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JBL 1991, Jul, 365-397 FOR EDUCATIONAL USE ONLY J.B.L. 1991, JUL, 365-397 (Cite as: J.B.L.

1991, JUL, 365-397)

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Journal of Business Law 1991 Article FIDUCIARY OBLIGATIONS TO CORPORATE CREDITORS Razeen Sappideen. Copyright (c) Sweet & Maxwell Limited and Contributors Subject: INSOLVENCY Keywords: Australia; Corporate insolvency; Creditors; Fiduciary duty Abstract: On insolvency - comparison between UK and Australia. *365 There is general recognition in both United Kingdom and Australian courts that creditor interests merit special attention when a company is insolvent. For example, Street C.J. in the Australian case of Kinsela v. Russel Kinsela Pty Ltd. (in liq.) said as follows [FN1]: In a solvent company the proprietary interests of the shareholders entitle them as a general body to be regarded as the company when questions of the duty of directors arise. If, as a general body, they authorise or ratify a particular action of the directors, there can be no challenge to the validity of what the directors have done. But where a company is insolvent the interests of the creditors intrude. They become prospectively entitled, through the mechanism of liquidation, to displace the power of the shareholders and directors to deal with the company's assets. It is in a practical sense their assets and not the shareholders' asset. It is in a practical sense their assets and not he shareholders' assets that, through the medium of the company, are under the management of the directors pending either liquidation, return to solvency, or the imposition of some alternative administration. This statement has been cited with approval by Dillon L.J. in the United Kingdom case of West Mercia Safetyware Ltd. v. Dodd [FN2] and maybe taken to fairly represent the United Kingdom and Australian positions. More recently, courts in both of these jurisdictions have gone further and recognised creditor interests as requiring of protection at a stage much earlier than the onset of insolvency. These decisions recognise that certain actions by corporate management can hurt creditor interests long before the company becomes insolvent, and in some cases be the cause of the company becoming insolvent. A notable opinion in this regard in the United Kingdom is the decision of Templeman L.J. in Winkworth v. Edward Baron Development Co. Ltd. [FN3] A similar view has been expressed in Australia in the decision of Mason J. in the High Court in Walker v. Wimborne, [FN4] and the Full Supreme Court of Western Australia in Jeffree v. National Com*366 panies and Securities Commission. [FN5] In Winkworth's case Templeman L.J. said as follows [FN6]: But a company owes a duty to its creditors, present and future. The company is not bound to pay off every debt as soon as it is incurred and the company is not obliged to avoid all ventures which involve an element of risk, but the company owes a duty to its creditors to keep its property inviolate and available for the repayment of its debts. The conscience of the company as well as its management, is confided to its directors. 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 creditors. (Emphasis added.) This statement was followed by the court in Jeffree's case. In Walker v. Wimborne, Mason J, noted that creditors could only look to the company for payment of their debts and would, therefore, always be

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threatened by the possibility of future insolvency. For this reason, thought his Honour, there existed the need for a continuing obligation on directors to consider the interests of creditors irrespective of the financial health of the company. This paper analyses the need to recognise creditor interests long before the onset of insolvency. It examines research done by finance theorists in this area and advances the view that creditor interests be treated as being at par with shareholder interests during the solvency of the corporation and that these claims be given expression through an extension of directors duties to creditors as with respect to shareholders. Creditor and shareholder claims: the problem defined Corporations' law regards creditors as contractual claimants and shareholders as owners of the corporation. Consequently, creditors are treated as not being entitled to any more than what has been agreed to under the particular debt/sale/service agreement and shareholders as being entitled to unlimited claims on the remaining assets of the corporation. Since the claims of both creditors and shareholders are to the same pie and its division thereof, their respective claims often conflict. In the face of such conflict, it may be argued that creditors ought to ensure primacy of their interests as against shareholder claims by express contract. But such express contractual stipulation is generally not possible in the case of normal trade/service agreements and is often extremely difficult even in the case of debt contracts. Difficulties encountered include the costs and difficulty of documenting such transactions, the difficulty of monitoring such transactions (detecting breaches), and the time factor involved in enforcing rights even if such breaches were detectable. Viewed from the borrower's perspective, the greater the restrictions imposed on its freedom of action (to ensure non-default of the debt obligation) the greater are the business opportunities foregone (opportunity cost). Where presented with such restrictions, the borrower *367 would inevitably spend time and effort trying to circumvent such restrictions with the lender likewise trying to monitor such breaches and attempting to enforce its rights. This potential for conflict is recognised by the law in some situations. Where this is so, the law seeks to confer priority on creditor interests. Thus, in the event of bankruptcy of the corporation, the relevant Insolvency/Bankruptcy Act [FN7] accords a system of priority, and in the event of winding up of the corporation, the companies legislation [FN8] likewise accords a system of priority to creditors over shareholders. No such priority is accorded to creditors while the corporation is a going concern. The creditor, in these circumstances, is left to enforce whatever rights it has under contract. The difficulty, however, is that very often creditor interests can be defeated without any formal technical violations of covenants intended to protect creditor interests. In this matter, the law lags far behind finance theory. Finance theory recognises that corporate management acting in the interests of shareholders can prejudice the claims of creditors in several ways while the corporation is still a going concern. To focus more sharply on the problem of creditor-shareholder conflict during the life of the corporation, the discussion in this paper will centre on the position of debentureholders where the debentures have been acquired under a public issue. An issue of debentures to the public requires the issuance of a prospectus and the creation of a debenture trust deed in accordance with the requirements of the companies legislation. The former aims at providing certain mandated financial information, while the latter attempts to define the rights, obligations and liabilities of the three parties to the deed, viz., the debentureholder, the company issuing the debenture, and the trustee under the trust deed. The thesis advanced in this paper is that the protection offered to debentureholders under these instruments being of a contractual nature, cannot be and are not sufficiently comprehensive or efficient to achieve their aims. Instead, it is suggested that corporate management be required to demonstrate a general fiduciary obligation towards debentureholders. Managerial action and creditor welfare

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Creditors require protection from certain types of actions corporate management may resort to. Sometimes, however, they may require to be protected against managerial inaction. Shirking, under-investment, asset substitution, diluting creditors' claims, and excessive dividend payouts are illustrations of this problem. Shirking (or inadequate effort), commonly results where a fixed percentage of profits is required to be paid out to the lender. Management, here may be tempted to invest less effort in the development of this form of opportunity (beyond what is necessary to make an appropriate minimum payout) and to concentrate on opportunities that do not require the rewards to be shared with the creditor. The end result is a failure to exploit to its fullness the opportunity *368 for which the loan was advanced. Under investment is a variant of shirking. Thus where a substantial part of the value of the firm is composed of intangible assets in the form of future investment opportunities, management may be tempted to reject projects which have a positive net present value if the benefit from accepting such projects would accrue to debentureholders whose claims mature over a long period of time. [FN9] Asset substitution takes the form of embarking the loan on a different and more riskier venture than that which the creditor may have contemplated so as to obtain higher returns, or by making the venture for which the loan was advanced (same venture) more riskier, again, for higher returns. Where the additional risk added project succeeds, the market value of the firm will increase but it will be the stockholders who will pick up most (if not all) of the gains. Conversely, where the project fails, the market value of the firms will decrease but it will be on the bondholders that most of the loss (if not all) will fall. [FN10] The effect of such action is to effectively reduce the interest costs of the loan, or conversely a higher risk loan is obtained at a lower rate of interest. This type of misbehaviour occurs where loans are obtained at fixed rates of interest. Interest rates, for their part, partially reflect the risk of default (other factors influencing interest rates being the rate of inflation, the opportunity cost-factor, and the availability of security for credit), such risk itself being a function of the riskiness of the debtor's business. Diluting creditors' claims, in its simplest form, involves taking further credit on terms where the new debt competes with the original debt for the security. The problem is exacerbated where the later loan is obtained at a higher rate of interest and is used for higher risk ventures. Excessive dividend payments is in a sense a more blatant form of creditor claim dilution. It too has the effect of reducing creditor's claims to available security. Thus where the company decides not to retain any part of its projects as working capital or as development capital but to distribute all of it as dividends to its shareholders, the interests of creditors are affected adversely. This is because the company's working and development capital will now have to be financed out of additional borrowings. The borrowing corporation can go even further. It can pay dividends to its shareholders out of the excess of book value based on the sale or revaluation of its assets. As the pricing of bonds and securities, more than shares, depends on the borrowing company's asset backing, the impact of such payouts on the value of such securities would be disastrous. [FN11] Similar consequences follow where management resort to leasing and off *369 balance sheet financing. The effect of a leasing transaction known as a finance lease, [FN12] is to increase a company's gearing without providing additional assets to underlie a floating charge. Consequently, there is an increase not only in total liabilities, but also in liabilities on which there is a fixed charge to pay. [FN13] When a firm obtains off-balance-sheet financing, the conventional measures of financial leverage, such as the debt-equity ratio, understate the true degree of financial leverage. Problems have arisen for many companies because of changes in their business activities and the restrictive nature of the definition of ""assets" in calculating maximum liability ratios. Companies have responded to this situation in various ways. Some have undertaken defeasance transactions or brought back outstanding debentures in order to retire trust deeds. This has sometimes been accompanied by refinancing under less restrictive arrangements which may be on or off balance sheet. Where off-balance-sheet financing is adopted, there is no doubt that the greater volatility of earn-

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ings reduces the value of debt. The consequences of such managerial action impact even on secured creditors such as debentureholders who may have lent to the corporation under a trust deed reinforced by a floating or fixed charge. As an often cited study [FN14] notes: (1) Firm value rises with increases in debt; (2) Stock prices rise with increases in debt; and conversely, (3) Bond prices fall with increases in debt; and (4) Bond prices fall more when the new debt is senior or equal in priority to existing bonds. For example, takeovers and recapitalisations that substitute new debt for equity result in the creation of two classes of debentureholders. The new debentureholders are paid interest at rates that reflect the company's increased financial risk. Interest rates paid to old debentureholders do not reflect this new risk and consequently those debentureholders may suffer capital losses because the market would discount the value of the old security to accommodate the *370 additional debt. Leverage buy-outs [FN15] and spin-outs [FN16] are other examples. Correspondingly, and of equal concern, is the law of conservation of value, according to which losses in debt value do not disappear, but are transformed into increases in share value. [FN17] The theory can be explained as follows. The value of a firm is a reflection of both, the debt and equity contributions to the firm. A rise in the value of the firms equity is explicable by reason of the firm's overall increase in value (attributable to both debt and equity), or by reason possibly of equity benefiting at the expense of debt. One way of handling this difficulty is by express contractual stipulation against such managerial action/inaction. But such a solution is not without its costs and may not be an efficient solution at that. From the lender's end there is the task of second-guessing and policing managerial action. From the borrower's end there is the cost of missed opportunities and the temptation to circumvent restrictions. Thus the tighter the loan agreement is drawn, the more costly it will be to monitor its operation. Finance theorists explain this phenomenon of dependence and costs incurred in ensuring that arrangements entered into are complied with as part of Agency theory or the Costly Contracting hypothesis. [FN18] What it implies is that a point is reached where the costs involved in ensuring that arrangements entered into are complied with exceeds their intended benefits. Consistent with such a costly contracting framework, finance theorists have devised a way of viewing corporate liabilities as combinations of simple options *371 contracts. Under such an option pricing model (also called contingent claims analysis), whenever a firm borrows the lender is said to acquire the company and the shareholders to obtain an option to buy it back from the lender by paying off the debt. [FN19] In effect the shareholders are treated as having purchased a call option (the right to buy) from debt holders. What the theory establishes is that creditors have claims equal, if not superior, to the corporation's assets as shareholders do, these being contingent upon the happening of certain events. To illustrate, take the case of a firm which has only two classes of liabilities, equity and a zero-coupon bond which matures in one year into a principal amount of $10 million. If at date of maturity, the value of the firm exceeds $10 million, the firm will retire the debt and the equity will be the amount received in excess of the amount ($10 million) needed to retire the debt. Conversely, where the value of the firm is less than $10 million, the firm will default. In the latter event, the equity will be worth zero and the debt will be the value of the firm. Thus, the *372 value of both debt and equity are contingent upon the value of the firm and are, therefore, contingent claims. [FN20] Information disclosure, market forces and express contracting Ever since shareholders first delegated control of their funds to management, the need arose for management to report progress to those who owned the capital. Commercial efficacy dictated that creditors too have access to certain information pertinent to their interests. Indeed, so far as debt holders are concerned, there is evidence that the existence of leverage limitations and dividend restrictions often determines management's choice of accounting method. [FN21] Use of such methods to ""play for time" is not in the best interests of

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debentureholders. [FN22] Disclosure laws, like bond ratings, offer protection against gradual declines in a company's fortunes, but they offer no protection against an unexpected announcement. While debentureholders rely upon disclosure and other sources of creditor protection, their primary shelter at present lies in the terms of the debentures trust deed. On the other hand, shareholders claim the benefit of the broad duties intrinsic in a director's fiduciary relationship to a company. Before examining an extension of these duties and whether debentureholders can rely upon it, this paper considers some other sources of creditor protection. According to the ex ante adjustment process, the price an institution is willing to pay for debentures would reflect its assessment of the default risk, that is, the agency cost of debt. [FN23] In an efficient market, the smaller investors need not make their own assessment of the default risk because the anticipated default risk is impounded in the price. Smaller investors, therefore, can free ride on the research and pricing strategy of the larger institutional investors. For this reason, all debentureholders are said to be compensated ex ante for any anticipated risk of default ex post. The ex ante adjustment process works flawlessly in *373 a world of perfect certainty. The real world, however, is far from certain. [FN24] To overcome this, economists have devised the ""rational expectations hypothesis." According to this hypothesis, an efficient market of rational investors can predict the future. [FN25] When such an investor holds a fully diversified portfolio and accurately predicts the average risk of expropriation for all debentures, that investor will not suffer losses overall. However, the rational expectations hypothesis assumes an efficient market. Empirical studies reveal that securities markets are, at their best only semi-strong form efficient. [FN26] This implies that the information contained in the post sequence of prices of a security is fully reflected in the current price of that security. In the real world, it is not possible to say that all information is impounded into debenture prices. Nor is it the normal practice for debentureholders to hold a fully diversified debenture portfolio. [FN27] The point then is, if the debentureholders need protection from expropriation by shareholders, diversification is not the solution to the problem. [FN28] There is the alternative argument, again based on market forces, that a company with a reputation for hurting its debentureholders will find it more difficult to sell debentures in the future. As the saying goes, a company that makes a killing *374 today at the expense of a creditor will be coldly received when the time comes to borrow again. [FN29] However, there is disagreement as to whether reputation is an effective constraint. [FN30] It is clear at least that for market constraints in the sense of reputation to work actions need to be repeated. In the context discussed here, there must be further debt issues. A company confident that it will not need to enter the debt market again will have more incentive to exploit existing debentureholders. Market forces are an important constraint only in normal circumstances. In unusual circumstances, such as for example in a takeover contest, managers may become more willing to sacrifice existing debentureholders in order to maximise shareholder gains. The market for corporate control is not a constraint likely to deter this. [FN31] A way out is to exit. This option of selling out, however, is good protection only against gradual deterioration in a company's financial condition. It is no protection against the surprise announcement of a major decision that alters debentureholder risk. In some circumstances, covenants protecting other lenders such as restrictive covenants in a bank or insurance company loan agreement, or in an older but still outstanding debt issue, might benefit debentureholders indirectly. Then again, they may not. [FN32] Nor is debenture holder voting the best answer. Although debentureholders do have incentives to seek representation on the board, the disincentives are equally great. They include the burden of the duties and responsibility that come with the office of director. Debenture trust deed or fiduciary duty

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The protection afforded to the holder of a debt security currently depends largely upon the document evidencing the debt, that is the debenture trust deed. A debenture trust deed is a contract between the borrowing company and trustee and an instrument of trust governing the position between trustee and debentureholders and debentureholders themselves. It would appear that debentureholders could require the trustee to enforce the agreement. [FN33] It is important, therefore, that the deed contains provisions enabling the trustee to act, if necessary, to safeguard debentureholder's interests. [FN34] Companies legislation in the United Kingdom and Australia require that in all cases where debentures [FN35] are issued in pursuance of an offer or invitation to the *375 public, there must be a trustee and a trust deed. [FN36] Likewise, the Stock Exchange Listing Requirements specifically require a trust deed in every case where the debentures are to be listed. [FN37] Where the law does not make a trust deed compulsory, convenience and marketing advantages may prompt its drafting and the appointment of a professional trustee to supervise it. [FN38] The predominant features of trust deeds are the borrowing limitations and (except of course in the case of unsecured notes) the charges securing the debentures. [FN39] The purpose of limitation clauses in a trust deed is to provide constraints on the financial structure of the borrowing company when that company is seeking to raise additional finance. [FN40] Consequently before any further borrowing by way of debentures can take place, it is essential that the borrowing company can satisfy these constraints. Regardless of any other reasons for having limits on borrowings and other liabilities in trust deeds, section 1054(1) of Corp. that where debentures are offered to the public, the relevant trust deed must ""contain a limitation on the amount that the borrowing corporation may pursuant to those debentures on that deed borrow." The two basic types of limitation which are appropriate for both secured and unsecured trust deeds are those on total external liabilities and total secured liabilities. [FN41] The effectiveness of these limitations is very much up to the skill and foresight of the drafter. For example, in relation to restrictions on prior-ranking securities, [FN42] restrictions should be expressed to apply not only to their ""creation" but also to ""permitting or suffering them to exist." If the trust deed only limits the ""creation" of such securities, such a restriction does not operate against a mortgage given to a vendor or otherwise in connection with the acquisition of a property. [FN43] Other tests of the drafter's method exist. For example, limitations should be based on the assets and liabilities of the borrowing company and its guarantors rather than on the consolidation of the borrowing company and all of its subsidiaries. [FN44] Most trust deeds contain a clause requiring interest to be covered a stated number of times. [FN45] It is this, and only this, covenant which gives the trustee a measure of *376 the value of the entity as a going concern. It is this value which constitutes the debentureholders' security. However, it is important to note that failure to cover interest the required number of times does not generally constitute default. [FN46] Only if a company issues any further debentures or creates a prior-ranking liability or one ranking equally while interest is not covered the stated number of times is a default committed. [FN47] As profits give an indication of the going concern value, it would seem desirable that the breach of the interest requirement should constitute a default. [FN48] In the final analysis, the major protection afforded to the debentureholder is the continuing profitability, of the investee company. [FN49] Debentureholders are not protected by non existent covenants or ratios that vary with the accounting method adopted. [FN50] Debentureholders' rights also depend on whether their security is floating or fixed. The floating charge leaves the borrowing company and its guarantors free to deal with their assets in the ordinary course of and for the purpose of carrying on their respective business. It is usual for this freedom to be expressly confirmed by the trust deed. [FN51] The trust deed must be relied upon if a trustee is to crystallise the security before a large part of it is eroded. (1) The contractual approach

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A contract between a principal and an agent can be a contingent contract or a relational contract. In a contingent contract, the parties attempt to specify a response for various contingencies. A complete contingent contract is beyond human capability. No contract can anticipate all future contingencies. Uncertainty and complexity may, therefore, cause the principal and agent to enter into a relational contract. A contract is relational when the parties are unable to specify important obligations in precise terms. A contract defined by fiduciary obligations is a good example of a relational contract. In general, the contract between managers and shareholders is an implicit relational contract, whereas the contract between managers and debentureholders (which takes the form of a trust deed) is generally an explicit contingent contract. [FN52] Although all investors have access to information concerning residual risks, different individual investors in fact possess different amounts of information. For this reason, debentureholders lack a unitary set of expectations. [FN53] This factor *377 alone may justify invocation of good faith principles to protect debentureholders from residual risks. Furthermore, exclusive reliance on express covenanting may prove wanting because a trust deed cannot, and will not contain a complete set of protective covenants. This is so for at least two reasons. First, a debt contract, like any contingent contract, can never be complete because it is impossible to write a detailed contract that covers every contingency. Secondly, the trust deed will be incomplete because managers will resist covenants that limit their ability to take value increasing actions. [FN54] This will be so even in relation to a large, individual, privately negotiated debenture issue. Typically, among the more important terms of a trust deed are the amount of money borrowed, the interest rate and the time(s) for repayment of interest and capital. The deed will also refer to any security interest given as collateral, and what that interest is. Additional clauses would require the insurance of plant and equipment. But the heart of the trust deed will centre on the essence of corporate finance decision making, viz., the investment, finance, and dividend payout decisions of the borrower. Negotiating in this regard is a delicate matter as it involves a close balancing of interests. This latter point is illustrated below in relation to the investment, payout and financing decisions. (i) Covenants on the production/investment function. Restriction could be imposed by way of explicitly specifying the type of activity the firm should, or should not engage in. Common examples of the latter include the prohibition on on-lending and investment in the securities of other corporations. Another notable example is the prohibition against disposition of particular assets specified or of assets of a type or class with/without the consent of the lender. Conversely, the covenant might require the corporation to hold particular assets, for example certain fixed assets and working capital (current assets less current liabilities), or pursue particular projects with certain targets of achievement specified in relation to the latter. Restrictions of these types are intended to monitor shirking, under-investment and asset substitution. Constraints of these types normally are continuing constraints, i.e. their violation at any time during the continuation of the debt obligations constitutes a default. They also vary with the type and seniority of the debt and also with industry practice. But they are not without costs. For example, prohibitions on the disposition of assets or on the carrying on of particular types of activity impose, amongst others, an opportunity cost. Again, the costs of monitoring in relation to any positive obligations that may be imposed (in pursuance of specified projects and investments) may require second guessing of management decision making and effort, and prove *378 to be too costly. An alternative and easier method of overcoming the problem of asset substitution is by taking up the right to convertibility (convertible note), and this is often done. (ii) Covenants regulating payouts. Trust deeds often restrict the discretion of directors to distribute funds to shareholders by way of dividends, share buybacks and reductions of capital. All of these forms of distributions reduce funds that would otherwise be available for investment. In extreme situations it may disable corporations from servicing their debt obligations. Their total impact would be to decrease the value of

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the firm's assets at their expected maturity date making default more likely. Often, therefore, covenants seek to regulate the circumstances and amount of dividends that can be paid out while prohibiting share buybacks and capital reduction. Where the prohibition ensures a flow of funds for investment, it may be a useful weapon against the problem of under-investment since, the argument goes, so long as the firm has to invest, profitable projects are less likely to be turned down. [FN55] The argument also has its downside. This is that the corporation may be forced to invest in less profitable projects rather than distribute the funds, because it is under an obligation to invest. Alternatively, the corporation may resort to asset substitution. The creation and payment into a sinking funds has been suggested for this reason. More often, the aim of a dividend payout prohibition is to prevent the corporation doing so when it is in different financial circumstances (e.g. situations of nimble dividends--current year profits with past year losses; and the reverse situation--current year losses, previous year profits). Thus, typically, dividend restriction prohibition clauses prohibit the payment of a dividend unless the amount of current assets less current liabilities is at least 25 per cent. of middle or long term debt. [FN56] As these measures need to be measured by reference to financial data, it *379 is inevitable that financial accounting reports assume the role of surrogate to the borrowers' decision making process. [FN57] (iii) Covenants regulating the financing decision. The main concern for existing creditors is the probability of claim dilution, i.e. the granting of a superior claim over existing assets to later creditors. There are several ways of handling this problem. One, is to prevent the granting of subsequent higher priority claims (the first in time, therefore, having a superior claim). Another, is to ensure that existing creditors rank pari passu with future creditors. The common method of achieving this is through the negative pledge combined with a prohibition on sale and lease-back. The two act in combination because the latter produces the same economic results as the former. To explain, the negative pledge prohibits further borrowing pari passu or in priority. The result of a sale and lease back is that the corporation sells an asset otherwise available to satisfy existing creditor claims, thus conferring priority on the new holder of the asset. Thus the negative pledge and the prohibition on sale and lease back are combined. A third way of regulating corporate borrowing is to subject it to an overall dollar limit or limit it by reference to certain financial ratios, some of which are: (1) net tangible assets and long term debt; (2) capitalization and long term debt; (3) tangible net worth and long term debt; (4) income and interest charges (earnings test); and (5) current assets and current debt (working capital tests). A combination of these may be used. The main argument against covenants imposing absolute restrictions on borrowings is that it may prevent what could be a last ditch attempt at saving a corporation from bankruptcy. Those willing to lend and rescue in these circumstances will almost invariably want priority in payout over all existing creditors. Again, an absolute prohibition may cause shirking as management may not persevere in their efforts when the corporation is heading towards crises. Classical contract law tends to allocate the burden of drafting an explicit provision to the party seeking to enforce the right. The court refuses to make contracts for the parties and infers that the parties intend the debentureholder to bear the risk of dilution and fall in value. The court confines its analysis to the ""four corners of the contract." [FN58] This approach relies heavily on standard contracts. While standard form contracting has its advantages and may have been effective in the past, it may no longer be so because of the risks of dilution inherent under this approach. For this reason, the standard form contract does not attain the ideal of a complete contingent contract. Under the neo-classical approach the parties act in ""good faith" so as not to destroy or injure the rights of the other party to receive the fruits of the contract. The neoclassically inclined court seeks to effectuate the parties expectations without a preconceived placement of the drafting burden. The court considers the entire circumstances of the relationship to assure selection of the meaning most consonant with the parties' expectations. [FN59] In a market that is at best only semi-strong form efficient, the *380 neoclassical approach appears to be the one that treats debentureholder expectations most

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fairly. [FN60] The adoption of the neo-classical approach ultimately rests on the rules relating to the admissibility of ""parol" or ""extrinsic" evidence. The Anglo-Australian position in this regard seems to be open ended. According to one leading text [FN61]: Extrinsic evidence is generally inadmissible when it would, if accepted, have the effect of adding to, varying or contradicting the terms of a judicial record, a transaction required by law to be in writing, or a document constituting a valid and effective contract or other transaction. But this general rule has its exception. As stated by Lord Davey [FN62]: Extrinsic evidence is always admissible, not to contradict or vary the contract: but to apply it to the facts which the parties had in their minds and were negotiating about. Thus, evidence of antecedent negotiations is admissible if they retain their contractual effect or legal significance after the writing has been brought into existence to, for example, identify the subject matter of the contract, establish the existence of a contract collateral to the writing, or the conclusion of a contract which is partly oral and partly in writing. [FN63] Likewise, evidence of surrounding circumstances or the matrix may also be taken into account. As expressed by Lord Wilberforce [FN64]: ""In order for the agreement of July 6, 1960 to be understood, it must be placed in its context. The time has long passed when agreements, even those under seal, were isolated from the matrix of facts in which they were set and interpreted purely on internal linguistic considerations. There is no need to appeal here to any modern antiliteral tendencies, for Lord Blackburn's well-known judgment in River Wear Commissioners v. Adamson provides ample warrant for a liberal approach. We must, as he said, enquire beyond the language and see what the circumstances were with reference to which the words were used, and the object, appearing from those circumstances, which the person using them had in view." *381 But the limits of the exception in the latter situation must be also be noted. Thus Mason J. in the Australian High Court decision of Codelfa Construction v. State Rail Authority of NSW said [FN65]: ""The true rule is that evidence of surrounding circumstances is admissible to assist in the interpretation of the contract if the language is ambiguous or susceptible of more than one meaning. But it is not admissible to contradict the language of the contract when it has a plain meaning. Generally speaking facts existing when the contract was made will not be receivable as part of the surrounding circumstances as an aid to construction, unless they were known to both parties, although, as we have seen, if the facts are notorious knowledge of them will be presumed." Furthermore, the cases emphasise that the commercial purpose of the transaction is to be discerned not from what the parties then intended but from an objective inference drawn from the facts within their knowledge, from the market in which they dealt or from the document itself. [FN66] However, the proved actual intention of the parties may be admissible as an aid to construction where the parties have expressly refrained from including in the contract a provision which would have given effect to their presumed intention. To quote again Mason J. in the Codelfa case [FN67]: If it transpires that the parties have refused to include in the contract a provision which would give effect to the presumed intention of persons in their position it may be proper to receive evidence of that refusal. After all, the court is interpreting the contract which the parties have made and in that exercise the court takes into account what reasonable men in that situation would have intended to convey by the words of the contract a meaning which the parties have united in rejecting? It is possible that evidence of mutual intention, if amounting to concurrence, it receivable so as to negative an inference sought to be drawn from surrounding circumstances: see Heimann v. Commonwealth [(1938) 38 SR (NSW) 691, 695].

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The underlying question then is whether the meaning of the words as used by the parties (in the case here, the company and the debenture trustee/creditor) should be construed as they had intended it to be or whether a more objective meaning should be arrived at. The answer to this may well influence whether past evidence of circumstances both antecedent and/or surrounding should be admitted. As the answer to it is not easy, the courts will have to necessarily vacillate between the two views influenced by such considerations as the issue before the court, and the party(ies) whose interests are affected. While the argument in favour of a subjective approach (in the sense of what the parties intended as distinct from what the document appears to state) may be justified where the disputants themselves are parties to the contract, this approach becomes less easy to justify where third parties have assumed rights or have acted in reliance on the terms of the contract unaware of the events leading to, and surrounding, the agreement. *382 (2) The issue of fiduciary duty: the economic perspective The economic function of fiduciary duties is to regulate the complex web of agency relationships which comprise the structure of the corporate enterprise. [FN68] Within the modern publicly-held corporation, investors delegate authority to directors, who in turn delegate authority to other agents operating at many levels within the enterprise. [FN69] This delegation is efficient because it allows directors and officers to specialise in risk-bearing. [FN70] The fiduciary principle is a relatively low-cost approach, substituting deterrence for costly and ineffective direct supervision of agents' behaviour. [FN71] From an economic perspective, fiduciary principles, are simply contractual devices. [FN72] The principle that officers and directors owe a fiduciary duty to shareholders serves as a ""standard-form penalty clause" in contracts to which investors are interested parties. This economic perspective is important because it generates a mechanism by which courts can decide cases. In particular, when scrutinising managerial behaviour, courts should treat an allegation of breach of fiduciary duty as they would treat any alleged breach of contract. This analytic method often is described as the ""hypothetical bargain" approach. [FN73] Under this approach to fiduciary duty, courts would evaluate whether the managers' action were consistent with the terms of a hypothetical fully specified, contingent contract that informed, value-maximising investors would have agreed to ex ante. [FN74] Since debtholders are not always compensated ex ante for expropriation loss, the fiduciary duties of corporate law provide a mechanism for compensating debtholders ex post. [FN75] Furthermore, fiduciary duties to debtholders can dramatically reduce the average agency costs of debt for all corporations and sharply reduce the systematic risk of expropriation loss which in turn will lower average borrowing costs for all corporate borrowers. [FN76] Again, in economic terms, shareholders and debtholders are all security holders with differing claims on the assets and cash flow of an enterprise. [FN77] The investor who buys shares and the investor who lends money are, as a matter of economics, engaged in the same kind of activity and are motivated by the same basic objectives. [FN78] Both are making a capital investment and both expect to get their money back plus a return on their investment. Many investors hold both shares and debentures. [FN79] *383 (i) Who is a Fiduciary? To describe a person, or the exercise of a power, as being fiduciary does not take the discussion far as such a description only begs the question, to whom or what? [FN80] The issue is better understood if analysed in terms of when fiduciary obligations have been breached rather than what they actually mean. Fiduciary obligations are said to be commonly breached in the following three situations [FN81]: (1) Where there is a conflict of interest and duty; (2) in situations where undue influence is exerted; and (3) where confidential information is misused. Conflicts of interest and duty are common in relationships such as principal and agent--a classic example being a company and its directors--, and trustee and beneficiary re-

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lationships. The second category, undue influence, is generally considered present in a normal solicitor-client, doctor-patient relationship. A good example of the third category, misuse of confidential information, is the employer-employee relationship where the employee is entrusted with, for example, trade secrets such as a client list or a secret manufacturing process. Relationships to which these obligations apply take on either a status based or fact based grouping. [FN82] Status based relationships assume their character from the relationships between the individuals such as trustee-beneficiary, and directors and the company. Fact based relationships exist where it is established that a person entrusted with an obligation that gave rise to the relationship has acted in breach of it. An example of this is an employee acting in violation of an employer's trade secrets. For purposes of discussion here, obligations owed by a director to the company can be treated as falling within the status based relationship category, while obligations owed by a director to shareholders and creditors can be treated as falling within the fact based relationship category. However, all three categories of breach discussed above can be found in the relationship governing directors and the company, between directors and shareholders, and directors and creditors. At least seven theories seek to justify and explain the imposition of these fiduciary obligations. [FN83] These are: (1) unjust enrichment, (2) commercial utility, (3) reliance, (4) unequal relationship, (5) property, (6) undertaking or contractual, and (7) power and discretion theory. The imposition of fiduciary obligations on directors with respect to the three parties under review, viz., the corporation, shareholders, and creditors, can be justified under each of the above theories. According to the unjust enrichment theory, a fiduciary relationship exists where one person obtains property or other advantage which justice requires should belong to another person. Even though the theory predicates the relationship on the remedy, rather than the other way round, it has been widely accepted. The commercial utility theory holds a person liable to a higher than average standard of ethics or good faith in the interests of protecting the integrity of a commercial *384 enterprise. [FN84] Unlike the unjust enrichment theory which is justified on grounds of morality, commercial utility theory is justified on grounds of public policy. Under the reliance theory, a fiduciary relationship exists where a person reposes trust, confidence, or reliance on another. Like the unjust enrichment theory it is descriptive and not analytic, but differs from the former in its requirement of reliance. Another point is that the theory does not deal with the actions of the proposed fiduciary, but with the actions of the proposed beneficiary. But as has been observed, ""not all relationships will be held to be fiduciary, even though reliance upon integrity and a party's presumption of full disclosure are involved." [FN85] The best statement of the unequal relationship theory is found in the decision of McTague J.A. in Follis v. Township of Albermarle [FN86] where his Honour said [FN87]: ""... it seems to me that there must be established some inequality of footing between the parties, either arising out of a particular relationship, as parent and child, guardian and ward, solicitor and client, trustee and cestui que trust, principal and agent, etc., or on the other hand, that it can be established that dominion was exercised by one person over another, no matter how the particular relationship can be categorized." This theory is similar to the reliance theory in that it recognises vulnerability as a criterion for establishing a fiduciary relationship. It, however, goes further in that it recognises power or dominion by one party over another. In this sense it is seen as providing a more firmer foundation. The shortcoming of the theory is its open ended nature, for rarely are relationships between individuals based on strict equality. Read in its widest sense, the mere possession of experience, ability, or economic power would place a person under a fiduciary restraint when dealing with another. The property theory is endemic to traditional trust law in that it recognises a fiduciary relationship

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where one person has legal title and/or control over property or other advantage, while beneficial ownership thereof resides in another. The shortcoming of the theory is that it is often difficult to identify the property interest that is being protected, and with it, the possibility of a great many relationships being branded as fiduciary. The undertaking or contractual theory is traceable to Austin Scott when in 1949 he wrote as follows [FN88]: Who is a fiduciary? A fiduciary is a person who undertakes to act in the interest of another person. It is immaterial whether the undertaking is in the form of a contract. It is immaterial that the undertaking is gratuitous. The genesis of the theory, however, is much earlier. [FN89] This theory, unlike the *385 reliance theory, requires acceptance of the obligation by the potential fiduciary and is seen as being if not a contract per se, a contract in form at least. The theory has been criticised for its reliance on quasi-contractual concepts. Defendants of the theory, however, point out that the undertaking contemplated here calls only for an acceptance and not also an offer, or alternatively that the required implied contractual relationship arises at the time the potential fiduciary has knowledge of the trust and confidence reposed by the plaintiff. The power and discretion theory propounded by Professor Weinrib has had growing acceptance. According to it, a fiduciary relationship exists where one person has (a) the power to change the legal position of another, and (b) a discretion in the exercise of that power. In other words, implied in the theory, is that the potential fiduciary had scope for the exercise of discretion, and secondly, the discretion was capable of affecting the legal position of the principal. As stated by Weinrib [FN90]: ""The reason that agents, trustees, partners, and directors are subjected to the fiduciary obligation is that they have a leeway for the exercise of discretion in dealings with third parties which can affect the legal position of their principals. As we have seen, if they have no discretion to advise or negotiate and if their instructions are narrow and precise there is nothing on which the fiduciary obligation can bite. Accordingly the hallmark of a fiduciary relation is that the relative legal positions are such that one party is at the mercy of the other's discretion." The theory subsumes several of the other theories discussed earlier. As Shepherd states [FN91]: ""Inherent in it is the subtlety of the unequal relationship theory, which itself subsumes both the unjust enrichment and reliance theories. As well, centring as it does on the transfer of power from one person to another, either expressly or by the relative strength of the parties, this theory has a natural affinity to the undertaking or contractual theory. But, the biggest strength seen here is the fact that this theory goes back to fundamentals. Instead of trying to work from analogy, e.g. contract, and instead of trying to deal with non-definitive concepts, like unjust enrichment, this theory concentrates on the powers, duties, and rights inherent in the relationship ..." More recently, the theory has been adopted by Mason J. in the High Court of Australia decision in Hospital Products Ltd. v. United States Surgical Corporation. [FN92] The case dealt with a fact-based fiduciary status. His Honour there said [FN93]: The accepted fiduciary relationships are sometimes referred to as relationships of trust and confidence or confidential relations (cf. Phipps v. Boardman), viz, trustee and beneficiary, agent and principal, solicitor and client, employee and employer, director and company and partners. The critical feature of these relationships is that the fiduciary undertakes or agrees to act for or on behalf of or in the interests of another person in the exercise of a power or discretion which will affect the interests of that other person in a legal or practical sense. The relationship between the parties is therefore one which gives the fiduciary a special opportunity to exercise the power *386 or discretion to the detriment of that other person who is accordingly vulnerable to abuse by the fiduciary of his position.

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In its broadest sense, this statement can be taken to mean that the presence of a discretion when acting for another identifies a fiduciary. This discretion exists because someone has trusted the fiduciary to exercise it. The mischief is that the discretion and therefore the trust [FN94] will be abused. This view may be re-stated in a stronger form to mean that the presence of a discretion in one person and reliance on its proper exercise by another person whose interests could be affected by the exercised of such discretion imposes a fiduciary obligation on the former. As one writer points out, discretion alone is not the significant fact; trust which leads to the trusted party gaining access to assets will attract the fiduciary obligation. [FN95] The presence of discretion is merely an indication in a particular case that such trust exists. It is the potential for the abuse of that trust which requires the obligation. Similar reasoning could be used in relation to secured creditors. Thus secured creditors have claims against either all of the company's assets or specific assets depending on the nature of the charge created in their favour. Directors have a discretion in that they have access to these assets. Having been placed in a position of trust in relation to those assets, it is the potential for abuse of this trust which creates the fiduciary obligation. [FN96] This fiduciary concept helps to define the factors directors should consider in making decisions for the corporation. [FN97] And when the object of directors' duties is the enterprise itself, it allows consideration of all factors which have a bearing on long term benefit. [FN98] (ii) Circumstances in Which the Duty Arises. Directors are under a general law duty to exercise their powers for the purposes for which they were conferred [FN99] and bona fide for the benefit of the company as a whole. [FN1] A central tenet of company law has been that directors owe duties to the company alone and not the company's shareholders or to its creditors. As was stated more than a quarter of a century ago by the Jenkins Committee in England when commenting on the effect of Percival v. Wright, [FN2] ""no fiduciary duty is owed by a director to individual members of his company, but only to the company itself, and a fortiori that none is owed to a person who is not a member." [FN3] Courts have struggled to move *387 from this and in this attempt have used the concept of the ""interests of a company" as the means through which to extend duties to shareholders and creditors. [FN4] This has been achieved in a roundabout way. There was first, the finding that the interests of the company could in certain circumstances include the interests of shareholders and creditors. This was followed by the reasoning that the two groups, were therefore entitled to the network of fiduciary protection. The view that duties to creditors are, or should be, dependent upon the company's insolvency (however defined) appears now to be well under siege. For example in Walker v. Wimborne, [FN5] Mason J. appeared to accept the existence of a continuing obligation on directors to consider the interests of creditors irrespective of the financial health of the company. He noted that creditors could only look to the company for payment and would, therefore, always be threatened by the possibility of future insolvency. Similarly, in Lonrho, [FN6] Lord Diplock's suggestion that the company's interest might include those of its creditors seemed to demand no special circumstances such as insolvency as a prerequisite to the existence of the duty. Again, in Winkworth, [FN7] Lord Templeman appeared to envisage a duty existing independently of questions of solvency. The most recent decision in this regard is that of the Full Court of the Supreme Court of Western Australia in Jeffree v. National Companies and Securities Commission. [FN8] In the case, Jeffree was a director of Warrup Pty Ltd. (referred to, post, as Warrup), while Warrup was the trustee of a family trust and the proprietor of a swimming pool business. A dispute arose between Warrup and a customer, Leighton Contractors Pty Ltd. and arbitration proceedings resulted. Fearing an adverse award which Warrup could not afford, Jeffree sold Warrup's assets for full value and transferred its business name to another company. Jeffree also became a director of the other company. Leighton obtained judgment but because of Warrup's state, liquidation proceedings were not justified. The National Companies and Securities Commission laid a complaint against Jeffree that in carrying out the exercise to defeat the arbitration claim being

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sought by Leighton, he was in breach of section 229(4) Companies (WA) Code (cf. section 232(4) of the Corporations Law (Aus.)). Jeffree was convicted at first instance. An appeal proved unsuccessful. The Full Court endorsed the comments of Lord Templeman in Winkworth to the effect that directors owe a duty to the company's creditors, present and future, that assets are not dissipated or exploited to their prejudice. With the onset of insolvency, [FN9] the interests of the company become the interest of the creditors alone and accordingly, only their interests must be borne in mind and pursued by the directors. Their status at this stage means that shareholders and directors are no *388 longer able to deal with the company's assets. [FN10] The directors are obliged to manage the assets through the company with creditors' interests in mind until the situation is finally resolved, for example through a winding up or a return to solvency. (iii) Statutory Intervention: The United Kingdom Position. In England, the Cork Committee proposed that directors should be made liable for the debts of a company where the company incurs ""liabilities with no reasonable prospect of meeting them." [FN11] It was hoped that the effect of such a reform would be that ""if the directors at any time consider the company to be insolvent, they [would] ... take immediate steps for the company to be placed in receivership, administration or liquidation." [FN12] The recommendations of the Committee were given effect to in what is now section 214 of the Insolvency Act 1986 (United Kingdom). This section has recently been applied by Knox J. in Re Produce Marketing Consortium Ltd. (No. 2), [FN13] the first decision to subject section 214 to a detailed analysis. Section 214 empowers the court to order a director [FN14] or shadow director [FN15] to contribute to the assets of a company where the company has gone into ""insolvent liquidation" and at some time before the winding up the director ""knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation." [FN16] For the purposes of the operation of the section a company goes into insolvent liquidation at a time when the company's assets are insufficient to pay its debts and other liabilities. [FN17] Critics, [FN18] however, have pointed out that the requirement of ""insolvent liquidation" and the narrow meaning of ""insolvency" limit the area of application of the statutory duty, and overlooks the fact that a company's financial position may fluctuate so that technically it moves in and out of insolvency, and that directors' decisions are taken with reference to the company as an ongoing business concern and should be judged by that broad standard. In an effort to counter such criticism, section 214(4) adopts a version which has been known for some years in United States law as the ""business judgment rule." [FN19] In applying *389 section 214(4) the court will consider the ""particular company and its business," [FN20] and of management decisions taken in this context. Section 214(1) empowers the court to declare anyone held liable under the section to make ""such contribution (if any) to the company's assets as it thinks proper." The way in which the court is required to exercise its jurisdiction under the section is to treat the extent of liability as one based on causation, that is, determine to what extent the conduct of the director has caused loss to the company's creditors. [FN21] For example, in Re Produce Marketing specific factors considered relevant by Knox J. in determining the amount the directors should contribute were [FN22]: a) The directors had ignored the warning given by the auditors of the dangers of continuing to trade; b) the fact any contribution would go in the first place to satisfy the claims of the bank as a secured creditor thereby correspondingly reducing the liability of the director on his guarantee to the bank; and c) because the bank as a secured creditor would be the first to benefit from any contribution, the court should exercise its jurisdiction ""in a way which will benefit unsecured creditors." [FN23] *390 (iv) Statutory Intervention: The Australian Position. The Senate Standing Committee on Legal and Constitutional Affairs has reported on the subject of company directors' duties. [FN24] The Report contains 24 recommendations many of which relate to matters of detail on the development of a more cogent system

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for reviewing the financial affairs of companies. Its first recommendation was that an objective duty of care for directors should be recommended that the business judgment rule be introduced into Australian company law. This would require company directors to inform themselves of matters relevant to the administration of the company. They would be required to exercise an active discretion in relation to the relevant matter, to attend all board meetings unless there is a reasonable excuse for non-attendance; further, there would be a limit on the extent to which company directors would in future be able to rely on others. The Report recommended that the legislation be amended to set out requirements which must be met where directors seek exoneration for breaches of their fiduciary duties. The recommendation represents the Committee's response to a trend of decisions culminating in Metal Manufacturers Ltd. v. Lewis. [FN25] In that case a director was held not to be liable under section 556 of the Code [Corporations Law 1989 s.592] because she had not given express or implied authority to the managing director. However, the Committee made no specific recommendations to deal with the decision in Jeffree. [FN26] Recognising that there are problems thrown up by the question of whether directors owe duties to creditors the Committee simply noted that the existing framework of company law does not allow creditors to seek a direct remedy against directors, creditors being only able to look to directors personally where the company is unable to pay. The only recommendation that the Committee made in relation to this problem was that the legislation should provide for creditors to share equally in the sums recovered from directors--this in line with the recommendation made by the Australian Law Reform Commission in its Report. [FN27] Under the current law individual creditors can sue under section 556 where a company incurs debts when it is unable to pay them and the sums recovered are kept by the creditor and not shared by all creditors of the company. Under the proposed change, sharing between creditors is to be achieved in large part by limiting the action under section 556 to the liquidator unless leave of the court was obtained for a creditor to sue. *391 (v) To Whom is the Duty Owed. There is a clear distinction between saying that a director owes a fiduciary duty to a creditor, and stating that a director has a duty to consider the interests of creditors. [FN28] The former statement not only imposes a duty upon the directors but more importantly, implies that the creditor can enforce that duty himself. In the latter case, the directors are bound to consider the interest of creditors, but that duty is still owed to the company and is accordingly enforceable by the company alone. This is the essence of the rule in Foss v. Harbottle. [FN29] Commonwealth cases on the whole articulate this view. The dicta of Lord Templeman in Winkworth goes against this grain. His Lordship seems to clearly indicate that the duty to consider the interests of creditors is owed not only to the company but also to the creditors themselves. [FN30] As noted previously, this approach was followed by the Full Court of the Supreme Court of Western Australia in Jeffree's case. It is disappointing that the Senate Committee did not choose to address this matter. The suggestion that not only a duty be owed to creditors but that it also be enforceable by them breaks tradition with company law, distinguishing also, such duty from the obligations imposed by insolvency law. [FN31] The economic case for derivative suits by creditors is compelling in that such action or the threat of such action may deter managerial misconduct in relation to bondholders thereby reducing agency costs and the cost of the firm's debt capital. [FN32] Furthermore, it would render the duty more effective and direct the proceeds of successful action to the particular creditor. [FN33] In a recent discussion of the New South Wales Supreme Court, Young J. has observed that it is not ""unarguably clear that a shareholder himself has no personal cause of action in respect of a breach of duty by a director." [FN34] While practical problems might be encountered if each creditor was able to sue for his own loss, [FN35] it may be but a short step from such reasoning to hold that creditors have individual rights of action. [FN36] (3) A duty of care in Tort?

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It has been suggested that the imposition of a duty of care in negligence would overcome problems of locus standii for a creditor before winding up. [FN37] There is *392 judicial authority for the view that the source of a director's duty towards creditors lies in tort. [FN38] But there are many snags. [FN39] It is not the director's primary role to take care but to take risks. For this reason, a duty of care and the liberty to embrace risk may be incompatible bedfellows. Moreover, it has been affirmed that directors have no liability to shareholders for the negligent, or even the dishonest, dissipation of corporation assets which indirectly causes loss. [FN40] The relationship between directors and creditors is comparable, but seemingly less ""proximate" by any standard. [FN41] There are also policy arguments against developing duties which could favour some categories of creditors at the expense of others. [FN42] Conclusion As this paper argues, the claim for the extension of directors duties to debenture holders is based on the argument that trust deed covenants are often ineffective, and where effective are economically inefficient to prevent wealth transfers from debenture holders to shareholders. In economic terms, shareholders and debenture holders are all security holders with differing claims on the assets and cash flow of an enterprise. The investor who buys shares and the investor who lends money are, as a matter of economics, engaged in the same kind of activity and are motivated by the same basic objectives. [FN43] Both are making a capital investment and both expect to get their money back plus a return on their investment. Some investors may hold both shares and debentures. The director's duty to act in good faith, it can be argued, imposes on directors the duty to prevent shareholders from being enriched at the expense of debtholders, that is, prevent unjust enrichment. [FN44] Based on somewhat analogous reasoning, economists would argue that directors be required to make Pareto superior moves and to refrain from making Pareto inferior moves. A move is Pareto superior if at least one person is made better off and no one is made worse off. Conversely, a move is Pareto inferior if one or more persons are made better off, but at least one person is made worse off. Only a Pareto superior move is efficient. A state of Pareto optimality is reached where no one can be made better off without another being made worse off. [FN45] As pointed out earlier, the value of a firm equals the value of its debt plus the *393 value of its equity. [FN46] Firm value and shareholder wealth are identical only when the firm has no bonds outstanding. A duty to maximise shareholder wealth creates perverse incentives because it invites managers to maximise shareholder wealth in whole or in part at debt holder expense. Such a duty is inconsistent with fiduciary debts to debenture holders. For this reason, directors should be required to maximise the value of the firm. In short, the duty of corporate managers should be to make the pie larger, not make one investor's slice larger at the expense of another investor. Prima facie evidence of a breach of this duty is a decision that causes share prices to rise and debenture prices to fall. [FN47] Maximising shareholder wealth can be equated with maximising firm value if debentures are perfectly protected in the sense that management is prohibited from making any operating, financial or investment decision that would decrease the market value of the debentures unless debenture holders are exactly compensated for their losses. If debentures are perfectly protected and debenture values insulated from adverse management decisions, management has no other choice but to maximise firm value. In addition, when there is an increase in firm value, debentures are perfectly protected if management is prohibited from making any decision that would prevent a full increase in the market value of the debentures. [FN48] Resort may also be had to the option pricing model [FN49] of modern finance theory to support fiduciary duties to debentureholders. Under the option pricing model, debenture holders and shareholders are correspondingly first and residual equitable owners, of the corporation's assets. The underlying reasoning is

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that because directors and officers owe fiduciary duties to the equitable owners of the corporation's assets, and since debenture holders and shareholders are such equitable owners, directors and officers owe fiduciary duties to both sets of investors. [FN50] So far as agency theory is concerned, managers are more likely to choose policies that reduce the agency costs of debt and equity if managers have fiduciary duties to act in the best interests of debenture holders and shareholders. Fiduciary duties are a fundamental mechanism for reducing agency costs and increasing the value of all the securities of the firm. Again, since debenture holders are not always compensated ex ante for expropriation loss, the fiduciary duties of corporate law provide a mechanism for compensating debenture holders ex post. Furthermore, fiduciary duties to debenture holders can dramatically reduce the average agency costs of debt for all corporations and sharply reduce the systematic risk of expropriation loss which in turn will lower average borrowing costs *394 for all corporate borrowers. [FN51] Fiduciary duties, therefore, provide a nearly perfect debenture contract that reduces the agency costs of debt almost to zero as they have the potential to eliminate contracting costs, opportunity loss [FN52] and expropriation loss. Thus, debenture holders would no longer need complicated covenants for protection. Managers no longer would need to forego valuable opportunities to maximise firm value. Debenture holders would no longer suffer expropriation loss because they would be compensated for such loss ex post. To summarise, debenture holders have suffered losses because the existing system of debt covenants and ex ante price adjustments has failed to protect them against expropriation. Fiduciary duties to debenture holders are an alternative or supplemental arrangement that provides for an ex post settling up. Common law fiduciary duties are a substitute for costly contracts and are more likely to prevent expropriation loss and to achieve Pareto efficiency at lower cost than existing arrangements. Moreover, fiduciary duties should run to debenture holders and shareholders alike because from an economic perspective, there is no fundamental difference between debt and equity claims. Recognition of obligations to creditors long before a company is insolvent in such United Kingdom and Australian cases as Winkworth, Walker v. Wimborne, and Jeffree go some distance toward recognising the issues raised in this paper. Reluctance in some quarters to so do, is reminiscent of the reluctance displayed by earlier judges to recognise directors as owing obligations to shareholders separate from the company. [FN53] Recognition and acceptance of the new learning that shareholders while in a technical legalistic sense are ""owners" of the enterprise are in reality mere investors along with those acquiring other types of interest in the enterprise (or alternatively shareholders as owners in a traditional sense but stakeholders in a broader sense), will go towards advancing creditor interests. The three cases noted above are trail blazers and it may well be that the economic climate of the 1990s will help nurture and place their claims at par with traditional shareholders in the modern corporate enterprise. There exist certain conceptual barriers in reaching this end. The main barrier is that legal literature treats shareholders as owners of the corporation and creditors as claimants under a contract. This is despite the fact that the corporation is a separate legal entity in its own rights with it alone being responsible for its assets and liabilities. This approach may have some relevance in a technical narrow sense to Private or Close companies where ownership is limited to a few individuals, but would seem irrelevant in relation to the widely held Public company. Shareholders of such large companies, like its creditors, invest not with any sense of commitment but with a view to changing their investment whenever it appears appropriate. To make such a statement is not to relegate the interests of creditors in Private companies to a lesser role, but rather, to emphasise the irrelevance of the strict *395 creditor-owner dichotomy in relation to the large public corporation. The claim that shareholders are owners, arises from the fact that shareholders supposedly appoint the Board of directors to run the corporation, vote on matters relating to the corporation that do not fall within the exclusive prerogative of the Board of Directors, and are entitled to dividends when de-

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clared by the corporation upon the recommendation of the Board of Directors. Additionally, shareholders are entitled to whatever is left after all outstanding debts have been paid upon the winding up of the corporation. Creditors on the other hand, are treated precisely as such; their rights (with respect to repayment of the loan and interest thereon) being limited to the terms of the borrowing/lending transaction. As against this accepted view, the argument may be made that shareholders, like creditors, are mere investors in the company with rights based on contract, the two groups having different rights. This is so because the effect of the Corporation's Memorandum under which the shares are issued, creates a contractual relationships between the corporation and shareholders and between shareholders themselves with a shareholder required to pay only the amount as yet unpaid on shares subscribed for. It may, in this context, be argued that shareholders have subordinated their claims against the corporation to creditors in return for greater rewards if the corporate venture proves successful. Likewise, it could be maintained that creditors have contracted for smaller reward in return for priority of interest as against shareholders. But this should not result in one group being regarded as the owner and the other not. Again, the fact that one group has the right to vote and appoint directors and the other not, can be remedied by the latter being given the same right. For this latter purpose the entitlement of the creditor could be made to depend on the proportion of share capital that would have been acquired at the time the debt contract was entered into. Moreover, debenture trust deeds do provide for the appointment of a director/representative to represent the interests of the debenture holder especially where the borrower has exceeded certain borrowing ratios and/or is seeking additional funds. Finally, the cornerstone of the creditor verses owner dichotomy has been shaken by the gradual erosion of the capital maintenance provisions under the companies legislation. There was first the holding that dividends (both cash and share) could be paid out of asset revaluation reserves without the need to make good in future times of any decline in value of the revalued asset, dividends out of present profits even in the face of past accumulated losses, followed by court authorised reductions of paid up capital, and share buy backs. The latter, in particular, removes any special claim that shareholders may have had against creditors as to ownership of the corporation. Debenture holders may be wedded to a corporate borrower for as much as 30 years at a time. This is so even under a debt-defeasance arrangement for the corporate debtor still remains the source liable. There are several other reasons as to why the conventional classification of shareholders as owners of the company and creditors as mere lenders of money for fixed returns is no longer appropriate to the large modern enterprise. First, most enterprises offer securities that are tailor-made to the investor and which are often of a hybrid nature. Convertible notes and redeemable preference *396 shares are good examples. Secondly, dividends are no longer received as a return in fulfilment of ownership but as a return on an investment, the investment itself being monitored and changed continuously. Thirdly, voting rights that follow from shareholdings are no longer exercised for their own sake with a view to running the affairs of the Company but with a view to enjoying the benefits of ""greenmailing" and the premium attached to ""control." Fourthly, where control of a corporation is obtained, the eventual goal may be liquidation of the acquired corporation. Fifthly, the investment decision itself is highly tax motivated. Thus almost all substantial share acquisitions are negatively geared (out of borrowed funds) bringing together the advantages of ownership of the share, dividend income, and deductible interest expense on the borrowing to acquire the shares. Finally, with debt securitisation, creditors' rights have become as freely transferable as shareholders' rights and with the advent of Modern Finance theory and resort to such standards aids as Portfolio theory, Capital Asset Pricing, Arbitrage pricing, and Option Pricing strategies, both shareholders and creditors have assumed the role of investors in the Modern Corporation. For these reasons, and others, it is time that the traditional distinction between shareholders as owners and debentureholders as creditors, was cast aside and both groups be treated as contractual claimants with different rights. The legal position, at present, is lagging far behind

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economic realities and the marketplace. While debenture holders are entitled to the same degree of protection as are shareholders when their capital is initially sought by the corporation through disclosure by way of the prospectus provisions, their capital once obtained, debenture holders are left to the mercy of corporate management and to manipulation by shareholders. Fairness requires that debenture holders, like shareholders, be extended the same level of obligations on a continuing basis. A final point should be noted. This is that management in its dealing with shareholders and creditors, has a natural empathy for the interests of shareholders. This is so for several reasons. First, management (at director and related levels) depend on the general shareholder body for their initial appointment and for their continued well being. Secondly, management is dependent for ratification of actions taken in excess of their authority on the shareholder body. Share allotments, in certain circumstances, are a good example. Thirdly, at the individual level, it is more common for management to hold equity in the entity rather than to have loaned moneys to it. Often, receipt of an equity stake in the company is the considered reward for services to the entity. For these, and other reasons, it is to be expected that management view shareholders in a way different to how it views debtholders. In other words, except in unusual circumstances such as a takeover bid when the interests of incumbent management come under direct threat, or there is available the opportunity for management to make secret profits, the interests of management and shareholders are not at variance. In this natural alliance between management and shareholders, creditor interests are viewed as being of an ""outside" nature. Given this factor the best form of achieving the contemplated level of creditor protection is through a general statutory provision requiring directors to be evenhanded to both shareholder and creditor interests with respect to the corporation's financing, investment and dividend decisions. However, recognition *397 of such an entitlement without a corresponding right of enforcement is of no use. It is necessary, therefore, to also recognise a right of enforcement through an appropriate application to court. Such an approach would also eliminate the ""prisoner's dilemma" [FN54] problem now present in relationships between equity-holders and debtholders. Both parties would then recognise the obligation of corporate management as being to enlarge the size of the pie rather than engage in unevenly dividing an already existing pie. Unless the need for such an evenhanded approach as between shareholders and creditors is recognised, creditors would see their interest as subject to the risk of being downgraded by management action. Consequently creditors would opt for higher interest rates, tighter security over the assets of the borrower and/or more restrictive debenture trust deed covenants. Whatever way the latter restrictions are viewed, they end up increasing the costs of credit either in terms of direct interest payments or lost opportunities. FN1. [1986] 4 N.S.W.L.R. 722, 730. FN2. [1988] B.C.L.C. 250, 252-53. FN3. [1987] 1 All E.R. 114. FN4. (1976) 137 C.L.R. 1. FN5. (1989) 7 A.C.L.C. 556. FN6. Supra. n. 3, 118. FN7. Insolvency Act 1986 (United Kingdom) s.328; Bankruptcy Act 1966 (Aus.) s.109. FN8. Companies Act 1985 (United Kingdom) s.614; Corporations Law 1989 (Aus.) s.556.

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FN9. C. W. Smith and J. B. Warner, ""On Financial Contracting--An Analysis of Bond Covenants" 7 Journal of Financial Economics 117, 119, (1979). FN10. M. W. McDaniel, ""Bondholders and Corporate Governance" (1986) 41 Business Lawyer, 413, 419 cited hereinafter as Corporate Governance. See also R. A. Brealey and S. C. Myers, Principles of Corporate Finance, 528 (McGraw Hill Book Co., 3rd ed. 1988). FN11. M. W. McDaniel, ""Bondholders and Stockholders," (1988) The Journal of Corporation Law 205 cited hereinafter as Bondholders, illustrates Stockholder gains at the expense of Bondholders as follows (at 229): ""For any firm, let A = Assets, B = Bonds, and C = Common Stock, where all values are at market. In that case, A = B + C. If A remains constant, any decrease in B produces a corresponding increase in C. This is called a zero sum game. If A increases and B decreases, C will increase, but part of the increase in C comes from the decrease in B. This is called a positive sum game. If A decreases while C increases, B will decrease. This is called a negative sum game. Since stockholders control the firm, they can play these games at bondholder expense. All the games have the same object--to make the bonds more risky, which will reduce their value." FN12. A finance lease, unlike an operating lease, is a lease which effectively transfers from the lessor to the lessee substantially all the risks and benefits incident to ownership of the leased property. Finance leases must now be capitalised and accounted for: See Australian Accounting Standards 17, Accounting for Leases. See also sections 297-298 of the Corporations Law which requires company accounts to conform with approved accounting standards. The same does not apply to leases ""tailored" as operating leases or to other forms of off-balance sheet financing like the establishment of highly leveraged corporate joint ventures. The characteristics of sale and lease-back agreements indicate that it is appropriate to classify them as finance leases: G. Pierson, R. Bird and R. Brown, Business Finance (4th ed., 1985), p. 513-514. FN13. D. Emanuel, ""Protecting the Debentureholder" (March, 1976) Business Law Review, 13-31, hereinafter cited as Emanuel. FN14. See R. W. Masulis, ""The Impact (1983) of Capital Structure Change on Firm Value: Some Estimates" (1983) 38 Journal of Finance, 107, 127; and ""The Effects of Capital Structure Change on Security Prices: A Study of Exchange Offers" (1980) 8 Journal of Financial economics 139, 143-144, 175. FN15. Leveraged buyouts (LBOs) are launched by management. The acquirers ""take out" shareholders with the proceeds of new borrowing. The target does not receive proceeds of this borrowing, even though its assets are pledged to secure the debt. A LBO does not occur because promoters decide to improve a corporation for the benefit of pre-existing investors; it occurs because it offers sure profits for the equity taken out and a chance for extravagant, but high-risk profits for the promoters and managers who take control and for financiers who help them. Pre-existing creditors share this risk, but get not compensation in the form of a higher interest rate or an option to exit at face value: See W. W. Bratton, ""Corporate Debt Relationships: Legal Theory in a Time of Restructuring" (1989), Duke Law Journal, 92, 151, hereinafter cited as ""Debt Relationships." FN16. In a spin-off, a parent company distributes shares of a subsidiary pro rata to shareholders of the parent as a dividend in kind. The spin-off itself does not change the proportional interest in the parent and the subsidiary, but it does permit the shares of parent and subsidiary to be traded separ-

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ately. Empirical studies show that spin-offs create shareholder wealth and that the larger the spinoff relative to the parent, the greater the relative increase in shareholder wealth. But even if debenture holder losses in any one spin-off are not sizeable, a serious policy question remains, viz., should shareholders ever be allowed to transfer wealth from debentureholders to themselves? See generally McDaniel, ""Corporate Governance" 421. See also K. Craft Denning, ""Spinoffs and Sales of Assets: An Examination of Security, Returns and Divestment Motivations" (1988) 19 Accounting and Business Research 32. FN17. R. Brealey and S. Myers, Principles of Corporate Finance (3rd ed., 1988), pp. 368-87. FN18. M. C. Jensen & W. H. Meckling, ""Theory of the Firm: Managerial Behaviour, Agency Cost and Ownership Structure" (1976) 37 Journal of Financial Economics 305; E. Fama, ""Agency Problems and the Theory of the Firm" (1980) 88 Journal of Political Economy 288, and M. C. Jensen and C. W. Smith Jr., Stockholder, Manager, and Creditor Interests: Applications of Agency Theory in Recent Advances in Corporate Finance, E. I. Altman and M. G. Subrahmanyam (eds.), (Richard D. Irwin, 1985), p. 93. FN19. There are five factors which influence the price of debt securities under this application of the options pricing model. (1) The Market Price of The Firm: As the market price increases, the value of debt increases. There is a greater chance of debt holders being repaid because of the increase in the value of the firm's asset backing. The actions of management play an important part here. Managerial theft reduces firm value and reduces equity which increases the ratio of debt-to-equity and increases the risk of default. This in turn decreases bond values and produces capital losses: McDaniel, Bondholders, 235. Managerial diligence has the opposite effect. (2) The Exercise Price of the Option: The exercise price can be likened to the face value of the debt. The larger the amount to be repaid, the greater the market value of the debt. (3) The Variance of the Returns on the Assets of the Firm: The value of a call option increases with the volatility in the potential value of the asset subject to the option. Although greater volatility increases shareholders' potential gain or loss relative to the exercise price, the gain is unlimited while the loss cannot exceed the price paid for the option. This is because shareholders have limited liability. Once bonds are issued, shareholders can make their call option more valuable by making the firm more risky. Debentures with a higher risk of default have greater default premiums: See McDaniel, Corporate Governance p. 421. (4) The option's time to expiration (Time to Maturity of the Debt): As this decreases, the value of debt increases. This is because there is less time to return volatile earnings and also because the present value of the debt payments is higher. If management extended the time for repayment, the price of debt would decrease. (5) Risk Free Rate: If the risk free rate on any government bonds with equivalent terms increases, the price of debt will decrease. The government bonds would be providing an attractive return for practically no risk. Obviously the management of an individual firm cannot influence the risk free rate. See generally F. Black and M. Scholes, ""The Pricing of Options and Corporate Liabilities" (1973) 81 Journal of Political Economy 637. See also G. R. Courtadon and J. J. Marrick Jr., The Option Pricing Model and the Valuation of Corporate Securities, in The Revolution in Corporate Finance, J. M. Stern and D. H. Chew Jr. (eds.) (Basil Blackwell, 1986), p. 197, cited hereinafter as Courtadon; and S. P. Mason and R. C. Merton, The Role of Contingent Claims Analysis in Corporate Finance in Recent Advances in Corporate Finance, E. I. Altman and M. G. Subrahmanyam (eds.) (Richard D. Irwin 1985), p. 7, cited hereinafter as Mason.

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FN20. See Mason at 11. The notion of ""contingent claims" is illustrated as follows (at 10-11): Recently, with IBM stock trading at $118 per share on the New York Stock Exchange (NYSE), the CBOE was trading both calls and puts written on 100 shares of IBM stock with an exercise price of $120 per share and maturity of eight months. The calls were trading for $1150 and the puts for $750. These options have value because they are ""right," not obligations, to transact in the IBM stock. The owner of the IBM call options will exercise his right to purchase IBM stock in eight months only if the price then exceeds $120. The IBM put options owner will exercise his right to sell IBM stock in eight months only if the price is then below $120. The value of the options is contingent upon the value of IBM stock, i.e., the options are contingent claims. FN21. L. A. Daley and R. L. Vigeland, ""The Effects of Debt Covenants and Political Costs on the Choice of Accounting Methods" (1983) 5 Journal of Accounting and Economics 195; R. M. Bowen, E. W. Noreen and J. M. Lacey, ""Determinants of the Corporate Decision to Capitalise Interest" (1981) 3 Journal of Accounting and Economics 151; G. Whittred, ""The Derived Demand for Consolidated Financial Reporting" (1987) 9 Journal of Accounting and Economics 259, 264. FN22. Brealey and Myers, supra n. 17, 398. FN23. McDaniel, Corporate Governance, 418. FN24. R. Sappideen, ""Securities Markets Efficiency Reconsidered" (1988) University of Tasmania Law Review, 132. FN25. McDaniel, ""Bondholders," supra, n. 11, 240. FN26. Following E. F. Fama, ""Efficient Capital Markets: A Review of Theory and Empirical Work" (1970) Journal of Finance 383, three forms of the hypothesis have been recognised, viz., weak, semi strong and strong. The weak form holds that past security prices are of no value in predicting future prices since current security prices fully reflect all the information upheld by the historical sequence of prices and returns on investments. The semi strong version holds that since securities prices fully reflect all generally available public information, investors cannot profit from acting on such information. For example, once a piece of information is in The Wall Street Journal, it is too late to use it to earn superior returns. See J. M. Murphy, ""Efficient Markets, Index Funds: Illusion and Reality" (1977) The Journal of Portfolio Management 6. The strong form holds that even investors with non-public information cannot earn superior investments results. Non-public information includes insider information and proprietary conclusions developed from public data by professional investment managers. Implications of the hypothesis in total are: (1) Resort to Technical Analysis is worthless since securities prices reflect more than the information available in past prices (i.e. market prices reflect all publicly available information); and (2) resort to Fundamental Analysis is of no help either since prices reflect information in excess of what is publicly available (i.e. reflect insider and proprietary information). Market price alone is appropriate, the argument goes. See generally Sappideen, ""Securities Market Efficiency Reconsidered" supra, n. 24, 135. Evidence of semi-strong form efficiency is not conclusive: G. Pierson, R. Bird and R. Brown, supra, n. 12, 443-67. FN27. McDaniel, ""Bondholders," 245. FN28. As McDaniel, ""Corporate Governance" supra, n. 21 points out (at 436): To the extent that the ex ante adjustment process works, it raises the cost of borrowed money for all companies, which

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slows investment at the margins and hurts the economy. To the extent that the process does not work in general, diversified debentureholders will have systematic losses because systematic risk-including wealth transfers--cannot be diversified away. To the extent that the process does not work for particular debenture issues, undiversified debentureholders will have losses. All these effects represent undesirable social costs. FN29. Brealey and Myers, n. 17, 399. FN30. McDaniel, ""Bondholders," 238. FN31. See Sappideen, ""Motivations of Offeror Company Directors in Corporate Acquisitions" (1987) University of Pennsylvania Journal of International Business Law, 67. FN32. McDaniel, ""Corporate Governance," 439-41. FN33. K. E. Lindgren, J. W. Carter and D. J. Harland, Contract Law in Australia (1986), p. 295. FN34. In the United Kingdom Companies Act 1985, s.192 (1) declares void any provision contained in a trust deed or in any contract which seeks to exempt from liability, or indemnifies against liability, for breach of trust where the trustee has failed to show the degree of care and diligence required of a trustee. In Australia Corporations Law, s.1056 (1) imposes numerous duties in this regard. FN35. See the definition in Companies Act 1985, s.744 (United Kingdom), and in Corporations Law 1989, s.9 (Aus.). FN36. See generally Palmer's Company Law, C. Schmitthoff (ed.) 24th ed. 1987, at p. 727, and Corporations Law 1989, s. 1052(1) (Aus.). FN37. Admission of Securities to Listing, section 9, Chapter 2 (United Kingdom); Stock Exchange Limited Listing Rules, Section 2A(7) (Aus.). FN38. J. K. Armitage, ""The Debenture Trust Deed," in The Law of Public Finance (Law Book Co., 1986) 261, hereinafter cited as Armitage. FN39. Ibid. 267. FN40. Emanuel, supra, n. 13, 13. Note that the covenants required by s.154(1) ""to the effect" stated in paras (c), (d), (e), if not expressly contained in the trust deed, are deemed to be contained in it. Note also that securities legislation like this does not generally result in wealth transfers from shareholders to debentureholders: C. W. Chow, ""The Impacts of Accounting Regulation on Bondholder and Shareholder Wealth: The Case of the Securities Acts" (July, 1983) LVIII The Accounting Review, 485. FN41. Armitage, 268-69. FN42. Covenants restricting sale-leaseback arrangements invariably appear with negative pledge clauses. McDaniel, ""Corporate Governance." FN43. Re Connolly Bros. Ltd (No. 2) [1912] 2 Ch. 25 confirmed by Privy Council in Security Trust

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Co. v. The Royal Bank of Canada [1976] A.C. 503. FN44. Armitage, 275. FN45. The general form of the covenant is stated in Armitage, 272. FN46. Emanuel, supra, n. 13, 38. FN47. Ibid. 39. Armitage, supra. n. 36, 272-73, proposes that, particularly because of the requirements' retrospective nature, there should be no prohibition in the trust deed or making the proposed issue of debentures, but the borrowing company might need to provide the additional information that could persuade prospective investors that the debentures being offered were nevertheless an attractive investment. FN48. Emanuel, supra, n. 13, 39. FN49. Ibid. FN50. Armitage, supra, n. 38, 299. FN51. Ibid. FN52. See generally, W. W. Bratton, ""The Economics and Jurisprudence of Convertible Bonds" (1984) Wisconsin Law Review 667, hereinafter referred to as ""Convertible Bonds." FN53. Sappideen, ""Securities Markets Efficiency Reconsidered," supra, n. 24. FN54. See McDaniel, ""Corporate Governance." McDaniel, in ""Bondholders," cites empirical evidence to rebut the claim that restrictive covenants cover most contingencies and provide substantial protection to debentureholders. Whilst virtually all of the american companies surveyed had negative pledge covenants, restrictions on dividends, asset sales and unsecured debt were seldom seen. Even if adopted, a good lawyer may be able to get around them. At 236-37. FN55. See Smith and Warner, supra, n. 9, at 134. FN56. G. Whitred and I. Zimmer, Financial Accounting, Holt, Rinehart and Winston, 1987 at 32. The authors go on to state (at 32-33): ""For example, debentures typically restrict secured liabilities to 40%, total liabilities to 60%, of total tangible assets. Unsecured notes tend to restrict secured liabilities to 60% of total tangible assets, total liabilities to between 80% and 85%. Consistent with the dual debt/equity nature of junior debt, the allowable percentages for secured and total liabilities for convertible notes tended to lie between those for debentures and unsecured notes, 40-50% and 70-75% respectively. Industry variation in the limits is also predictable. For example, the allowable percentages for industrial companies are at the lower end of the spectrum while those for finance companies lie at the upper end. The limits for property developers/builders tend to lie in between. Restrictions on prior charges (liabilities ranking ahead of those secured under the deed) exist in the majority of debenture deeds. Such charges are typically restricted to 10% of total tangible assets. As with the constraints on total and secured liabilities, this is a continuing restriction. About one-third of debenture deeds also contain an interest coverage constraint--with coverage typically defined as a factor of 3. This constraint applies only at the time a debt issue is proposed and violation implies the proposed issue cannot

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proceed. These two restrictions do not usually appear in unsecured note or convertible note deeds." FN57. See generally, American Bar Foundation: Corporate Debt Financing Project (1971), 402-17. FN58. Bratton, ""Convertible Bonds," p. 692. FN59. Ibid. FN60. Contra, Bratton, ""Convertible Bonds," at pp. 708-17, who lists the following reasons as favouring the classical approach: (a) The unsophisticated investor occupies a somewhat incidental place in the overall investment picture; (b) To impose a rule favouring debentureholders risks wealth transfers to all members of the debentureholder group at the expense of shareholders; (c) The risk of judicial meddling to restrain self-interested issuer conduct not explicitly prohibited by the trust deed might cause the issuer to refrain from taking steps which increase the overall value of the firm. However, Bratton says that charity counsels selection of the neo-classical approaches. Uninformed debentureholders are the least well situated to accomplish self protection. As a general rule, where a contract is construed, the court will apply a presumption that the parties did not intend its terms to operate unreasonably. This principle encourages protection of uninformed investors. FN61. D. Byrne and J. D. Heydon, Cross on Evidence, (3rd Australian ed. 1986, Butterworths), p. 1023. FN62. Bank of New Zealand v. Simpson [1900] A.C. 182, 187 (Privy Council). FN63. Byrne and Heydon, supra, n. 61 at 1024-25. FN64. Prenn v. Simmonds [1971] 3 All. E.R. 237, 239-240 (House of Lords). FN65. (1982) 149 C.L.R. 337, 352. FN66. Prenn v. Simmonds, supra, n. 64; Secured Income Real Estate v. St Martin's Investments (1979) 144 C.L.R. 596. FN67. Supra, n. 65, at 352-53. FN68. F. H. Easterbrook and D. R. Fischel, ""Corporate Control Transactions" (1982) 92 Yale Law Journal 698, 700. FN69. Ibid. FN70. E. F. Fama, ""Agency Problems and the Theory of the Firm" (1980) 88 Journal of Political Economy 288. FN71. Easterbrook and Fischel, supra, n. 68, 702. FN72. J. R. Macey and G. R. Miller ""Good Finance, Bad Economics" An Analysis of the Fraudon-the-Market Theory" (1990) 42 Stanford Law Review 1059, 1068.

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FN73. J. C. Coffee, Jr., ""The Mandatory/Enabling Balance in Corporate Law: An Essay on the Judicial Role" (1989) 89 Columbia Law Review 1618, 1622. FN74. R. A. Posner, Economic Analysis of Law (3rd ed., 1986), pp. 81-85. FN75. McDaniel, ""Bondholders," p. 245. FN76. Ibid. FN77. McDaniel, ""Corporate Governance," p. 416. FN78. B. Manning, A Concise Textbook on Legal Capital (2nd ed., 1981), p. 8. FN79. McDaniel, ""Corporate Governance," p. 417. FN80. See P. D. Finn, Fiduciary Obligations (The New Book Co. Ltd., 1977), pp. 1-5. FN81. R. Flannigan, ""The Fiduciary Obligations" (1989) 9 Oxford Journal of Legal Studies, 285, 286. FN82. Ibid. FN83. J. C. Shepherd, ""Towards a unified concept of fiduciary relationships" (1981) 97 The Law Quarterly Review 51. The discussion in the paragraphs following in this section is based on Shepherd's paper. FN84. E. J. Weinrib, ""The Fiduciary Obligation," University of Toronto Law Journal 1, 9-15. FN85. D. W. M. Waters, ""The Law of Trusts" (Toronto, 1974) at p. 33, cited in Shepherd, supra, n. 83, at 54. FN86. [1941] 1 D.L.R. 178. FN87. At 181-82. FN88. The Fiduciary Principle, 37, California Law Review 539, 540 (1949). FN89. See Shepherd, supra, n. 83 at 65 where he cites the judgment of Bowen L.J. in Boston Deep Sea Fishing and Ice Co. v. Ansell (1888) 39 Ch.D. 339, 367. FN90. Supra., n. 84 at 7. FN91. Supra, n. 83 at 71. FN92. (1984) 156 C.L.R. 41. FN93. At 96-97. FN94. Contra Gibbs C.J. in Hospital Products, supra, n. 92, at 69, according to whom, trust is not necessary for a fiduciary relationship. FN95. R. Flannigan, ""The Fiduciary Obligation" (1989) 19 Oxford Journal of Legal Studies, 285,

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308. FN96. McDaniel, ""Bondholders," pp. 272-73. FN97. R. L. Knauss, ""Corporate Governance--A Moving Target" (1981) 79 Michigan Law Review 478, 496. FN98. Ibid. 497-98. FN99. The test of proper purpose is objective: Whitehouse v. Carlton Hotel Pty Ltd. (1987) 5 A.C.L.C. 421. FN1. The test here is subjective: Howard Smith Ltd. v. Ampol Petrol Ltd. (1974) 48 A.L.J.R. 5. FN2. [1902] 2 Ch. 421; Duties are enforced through the medium of the company in general meeting: Winthrop Investments Ltd. v. Winns Ltd. [1975] 2 N.S.W.L.R. 666, 680. FN3. Cmnd. 1749 (1962), para. 89. FN4. D. D. Prentice, ""Creditor's Interests and Director's Duties" (1990) 10 Oxford Journal of Legal Studies 265, 273. FN5. (1976) 137 C.L.R., 6-7. FN6. Lonrho Ltd. & Anor v. Shell Petroleum Co. Ltd. & Anor (1980) 1 W.L.R. 627, 634. FN7. Winkworth v. Edward Baron Development Co. Ltd. & Ors (1987) 1 All E.R. 114. FN8. Supra, n. 5. FN9. Or perhaps when it is or should have been, clear to the directors that the company was insolvent: Dawson, ""Acting" in the Best Interests of the Company-- For Whom are Directors' Trustees?" (1984) 11 New Zealand Universities Law Review 68, 70-71. FN10. Kinsela's case, supra, n. 1. See case note by J. Hill (1986) 60 Australian Law Journal 525. FN11. Report of the Review Committee on Insolvency Law and Practice (Cmnd. 8558), Chap. 44, para. 1783 (1982). FN12. Ibid. para. 1786. FN13. [1989] B.C.L.C. 520. FN14. Defined in s.214(2)(c). FN15. Defined in s.214(7). This extension entails for example that in many cases, a parent will be liable for the debts of its subsidiary: D. D. Prentice supra, n. 4, 267. FN16. s.214(2)(a) and (2)(b). FN17. s.214(6), i.e. balance sheet insolvency as opposed to liquidity insolvency required in s.460(1) Corporations Law (1989) (Aus.) and defined in s.460(2).

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FN18. L. S. Sealy, ""Directors' "Wider' Responsibilities--Problems Conceptual, Practical and Procedural" (1987) 13 Monash University Law Review 164, 179. FN19. The effect of this rule is that a corporate transaction not involving a conflict of interest will not be subject to judicial inquiry if made in good faith. Courts distinguish between inquiry into the procedure by which the directors reached their decision, and an inquiry into the correctness of the decision. The good faith requirement places a burden on directors to show that they reached the decision and what factors they considered. To demonstrate good faith the directors need show only that the decision was made on a reasonable basis under the circumstances: R. L. Knauss, ""Corporate Governance--A Moving Target" (1981) 79 Michigan Law Review 478, 490-491. FN20. Re Produce Marketing, supra, n. 112, 550. FN21. D. D. Prentice, supra, n. 4, 270. FN22. Supra, n. 13, 554. FN23. An implicit assumption of Knox J.'s judgment is that the charge of the bank in question would attach to the contribution the directors were ordered to make under s.241(1). This is contrary to the principle in Re Yagerphone [1935] Ch. 392, by which a right of action which may arise in the future but which is not connected with any existing right (contingent or otherwise) cannot be caught by a charge at the time it is created. There appears to have been little argument on this and it has been submitted that should the point assumed by Knox J. on the relationship of s.214 contributions and a charge over the company's assets be expressly argued, his decision would not be followed. Note that Australian courts may recognise an exception to it where specific property which has been the subject of a fraudulent preference is recovered and it is covered by the terms of the charge: See Kratzmann Pty Ltd. v. Tucker (1970-71) 123 C.L.R. 295, 301-302. The question must be asked whether there is any need for a common law duty in the light of s.214 of the Solvency Act 1986 (U.K.). Prentice, supra, n. 82, at 276 identifies several ways in which the common law doctrine still has a role to play in England: (a) It prevents a director from proving in the liquidation for any claim he might have against the company. (b) If there is a breach of the common law duty there will be no question of the court exercising its discretion to reduce the amount that the company is entitled to recover. This is because the claim being made by the liquidator is proprietary in nature and the court has no jurisdiction to deprive the company of what it owns. (c) The courts power to grant relief under s.727 of the Companies Act 1985 (compare s.1318 of Corporations Law 1989 (Aus.)) would apply to breach of the common law duty whereas it has no application to s.214 liability: Re Produce Marketing Consortium Ltd. (d) Perhaps the most important aspect of the development of this doctrine is the way in which it will restrict the power of the shareholders to ratify a breach of duty by directors. Shareholders in certain circumstances can ratify a breach of duty by directors which has the effect of insulating the directors against a subsequent action by the company, e.g. an action by the liquidator against the directors for misfeasance (compare s.598 of Corporations Law (Aus.)). However, where a company is insolvent the shareholders no longer have an interest in the company and there should be no question that the breach can be ratified by the shareholders. For a recent example of a case dealing with the limitations on the power of a company to ratify a transaction: Aveling Barford Ltd. v. Perion Ltd. [1989] B.C.L.C. 626.

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FN24. Report on the Social and Fiduciary Duties and Obligations of Company Directors (Australian Government Printing Service, Nov 1989). FN25. (1988) 13 N.S.W.L.R. 315; 6 A.C.L.C. 725. FN26. Supra, n. 5, 398-400. FN27. A.L.R.C. 45, General Insolvency Inquiry, Vol. 1, p. 125 (1990). FN28. C. A. Riley, ""Directors Duties and the Interests of Creditors" (1989) 10 Company Lawyer 87, 91. FN29. 67 E.R. 189. Note the exceptions to the rule. See, e.g. H. A. J. Ford, Principles of Company Law, 5th ed., Sydney: Butterworths Pty Ltd., 1990, 139- 151. FN30. Supra, n. 7, 117. FN31. Riley, supra, n. 28, 91. FN32. McDaniel, ""Corporate Governance," p. 452. FN33. Riley, supra, n. 28, 91. FN34. Hooker Investments Pty Ltd. v. Email Ltd. (unreported) S.C. of N.S.W. 24 Apr, 1986. FN35. Riley, supra, n. 28, 91. FN36. See case note by J. Hill, supra, n. 10, 527. FN37. D. H. Farrar, ""The Responsibility of Directors and Shareholders for A Company's Debts" (1989) 4 Canterbury Law Review, 12, 20. Note that the Australian Law Reform Commission's latest proposal includes the requirement that an action for breach of the duty to prevent a company from engaging in ""insolvent trading" as defined may be brought through a creditor if the court grants leave: The Law Reform Commission of Australia, General Insolvency Inquiry Report, No. 45, Vol. 1, Chap. 7, para. 283. FN38. Cooke J. in Nicholson v. Permakraft (NZ) Ltd., [1985] I.N.Z.L.R. 242, 249 (C.A.). FN39. Sealy, supra, n. 19, 176-177. FN40. Prudential Assurance Co. Ltd. v. Newman Industries Ltd. (No. 2) [1982] Ch. 204. FN41. Sealy, supra, n. 18 176-177. FN42. Ibid. 185-187. FN43. B. Manning, A Concise Textbook on Legal Capital (2nd ed., 1981), p. 8. FN44. The concept of unjust enrichment explains why the law recognises an obligation on the part of the defendant to make just restitution for a benefit denied at the expense of the plaintiff: Pavey & Matthews Pty Ltd. v. Paul (1987) 162 C.L.R. 221, 257, per Deane J.

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FN45. McDaniel, Bondholders, 303-4, surveyed 20 American cases and concluded that when a transaction is non-Pareto efficient, courts find a breach of a common law duty and award damages to the debt holders to compensate them for their losses. The damage award changes that transaction into one which is Pareto efficient and serves to deter other managers from engaging in non-Pareto efficient transactions. Bratton, Convertible Bonds, felt unable to reconcile the cases (at 698). FN46. F. Modigliani and M. H. Miller, ""The Cost of Capital, Corporation Finance and the Theory of Investment" (June, 1958) 48 American Economic Review, 261-297. FN47. McDaniel, ""Corporate Governance," p. 449. FN48. McDaniel, ""Corporate Governance," p. 448. FN49. Supra, n. 19. FN50. A. H. Barkey, ""The Financial Articulation of a Fiduciary Duty to Bondholders with fiduciary Duties to Stockholders of the Corporation" (1986) 20 Creighton Law Review 47. McDaniel, ""Bondholders," 269-273 draws several analogies from other fiduciary relationships. One such analogy is that debentureholders are comparable to income beneficiaries of a trust while shareholders are comparable to remaindermen. FN51. McDaniel, ""Bondholders," p. 245. FN52. Opportunity loss it the loss that occurs when covenants prevent managers from taking actions that would increase the value of the firm. Expropriation loss is the residual loss to debt holders when managers take actions that transfer wealth from debentureholders to shareholders: McDaniel, ""Bondholders," p. 235. FN53. See Percival v. Wright [1902] 2 Ch. 421. FN54. The ""prisoner's dilemma" represents a situation where an inability to coordinate decisions leads to less than optimal results for the persons affected. See Samuelson, ""Economics" 506-07 (1976). To illustrate, assume a corporation has issued $100,000 worth of shares and $100,000 worth of debentures but otherwise has net assets of $300,000. Both debt and equity holders would stand to gain if they can ensure that management acts to enlarge the size of the pie ($300,000) rather than compete with each other to get a share of the existing pie or still worse a shrinking pie. The inherent danger is that in a system where fiduciary obligations are owed to one group and not also to the other, management will have incentive to act in favour of the group to which obligations are owed thereby accentuating the problem. Where management is held to owe obligations to both shareholders and creditors these two groups can join forces and effectively monitor managerial action rather than be mere pawns in the managerial decision making process. See also Sappideen," Takeover Bids and Target Shareholder Protection: The Regulatory Framework in the United Kingdom, United States and Australia" (1986) 8 Journal of Comparative Business and Capital Market Law 281, n. 174, at 314. END OF DOCUMENT

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