Directors Legal Liabilities - Term Paper Example

«Directors Legal Liabilities» Introduction The Companies Act 2006 did not change the common law position that the directors’ duties are first and foremost to the company. With respect to the company’s creditors there is no fiduciary duty on the part of the company’s directors. However, as the company approaches insolvency, the term company incorporates not only the company’s shareholders, but also its creditors.1 In fact there is a line of authority in UK courts also known as the West Mercia principle, indicating that company directors are required to take into account the creditors’ interest not only when it is obvious that insolvency is eminent, but also when insolvency is a significant threat. When the threat is significant, directors are required to take steps calculated to protect its creditors even if such steps are at the shareholder’s expense.2 Ultimately, insolvency laws are structured so as to protect creditors from an “errant director”.3 This means protecting creditors from vulnerable transactions which are essentially transactions at an undervalue at or near the time of insolvency or transactions that can be rendered vulnerable because they were calculated to enhance the company’s assets in anticipation of insolvency.4 It would therefore appear that directors are under a duty to protect the creditor and to safeguard his/her interest at the expense of the company and its shareholders not only during actual insolvency, but also where there is a significant threat of insolvency. This paper will therefore examine the extent to which this hypothesis is correct by reference to the laws on corporate insolvency and the laws relative to vulnerable transactions. I. Directors’ Legal Duties to Creditors under Insolvency Law A. Definition of Creditors In order to put directors’ duties toward creditors of the company in its proper perspective, it is first necessary to define or explain the term creditors. This is because significant issues may arise. To start with, distinguishing between future and present creditors is pivotal to sorting out directors’ duties. This is because there may be a conflict between future and existing creditors’ interests.5 Lord Templeman was of the opinion that the term creditors in terms of directors’ duties would include future creditors.6 On the other hand, it was determined in Brady v Brady by Nourse J. that the duty was owed to present creditors.7 Cooke J. said in Nicholson v Permakraft (NZ) Ltd. [1985] 1 N.Z.L.R. 242 any future creditors would be required to accept the company exactly as it were and would therefore be expected to safeguard their own interests.8 However, Nourse J.’s opinion has been the subject of criticism on the grounds that when the company becomes or is on the verge of insolvency, “there is little justification for differentiating between the two groups of creditors.”9 Richard Field Q.C. suggested that creditors referred to “creditors as a whole” because: if the directors acted consistently with the interests of the general creditors but inconsistently with the interest of a creditor or section of creditors with special rights in a winding up, they [would not be] in breach of [their] duty to the company.10 In actuality there appears to be no agreed definition of creditors and the definition offered by Richard Field raises more questions than it answers. For instance, who are general creditors and who are creditors with special winding up rights? The only logical conclusion that can be gleaned from these disparaging definitions is that some distinction must be made between the different classes of creditors depending on the facts and circumstances of each case. B. Emerging Trends in Directors’ Duties to Creditors Corporate governance in the UK has always promoted the concept of shareholder primacy with respect to the solvent corporation. To this end it has become a firmly established doctrine of British company law that directors’ duties are to the company as a whole and not to a specific individual such as the company’s creditors.11 However, European Community influences have shifted this shareholder primacy approach to one where stakeholder interest has better representation in times of actual insolvency or where there is a significant threat of insolvency.12 Ultimately, under the shareholder primacy theory, the corporate directors have a fiduciary duty which means that the company directors’ duties is “solely to its shareholders”.13 Be that as it may, there has been concern for conflicts that could arise between the expectations of shareholders and creditors in attempts to maximize shareholder value.14 This concern has given way to the principle that companies experiencing financial difficulties have a duty toward creditors.15 Over the last twenty of so years, judicial and legislative developments in the UK and other commonwealth nations have “significantly” changed “the status of general creditors as stakeholders in the modern corporation”.16 It is rationalized that when a company is insolvent or approaching insolvency or taking on a venture that is will not be able to sustain unless it can rely on the funds of creditors “the interests of the company are in reality the interest of existing creditors alone.”17 According to Keay, the Australian High Court’s decision in Walker v Wimborne [1976] 3 ACLR 529 initiated the trend toward directors’ duties to creditors.18 In this case Mason J stated that in certain circumstances, directors will have a duty to the company’s creditors: In this respect it should be emphasized that the directors of a company in discharging their duty to the company must take into account the interest of its shareholders and its creditors. Any failure by the directors to take into account the interests of creditors will have adverse consequences for the company as well as for them.19 Whether or not this had any influence on the UK’s direction in this area is not clear, but similar thinking can be deduced from UK cases following the Australian decision. For instance in Re Horsley and Weight Ltd [1982] Ch 442, one of the first cases in the UK to allude to the duty to creditors it was noted that directors do have an “indirect duty” to its creditors to prevent the unlawful depletion of its capital.20 This duty is said to arise during financial difficulties because at that particular time, companies are relying on creditors’ funds which arguably make them the only stakeholders during this time.21 This approach to creditors’ protection is fair enough, considering that the interests of creditors are largely left to the law of contract which seems inadequate to protect them during times of the debtor company’s insolvency. It is arguably, only fair that creditors should during these times be accorded some fiduciary obligations on the part of the company’s directors.22 The fact is, if directors were not required to look after the interests of the company during or under the threat of insolvency, there is an increased likelihood that directors, under the pressure of insolvency would take risks that could either benefit the company or just as likely accelerate its insolvency or otherwise put the company at peril.23 While there have been the occasional judgment and commentary suggesting that the directors duty toward the creditors during insolvency or pending insolvency is a direct duty, the majority of scholarly and judicial opinion does not agree. For instance, Lord Templeman stated in Winkworth v Edward Baron Development Co.Ltd.[1987] 1 All ER 114 that: A duty is owed by the directors to the company and to the creditors of the company to ensure that the affairs of the company are properly administered and that its property is not dissipated or exploited for the benefit of the directors themselves to the prejudice of the creditors.24 However, the prevailing view is that the directors’ duties to safeguard the interest of the creditors is a duty to the company as a whole.25 In fact Lord Diplock noted that the company’s best interest were “not exclusively those of its shareholders but may include those of its creditors”.26 Other developments would follow such as Re Horsley’s ruling relative to directors’ indirect duty to creditors and the duty to prevent a reduction in company capital. It was not until the Court of Appeal’s ruling in Liquidator of West Mercia Safetywear Ltd v. Dodd and Another [1988] BCLC 250 that the court spoke explicitly of directors’ duties in the context of insolvency. Other cases had merely alluded to this duty in general terms and noted that the general duty would arise in certain circumstances without expressly identifying those circumstances. The West Mercia would set a more specific precedent. In this case it was held that the best interest of the company would necessarily include the creditors’ interest since the company was insolvent.27 In a number of the previous cases, insolvency had not been an issue.28 Thus far it has been clearly established that the shareholder primacy theory has taken a shift toward the enhancement of stakeholder theory. In other words, it is clear that directors’ duties are no longer focused solely on shareholders’ interest and that other stakeholder interests are also to be taken into account. Specifically, developments over the years, although not altogether consistent have established that during times of insolvency, the creditors have an interest and directors are duty bound to take account of those interests. There appears to be some confusion however over the extent to which directors must safeguard the interest of creditors. Are directors’ required to safeguard the interest of creditors during insolvent times at the expense of shareholders? C. Creditors’ Interests vs Shareholders’ Interests The emphasis on the director’s duty to safeguard the interest of the creditors often to the detriment of the shareholders is demonstrated by the ruling in Standard Chartered Bank v Walker [1992] 1 WLR 561 where it was held that the creditors’ wishes were more important and outweighed the majority shareholders’ wishes.29 Even so, the case law on the issue of directors’ duties toward creditors to the exclusion of shareholders is largely inconsistent.30 The court in the Brady v Brady case specifically rules that when a company is insolvent it is the creditors alone that have an interest to protect.31 The obvious implication is that the creditor’s interest are paramount and exclude the interest of the shareholders. It has also been suggested that when a company is insolvent, the company is in essence merely managing the assets of the creditors. This approach was approved and confirmed in West Mercia Safetywear Ltd v Dodd by Dillon J. 32 In Re Pantone, Richard Field Q.C. stated that it has been: Firmly established that when a company becomes insolvent, the directors must act in the interests of its creditors and not its shareholders.33 The suggestion is therefore that the directors’ duties during insolvency is on the creditors exclusively. However, these cases do not absolutely establish that the creditors become the sole focus of the directors or the liquidators’ concerns. There is some authority for the proposition that the duty is evenly split. For instance, in Lonrho Ltd. Shell Petroleum Co. Ltd. Lord Diplock did speak of the best interest of the company as whole suggesting that the directors’ duties were at all times toward both the shareholders and the creditors.34 However this case was not confined to the issue of insolvency or the threat of insolvency. Further guidance can be obtained from the ruling in Clydebank Foot Club Ltd. v Steedman, a Scottish case. In this case it was held that during insolvency and times of economic distress, directors ought to take account of the interests of both the creditors and the shareholders.35 This ruling was repeated in the English case of Re MDA Investment Management Ltd.36 The only way to resolve the differences in these inconsistent rulings, according to McKenzie-Skene, is to look at the case law as “being concerned with the reorientation of focus from shareholder to creditor interests” around the time of insolvency “rather than the issue of exclusivity of interests”.37 Moreover, it would be more appropriate and useful should the courts specifically point out that “although creditor interests” should be taken into account during insolvency or during the threat of insolvency: They do not have to be the exclusive concern of directors, in the same way as directors are entitled to look beyond shareholder interests before insolvency.38 In the final analysis the only certain doctrine that can be deduced from the body of case law in the UK, is that the shareholder primacy theory shifts somewhat when a company is facing insolvency or is actually insolvent. Since the interests of the creditor is increased during this time and it is the creditor’s capital and assets that suffer the greatest risk, the creditors’ interests is therefore more important than the interest of shareholders. Since this may not always be the case, there is no hard and fast rule that the directors must always safeguard the interests of the creditors to the exclusion of the creditors during insolvency or the threat of insolvency. It is therefore fair to assume that the safeguarding of the interests of creditors against the interests of shareholders is assessed in accordance with the likelihood of risk. In other words, it appears that should the courts form the view that the creditors in any specific case had a greater risk of loss, it would likely hold that the creditors’ interest were of paramount importance. Current company law appears to thrust the interest of all stakeholders under the portfolio of company directors at all times and especially while the company is solvent.39 Based on the new law it is reasonable to assume that since the company directors are expected to pay due regard to all stakeholders, including the creditors during solvent times, that duty is enhanced during insolvency when the creditors have more to lose than any other category of stakeholders. In this regard, vulnerable transactions have a special significance for directors during the insolvent period or during times of financial distress. II. Vulnerable Transactions Vulnerable transactions can be described as transactions that are made in anticipation of insolvency so as to favor a specific creditor so that he/she is preferred over another. Even prior to the Insolvency Act 1986, these kinds of transactions were dealt with by the courts under the Bankruptcy Act 1914.40 The fact is, the law relative to vulnerable transactions is a method by which directors are required to safeguard the interests of creditors during the period of insolvency or during the period where insolvency is imminent. Goode explains that the law relative to vulnerable transactions are such that they are designed to establish preference rules as a method for “preserving equality of distribution during the run-up to winding-up or administration.”41 Transactions at an undervalue are also primarily associated with vulnerable transactions. In this regard, transactions at an undervalue are different from preference transactions, although both are characterized as vulnerable transactions. For instance, while preference transactions typically enhance the company’s assets, transactions at an undervalue do not.42 The legal position relative to preferences is provided for in the Solvency Act 1986. Under Section 239 of the 1986 Act, a court may issue an order against a company in liquidation if it finds that the company had provided a preference in favor of one creditor or group of creditors over another.43 The order will typically restore the creditor to the position he/she would have been in had no preference been given.44 However, before an order can be made the court must be satisfied that the following factors exist: 1. The company is insolvent or in liquidation. 2. The liquidator or the administrator has made an application relative to the preference. 3. A preference was in fact provided to a creditor or a surety/guarantor. 4. The company gave the preference. 5. In providing the preference, the company was determined to ensure that the recipient of the preference would benefit from an improved position. 6. The preference was provided at a time that was relevant to the insolvency. 7. The company was unable to discharge its debts at the time of providing the preference or as a result of providing the preference.45 Likewise, transactions at an undervalue may be overturned if it is found that the transaction was made prior to and in anticipation of insolvency.46 A vulnerable transaction, whether it is a preference transaction or a transaction at an undervalue, is said to have occurred at the relevant time it occurred within two years of the petition for insolvency/liquidation.47 This means that once the company begins to suffer financial difficulties it is prudent for directors to begin to take account of the interests of all of its creditors. In this regard, at least as far as preference transactions and transactions at an undervalue are concerned, directors’ duties are significantly shifted toward the interests of the creditors. If conducting a vulnerable transaction favors the shareholders, the directors will be restrained from making those transactions in anticipation of the consequences of reversal as provided for under Sections 238 and 239 of the Insolvency Act 1986. Directors however, can defend themselves on the basis that the transaction was thought to be necessary for saving the company from insolvency. For instance in Re Fairway Magazine Ltd. [1993] BCLC 643, a company implemented a charge for securing a loan for an individual who had provided a guarantee for an overdraft held by the company. The court ruled that the transaction was not a preference despite the fact that a part of the loan would have been used to satisfy the overdraft because the loan’s purpose was primarily for enabling the company continued trading the creditor was not prepared to advance the loan unless it had security for it.48 Ultimately, the law relative to vulnerable transactions is structured so that all creditors are treated fairly with respect to the distribution of the insolvent company’s assets in the “period leading up to liquidation” which might confer upon others “improper advantages on certain creditors or other parties”.49 As Finch explains with respect to the law of vulnerable transactions, it is calculated: To protect collectively and the principle of pari passu distribution and to deal with the unjust enrichment of a particular party at the expense of the general body of creditors.50 The same principles apply to avoiding transactions designed to defraud creditors51 and the avoidance of floating charges.52 The underlying principles dictate that all creditors are treated fairly and that there is no disparity in the distribution of the company’s assets during the time leading up to liquidation. Ultimately, this means that in safeguarding the competing interest of creditors, company directors are required to avoid vulnerable transactions even if they may benefit the shareholders. In other words, insolvency and financial difficulties places directors in a position where the interests of the creditors take on more significance than the interests of the shareholders under the law of vulnerable transactions. Conclusion Prior to insolvency or the threat of insolvency, creditors are largely at liberty to engage in whatever lawful enforcement activities that they desire to recover debts owed by a company. For instance they may execute judgments or they may repossess goods. However, once a company becomes insolvent or is facing imminent insolvency, these options are not appealing and in most cases ineffective.53 Liquidation/insolvency ensures or at the very least attempts to ensure that the company’s assets are realized “for the benefit of all unsecured creditors” and that they are distributed “pari passu”.54 All of this means that the company directors’ priorities must shift. The emphasis typically placed on shareholder primacy is set aside in favor of protecting the interests of creditors. However, with the introduction of the stakeholder theory and its infusion with the shareholder primacy theory, even during the solvent period, directors are required to have regard to the interest of creditors. When the company becomes insolvent, the directors must set aside the interests of the shareholders and focus on the interest of the creditor. Although there is some inconsistency in the case law relative to the displacement of creditor’s primacy during insolvency, at the very least, directors are required to ensure that creditors’ interest do not lag behind the interest of shareholders. Whether this means avoiding vulnerable transactions in the run-up to insolvency or realizing assets during insolvency, creditors are in the forefront of directors’ duties during insolvency and in the period leading to insolvency. Bibliography Textbooks Dine,J. The Governance of Corporate Groups. (Cambridge University Press, 2000). Finch, F. Corporate Insolvency Law: Perspectives and Principles. (Cambridge University Press, 2002). Goode, R. Principles of Corporate Insolvency Law. (Sweet and Maxwell 2005). Horrigan, B. Corporate Responsibility in the 21st Century. (Edward Elgar 2009). Keay, A. Company Directors’ Responsibilities to Creditors. (Routledge 2007). Lutter, M. Legal Capital in Europe. (Walter de Gruyter, 2006). Articles/Journals Armour, J.; Deakin, S. and Konzelmann, S. ‘Shareholder Primacy and the Trajectory of UK Corporate Governance.’ (2003) 41(3) British Journal of Industrial Relations, 531-555. Halpern, P.; Trebilcock, M. and Turnbull, S. ‘An Economic Analysis of Limited Liability in Corporation Law’, (1989) 30(2) The University of Toronto Law Journal, 117-150. Keay, A. ‘Directors’ Duties to Creditors: Contractarian Concerns Relating to Efficiency and Over-Protection of Creditors.’ (2003) 66(4) The Modern Law Review, 665-699. Mckenzie-Skene, D. ‘Directors’ Duty to Creditors of a Financially Distressed Company: A Perspective from Across the Pond.’ (2007) 1(2) Journal of Business and Technology Law, 499-528. Rao, R.; Sokolow, D. and White, D. ‘Fiduciary Duty a la Lyonnais: An Economic Perspective on Corporate Governance in a Financially-Distressed Firm’ (1996) 2 Journal of Corporation Law, 53. Schwarcz, S. ‘Rethinking A Corporation’s Obligations to Creditors.’ (1996) 17 Cardozo Law Journal, 647-690. Ziegel,J. ‘Creditors as Corporate Stakeholders: The Quiet Revolution – An Anglo-Canadian Perspective.’ (1993) 43(3) The University of Toronto Law Journal, 511-531. Government Papers Jenkins Committee, ‘Report of the Company Law Committee’ Cmnd 1749, 1962. Cases Brady v Brady [1987] 3 BCC 535. Clydebank Foot Club Ltd. v Steedman [2002] SLT 109. Liquidator of West Mercia Safetywear Ltd v. Dodd and Another [1988] BCLC 250. Lonrho Ltd. v Shell Petroleum Co. Ltd. [1980] 1 WLR 627. Nicholson v Permakraft (NZ) Ltd. [1985] 1 N.Z.L.R. 242. Re Fairway Magazine Ltd. [1993] BCLC 643. Re Horsley and Weight Ltd [1982] Ch 442. Re MDA Investment Management Ltd.[2005] BCC 783. Re Pantone [2002] 1 BCLC 266. Standard Chartered Bank v Walker [1992] 1 WLR 561. Walker v Wimborne [1976] 3 ACLR 529. Winkworth v Edward Baron Development Co.Ltd.[1987] 1 All ER 114. Statutes Companies Act 2006. Insolvency Act 1986. Read More