarding liabilities upon the shareholders where the company is a profitable
going concern runs the danger of generating incentives for directors to engage only in
excessively low-risk projects. As long as the company is a going concern, creditors do
not benefit proportionately from the up-side and down-side of corporate decisions,
since their returns are, normally, fixed. If there is substantial shareholder equity in the
company, creditors will normally tend to favour projects which do not imperil that
situation, even if a riskier project has a higher present value, because the creditors’
position will not be materially enhanced by the higher-value project. In short, the
argument for not imposing wide-ranging creditor-regarding duties where there is
substantial shareholder equity in the company is that the company is designed as a
vehicle for taking entrepreneurial risks; that the creditors therefore have no a priori
claim that corporate enterprise should be low risk (unless they contract for it);
8
and
that the shareholder-regarding duties give the creditors adequate protection against
excessively risky projects. Hence, no modern company law system adopts a creditor
focus as its dominant principle of corporate governance.
about. However, the excessive distribution route to insolvency does justify legal controls over
distributions, which all company laws contain. The debate in that area, which is dealt with in other
papers to this conference, is whether legal capital or solvency-based controls do the better job in
controlling excessive distributions.
7
This explains as well why the ordinary shareholders have a continuing interest in monitoring the
performance of the company’s management and not just an interest which arises when the value of the
shares is about to fall below what the shareholder paid for his or her holding.
8
Of course, if an enterprise is solely financed by debt, as with some utilities, a cautious approach to
corporate projects is entirely appropriate; and large creditors in such cases will rightly contract for such
an approach.
4
For the avoidance of doubt, it should be made clear that the above argument is
confined to the adoption by directors of strategic decisions about the company’s
future trading plans. It does not pretend to deal with argument that long-term lenders
may be in danger of having the risk-profile of the company altered unfavourably to
them after they have made the advance and thus priced the loan, within the context of
projects which are not overall excessively risky. Even here, however, mandatory legal
protection may be inappropriate, since the lenders in question may well be able to
protect themselves through covenants.
9
As for short-term creditors (notably trade
creditors and tort victims), if the company is a going concern, they will be paid, by
and large, through a combination of legal pressure from the creditors (applied from
outside company law) and the company’s concern to maintain its reputation and so
obtain further credit.
10
There is still an issue where the short-term claim is such as, by
itself, to put the company’s continued existence in jeopardy, a situation which has
arisen in relation to tort claims in the United States but, apparently, not yet in
Europe.
11
In general, the European approach is to deal with such risks through
mandatory insurance schemes.
12
In any event such claims will destroy the
shareholders’ equity first and so they not cases where directors’ shareholder-regarding
duties create incentives for them to run such risks.
13
Companies in the vicinity of insolvency and the generation of perverse incentives
However, once the shareholders’ equity has been dissipated, or has been reduced to a
very low level, and there is no prospect of its being re-built through the company’s
established business model,
14
the incentive is for company controllers (if acting in the
shareholder interest) is to take on excessively risky projects, for their attention can
focus exclusively on the potential up-side of decisions. The doctrine of limited
9
This is the subject of Professor Bratton’s paper in this volume at p. 000.
10
This is not to deny that short-term creditors may not suffer problems, often severe, of late payment.
11
Though in multi-national companies, the line between states is not so easy to draw. See the decision
of the English High Court in Re T&N Ltd [2005] 2 BCLC 488, which represents in many ways a clash
between the US tort claimants and the pension claims of the British subsidiary’s workforce.
12
Such as mandatory employer liability schemes, which, it should be noted, usually apply to non-
corporate employers as well. It is a myth to think that, in the absence of limited liability, the creditor is
not likely to be faced with an insufficiency of assets on the part of the defendant.
13
Though the potential for such tort claims may create an incentive for directors, acting in the interests
of both shareholders and non-tort creditors, to make opportunistic use of group structures in such cases.
14
This is an important qualification to the argument. If a company is operating profitably but its profits
are fully distributed at the end of each year (so that the shareholders retain little equity in the company),
nevertheless the incentives to take on excessively risky projects will be weak, because the shareholders
may thereby destroy the company’s established profit-making potential.
5
liability provides the standard justification for the imposition of creditor-regarding
liability on directors in such cases.
15
Since limited liability normally restricts the
creditors to the corporate assets for the satisfaction of their claims, shareholders are
relieved against the downside risk of business decisions once their equity in the
company has evaporated. At this point the creditors can no longer rely on the
‘shareholders’ first’ rule in relation to losses to protect their interests in respect of
excessively risky projects. On the contrary, the corporate law doctrine of limited
liability creates an incentive structure for directors which positively favours
excessively risky projects, because shareholder-regarding directors can focus solely
on the up-side of potential projects, no matter how remote the possibility of success
may be. The position of the shareholders is now equivalent to that of the creditors
when the company has significant shareholder funds, except that, where the company
is a successful going concern, the creditors have only a very limited interest in the up-
side of corporate projects and are more focussed on the potential downside, whilst the
shareholders in the vicinity of insolvency are in the reverse position, having little
interest in the downside of corporate projects but standing to gain enormously from
the potential up-side. Thus arises the argument for creditor-regarding duties to be
imposed on directors of companies in the vicinity of insolvency.
Obviously, even in this situation, company controllers are not completely indifferent
to the riskiness of corporate projects. A project with a higher chance of a positive
outcome is preferable to one with a lower chance of one with the same outcome.
However, controllers are in a position to ignore, when comparing projects, the
chances of a negative outcome.
16
Thus, projects with a negative present value may be
undertaken as insolvency approaches and the downside risk of such projects will fall
on the company’s creditors. In particular, the risk will fall on the unsecured creditors,
who stand next in line to bear the company’s losses after the shareholders. Of course,
as we have already remarked, the opportunism of corporate controllers in the vicinity
of insolvency is not confined to embarking on overly risky projects in the hope of
turning the company around. In fact, the greater temptation (because it demands less
15
The argument made below is not new. For an earlier statements of it see P. L. Davies, ‘Legal Capital
in Private Companies in Great Britain’, Die Aktien Gesellschaft (1998) pp. 346, 349 and D Prentice,
‘Creditors’ Interests and Directors’ Duties’, 10 Oxford Journal of Legal Studies (1990) p. 265.
16
Thus controllers will prefer a project with, for example, a 30% chance of yielding 10 over one with a
20% chance of yielding 10, even if the former has a 70% chance of yielding –100, whereas the latter
has an 80% chance of yielding –5.
6
entrepreneurial effort) may be to spirit assets out of the company, so that creditors can
no longer lay their hands on them, rather than to run the risk of increasing its
liabilities by undertaking new projects. However, as stated, the focus of this paper is
on the incentives to embark on overly risky projects in insolvency.
Further points
Four further points can be developed from the above analysis. First, whatever
remedies are used to redress the perverse incentives identified above, their focus
should normally be the unsecured creditor. In particular, recoveries should be in
favour of the unsecured rather than secured creditors. Second, if unsecured creditors
are to be the focus of remedial measures, it is likely that those measures will consist
of mandatory law rather than self-help measures, given the collective action problems
of unsecured creditors. Third, and by way of qualification, in extreme cases unsecured
creditors may have as much appetite for risk as shareholders. If the company’s
descent into financial difficulty is sudden and deep, the company’s assets may no
longer be enough to provide a substantial dividend to the unsecured creditors at the
point when the controllers come to decide what steps to take. In this situation the
unsecured creditors may be as much in favour of overly risky projects as the
shareholders and for the same reasons: they no longer have anything to lose if such a
project fails but will be the first to gain if it is successful. So in designing and
applying legal rules it is important not to provide recovery to creditors who have
consented to or even encouraged the controllers’ decision to embark on an overly
risky project.
17
Fourth, even if the unsecured creditors have lost their financial interest
in the company at the point when the company’s controllers come to decide what to
do, there is probably no need in that situation to make the secured creditors the focus
of mandatory legal protection: they can, and do, look after themselves.
18
Directors not accountable to shareholders
It may be argued that this analysis is plausible so long as the directors are the
shareholders or are effectively accountable to the shareholders. Where the directors
17
Thus, section 588Y of the Australian Corporations Act 2001 provides that recovery for breach of
section 588G (discussed below) should not be allowed where the creditor knew at the time the debt was
created that the company was insolvent. Why should a creditor advance money to an insolvent
corporation? Possibly where the creditor sees this as an attractive way of enhancing the chances of the
repayment of monies previously advanced.
18
R Mokal, Corporate Insolvency Law (Oxford, OUP 2005) pp. 293-295.
7
are independent of the shareholders, the analysis may appear less persuasive. There is
certainly anecdotal evidence that in practice the problems generated by the incentive
structure analysed above are to be found predominantly in close companies.
19
However, even directors without shareholdings may suffer losses if the company
moves into insolvency, notably the loss of their jobs, and so the above analysis may
apply in those cases as well. This is obviously a stronger argument in jurisdictions
where, as is common in Europe, the initiation of an insolvency procedure leads to the
immediate side-lining of the existing management of the company. In debtor-in-
possession systems of corporate insolvency loss of a job may not be an automatic
consequence of triggering insolvency procedures, but it is nevertheless a real threat in
these systems as well. In addition, directors may suffer reputational losses by entering
into insolvency procedures, even if liquidation is ultimately avoided.
In relation to non-controlling directors of public companies, however, there is the
argument that the market for executives operates so as to counteract pressure from
shareholders in a particular company to embark on excessively risky projects.
Executive directors will enhance their reputations with shareholders generally by
dealing responsibly with corporate failure, because in future creditors will be prepared
to lend at lower rates to companies run by such managers and this will be of benefit to
shareholders.
20
This is a complex matter. Even where the market for executive talent
is open to a particular director, it does not follow that any particular director will place
a higher value on a new job (and thus act responsibly towards creditors) as against
maintaining his existing post (and so support high risk strategies to save the
company). Even when one has marketable talents, changing jobs involves risks and
costs which may be (or be perceived to be) higher than those associated with taking
action to maintain one’s existing job. In any event, even if corporate controllers who
are not shareholders or shareholder-controlled are less prone to embarking on
excessively risky projects as insolvency approaches, this is not a strong argument
against deploying the legal strategy suggested by the above analysis. Provided the
rules are shaped appropriately, where directors do not embark on overly risky
projects, they will not be caught. This is probably a better approach than making the
creditor-regarding rules dependent upon judicial assessment of whether the directors
19
Mokal, op. cit. n. 18, at pp. 289-292.
20
Mokal, op. cit. n. 18 at pp. 285-288.
8
were subject to shareholder control, since that would simply increase the costs of
litigation.
Perverse incentives and legal capital
It should also be noted that the issue of perverse incentives in the vicinity of
insolvency arises even if in a particular legal system there are strong rules on legal
capital. A high level of initial legal capital is no guarantee that assets will be
maintained within the company as it trades. Equally, capital maintenance rules
regulate only one form of loss of corporate assets (through distributions) and not
trading losses. So, it is not irrational for a jurisdiction to have both legal capital
requirements and, in addition, separate rules counteracting the incentives identified
above, as the UK does in relation to public companies. It is conceivable that there
might be added to a country’s legal capital rules a provision to the effect that loss of
legal capital requires a company to cease trading even before insolvency is reached,
thus pre-empting the rules governing trading near insolvency. However, such a rule is
obviously inefficient. Even Germany stops short of such a requirement and thus has to
supplement its legal capital rules with rules which focus on the duties of the directors
of an insolvent company, irrespective of what the position is in regard to its legal
capital. Article 92 Aktiengesetz 1965 [Stock Corporations Act – hereafter AktG]
illustrates both points. Article 92(1) requires the Vorstand [managing board] to
summon a meeting of the shareholders when one half of the company’s legal capital is
lost, but does not by itself require the company to stop trading; Article 92(2) requires
the Vorstand to commence insolvency proceedings at the latest within three weeks of
the company becoming insolvent, even if its legal capital is unimpaired.
21
This could
happen, for example, if the company’s assets, whilst exceeding its liabilities by the
amount required by the applicable legal capital rules, were illiquid, so that the
company could not pay its debts as they fell due. Thus, legal capital rules are not a
substitute for rules directly addressing controllers’ perverse incentives in the vicinity
of insolvency.
21
For similar provisions in relation to private companies see Arts. 49(3) and 64(1) of the Gesetz
betreffend die Gesellschaften mit beschränkter Haftung 1892 [Limited Liability Company Act –
hereafter GmbHG].
9
However, is the opposite the case? Can creditor-regarding rules in the vicinity of
insolvency be a substitute for legal capital requirements? Formally, the answer must
be in the negative. Minimum capital and capital maintenance rules are designed to
slow or prevent the descent into insolvency, not to deal with the perverse incentives
which may arise once insolvency is reached. However, trading rules may be
functional equivalents for capital rules. Tough rules on directors’ duties in the vicinity
of insolvency may reduce shareholders’ incentives to incorporate with inadequate
legal capital, even if, at that point, they are legally free to do so. Thus, effective
director liability rules in the vicinity of insolvency may operate so as to reduce
pressure to strengthen or introduce minimum capital rules. The difference between the
two is one between ex ante and ex post controls.
22
Legal capital rules aim (probably
with little success) to prevent the incorporation of inadequately capitalised companies.
Rules focussing on controllers’ incentives near insolvency do not procure adequate
capitalisation but aim (with a degree of success which is unclear) to restrict the harm
caused to creditors by undercapitalisation if undercapitalisation leads towards
insolvency.
Conclusions to Section II
The theory of perverse incentives, outlined above, seeks to explain the imposition of
creditor-regarding duties on corporate controllers as insolvency approaches. At least
in relation to directors accountable to shareholders such rules arguably meet the
hypothetical bargaining model. Controlling shareholders might bargain ex ante with
creditors for the impositions of constraints upon the directors’ activities in the vicinity
of insolvency, because the benefit of such rules is ultimately secured by them in the
form of a lower cost of borrowing.
23
However, the above theory gives no warrant for
imposing on corporate controllers, as a general principle of corporate governance, a
creditor-centred view of corporate decision-making. This is likely to lead to the
opposite vice to that identified above, viz. an excessively cautious approach to
corporate projects.
22
Davies, loc. cit. n. 15 at pp. 352-354.
23
Mokal, op. cit. n. 18 at p 265, denying the contrary argument by B Cheffins, Company Law: Theory,
Structure and Operation (Oxford, OUP, 1997) pp 537-548.
10
The positive and normative predictions from the above arguments are thus that
legislatures will (should) impose creditor-regarding duties on company controllers in
the vicinity of insolvency but will (should) not do so outside of that zone. In order to
explore these hypotheses the paper proceeds, after having dealt with some preliminary
matters (III) to look at directors duties when the company is in a state of insolvency
(IV), when it is in the vicinity of insolvency (V), and, finally, when it is in a
financially healthy state (VI).
III. Preliminary issues
Insolvency
The above analysis depends on the identification of perverse incentives arising for
corporate controllers in the vicinity of insolvency. But how do we define insolvency?
It is well established that there are two main approaches. The first is an excess of
liabilities over assets (the balance sheet test) and the second an inability on the part of
the company to meet its debts and liabilities as they become due (the cash flow test).
24
In legal systems which do not demand any or any significant initial legal capital, the
balance sheet test would appear to be an inappropriate one for the impositions of
creditor-regarding duties, since many companies without significant legal capital are
insolvent on a balance sheet test the minute they begin to trade.
25
To impose creditor-
regarding duties at this early point would be to suggest that the company ought to
have raised legal capital to some extent before it began trading. By contrast,
jurisdictions which regard minimum capital rules as important would not be inhibited
from using a balance-sheet test for insolvency (as well as a cash-flow test). Thus,
Article 92(2) AktG requires the Vorstand to take action (by way of instituting
insolvency proceedings) when or shortly after the company becomes insolvent on
either of the two tests for insolvency. By contrast, in Australia, a country which
inherited the British scepticism about the value of minimum capital requirements and
was not required to depart from that view by Community law, section 588G of the
24
R Goode, Principles of Corporate Insolvency Law (London, Sweet & Maxwell 2005) paras. 4-04 to
4.06. The distinction between the two approaches somewhat narrows if the balance-sheet test is carried
out on a going concern, rather than a break-up, basis.
25
This is because commencing trading usually involves exchanging cash for business-specific assets,
whose open-market value may immediately fall below the cash price and whose value within the
business may be uncertain.
11
Corporations Act 2001, which imposes a rather similar
26
duty upon directors to that
imposed by Article 92(2) AktG, applies only where the company is insolvent on a
cash-flow basis.
27
This point is considered further below in relation to section 214 of
the British Insolvency Act 1986.
Controllers
Although the perverse incentives mentioned above operate most strongly on
shareholders, the legal techniques generated in response normally identify the
directors as the subjects of the duties and liabilities. This, though at first sight odd, is
explicable. Shareholders as shareholders are in a weak position to cause the company
to take action which responds to those incentives. They normally need to act as
directors or through the directors. Imposing liabilities on directors will thus catch the
shareholders who act as directors and also provide a counter-incentive to directors to
do what the shareholders want where the controlling shareholder sits outside the
board. To the extent that directors are subject to the perverse incentives identified
above, whether or not they are shareholders or subject to shareholder influence,
focussing the liability rules on directors is also appropriate.
Nevertheless, there is something incomplete about imposing liability only on the
directors where the shareholders act through the board (but are not directors
themselves) and so many (perhaps all modern) systems extend at least some of their
creditor-regarding duties to shareholders (and others) who exercise director-like
influence over the company, whether they have been appointed formally to the board
or not. Section 214 of the British Insolvency Act applies to both de facto and shadow
directors,
28
as well as to those formally appointed as directors. The concept of a de
facto director catches a person who acts as a director, whether or not he has been
formally appointed to that position. A shadow director is one ‘in accordance with
26
Art 92(2) requires the Vorstand to file for insolvency; s 588G prohibits the board from incurring
debts, but leaves the board a somewhat wider margin of discretion than the German law as to the
choice of procedure for dealing with the insolvency. It also imposes liability only if the directors ought
to have suspected the company was insolvent.
27
R. P. Austin, H. A. J. Ford and I. M. Ramsay, Company Directors (Australia, LexisNexis
Butterworths, 2005) para 10.27. On minimum capital requirements in Australia see R. P. Austin and I.
M. Ramsay, Ford’s Principles of Corporations Law, 12th edn. (Australia, LexisNexis Butterworths,
2005) para. 24.360: ‘there are no significant minimum capital requirements to be met by those who
wish to obtain the privilege of limited liability.’
28
Insolvency Act 1986, ss 214(7) and 251. The line between the two concepts has caused some
controversy but it is not normally necessary to distinguish between them:
12
whose directions or instructions the directors are accustomed to act’, ie he or she is a
person who dictates to the directors what decisions are to be taken without being a
member of the board de jure or de facto. The French action en comblement de passif
(discussed below) applies to the dirigeant de fait [de facto director] as well as to the
dirigeant de droit [de jure director] and the notion of a dirigeant de fait is apparently
broad enough to capture the two British notions of de facto and shadow directors.
However, this extension is not without its problems. Too wide a definition of
‘director’ might discourage banks or shareholders (including parent companies) from
providing further funds to companies in financial difficulty. Providers of funds to
companies in distress are likely to impose greater restrictions on the management of
the company than those funding healthy companies. If such restrictions are likely to
lead to the funders being treated as directors of the company, such funds may become
less readily available.
29
IV. Directors’ duties arising upon insolvency
An implication of the arguments made in section II of this paper is that directors’
creditor-regarding duties which bite only when the company is in a state of insolvency
are triggered too late in the process of corporate decline. The perverse incentives there
identified will begin to affect the decisions of the company’s controllers as soon as the
shareholders’ equity has been reduced to negligible proportions or even is anticipated
to be so reduced, whether or not the company is at that point in a state of insolvency.
A legal strategy to re-set the controllers’ incentives should apply at an earlier stage.
Nevertheless, a number of jurisdictions contain provisions which apply only when the
company is in a state of insolvency and such provisions, whilst inadequate to deal
with the whole of the problem identified in section II, are not without purpose. Their
aim appears to be to require the directors of a company which is in a state of
insolvency to put it into some type of formal insolvency proceeding with reasonable
promptness.
30
This is clearly expressed in Article 92(2) of the AktG,
31
where, upon
29
British judges have shown themselves sensitive to this risk. See D Prentice, ‘Corporate Personality,
Limited Liability and the Protection of Creditors’ in R Grantham and C Rickett eds, Corporate
Personality in the 20th Century (Oxford, Hart Publishing, 1998) at pp 114-115. On the German position
see D Skeel in this volume at p. 000.
30
R Kraakman et al, The Anatomy of Corporate Law (Oxford, OUP, 2004) p. 73.
31
To like effect Art 64 GmbHG (and Swiss law has similar provisions). Although Art 92 does not
expressly deal with the civil liability consequences of a breach, by virtue of the German tort law a
violation gives rise to damages claims by creditors against directors: H Fleischer, ‘The Responsibilities
13
the company reaching a state of insolvency, the board must within three weeks file a
petition for the institution of insolvency proceedings. This requirement is bolstered by
the provisions of Article 92(3) which prevents the board from making further
payments out of the company’s assets, except such as are ‘consistent with the care of
a diligent and conscientious manager’. The duty created by Article 92 is thus one
which applies, apparently, late in the day
32
but is also quite specific as to what the
board is required to do, ie it is embodied in a rule rather than a standard.
Somewhat similar is section 588G of the Australian Corporations Act 2001 which
also applies only when the company is insolvent
33
and imposes a specific duty, but in
this case a negative one – to cause the company not to incur further debts – which
gives the directors slightly greater freedom of manoeuvre in deciding how to deal
with the company’s insolvency than does the German provision. It also relieves the
directors from liability if there were no reasonable grounds for suspecting that the
company was in fact insolvent. Nevertheless, the rationale of the provision seems
close to that of Art 92 AktG, namely, that the directors’ ‘proper course is to relinquish
control so that the company’s creditors can determine its future. Any question of the
company having a possibility of being rehabilitated and incurring further debts is a
question for the creditors, rather than the directors.’
34
Two criticisms can be advanced of the German and Australian provisions. The more
important is that already indicated. Although the provisions deal eventually with the
problem of perverse incentives by replacing the directors with an appointee
accountable to the creditors or in some other way subjecting the directors to effective
third-party control, they do so only at a very late stage. Second, it can be questioned
whether mandatory invocation of a formal insolvency procedure is always the correct
course of action, even if the company is insolvent. Such a rule involves the
compulsory exposure of the company to the costs of the insolvency procedure and a
reduction of the chances of an informal work-out with the creditors. Perhaps for this
of the Management and its Enforcement’ in G. Ferrarini, et al., eds, Reforming Company and Takeover
Law in Europe (Oxford, OUP, 2004) p 399.
32
Subject to the important qualification that balance sheet insolvency triggers the duty to invoke formal
proceedings. See section V below.
33
But see the discussion above on different definitions of insolvency employed in the German and
Australian provisions.
34
Austin, Ford, Ramsay, op. cit., n 27, at p 408.
14
reason, given the British tradition of dealing with insolvent companies out of court,
that country has no provision equivalent to Article 92 or section 588. Trading while
insolvent is not by itself either a criminal offence or a civil wrong. On the contrary,
there is judicial authority that putting an insolvent company into liquidation may itself
be a breach of the creditor-regarding duties created by section 214 of the British
Insolvency Act 1986 and discussed further below. In Re Continental Assurance Co of
London plc
35
it was said that ‘Ceasing to trade and liquidating too soon can be
stigmatised as the coward’s way out.’
Nevertheless, it must be pointed out that the British provisions on wrongful and
fraudulent trading (discussed below) do normally produce the result that the directors
of a company which they realise or ought to have realised is in a state of insolvency
have little option but to invoke a formal insolvency procedure. It is only where there
is a realistic prospect of trading out of insolvency that the British provisions give the
directors a freedom of action apparently denied by the German and Australian rules.
In other words, the German and Australian rules seem to take as their point of
departure that the company’s reaching a state of insolvency is by itself a sufficient
reason for transferring control to the creditors, whilst the British provisions keep the
door open for the argument that the directors may appropriately in some cases
continue to keep control and implement a plan to turn the company around. The aim
of the British rules is to re-balance the incentives which operate on the directors when
they take the decision whether to trade or enter formal insolvency proceedings, but
not to determine the decision for them.
It is also important to note that, whilst not requiring directors of insolvent companies
to invoke formal insolvency proceedings, British law gives to any creditor, who may
think he or she is suffering from directorial delay in this regard, a simple mechanism
for invoking such proceedings him- or herself. If a company fails to pay an
undisputed debt of at least £750 after demand for payment has been made, that will be
taken as sufficient evidence that it is unable to pay its debts as they fall due, even if all
35
[2001] Bankruptcy and Personal Insolvency Reports 733 per Park J at para. 281.
15
other circumstance suggest that the company is solvent.
36
It has been argued that this
provision is the functional equivalent of Article 92 AktG.
37
Other countries, for example, the United States and Japan, which lack any equivalent
to Art 92 or section 588, achieve timely invocation of the insolvency procedures by
means of a carrot rather than a stick, ie by permitting the incumbent management to
remain in place in insolvency, which may then operate principally as a mechanism for
the management unilaterally to amend the terms of unfavourable contracts (for
example, with trade unions) and introduce new finance on the basis of this re-adjusted
cost-base.
38
Although the incumbent management may remain in charge in such
insolvency procedures, creditors are protected to some extent by the court scrutiny to
which the directors are now exposed – though again such third-party protection comes
again only at a very late stage in the company’s decline.
V. Directors’ liabilities in the vicinity of insolvency
The theory argued for in section II suggests that creditor-regarding duties which are
triggered only when the company is insolvent operate too late. Rather, the creditor-
regarding duties should be imposed at the point at which the directors’ incentives to
adopt overly risky strategies become effective, ie when the shareholders’ equity has
become negligible or is anticipated to do so. We thus identify the first policy issue in
designing such laws, ie defining in terms which courts can efficiently handle the point
at which the creditor-regarding duties are to be triggered. The second policy issue is
the definition of the nature of the creditor-regarding duty. Since the company
typically will not be in a state of insolvency (at least on a cash-flow test) at the point
the duty bites, the simple solution of requiring the directors to enter into formal
solvency proceedings or to cease trading is not obviously the appropriate course of
action. Nor is any alternative precise course of action obviously identifiable ex ante to
be imposed on the directors. Consequently, legislation designed to give effect to
creditor-regarding duties in advance of insolvency is likely to rely on standards rather
36
See Goode, op. cit., n 24, at para 4-23 and Cornhill Insurance plc v Improvement Services Ltd
[1986] 1 W L R 114.
37
A. Schall, ‘The UK Limited Company Abroad’ 16 European Business Law Review (2005) 1577 at
1581.
38
Kraakman et al, op. cit., n. 30, p 74.
16
than rules for the specification of the duty, just as the legal regulation of the duties of
directors when the company is in a fully solvent state is normally based on standards
rather than rules.
Section 214 of the British Insolvency Act 1986
The European Commission’s High Level Group of Company Law Experts identified
section 214 of the British Insolvency Act 1986 (the wrongful trading provision) as a
model for creditor-regarding duties imposed in advance of insolvency.
39
The section
certainly aims to meet the problem identified in section II.
40
It exposes to personal
liability the directors (and shadow directors) of a company who, at the point that they
realise or ought to have realised that the company had no reasonable prospect of
avoiding insolvent liquidation, fail to take all steps which a reasonable director would
have taken to minimise the potential loss to the creditors. What the directors ought to
have realised and the steps they ought to have taken to minimise creditors’ losses are
assessed on an objective basis, ie according to the standard of what a reasonable
director ought to have done, irrespective of the cognitive and executive talents of the
particular directors in question.
41
However, no specific course of action to protect
creditors is mandated by the section: the directors’ actions are assessed ex post by a
court by reference to the standard of the reasonable director. Action against the
directors may be brought only if the company goes into insolvent liquidation and only
by the liquidator. The principal liability of a director who has broken section 214 is to
make such a contribution as the court thinks proper to the assets of the insolvent
company which are then available for distribution to creditors.
42
That contribution is
made available mainly to the unsecured creditors, because the courts have treated
recoveries under section 214 as not representing the proceeds of an asset held by the
company prior to insolvency and so the recoveries are not caught by security interests
granted by the company prior to insolvency.
43
Overall, the section can be seen to aim
to re-balance the incentives of the directors as the shareholders’ equity nears
39
Report of the High Level Group of Company Law Experts on a Modern Regulatory Framework for
Company Law in Europe (Brussels: 4 November 2002) section 4.4.
40
P Davies, Introduction to Company Law (Oxford, OUP, 2002) pp 93ff; Mokal, op. cit. n 18, ch 8.
41
S 214(4): this may seem obvious but in the context of British company law, which has traditionally
assessed directors’ duties of skill and care on a subjective basis, the point is worth noting: Gower and
Davies, Principles of Modern Company Law 7th ed. (London, Thomson, 2003) pp 432ff.
42
S 214(1).
43
Re Oasis Merchandising Ltd [1998] Ch. 170, CA. However, the now much-reduced group of
preferential creditors will have a first claim on the recoveries.
17
vanishing point. The directors (and shadow directors) are left in control of the
company, but section 214 has the effect of exposing them to the downside of their
decisions if they adopt excessively risky strategies.
Despite the apparent appropriateness of section 214 to the problem identified in
section II it has been criticised on a number of grounds. These relate to the point at
which the duty is triggered, the range of insolvency situations caught by the provision,
the assessment of the contribution to be made by directors in breach, the chances of
the duty being enforced in practice and the lack of guidance provided by the section to
the directors subject to it.
Triggering the duty
Although the section does bite in advance of insolvency, it has been argued that it
does not operate far enough in advance of insolvency. The test of ‘no reasonable
prospect of avoiding insolvent liquidation’ has been argued not to identify accurately
the point at which creditors’ interests cease to be protected by the shareholders’ desire
to preserve their equity in the company. This argument was considered by the
Company Law Review in the United Kingdom. It considered the proposition that
directors should be required ‘where they know or ought to recognise that there is a
substantial probability
44
of an insolvent liquidation, to take such steps as they believe,
in their good faith judgement, appropriate to reduce the risk, without undue caution
and thus continuing also to have in mind the interests of members.’
45
The qualified
way in which this proposition is put indicates the lack of agreement among the
members of the Steering Group about the attractiveness of the idea. Those in favour
thought the principle expressed simply what good directors ought to do; those against
that fears of personal liability would lead to excessive caution on the part of directors
and induce premature decisions to end or scale down trading, especially as the trigger
point for the new duty might well be difficult to identify. The Steering Group simply
put the idea forward for further consideration by the relevant Government
Department, which later, and probably rightly, rejected it as inconsistent with its
44
To be defined as meaning more probable than not.
45
Company Law Review Steering Group, Final Report (London, Department of Trade and Industry,
2001) vol 1,para. 3.17. The 214 duty would remain in place and bite where there was no reasonable
prospect of avoiding insolvent liquidation.
18
policy of promoting a ‘rescue culture’ for companies in financial difficulty.
46
Certainly, in the form quoted above, the court is given a very difficult balancing
decision because of the lack of guidance as to how to strike the balance. The most
likely result of the introduction of such a duty is that the British courts would have
been highly reluctant to conclude that any particular directorial decision infringed the
legal standard, so that its impact in practice would have been severely limited. In any
event, the suggested duty does not appear in the Company Law Reform Bill
introduced into Parliament in November 2005.
Thomas Bachner
47
has criticised section 214 from a somewhat similar standpoint,
arguing that it operates too late in the company’s economic decline. He argues further,
and interestingly, that in fact Article 92 AktG (and the equivalent provisions for
private companies) operate at an earlier point. How can the German provision, which
has been criticised in the previous section as operating at too late a stage, ie only
when the company is in a state of insolvency, be argued to come into effect at an
earlier point in time than the British provision which specifically focuses on
companies which have not yet reached a state of insolvency? The answer to this
puzzle is to be found in a point already alluded to, namely, the different definitions of
insolvency used in the two countries. The British provision operates in advance of
insolvency but defines insolvency in cash-flow terms; the German provision requires
the company to be in a state of insolvency but defines insolvency in both balance
sheet and cash-flow terms. To see how this difference in the applicable definition of
insolvency relates to the point at which the duties created by the provisions begin to
regulate the behaviour of directors, let us look more carefully at each set of provisions
in turn.
Does section 214 of the British Insolvency Act operate on a cash-flow definition of
insolvency? It is submitted that this is in fact the case, though the section does not
appear at first sight to do so. That section imposes liability on directors who fail to
take the requisite action to protect creditors when they realise or ought to have
realised that the company has no reasonable prospect of avoiding insolvent liquidation
46
Modernising Company Law (London, Her Majesty’s Stationery Office, July 2202, Cm 5553-I) para.
3.11.
47
T. Bachner, ‘Wrongful Trading – A New European Model for Creditor Protection?’ 5 EBOR (2004)
p. 293.
19
and the company does in fact subsequently go into insolvent liquidation. Insolvent
liquidation is defined, however, on a balance sheet basis (ie going into liquidation ‘at
a time when its assets are insufficient for the payment of its debts and other liabilities
and the expenses of winding up.’). Why is this? It is important to note that section 214
does not use the fact of the company going into insolvent liquidation as the trigger
point for the imposition of the creditor-regarding duties. Rather, the company going
into formal liquidation proceedings is a necessary condition for the enforcement by
the liquidator of duties which have arisen (and been broken) previously. (The
significance of this aspect of the section is discussed further below.) Defining
insolvent liquidation, as a condition for liability, in balance sheet terms makes good
sense, because if the company is not insolvent at the point of liquidation on a balance
sheet test (but only in cash-flow terms), there is no reason to impose liability on the
directors, since the creditors, ex hypothesi, will be fully paid in the liquidation.
48
Going into insolvent liquidation thus does not define the point at which the creditor-
regarding duties are triggered. The whole rationale of the section requires that these
duties should be triggered at an earlier time. This point is in fact the point at which the
directors realise, or ought to have realised, that the company has no reasonable
prospect of avoiding insolvent liquidation, a point which is necessarily prior to the
company’s entering into formal liquidation proceedings. The crucial question is what
tests the courts have developed for determining whether the company has no
reasonable prospect of avoiding insolvent liquidation. For that purpose, it seems clear
from the case-law (the section does not deal with the point) that the courts use a cash-
flow test. Thus, in Re Purpoint
49
the company was undoubtedly insolvent on a
balance sheet test when it commenced trading in February 1998, but the court held
that the director did not contravene section 214 until the end of that year, because only
then was it clear that ‘the company could not meet its trade debts as they fell due.’
Likewise, in Re Rod Gunner Organisation,
50
the directors of a company, insolvent on
a balance sheet basis, were held not to have breached section 214 until the point at
which it became clear that the person who had come in with funds to meet the
48
R Goode, op. cit. n 24 at para 4.06. For example, the company might have a clear excess of assets
over liabilities, even when the assets are valued on a break-up basis, but be unable to pay its debts as
they fall due because the assets are illiquid. In this case the liquidation should lead to the creditors
being paid in full.
49
[1991] BCLC 491.
50
[2004] 2 BCLC 110.
20
company’s day-to-day needs was not going to stick by the original re-financing plan
and was proposing instead an implausible flotation of the company. It is further clear
that the cash-flow test is applied on a ‘commercial reality’ basis, so that companies
which have not in fact been paying their debts on time are not regarded as insolvent
on a cash-flow basis if they have been making payments within time-scales acceptable
to their creditors.
51
In the eyes of the British courts, if the company is cash-flow
solvent, it will normally be safe to proceed on the basis that no creditor is likely to
want or be in a position to put the company into liquidation
52
and so the company can
be said to have still a reasonable prospect of avoiding insolvent liquidation.
The above analysis of the British provisions also explains the claim that the German
provision operates at an earlier stage in the company’s financial decline. As the above
British cases show, a company may be insolvent on a balance-sheet test at some point
before the section 214 duty is triggered. To the extent that the German provision
would bite at this earlier stage, because it uses a balance-sheet test of insolvency as
well as a cash-flow test, the claim to earlier operation of the German provision can be
considered to be made out. Thus, Bachner rescues the German provision from one of
the criticisms made of it in the previous section, ie that its duty is triggered too late.
However, it does not rescue the German provisions from the second criticism,
namely, that the content of the duty – to put the company into a formal insolvency
procedure – is inappropriate. In fact, this second criticism is strengthened by
Bachner’s argument. If the company is solvent on a going-concern test, it seems
highly inapposite that the directors should be required to impose on the company the
costs of a formal insolvency procedure, if there is a reasonable prospect of the
company trading out of its financial difficulties. In short, early triggering of the
creditor-regarding duty is not in itself a virtue. If that duty is formulated in terms of
putting the company into insolvency, as the German provision is, it may in fact reduce
the chances of saving viable companies. The German provision, by requiring the
invocation of a formal insolvency procedure, is not apposite for operation at an early
51
Re Brian D Pearson (Contractors) Ltd [1999] BCC 26.
52
See text attached to notes 36 and 37 above.
21
stage in the company’s financial decline because it deprives the directors of all but
one of the available course of action for dealing with the company’s troubles.
53
Of course, the German provision could be saved from this second criticism as well by
reformulating it so as to require the directors to take reasonable steps to protect the
interests of the creditors rather than, as at present, specifying a particular course of
action. However, this re-formulation would move Article 92 very much closer to the
approach of section 214 of the British Act. Article 92 would have recourse, as does
section 214, to a general standard of review of director’s actions, but the duty to act
would be triggered at an earlier stage than under section 214. It has already been
indicated that there is a debate to be had about whether the section 214 duty is
triggered too late and so earlier triggering of a non-specific would not by itself be
unwelcome. A more difficult question is whether a balance-sheet test for insolvency
defines the appropriate earlier moment at which the duty should be triggered. It is
difficult to see reasons for regarding the balance-sheet test as defining the appropriate
moment. Its presence in the German legislation seems more a reflection of the
commitment of the German system to a far-reaching system of legal capital rules than
of a search for the point at which creditor-regarding standards should be triggered.
The range of insolvencies caught
This set of criticisms require us to return to the point that it is condition of liability
under section 214 that the company goes into insolvent liquidation. This has three
consequences. First, if the directors break their section 214 duty but their gamble in
fact pays off, because the company recovers, they are not exposed to liability. This
may be justified on the grounds that the breach of duty has not harmed the creditors;
in fact, they have benefited from it. Second, and more serious, if the company does
end up insolvent but is not put into insolvent liquidation but is simply at some later
date struck off the register of companies, the section 214 machinery will not operate.
54
Third, if the company reaches a state of insolvency but is not put into liquidation but
53
It is true that Art. 92(2) gives the directors a three-week window to find an alternative solution, but it
is doubtful whether this is an adequate response to the difficulty outlined in the text. French law
contained a similar provision until January 2006 in Art. L621-1 of the Code de Commerce
[Commercial Code]. As part of the 2005 reforms (see text attached to nn. 97-99 below) the obligation
was removed precisely in order to give greater scope for the operation of a rescue procedure.
54
I am particularly grateful to Professor Spindler for emphasising in his formal comments on my paper
at the conference the significance of this point.
22
rather is dealt with through the alternative mechanism of administration, again the
machinery of section 214 will not operate. Let us look at the second and third points
in a little more detail.
A company’s dissolution without going through a formal liquidation procedure is
clearly a serious potential problem for creditor-protection systems which are based on
use of the formal procedure. This is so even if the dissolution of the company does not
formally relieve the directors of liabilities incurred whilst the company existed or if
the relevant law provides for the resurrection of dissolved companies so that they can
enforce their rights.
55
This is because, without the use of a formal procedure, no
independent person is likely to examine whether the company has a viable claim
against the previous directors of the company. If on a cursory view the company
appears not to have sufficient assets to support the costs of the formal procedure, that
procedure will not be invoked, even if examination in the formal procedure might
have revealed the existence of further assets in the shape of claims against the
directors. On the other hand, since there will be many companies which genuinely
have no assets, of any type, to support the costs of the formal procedure, some
mechanism must be provided for dissolving unliquidated companies.
It is difficult to know how this situation can be handled effectively. A formal duty on
the directors, as Article 92 AktG imposes, to petition for the opening of formal
liquidation proceedings seems not to solve the problem. Schall has remarked that ‘in
about one third of all insolvency cases in Germany the proceedings are not opened by
the court due to lack of assets.’
56
The functional problem is the same in Britain and
Germany: the lack of incentive to devote resources (public or private) to handle the
affairs of companies which appear to have no significant assets. A bolder step would
be to give the right to sue the directors for breach of the creditor-regarding duties to
individual creditors, at least in those cases where the representative of the creditors
collectively is not in a position to enforce it. German law already treats breaches of
Article 92(2) AktG as conferring tort claims for damages on creditors individually.
57
55
For the relevant British law see Gower and Davies, op. cit. n. 41 at pp. 864-870.
56
Schall, loc. cit. n. 37 at p. 1590.
57
Fleischer, op. cit. n. 31 at pp. 399-400. This is perhaps an example of a situation where certain
assumptions follow from placing a rule in either insolvency or company law. Britain places the rule in
23
British law could follow this lead, for example, by conferring the right to enforce
section 214 on individual creditors in those cases where the company was dissolved
on the grounds it was failing to carry on any business and either no liquidator had
been appointed or the liquidator had ceased to act without completing the winding up.
The action would be to recover a proportionate part of the contribution which the
court would have ordered the director to make to the company.
58
This would give the
creditor who acted first the best chance of recovery from the director’s personal
assets, but this might be regarded as an appropriate reward for taking the initiative.
However, it is unclear how much use would be made of such a right on the part of
individual creditors. In most cases, they would still lack the information on which to
judge whether such litigation was likely to be successful and the right to recover a
proportionate part of the directors’ contribution might not provide a strong incentive
to bring litigation.
The other problem in this area is that section 214 does not apply if the insolvent
company goes into administration
59
rather than liquidation. This is a major issue since
administration is clearly now the legislature’s preferred way of handling insolvent
companies because that process is thought to increase the chances of (parts of) the
company’s business being saved. Under this procedure, as re-vamped by the
Enterprise Act 2002, the primary objective of an administration is to ‘rescue the
company as a going concern’; only if that is not reasonably practicable should the
administrator pursue the secondary objective of ‘achieving a better result for the
creditors as a whole’ than would be likely to be achieved by an immediate liquidation;
and only if achieving the secondary goal is not reasonably practicable should the
administrator pursue the tertiary goal of ‘realising property in order to make a
distribution to one or more secured or preferential creditors.’
60
Where the
administrator succeeds in achieving the primary goal, then the directors escape
liability under section 214, even if it was their excessively risky business decisions
which brought the company to the point of needing to be rescued. Nor can the defence
necessarily be used that, if the company is rescued, the creditors will have suffered no
insolvency law and so naturally adopts the collective enforcement principle of that branch of the law;
German places the rule in company law and so does not adopt the collectivist approach.
58
For a discussion of the different recovery rules in Britain and Germany see below.
59
Administration is governed largely by Schedule B1 of the Insolvency Act 1986, as amended by the
Enterprise Act 2002.
60
Insolvency Act 1986, Sched. B1, para. 3.
24
loss. An element of the rescue operation on the part of the administrator is likely to
involve the agreement (partially forced, given the situation) by some or all of the
creditors to scale down their claims against the company,
61
so that the creditors are
likely to bear part of the costs of the rescue. In this situation there is a major gap in the
protection afforded to creditors against the perverse incentives identified in Section
II.
62
Why should the wrongful trading provisions be limited in this way? One possible
explanation is that, at the time of their adoption in the mid-1980s, the administration
procedure was much less significant than it now is following the 2002 reforms.
Against this is the fact that the Committee which recommended the introduction of
wrongful trading in 1982 did envisage its application to the administration process.
63
This suggests a more substantial reason. Two justifications for the restriction can be
advanced. The first is the desire of the legislature to encourage use of the
administration procedure and especially to encourage directors of companies to
initiate administration as soon as the need for it arises. As insiders, directors are better
placed than external creditors to take timely action and so directors’ commitment to
the administration process might be thought to be worth encouraging. Removing the
threat of a wrongful trading investigation by the administrator takes a way a
disincentive for directors to seek an appointment. It is consonant with this argument
that directors are able to appoint an administrator out of court on the basis of a simple
notice filed with the court stating that the company is or is likely to become unable to
pay its debts.
64
By contrast, creditors, other than the holder of a floating charge,
65
are
required to apply to the court for the appointment of an administrator and the court
needs to satisfy itself not only that the company is or is likely to become unable to pay
its debts but also that an appointment by the court is likely to achieve one of the
61
As is recognised in para. 49(3). And see Mokal, op. cit. n. 18 at p. 248. During the administration
there is a moratorium on creditor enforcement of their claims and, indeed, on the appointment of a
liquidator: paras. 42 and 43.
62
Where the administrator pursues the second or third objectives the problem is less pressing because
there the administration is likely to be followed by a liquidation.
63
Report of the Review Committee on Insolvency Law and Practice (London, Her Majesty’s Stationery
Office, 1982, Cmnd. 8558) – usually referred to after the name of its chairman as the ‘Cork
Committee’ – at para. 1791.
64
Insolvency Act 1986, Schedule B1, para. 27(2) – note the absence of a reference to balance sheet
insolvency.
65
Paras. 14-21 – the traditional British fondness for the floating charge, although much reduced by the
2002 Act, shows itself here, but that is a topic which lies outside the scope of this article.
25
purposes of an administration,
66
a requirement which imposes a substantial evidential
burden on those seeking court appointment of an administrator.
A further argument along the same lines is that, although the administrator displaces
the existing management in terms of the formal, legal allocation of authority to run
the company,
67
nevertheless he or she may in practice have to rely heavily on the
existing management of the company to effect the rescue plan. In fact, it can be
argued that the very incentive structure which led the directors to expose the company
to excessive risk can now be put to use in support of the administrator’s plan to rescue
the company. At least in family controlled companies, the shareholder/directors will
have made idiosyncratic investments in the company and ‘given therefore that they
are likely to consider themselves deeply tied up with the fortunes of the company, and
given that they would often clearly be its residual claimants, shareholder-directors
have every incentive to ensure that the company’s value would be maximised.’
68
Given the administrator’s control of the setting of the company’s strategy, we need no
longer fear that the incentive structure will lead to excessively risky decisions and can
be more confident that the former management will work loyally to implement the
rescue plan the administrator proposes and the creditors adopt. Again, it can be argued
that this (perhaps optimistic) scenario would be disrupted if administrators were under
a duty to investigate claims against the directors for wrongful trading. Both the
arguments made above demonstrate a legislative strategy of promoting corporate
rescue or turn-around over a policy of bringing home to directors a liability for the
harm they have inflicted on creditors through excessively risky business decisions.
Compensation
Bachner has also pointed out
69
that the British rules on the level of compensation
payable appear to be more favourable to directors than those developed under the
German rules. Although the British statute confers a discretion on the court as to the
size of the contribution to be demanded from the directors who have acted in breach
of section 214, the courts seem to have settled down with an approach whereby the
66
Para. 11.
67
Paras. 59-64.
68
Mokal, op. cit. n. 18 at p. 228. However, he seems later to take the view that evidence that the
directors have engaged previously in wrongful trading should disqualify them from involvement in
executing the rescue plan: at p. 249.
69
Loc. cit. n 47 at pp 310 ff.
26
maximum contribution is the diminution in the company’s net asset position during
the period of wrongful trading, with discounts being available from that theoretical
maximum for directors who are not regarded as strongly blameworthy. There is no
room here for taking account, as German law does, of unfavourable developments in
the position of particular creditors within an overall stable net asset position for the
company;
70
still less for the development of a distinction between ‘old’ and ‘new’
creditors, under which the latter (those becoming creditors after the creditor-regarding
duty has been broken) are entitled to full compensation for their reliance loss.
71
The
British approach reduces the chilling effect of the creditor-regarding duties on
directorial decision-making and thus probably demonstrates again the British
tendency to promote the ‘rescue culture’: even if directors do embark on an
excessively risky project once insolvent liquidation threatens and that project is not
successful, they will not incur liability if the company is no worse off as a result. The
German approach to compensation, by contrast, is consistent with the policy of
requiring directors to institute formal insolvency proceedings, thus making any further
trading under the directors’ control illegitimate. As the BGH has memorably put it,
the purpose of the provision is to keep insolvent companies out of commerce.
72
Enforcement
The most frequent domestic criticism of section 214 concerns no so much the
principle it embodies but its alleged lack of effect in practice, a conclusion drawn
from the relatively few reported cases in which it has been invoked. Although the link
between the level of reported cases and the impact of any particular law is complex
and not by any means unilinear, there are in fact grounds for being concerned about
whether financing is available for all section 214 claims which could appropriately be
pursued. The Oasis Trading case,
73
which confirmed that the proceeds of a section
70
By means of the notion of Quotenschaden.
71
BGH 6 June 1994, NJW 1994 p 2220. See also Fleischer, op. cit. n. 31 at p. 400.
72
BGZH 126, 181 at 184: the purpose of the legislation is ‘konkursreife Gesellschaften mit
beschränktem Haftungsfonds von Geschäftsverkehr fernzuhalten.’ (see Fleischer, above n. 31 at p 400).
Similar debates have arisen in Australia and New Zealand, where the current decisions seem to favour
the German approach of protecting individual creditors: Re BM and CB Jackson Ltd (2001) 9 NZCLC
262,612 (criticised by Peter Watts, ‘Company Law’ New Zealand Law Review (2001) p. 293) and
Powell v Noclex Yachts (2001) 37 ACSR 589.
73
Re Oasis Merchandising Ltd [1998] Ch. 170, CA. This can be seen as an application of the long-
established general principle that causes of action not created until the commencement of the
insolvency proceedings and enforceable only in the liquidator’s name benefit the unsecured creditors:
Re Yagerphone Ltd [1935] 1 Ch. 395.
27
214 contribution claim are not caught by security interests the company may have
granted, also made it of no interest to secured creditors to fund 214 actions. The
liquidator will naturally be cautious about using the company’s assets available for
unsecured creditors to pursue 214 claims, and is likely to pursue only the clearest
cases.
74
The obvious solution is for the liquidator to transfer less-than-clear cases to a
third-party financier in exchange for a share of the proceeds, if the claim is
successful.
75
The third-party can spread its risks over a body of 214 claims and thus
pursue some risky claims which a liquidator of a particular company might be
unwilling to take up. In Oasis Trading, however, such a course of action was held to
infringe an ancient if arcane principle of civil procedure law (the rule against
champerty) which was held not to have been overridden by the insolvency legislation.
It seems unnecessary to pursue this domestic civil procedure debate here: it is obvious
that funding for 214 claims could be made available from third parties if there was to
will to adopt an appropriate mechanism.
76
The costs of using standards
Section 214 is also often criticised in practitioner circles for not giving directors
sufficient guidance on what it is necessary to do to comply with its requirements. This
is a criticism inevitably attracted by standards, in the setting of which the legislature
externalises some of the costs of law-making to the courts which have to apply the
standard and the persons who are subject to it. However, standards are the traditional
74
At one stage it appeared that the costs of pursuing a wrongful trading claim were not to be counted as
‘expenses of the insolvency’ and so were not recoverable by the liquidator from the company’s assets if
the litigation were unsuccessful – a disastrous disincentive to enforcement by the liquidator. However,
this problem has now been remedied by an amendment to the Insolvency Rules (see the Insolvency
(Amendment) (No. 2) Rules 2002 (S. I. 2712) amending Rule 4.218(1)(a) of the Insolvency Rules 1986
(S.I. 1925). However, this change does not remove the pressures on the liquidator, in discharging his
duties to promote the interests of the unsecured creditors, not to take speculative cases, pressures
reinforced by the requirement that liquidator obtain court or creditors’ committee approval for section
214 litigation: Insolvency Act 1986, Schedule 4, para. 3A (a linked amendment also made in 2002).
75
The alternative of contingent fee litigation is less attractive in the UK setting where the losing party
pays the winner’s legal costs and so the British rules in this area (the so-called ‘conditional fee’
arrangement) require insurance against this risk to be taken out on the commencement of the litigation.
Further, the ‘up-lift’ in costs which the lawyers achieve where the litigation is successful is less than in
contingent fee litigation in the United States, so that it is less attractive to British law firms practising
commercial law to fund claims (including insurance costs) where the chances of success are not great
on the basis that the costs thus incurred will be covered by recoveries in the successful cases.
76
For an argument that the Oasis Trading decision has been overruled impliedly by the subsequent
decision of the House of Lords in Buchler v Talbot [2004] 2 A.C. 298 see J. Armour and A. Walters,
‘Funding Liquidation: A Functional View’ 122 Law Quarterly Review (2006) forthcoming. Their
argument is probably still good despite the proposed legislative repeal of the result in Buchler: see the
Company Law Reform Bill (H L Bill 34, November 1, 2005) cl. 868.
28
technique for defining the duties of directors of companies in a healthy financial state,
and there is no evidence as yet that the courts will apply the section 214 standard any
less appropriately than the standards embodied in the common law duties of directors.
The solution to the problem (perhaps easier to articulate than to apply) is for the
courts to develop the legal standard so that it reflects current mores of good business
practice recognised by the business community. Although difficult cases are bound to
arise in the courts, it is suggested that the notion of wrongful trading is firmly
grounded in the principle that companies should not trade at their (unsecured)
creditors’ expense and this is a recognised social principle in the business
community.
77
Common law developments of directors duties ‘to creditors’
Although section 214 of the British Act provides a convenient focus for debate about
the introduction of creditor-regarding duties, it is by no means the only legal
development tending towards the recognition of the theory expressed in section II of
this paper. In fact, much more widespread are judicial innovations of this type.
Starting in Australia in the 1970s,
78
the notion of a duty upon directors to take account
of the interests of creditors as insolvency approaches has been widely accepted
throughout the common-law world, including in the United States.
79
As with most
significant common-law developments in their early stages, there is considerable
uncertainty about the conceptual boundaries of the new doctrine. For example, it is
clear that creditor-regarding duties are being developed by extension of the common
law duties which the law has traditionally recognised the directors as owing to the
company. However, it is not always clear which of the two main strands of those
traditional duties is being developed. The traditional duties may be viewed in terms
of a duty to promote the interests of the protected group (fiduciary duties or duties of
loyalty in common law parlance) or to avoid harm to the interests of the protected
group (for example, duties of competence). It would be conceptually possible to
extend either or both of these duties to creditors. The former is a more demanding
duty: in exercising their discretionary powers, directors would be required to give
priority to promoting the interests of the creditors, either exclusively or, more likely,
77
Cork Committee, op. cit. n. 63 at paras. 205-223 and 1785.
78
Walker v Wimborne (1976) 137 CLR 1.
79
The current state of play is conveniently summarised by Andrew Keay, ‘Another way of skinning a
cat: enforcing directors’ duties for the benefit of creditors’ 17 Insolvency Intelligence (2004) p. 1.
29
along with the interests of the shareholders. The latter would permit the directors to
continue to exercise their discretion so as to promote exclusively the shareholders’
interests, but impose the constraint that their action should not, as a by-product,
damage creditors’ interests. To the extent that the new common law duty bites in
advance of insolvency the distinction is a potentially important one.
80
Equally unclear from the decisions is the definition of the trigger point for the
creditor-regarding duty, except that there appears to be general acceptance that the
duty can bite in advance of the company being in a state of insolvency. In Credit
Lyonnais Bank Nederland NV v Pathe Communications Corp
81
Chancellor Allen
suggested the test of the company ‘operating in the vicinity of insolvency’, whilst in
Nicholson v Permakraft (NZ) Ltd
82
the judge conceivably was prepared to go a bit
further by suggesting the duty was triggered by ‘a course of action which would
jeopardise solvency.’ Given the difficulty, already noted, of defining in operational
terms the point at which the creditor-regarding duty should be triggered, it seems
likely that the courts will continue to experiment with different formulations of the
trigger point for some time to come.
On the other hand, the majority view is that this duty is not in fact owed directly to
creditors, but is an extension of directors’ duties as traditionally understood and so is
a duty owed to the company.
83
The importance of this point is that it is thus a duty
which can be enforced
84
only by the company (or in a derivative action on its behalf)
and not directly by creditors, so long as the company has not entered into a formal
insolvency procedure. Even at that point, the duty is enforceable only by the creditors
collectively (for example, by the liquidator) and not by individual creditors. As
80
If the directors must promote (not just protect) the interests of the creditors and the creditors’ claims
are currently (just) covered by the company’s assets they might feel constrained to favour a project
which has a 90% chance of producing 5 and a 10% chance of producing 0, as against one with a 50%
chance of producing 100 and a 50% chance of producing –50. Although both projects have a positive
current value, the former is less risky.
81
Printed in 17 Delaware Journal of Corporate Law (1992) p. 1099. Note that in this case the duty to
take account of creditor interests was invoked, not by creditors, but by directors in order to resist a
claim by shareholders, a situation equally to be found in relation to the current statutory duty upon
directors of British companies to take into account the interests of employees: Re Saul D Harrison &
Sons plc [1995] 1 BCLC 13, CA.
82
[1985] 1 NZLR 242.
83
See below for a discussion of the contrary view of the Supreme Court of Canada.
84
The duty may have legal consequences short of enforcement even before the opening of formal
insolvency proceedings: see n 87.
30
Gummow J said in the Australian High Court, ‘the result is that there is a duty of
imperfect obligation owed to creditors, one which the creditors cannot enforce save to
the extent that the company acts on its own motion or through a liquidator.’
85
Subject the inevitable uncertainties involved in common law developments, especially
as in relation to the trigger point of the creditor-regarding duty, the cases summarised
above seem to fit reasonably well the theory advanced in section II as to when it
would be appropriate to re-set the directors’ incentives. The modified directors’ duty
exposes directors to personal liability if they embark on overly risky projects in the
vicinity of insolvency and in consequence the down-side of potential projects
becomes again of relevance to their decision-making.
Even in the UK, where the courts have also adopted the modified common law duty,
it can play a useful supplementary role to section 214. First, it may operate at an
earlier stage than s 214 and thus allow the courts to impose liability in appropriate
cases where 214 does not apply. To the extent that the 214 trigger point is too late (see
the discussion above) the common law duty permits the courts to experiment with
definitions which apply earlier. Second, it can be invoked in all insolvency
proceedings (for example, by an administrator) and not just in liquidation.
86
Third, the
duty has legal consequences beyond the payment of compensation. In particular,
breaches by directors of the creditor-regarding duty cannot be authorised or ratified by
the shareholders at some time before the company enters into a formal insolvency
procedure, so that the cause of action against the directors survives to be enforced by
the liquidator or administrator.
87
Before the recognition of creditor-regarding duties,
there was a strong risk that directors would seek authority or forgiveness from the
shareholders for their actions, which the shareholders would presumably be only to
happy to give since the action was aimed to promote their interests. The main
disadvantage of the common law duty – and it is a significant one - is that its proceeds
would appear not to go primarily to the unsecured creditors. Since the company’s
cause of action against the directors exists at the point the company goes into
85
Sycotex Pty Ltd v Baseler (1994) 122 ALR 531, 550.
86
Under the administrator’s general management powers.
87
See Liquidator of West Mercia Safetywear v Dodd [1988] BCLC 250, CA and the cases mentioned
in nn 82 and 85.
31
liquidation, the proceeds of its enforcement will be caught by any security interests
the company has granted.
VI. Directors’ Duties to Creditors when Company not in Financial Difficulty
Laws imposing on directors effective creditor-facing duties even when the company is
in financial good health are, usually, inconsistent with the theory developed in section
II of this paper. If such laws are widespread, that would suggest that some alternative
or additional theory would have to be developed to explain their presence.
88
As
argued above, on the one hand, it appears unnecessary for the protection of the
creditors, since at this stage the interests of shareholders and creditors are sufficiently
aligned for the creditors not to need distinct protection or the creditors can deal with
the problem through self-help. On the other hand, if the interests of the creditors were
to be taken seriously as separate from those of the shareholders, the effect might be to
discourage the directors from embarking on risky projects, even if those projects have
a high present value. Professor Sealy has gone so far as to remark that ‘it would be
contrary to all reason to burden directors with any duty towards creditors when their
company is solvent: their function is to make judgements about business risks, and to
take those risks . . .’
89
When looking at potential examples of general creditor-regarding duties, two
questions need to be distinguished. The first is whether such duties are imposed on the
directors at all and the second is whether they can be enforced by the creditors in
advance of the company being put into a formal insolvency proceeding. If the general
creditor-regarding duties cannot be enforced by the creditors in advance of
insolvency, it is suggested that they will probably operate in practice in a way similar
to duties triggered only in the vicinity of insolvency. It may be true that, formally, the
court may range over the whole of the directors’ conduct when the duty is enforced by
88
Andrew Keay, ‘Directors’ Duties to Creditors: Contractarian Concerns Relating to Efficiency and
Over-Protection of Creditors’ 66 Modern Law Review (2003) p. 665, argues that what he terms
contractarian arguments developed by the law and economics school cannot explain the adoption of
creditor-regarding duties in the vicinity of insolvency and that a ‘fairness’ theory needs to be developed
to do this job. In so far as the argument developed in Section II of this paper is ‘contractarian’ or based
in the law-and-economics tradition then its implication is that a broader ‘fairness’ theory is not needed
to explain the presence of creditor-regarding duties at that stage in the company’s decline. However, it
does seem certain that some broader theory would be needed to explain general creditor-regarding
duties, though he does not seem to argue for them.
89
L S Sealy, Cases and Materials in Company Law 7th ed. (London, Butterworths, 2001) p. 267.
32
the liquidator, but it is suggested that the desire to reduce the costs of litigation is
likely to lead to a concentration of analysis upon the directors’ conduct in the period
prior to insolvency. Thus, the bigger challenge to the theory of Section II is presented
by laws which both create general creditor-regarding duties and permit the creditors to
enforce them short of insolvency. Such provisions are rare, but not unknown.
Fraud
One set of general creditor-regarding rules is explained by the fact that we are happy
to accept, at all times, some restraints on directors’ risk-taking, in favour of protecting
creditors, when the risk-taking is based on conduct which is outside the bounds which
society has set for entrepreneurial activity. The obvious example is fraud, but others
such as coercion in various forms come to mind. In general such provisions do not
have a high profile in company law, because legal systems rely on general civil or
criminal law to control such conduct.
90
However, isolated examples can be found.
Thus, section 458 of the British Companies Act makes directors (and others)
criminally liable for carrying on the company’s business with intent to defraud its
creditors (or for any other fraudulent purpose), irrespective of the company’s financial
position, since there is no legal policy reason for encouraging fraudulent management,
even if the fraud has no adverse impact on the company’s performance. There is an
equivalent civil provision in section 213 of the Insolvency Act 1986, but one
enforceable only when the company is in liquidation and by the liquidator. In theory,
the section allows the liquidator to traverse the whole of the company’s business
history searching for fraud on creditors, but the requirement of intent makes the
section a difficult one for liquidators to use.
91
French law has a broader concept of
‘abus de biens sociaux’ (misuse of corporate assets) (not confined to insolvent
companies) which provides for criminal sanctions in respect of a range of directorial
conduct damaging to the company, but only where the action was in bad faith.
92
90
Indeed, the apposite question might be the opposite: given the existence of general anti-fraud laws,
why are specific company or insolvency law provisions needed? In the case of section 213 of the
British Insolvency Act (discussed below) the answer appears to be that it allows recovery from the
directors by the liquidator on the part of creditors generally, whereas general anti-fraud law provides
only for individual recovery: Morphitis v Bernasconi [2003] 2 BCLC 53.
91
For the most recent decisions see Re Bank of Credit and Commerce International SA (No. 15) [2005]
2 BCLC 328; ditto (No. 14) [2004] 2 BCLC 236.
92
Code de commerce, art. L 242-6. In fact, the discussion of this provision in the books focuses on
issues of self-dealing rather than of ignoring the interests of creditors: M Cozian, A Viandier and F
Deboissy, Droit des sociétés, 18th ed. (Paris, Litec, 2005) paras. 589-595.
33
Action en comblement de passif [action to restore the company’s assets]
Another larger and apparently more troubling set of provisions does not confine
directorial liability to fraud and operates, at least formally, at all points in the
company’s existence. However, although such provisions are enforceable only in the
company’s insolvency, they do not appear to require the court to adopt a creditor-
regarding formulation of the liability when applying it to periods when the company
was in good financial health. This appears, for example, to be the case with the action
en comblement de passif of French (and Belgian) law,
93
mentioned with approval
along with the wrongful trading provisions by the High Level Group.
94
This provision
applies only to companies in formal insolvency proceedings
95
and empowers the court
to require the directors to make a contribution to remedy the company’s deficiency of
assets, where their negligence (faute legère) has contributed to the deficiency. To that
extent it is like section 214 of the British Insolvency Act. However, unlike section
214, the duty created by the French action is not triggered by the prospect of
insolvency but applies throughout the company’s life, and the fault in question is not
limited to a failure to protect the interests of creditors. In fact, in the typical list of
examples, found in French text books, of successful recoveries in this action what
predominate are activities which would be analysed in common law jurisdictions as
breaches of the duties of loyalty or competence owed by directors to shareholders.
96
As such, one can say that the action en comblement de passif combines the functions
of sections 214 and 212 of the British Insolvency Act, since section 212 also provides
for a summary procedure in winding-up for the enforcement for the benefit of the
creditors of the directors’ shareholder-regarding duties, which the shareholders could
have enforced whilst the company was solvent, had they been aware of the breaches
and able to overcome their collective action problems. For the purpose of the current
analysis, however, what is important is that the action en comblement de passif does
not require French courts to impose creditor-regarding duties on directors whilst the
companies is in a healthy financial condition and there is little evidence that French
courts do in fact do so.
93
Ibid, art. L624-3.
94
Report of High Level Group, op. cit. n. 39.
95
‘Redressement’ or ‘liquidation judiciaire’
96
M Cozian, op. cit. n. 92, para. 278.
34
From January 2006 the action en comblement de passif was replaced by the action en
obligation aux dettes sociales (action to enforce liability for corporate debts).
97
The
new action displays two contrasts with the former one. First, the grounds of liability
are more explicitly stated, under five heads, the first three of which are examples of
liability for self-dealing. The fifth heading is analogous to fraudulent trading under
British law. The fourth heading gives the court power to make the director personally
liable for some or all of the company’s debts where the board has pursued a loss-
making business which could not but lead to the company’s inability to pay its debts
as they fell due, provided such a decision was taken ‘abusively’ and in furtherance of
a personal interest. This reformulation may be thought to have brought the French
provision closer to the British wrongful trading legislation than the action en
comblement de passif, even if the verbal formulation is still very different.
Second, the range of the insolvency proceedings in which the new action can be
invoked was been narrowed in a way which is very interesting from our point of view
because it produces an outcome similar to that analysed above in relation to section
214 of the British Insolvency Act. The action en comblement de passif was available
not only in cases of liquidation (liquidation judiciare) but also in cases of
administration (redressement judiciare). Under the new arrangements, not only is the
action en comblement de passif unavailable in the newly introduced procédure de
sauvegarde (safeguard procedure) but it is no longer to be available in redressement
judiciare. In short, the risk of personal liability of the directors for corporate debts and
liabilities will arise, as in the United Kingdom, only in the case of liquidation. The
reasons given for this step in the official statement of the purposes of the legislation
followed very closely the reasons suggested above for the similar outcome in the
United Kingdom. The action en comblement de passif was ‘incompatible’ with the
recovery plan which is to emerge from either the procédure de sauvegarde or from
redressement judiciare.
98
Somewhat optimistically, it was said that, if the plan was
implemented, the creditors will be paid off, a statement which ignores the fact that the
rights of the creditors may be scaled down as part of the recovery plan. Consequently,
97
Code de Commerce, Art. L652-1, the former text of Art. L624-3 being repealed.
98
Assemblée Nationale, Projet de loi de sauvegarde des enterprise, Document No. 1596, 12 May,
2004, Exposé des motifs, Section VIIIB. Although the text of the law changed in various ways in its
passage through the legislature, this particular provision remained intact. (The document is available
on: www.assemblee-nationale.fr/12/projets/pl1596.asp.)
35
the scope of the action which replaced the action en comblement de passif should be
confined to liquidation. It is also worth noting that this whole legislative change was
driven by a desire to promote a rescue culture and an analysis which suggested that
the previous law led to excessively high levels of liquidation, giving rise to adverse
results for both creditors and for the preservation of jobs.
99
Section 135 of the New Zealand Companies Act 1993
A further example of a provision raising the same issues is to be found, surprisingly,
in the generally deregulatory New Zealand Companies Act 1993, section 135 of
which makes directors civilly liable who ‘agree, cause or allow’ the company’s
business to be carried on ‘in a manner likely to create a substantial risk of serious loss
to the company’s creditors’. This duty applies, apparently, at all stages of a
company’s history and liability under it is not dependent upon proof of fraud,
negligence being enough to ground liability.
100
The section thus appears to impose a
general creditor-regarding duty upon a company’s directors. It is arguable that in
high-risk industries such a provision is potentially infringed every time the directors
take a significant investment decision and the directors are thus exposed to having
their judgement second-guessed by the court.
101
However, the duty appears not to be
enforceable by creditors outside a formal insolvency procedure.
102
In practice,
however, the section has not been heavily relied on nor have the courts interpreted it
so as to realise the worst of these fears. This may be because the side-note to the
section (though not conclusive for the purposes of interpretation) uses the description
‘reckless trading’ and because the section has its origins in the fraudulent trading
provisions of the British legislation, discussed above.
The Supreme Court of Canada
The unthinking tendency of law-makers, whether legislatures or courts, to create
creditor-regarding duties operating generally, but then, in one way or another, to
99
Assemblée Nationale, op. cit. n. 98, p. 1.
100
This is a disputed point in the case-law.
101
And the section is so criticised on this ground by Thomas Telfer in ‘Risk and Insolvent Trading’ in
R Grantham and C Rickett eds, Corporate Personality in the 20th Century (Oxford, Hart, 1998) at pp.
140-144.
102
Although a shareholder, it seems, can obtain an injunction to restrain a course of action proposed by
the directors in breach of the section and a shareholder who was also a creditor might have an interest
in so doing: s 164.
36
avoid the consequences of their actions, may finally be illustrated by a recent decision
of the Supreme Court of Canada, Peoples Department Stores v Wise.
103
In this case
Wise Stores took over Peoples Stores, but the merger proved difficult. In order to
address the problems, the directors of Wise (who were also now the directors of
Peoples) took various steps, including splitting procurement between the two
companies, so that one company procured for both from overseas and the other for
both within Canada. At the time these steps were taken the group was apparently
solvent, though not in good financial shape. Shortly thereafter both companies
became insolvent and the creditors’ representative in Peoples sued the directors of
Peoples and focused in particular on the steps taken to address the merger problems,
which were said to be unfavourable to Peoples. The allegations were based on
breaches of section 122 of the Canada Business Corporations Act (CBCA), which
establishes the general duties of competence and loyalty owed by directors to their
company. Thus, section 122 does not create special creditor-regarding duties in the
vicinity of insolvency.
104
The case is mainly known for its holding that the fiduciary duties created by section
122 are not owed to the creditors of the company.
105
To this extent, the decision is
fully in accordance with the theory developed in section II of this paper. Less often
noted, however, is the Court’s holding that the duty of competence created by section
122 is owed to creditors (at least in Quebec) and apparently at all times during the
company’s existence. As such, it is apparently enforceable by the creditors
(presumably individually) and not only by the corporation, even when the company is
fully solvent.
106
This aspect of the case is not in accordance with the theory of section
103
[2004] 3 S C R 461.
104
There was a separate argument based on section 100 of the Bankruptcy and Insolvency Act, relating
to transfers at an undervalue in the period before insolvency. That does not concern us here. It also
failed.
105
On the other hand, Canadian courts have held that the oppression remedy (CBCA, s 241) is
available to creditors, to secured creditors as of right and unsecured creditors at the discretion of the
court. However, the practice seems to be to allow the oppression claim only in cases arising in the
vicinity of insolvency. See generally D Thomson, ‘Directors, Creditors and Insolvency’ 58 University
of Toronto Faculty of Law Review (2000) 31. There is a contrast here with the UK, where the general
oppression remedy (CA 1985, s 459) is available only to shareholders (members) and separate
provision is made in respect of unfair conduct by administrators within insolvency, which protection
does extend to creditors (Insolvency Act 1986, Sched. B1, para. 74).
106
This consequence is characterised by Stéphane Rousseau, correctly it is submitted, as a reversal of
‘a fundamental principle of corporate law’: ‘Directors’ Duty of Care after Peoples: Would it be Wise to
Start Worrying about Liability? 41 Canadian Business Law Journal (2005) at p. 225. She also indicates
37
II. On the facts of the case the court held that the directors were not liable because
they had not broken their duty of competence. Thus, the impact of the decision will
depend very largely on how deferential the Canadian courts continue to be to
managerial decision-making when applying the negligence standard (and in particular
how they develop the business judgement rule), but in this respect the directors’ risk
of liability seems to be the same with regard to both shareholder and creditor actions.
Art 93(5) AktG
Finally, a hybrid approach to general creditor protection may be noted. Article 93 of
the AktG imposes on directors a duty of competence (and perhaps loyalty) which is
owed, in the traditional way, to the company and so not to creditors. However, the
duty owed to the company is enforceable in certain circumstances by the creditors and
liability for damages cannot be waived by the shareholders. The circumstances in
which the creditors may enforce the duty owed to the company are not confined to
situations where the company is insolvent, though it appears that Art 93(5) is rarely
used outside of insolvency, where only the creditors’ representative may invoke its
provisions.
Overall one may conclude from this incomplete survey that, although some legal
systems appear to impose creditor-regarding duties on directors of companies which
are in a solvent state, this is still a minority approach except where fraud is involved.
Further, there is very little evidence of such duties, where they exist, being enforced
by creditors on any significant scale, outside of the vicinity of insolvency. This may
well be either because such enforcement is not permitted by the laws in question or
because, even where it is, effective enforcement of such duties requires a substantial
monitoring input from creditors. Before insolvency threatens, unsecured creditors
may regard such effort as not cost-effective, whilst secured creditors, for whom the
effort may be worthwhile, will establish their own contractual control mechanisms,
rather than rely on the general standards laid down in the law.
Conclusion
that the implication of the court’s reasoning is that not only creditors but also other stakeholders may
individually sue to enforce the duty of care.
38
This paper has sought to justify imposing personal liability on directors for trading
decisions taken in the vicinity of insolvency by reference to the incentive structure
created for board decisions once the shareholders’ equity in the company has become
exiguous. That structure creates incentives to engage in excessively risky projects.
However, the limited nature of the remedy put forward to address this situation should
be noted. It has been argued that the aim of the legal strategies adopted in this area
should be to restore the incentive structure which operates when the company is a
going concern. It has not been argued that the legal framework for directorial
decision-making should be amended across the board. On the contrary, the aim is to
produce a situation where the underlying principles of the legal framework for risk
assessment which is in place when the company is in a steady state, giving directors
an incentive to evaluate both the up-side and the down-side risks, continue to apply as
insolvency looms, up until the point, if it is ever reached, where the directors are
replaced by a creditor-appointed manager or the directors become subject to effective
third-party control. It is in order to secure a continuation of a set of incentives for
appropriate risk assessment that the creditors’ interests have to play a bigger role in
the legal formulation of directors’ duties in the vicinity of insolvency.
107
The normative implications of the argument are that countries should adopt legal
strategies to re-set directors’ incentives when the shareholders’ equity in the company
has been reduced to an exiguous level and there is no hope of replacing it through the
company’s established trading policies, so that more regard is paid to the interests of
the (unsecured) creditors, who are now the residual claimants on the company.
However, it is necessary to be careful not to allow the rules adopted to spill over so as
to re-order the directors’ incentives in a creditor-regarding manner when the
shareholders are still in fact the residual claimants on the company. Perhaps the most
interesting point to emerge from the analysis of incentive re-setting legislation is the
potential conflict between protecting creditor interests by means of compensation for
107
On this analysis the criticisms of some writers of the legal strategy here proposed seem overblown,
for they have misunderstood what is at issue. As an example see D. Oesterle, ‘Corporate Directors’
Personal Liability for “Insolvent Trading” in Australia, “Reckless Trading” in New Zealand and
“Wrongful Trading” in England (sic): A Recipe for Timid Directors, Hamstrung Controlling
Shareholders and Skittish Lenders’ in I. M. Ramsay ed. Company Directors’ Liability for Insolvent
Trading (Melbourne, Centre for Corporate Law and Securities Regulation and CCH Australia, 2000)
and the response by A. Keay, ‘Wrongful trading and the liability of company directors: a theoretical
perspective’ 25 Legal Studies (2005) p. 431.
39
past reckless business decisions and rescuing the company as a going concern for the
future, which is also likely to be in the interests of the creditors. Since enforcement by
the creditors’ representative of wrongful trading and similar laws is likely to be
incompatible with a productive working relationship between the creditors’ appointee
and the (former) managers of the company, both Britain and (since the beginning of
2006) France give that power and duty only to the liquidator, whose job is mainly to
get in the assets and divide the proceeds among the creditors rather than to seek to
rescue the company. By contrast, in those forms of insolvency procedure where
rescue is the primary goal of the law, the creditors’ representative is not given any
enforcement role, so as not to prejudice any relationship with the former managers
which that representative may seek to establish.
40
ABSTRACT
This paper is concerned with the risks to creditors from strategic business decisions
taken by directors. It seeks to explain both why the law should impose creditor-
regarding duties when the shareholders no longer have any substantial equity in the
company; and why such duties should not be imposed when the shareholders still
have a substantial economic interest in the company. It goes on to argue that duties on
directors to put the company into a formal insolvency procedure once the company
has reached a state of insolvency do not adequately meet the interventionist criterion.
The incidence of such duties depends in part on whether a balance sheet or a cash-
flow test is used for insolvency, but in any event duties to open formal insolvency
procedures are too rigid unless they operate only when all hope of rescue has
disappeared. However, the paper also argues that the need to promote a ‘rescue
culture’ for companies in financial distress may lead the legislature to limit the
creditor-regarding duty arising before, but in the vicinity of, insolvency to cases of
liquidation and not to extend it to companies being handled through procedures whose
main aim is to save the company or (parts of) its business as a going concern.
KEYWORDS
Directors’ duties – creditors – trading in the vicinity of insolvency – company rescue
