Company Directors' Responsibilities to Creditors

Andrew Keay

• Publisher: Routledge-Cavendish
• Year: 2007
• ISBN:
  9781135390334
• Edition: 1
• Topic: Law
• Subtopic: Law Theory & Practice
• Index: Law

This timely work is the first to comprehensively examine directors' responsibilities to creditors in times of financial strife, as well as addressing when these responsibilities arise, and what directors should have to do to ensure that they comply with their obligations.

Keay explores the relevant issues from doctrinal, normative and comparative perspectives and addresses the question as to when directors are liable for wrongful trading, fraudulent trading or breach of their duties to creditors and whether directors should be held responsible for the before mentioned. Besides the relevant UK legislation and case law, legislation and case law from Australia, Canada, Ireland and the United States are examined and compared and reforms which take into account the aims and rationale of the relevant legislation as well as creditors' interests are proposed and assessed.

Importantly, new approaches for courts which would make the nature of the responsibility and its timing more precise are suggested.

Company directors have certain responsibilities to creditors of their companies. In particular, they should avoid fraudulent and wrongful trading and consider, as part of their duties, the interests of creditors when their companies might be, or are, in financial difficulty.

The work is precipitated by the lack of coherence in the consideration of wrongful trading and the recent delivery of important cases on fraudulent trading. Also, this timely work is the first to comprehensively examine directors' responsibilities to creditors in times of financial strife, as well as addressing when these responsibilities arise, and what directors should have to do to ensure that they comply with their obligations. Keay explores the relevant issues from doctrinal, normative and comparative perspectives and seeks to address the question as to when directors are liable for wrongful trading, fraudulent trading or breach of their duties to creditors and whether directors should be held responsible for wrongful trading and failing to consider the interests of creditors. Besides the relevant UK legislation and case law, legislation and case law from Australia, Canada, Ireland and the United States are examined and compared, and reforms which take into account the aims and rationale of the relevant legislation as well as creditors' interests are proposed and assessed. Importantly, new approaches for courts which would make the nature of the responsibility and its timing more precise are suggested.

Part D
A duty to consider the interests of creditors

11 The development of the duty to consider the interests of creditors

Introduction

Thus far we have considered two responsibilities that are imposed on directors as a result of statute. We now turn to a responsibility that has been developed, not by the legislature, but by the courts, and they have done this over the past 20 years or so. This is a duty imposed on directors to consider the interests of their companies’ creditors in certain circumstances. There has been a substantial corpus of case law on this responsibility, and there has been a significant amount of debate as to whether the responsibility should exist. This latter issue is discussed in detail in Chapter 19. What this chapter and the following two chapters seek to do is to provide an exposition and analysis of the law as it has developed. This Chapter specifically charts the developments that have taken place since the responsibility was first raised in 1976. The focus is on the law in the UK, but the law is practically the same in Ireland, Australia and New Zealand, and some of the decisions in these jurisdictions are considered, particularly where they have contributed to the development of the jurisprudence in the area. The chapter includes some consideration of the law in these countries, together with Canada and the United States. The latter’s law shares some commonality with the UK and the other countries mentioned above, although it has tended to develop in different ways to that in Ireland, Australia and New Zealand.¹

It is trite law that in UK corporate law, directors of companies owe duties of loyalty to their companies as a whole.² What is meant by ‘companies as a whole’ is a vexed question, for it has been an extremely difficult phrase to interpret. However, it is fair to say that it has been traditionally interpreted as meaning that the duties are owed to present and future shareholders,³ andnot, absent exceptional circumstances, to any individual members.This approach involving⁴ maximising profits for shareholders is generally described in modern times as the shareholder primacy theory,⁵ and regarded probably as the pre-eminent position in Anglo-American corporate law. Whether in fact UK case law actually historically supports shareholder primacy is a moot point and not within the scope of this book per se.⁶ The principle is frequently justified on the basis that the shareholders ‘own’ the company and are, as a consequence, entitled to have it managed for their benefit.⁷ However, there is significant commentary to the effect that the company is not to be regarded, just as the shareholders, but as an enterprise and that this includes others besides shareholders, such as creditors in certain cases.⁸

While directors do not have any obligation under statute to ensure that their company does not trade while insolvent or at a loss (Secretary of Statefor Trade and Industry v Taylor [1997] 1 WLR 407 at 415; sub nom Re CS Holidays Ltd [1997] BCC 172 at 178, although this might later lead to a director’s disqualification order being made (Secretary of State for Trade and Industry v Creegan [2002] 1 BCLC 99 at 101, CA), in the UK,⁹ parts of the Commonwealth,¹⁰ Ireland (Re Frederick Inns Ltd [1991] ILRM 582, Irish HC, and affirmed at [1994] ILRM 387, Irish SC; Jones v Gunn [1997] 3 IR 1; [1997] 2 ILRM 245) and the United States,¹¹ courts have held that as part of directors’ duties to their companies, directors must, in their decision-making in relation to their company’s affairs, where varying degrees of financial difficulty exist, take into account the interests of the creditors of their companies. The responsibility does not exist at all times, and the circumstances that will precipitate the advent of the responsibility are discussed in Chapter 13. In a situation where creditors’ interests intrude, the shareholders cannot ratify any breach by directors,¹² as they can when creditors’ interests are not to be taken into account, for they are not the only group who is interested in the company’s funds. Hence, the directors cannot be sure, just because they have secured the ratification of their actions by the shareholders, that they are not going to be held liable.

In the ensuing discussion in this chapter and Chapters 12–19 I will talk about a duty to creditors. It is debatable whether the obligation owed by directors can be termed ‘a duty’, and even if it can be, that it is able to be regarded as a duty to creditors. The latter issue is discussed in detail in Chapter 15, but for ease of exposition, I will use the expression ‘duty to creditors’ from time to time.

The evolution of the duty

The duty owes its genesis in modern times to several decisions delivered in Australasia, although in the United States courts had found that directorswere liable to act in favour of creditors at certain times, for many years pursuant to the trust fund doctrine.¹³ The starting point for any consideration of a duty to creditors is the judgment of the High Court of Australia in Walker v Wimborne (1976) 137 CLR 1; (1976) 3 ACLR 529. In that case a liquidator had brought misfeasance proceedings, under the equivalent of s 212 of the Insolvency Act 1986, against several directors of the company being liquidated, Asiatic Electric Co Pty Ltd (‘A’). The claim was based on the fact that the directors had moved funds from A to other companies in which they held directorships. The relevant companies, including A, were treated by the directors as a group. The directors were accustomed to moving funds between companies and usually when this was done, no security was taken, and no interest charged or paid. At the time of the movement of funds that was the subject of the action, A was insolvent. A later entered liquidation. In his leading judgment, Mason J (whose judgment was approved by Barwick CJ) said (at 6–7; 531):

In this respect it should be emphasised that the directors of a company in discharging their duty to the company must take into account the interests 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.

His Honour went on to say that the transactions attacked by the liquidator were entered into pursuant to a course of conduct that involved a total disregard for the interests of A and its creditors (at 7; 532). The judge said that for there to be a misfeasance, there had to be a breach of duty, and in his view the actions of the directors constituted a breach of duty. His Honour was clearly accepting that directors had a positive obligation to creditors. The comments of Mason J were obiter, but it might be argued that what he said ‘has taken on an authoritative status over the years’.¹⁴

It was not for some years that the approach propounded in Walker v Wimborne was followed in England. There were some statements made in the occasional case that indicated that the judges might favour this approach, but no direct application of the principle. For instance, in Lonrho Ltd v Shell Petroleum Co Ltd [1980] 1 WLR 627 (HL) Lord Diplock said (at 634), without any further elaboration, that the best interests of the company are not exclusively those of the shareholders, ‘but may include those of its creditors’. It must be said that it is uncertain whether his Lordship was intending tomake the statement in the context of directors’ duties to creditors. But Re Horsley & Weight Ltd [1982] 1 Ch 442 was a case that examined the fact that the interests of a company could include those of the creditors. The case involved a claim by the liquidator of a company that the granting of a pension to a former director constituted a breach of duty, allowing for misfeasance proceedings to be brought. The liquidator failed in his claim, but Templeman LJ said (at 455) that:

If the company had been doubtfully insolvent at the date of the grant [of the pension] to the knowledge of the directors, the grant would have been both a misfeasance and a fraud on the creditors for which the directors would remain liable.

Subsequently, in Multinational Gas and Petrochemical Co v Multinational Gas and Petrochemical Services Ltd [1983] Ch 258, a differently constituted Court of Appeal rejected the argument that the directors owed a duty to take into account creditors’ interests after the directors made a bad decision and this led to the company becoming insolvent. Later in Liquidator of West Mercia Safetwear Ltd v Dodd (1988) 4 BCC 30, Dillon LJ said that the reason for the decision in Multinational Gas (his Lordship had been a member of the court in the earlier case) was the fact that the subject company was amply solvent and the decision of the directors was made in good faith. Christopher Riley asserted that the court in Multinational Gas was really only saying that directors owed no direct duty to creditors that was enforceable by creditors, as it went on to state that likewise there was no duty to individual shareholders, and ‘it could hardly be suggested that their [shareholders’] interests need not be taken into account by directors’.¹⁵

A very influential decision, as far as Ireland and most Commonwealth jurisdictions are concerned, in the development of the responsibility, is the Australian case of Kinsela v Russell Kinsela Pty Ltd (1986) 4 ACLC 215; (1986) 10 ACLR 395. This was a decision given by the Court of Appeal in New South Wales. In that case the liquidator of a company, RK, which carried on business as a funeral director, brought proceedings to have a lease over premises granted by RK to directors of the company, set aside. The lease had been granted three months before the commencement of winding up, and at a time when the company’s financial position was precarious. The company had sustained a significant loss during the previous year, had suffered less severe losses for several years and the accounts some six months before the lease was entered into showed that the company’s liabilities exceeded its assets by nearly A$200,000. Also of importance, was the fact that the company had committed itself to performing services in relation to prepaid funerals. The lease involved the directors being given a term of threeyears at a below market rental, there was no escalator clause to cover inflation and the directors were entitled, during the life of the lease, to purchase part of the premises for a sum which was well below true value. The court found that the intention of the directors was to put the assets of RK beyond the reach of its creditors, and to preserve what had been a family business for many years (at 219; 399). In delivering the leading judgment (with which the other members of the court concurred), Street CJ said that when a company is insolvent, the creditors’ interests intrude (at 221; 401). His Honour went on to point out that in such a situation the shareholders are not entitled to ratify what would constitute a breach of duty (at 223; 404). As will be discussed in Chapter 13, his Honour refrained from formulating a test as to the degree of financial instability that is needed before directors are obliged to consider creditor interests, because the facts of the case did not require him to do so; as the company was clearly in a state of insolvency at the time of the relevant transactions, the duty arose.

The first major statement that indicated that the English courts would embrace any duty to creditors was given in the House of Lords in the case of Winkworth v Edward Baron Development Co Ltd [1986] 1 WLR 1512; [1987] 1 All ER 114. Here, X, and his wife, Y, were the directors and shareholders of a company, Z, having used company money to purchase their shares. Z bought a property that X and Y occupied as their home. As a consequence of this and other payments, the company was overdrawn on its bank account. The company’s bank was given an undertaking by X that the deeds of the property purchased by Z would be held to the order of the bank. Y was unaware of this, as she did not take an active part in the company. X and Y sold their former marital home and paid part of the proceeds into Z’s bank account. Then X, without the knowledge of Y, initiated the mortgage of Z’s property to W in order to raise funds to discharge the indebtedness on the overdraft. Z subsequently became insolvent and went into liquidation. W commenced an action for possession against Z as it had defaulted on its mortgage payments. Y opposed these proceedings, on the basis that the payment of the funds from the former marital home gave her an equitable interest in the property. Ultimately t...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Preface
• Table of Cases
• Table of Legislation
• Table of Statutory Instruments
• Table of International Legislation
• Part A: Introduction
• Part B: Fraudulent trading
• Part C: Wrongful trading
• Part D: A duty to consider the interests of creditors
• Part E: Theoretical analysis