Professional Documents
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PRESENTED BY :
FARHAN RIYAZ KHAN
The director's duty to take into account the interests of company creditors: when is it triggered?
• Since the comments of Mason J in Walker v Wimborne, a strong line of judicial opinion has developed whereby in
certain circumstances it is mandatory for directors, in discharging their duties to their companies, to take into
account the interests of their companies' creditors. But there is uncertainty as to what the actual circumstances
are that will lead to directors being required to do this. It is a well-established principle in company law that
directors owe duties to their companies as a whole but not to any individual members or other persons, such as
creditors; in fact directors would be acting beyond the scope of their powers if they acted for the benefit of
creditors. Yet, by way of exception to this principle, and to the principle established in Salomon v Salomon, it has
been held in a significant number of cases that in certain circumstances it is mandatory for directors, in
discharging their duties to their companies, to take into account the interests of their companies' creditors.
However, this exception is ill-defined for there is a distinct lack of judicial unanimity as to the actual circumstances
which will cause directors to have to consider creditors' interests. The lack of precision in delineating the point at
which directors are to have regard for creditor interests, and may potentially become liable, is highly
unsatisfactory. While acknowledging the fact that establishing guidelines in this area of the law is not easy, it is
submitted that directors in undertaking their decision-making need to be guided by consistent and clear principles
so that they know the ground rules and at what point in time, if at all, they are subject to this duty. As a matter of
legal certainty and fairness, lines have to be drawn so that directors can be confident that when they act they are
taking into account the appropriate interests and that their action is safe from attack. If directors are unable to
ascertain, with a fair degree of certainty, what they can do and when they are potentially liable, then, from an
academic viewpoint, the law is unjust, and, from a practical perspective, directors will nearly always take the
safest option in order to prevent any possible lawsuits. In doing this, directors are likely to act defensively and
make decisions not on the basis of what is best for the company, but of what will avoid liability.
THE RATIONALE FOR THE DUTY
• the predominant amount of case law in many jurisdictions has taken the view that if a company is in various
states of financial difficulty the creditors warrant some special consideration. Certainly if the company is
insolvent, in the vicinity of solvency or embarking on a venture which it cannot sustain without relying totally
on creditor funds, `the interests of the company are in reality the interests of existing creditors alone.' At this
time, because the company is effectively trading with the creditors' money, the creditors may be seen as the
major stakeholders in the company. The creditors are protected only by contractual rights, but when
companies are financially stressed perhaps it is only fair that their position warrants some form of fiduciary
protection, whereby the directors become accountable principally to the creditors. Unless this occurs, then
the directors have every reason, at this time, to engage in risky ventures that could bring in substantial
benefits, but could, if they fail, imperil the company. The shareholders have little or nothing to lose by such a
gamble as they have already lost the money that they invested in the company and they cannot be pursued
by creditors because of the concept of limited liability. A venture, however risky, could conceivably turn the
company around and provide the shareholders with some return, but such action, if it failed, would see the
creditors suffer an even greater loss as they would be the ones to lose out if the company collapsed. So, while
the doctrine of limited liability shifts the risk of failure from the shareholders to the creditors, the duty to
take account of creditors' interests seeks to mitigate the shift. Breach of the duty is usually claimed when the
company is in liquidation and the duty is a way of compensating unsecured creditors for whom liquidation is
frequently perceived as an empty formality. While most jurisprudence sees debtors as the weaker party in
the lending situation, the fact of the matter is that when a company is in financial distress it is the creditors
who often occupy a position of weakness.
DEVELOPMENT OF THE DUTY
• The duty to creditors is seen as having its genesis in the leading judgment delivered by Mason J in Walker v
Wimborne. His Honour said:
• “ In this respect it should be emphasised that the directors of a company in discharging their duty to the
company must take account of 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.”
• While his Honour's statement may have been of a rather casual nature, the impact of the dictum is not to be
diminished as it has been either acknowledged or eagerly taken up by many other courts . By the 1980s, the
idea of directors owing some duty to take into account the interests of creditors had been regarded as
providing a real protection for creditors of companies. Notwithstanding the robust criticisms of the duty, or
aspects of it, by some leading academic commentators, and the rather ambiguous remarks of Hayne JA in the
Victorian Court of Appeal decision in Fitzroy Football Club Ltd v Bondborough Pty Ltd concerning the
existence of the duty, the duty has been referred to and applied in recent cases in jurisdictions which have
traditionally embraced it,as well as being accepted for the first time in an appellate court in the Republic of
Ireland.Only last year the High Court in Spies v The Queen,in obiter comments, implicitly acknowledged the
existence of the duty. So, while there remain misgivings concerning the time from which it operates, the duty
has been supported widely as an important protection for creditors in certain circumstances.
• The courts have, in general, preferred to found the duty on a traditional basis in that they have said that the duty
is owed to the company to take into account the interests of creditors, that is the duty is mediated through the
company, rather than holding that the directors owe a duty directly to the creditors.Nonetheless there have been
some who have taken the view that directors should owe a duty to creditors directly. It has been pointed out that
Mason J in Walker v Wimborne did not exclude a direct duty to creditors, and one can perhaps read the
judgments of Lord Templeman in Winkworth v Edward Baron Development Co Ltd and the Full Court of the
Supreme Court of Western Australia in Jeffree v National Companies and Securities Commission as providing
some support for an independent duty being owed to creditors. However, recent judicial comments are set
against such a duty. First, Gaudron, McHugh, Gummow and Hayne JJ of the High Court in a joint judgment in
Spies v The Queen said by way of obiter that `it is extremely doubtful whether Mason J intended to suggest that
directors owe an independent duty directly to creditors.' Second, in the English case of Yukong Lines Ltd of
Korea v Rendsburg Investments Corporation, Toulson J clearly rejected the notion of a direct duty being owed to
creditors. However, there are indications in the United States, which has seen different avenues being followed in
the development of its law in the area, that, while no duty is extended to creditors in general, there is a direct
duty owed in certain limited circumstances, such as when the company is insolvent.
• An important point to note is that hitherto all of the cases where a director has been found to be in breach of the
duty have involved closely-held companies in which the director is also a shareholder. Directors in these sorts of
companies are more likely to be the subject of attack as it is in their interests as shareholders to take on risky
ventures. Perhaps in cases involving larger companies, courts might be more reluctant to impose the duty. This
remains to be seen.
THE TRIGGER FOR THE DUTY: The issues and problems surrounding the points in time at which courts have found that the duty arises.
1. Insolvency :
It is almost non-contentious to say that directors have a duty to take account of the interests
of creditors when the company is insolvent. While Mason J in Walker v Wimborne did not
limit the duty to cases of insolvency or even of financial distress, several of the cases in the
1980s introduced insolvency as a requirement. A majority of the High Court in Spies v The
Queen approved of the comments of Gummow J in Re New Worm Alliance Pty Ltd when
his Honour said that insolvency created a duty to creditors.
Certainly it is possible to say that when insolvency exists the notions of corporate ownership
and creditors' rights converge. The creditors then are the real owners of the company, the
ownership rights of the shareholders having been expunged as there is nothing over which
they have a claim. Hence, if a company is insolvent, directors act improperly if they employ
funds that are payable to creditors in order to continue the activities of the company.
If the trigger for the liability of directors to creditors is insolvency, one major problem is:
what definition of insolvency applies? Some have said that insolvency is a broad and
ambiguous term, while others have focused on the indefinite nature of the concept.
TEST FOR INSOLVENCY
IN AUSTRALIA IN UK
• In the Corporations Act 2001 (Cth) there is a definition, • The United Kingdom also provides in its
albeit a little convoluted. Section 95A provides that `[a]
person is solvent if, and only if, the person is able to pay
insolvency legislation for a definition. For
all the person's debts, as and when they become due and instance, in relation to preferences and
payable.' This is followed in s 95 with the rather transactions at an undervalue, insolvency
redundant statement that `[a] person who is not solvent is
insolvent.‘
means either cash-flow or balance-sheet
insolvency.Hence, in Yukong Lines Ltd of
• This section provides for commercial or, as it is more Korea v Rendsburg Investments
frequently known, cashflow insolvency. It is clear that the Corporation, Toulson J applied the balance
test is not without its problems. The main difficulties with
the cash-flow test have been said to be that it is vague in
sheet test and said that in the case before
meaning, and the decision as to whether a company, on a him there was a clear breach of duty
particular day, is insolvent is often a difficult and imprecise because the liability to a creditor was well
one.While these comments continue to hold some water, in excess of the company's assets.
it is fair to say that in recent years, especially in Australia,
there has been greater certainty in assessing whether or
not a company is insolvent (on the cash-flow basis) at a • In the United States, the balance-sheet test
particular point of time.
is invoked.
CRITICISMS
Professor Len Sealy raises, in his attack on the use of insolvency as the trigger for the advent of the duty, the fact that a company may move
in and out of insolvency as its fortunes fluctuate, and that the duties of directors should be evaluated from a broad perspective and not on
the basis of technicalities. Undoubtedly the riposte to this view is that, if a company does move in and out of insolvency, obviously indicating
that it is highly unstable from a financial point of view, then it is exactly the type of company whose affairs should be run with consideration
for the creditors' interests; it is likely to collapse without much warning. In fact, the point Professor Sealy makes may well be a good reason
for having a less definite point at which the duty is triggered. Professor Ross Grantham has similarly commented that:
Another important point to note is that insolvency rarely occurs overnight, save where there are events like the share collapse in October
1987, and where there are telltale signs of a company's demise well before the point that technical insolvency occurs.
If the trigger for the duty to creditors is insolvency, should the duty apply strictly or only when it is, or should have been, clear to the
directors that the company is insolvent? In Liquidator of West Mercia Safetywear Ltd v Dodd, Dillon LJ found against the director who was
being pursued for breach of duty because that director knew that his company was insolvent when he gave a preference payment to a
related company. While his Lordship did not specify knowledge of insolvency as a prerequisite for the duty to arise, it is worth considering
whether knowledge should be taken into account.
There are two concerns that may be voiced in relation to the identification of insolvency as the trigger-point for the duty. First, there is the
problem of establishing insolvency, which is encountered by liquidators pursuing directors for breach of duty. Proving insolvency is not
infrequently onerous, and consequently this may mean that directors are being given the benefit of the doubt. Second, a goal of creditors
usually is the avoidance of insolvency, so the point when the company becomes insolvent is too late for the duty to creditors to arise.
2. Near or in the Vicinity of Insolvency
A majority of the High Court in Spies v The Queen approved of the comments of Gummow J in Re New World
Alliance Pty Ltd, when his Honour said that if a company is nearing insolvency directors have a duty to creditors.
In New Zealand in Permakraft, Cooke J included near insolvency, along with insolvency or doubtful solvency, as
the trigger for the imposition on directors of a duty to creditors. But perhaps the most important developments
in this regard have occurred in the United States and particularly in Credit Lyonnais Bank Nederlander NV v Pathe
Communications Corporation. In this case, Chancellor Allen of the Delaware Court of Chancery stated that `At
least where a corporation is operating in the vicinity of insolvency, a board of directors is not merely the agent of
the residual risk bearers [the shareholders], but owes its duty to the corporate enterprise.' The corporate
enterprise to which the learned judge refers clearly comprises both shareholders and creditors.
While Chancellor Allen failed to explain exactly what he meant by `in the vicinity of insolvency', he seemed to be
suggesting that the duty to creditors arises when the company is nearing insolvency. This requirement means
that, if a company is in the vicinity of insolvency, directors should take stock of the company's position to
ascertain whether the company will remain solvent after the action which is contemplated.
Although insolvency may suffer from imprecision, prescribing the triggering of the duty when the company is
near to insolvency suffers even more from that problem, for it is impossible in many situations to say from what
point a company is nearing insolvency, except where one is viewing the company's dealings ex post facto.
3. Doubtful Solvency
• While the comment in Linton v Telnet Pty Ltd is undoubtedly true, and
the latter comment in Kinsela understandable, some guidelines are
needed in order to be fair to directors so that they can plan and know
when they must exhibit some loyalty to creditors. Also, guidelines must
be identified if this development of the law is not to suffer further
criticism on the basis that it is imprecise and produces uncertainty.
Factors to Be Considered
• A third factor to consider is that concern has • Is the existence of a duty, when a
been voiced about the difficulty of stating
company is subject to financial
with precision when the shift in duty is to
occur. But the law does not seem to have a distress, likely to make directors
problem with requiring courts to do this in panic and place their company into
other areas. For instance, a director is liable administration or even liquidation
for the English equivalent of insolvent prematurely, thereby ensuring that
trading, wrongful trading, if he or she knew
or ought to have concluded that there was all stakeholders lose out? It is
no reasonable prospect of the company more likely that directors will take
avoiding going into insolvent liquidation. the decision to appoint an
This is imprecise, and the provision does not administrator or liquidate because
set out the kind of conduct which will
constitute wrongful trading, but there has of fear of liability for insolvent
been relatively little criticism of the test. trading or liability
MALAYSIA
Duty to act for proper purposes and in good faith