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To what extent should directors be under a duty to take into account creditors’ interests?

1 Introduction

It is firmly established that directors owe duties to their companies as a whole but not to any individual members or other persons, such as creditors. However, in certain circumstances it has become established in English law, that directors in discharging their duties to their companies must take into account the interests of creditors, on the basis that the interests of their companies encompass the interests of the companies’ creditors. This duty was first established by the obiter dicta of Mason J. of the Australian High Court in delivering the leading judgment in Walker v. Wimborne where his Honour said:

‘In this respect it should be emphasised that the directors of a company in discharging their duty to the company must take into account of the interests of its shareholders and its creditors. Any failure by the directors to take into account the interests of creditors will have adverse consequences for the company as well as for them.’

This statement was subsequently taken up by courts in the U.K. with the result that at certain points in the life of a company, its directors may be forced to give consideration to the interests of the creditors. Thus in Lonrho Ltd v. Shell Petroleum Co. Ltd where his Lord Diplock said that it is the duty of the board to do what would be in the best interests of the company and that ‘[t]hese are not exclusively those of its shareholders but may include those of its creditors.’ In this essay, we investigate whether rationale for this duty, its extent is and finally its limits and scope.

2 The nature and rationale for the duty

There has been a considerable amount of discussion as to whether the duty owed by directors is a direct duty owed to the creditors, or whether it is an indirect duty in that the duty is owed not to creditors, but to the company to consider creditor interests. In this regard, it should be noted that while there has been support for the view that the directors owe a direct duty to creditors, the predominant opinion, both within academic discourse and in judgments is that this is not correct. Rather directors owe a duty to their companies to take into account the interests of creditors. While the former provides for a direct duty, the latter allows for an indirect duty, a duty which is mediated through the company.

The rationale for this duty lies in the fact if a company is insolvent or doubtfully insolvent then ‘the interests of the company are in reality the interests of existing creditors alone.’ At this time, because the company is effectively trading with the creditors’ money, the creditors become the major stakeholders in the company and are, in effect, the real owners of the company; the ownership rights of the shareholders having been expunged as there is nothing over which they have a claim. The creditors, therefore, warrant some form of fiduciary protection. The directors become accountable principally to the creditors as they are the ones to lose out if the company collapses. Consequently, if a company is insolvent, the directors will be held to have acted improperly if they employ funds that are payable to creditors in order to continue the activities of the company. Thus, in situations of insolvency, whilst the doctrine of limited liability shifts the risk of failure from the shareholders to the creditors, the duty to take account of creditors’ interests seeks to mitigate the shift.

4 The extent of the duty to protect creditors’ interests

When a company has a significant amount of assets and the debts owed to creditors are relatively minimal then the interests of creditors should not count for a lot because the company will be able to satisfy them. However, where there is some element of insolvency or possibility of it, the situation is significantly different. In this regard, the courts have taken widely differing views. Some have taken the view that the duty of directors only arises when the company is insolvent whilst others courts have taken a broader view and held that the duty arises where the director has knowledge of a real risk of the company’s insolvency.

While accepting that the duty arises when a company is insolvent, Street C.J. in the frequently cited case of Kinsela v. Russell Kinsela Pty Ltd (in liq) was reluctant to state when the duty arises, save to acknowledge the fact that key factor wasfinancial instability. He held:

I hesitate to attempt to formulate a general test of the degree of financial instability which would impose upon directors an obligation to consider the interests of creditors.

In my view, it seems that deciding whether the duty to protect creditors’ interests had arisen will depend on the facts of each particular case. Clearly the courts have held that directors must take into account creditors’ interests when insolvency exists, but there is significant authority to suggest that this same duty is triggered when a company’s solvency is doubtful or even when a company is suffering financial instability, and possibly when directors are contemplating any action which if unsuccessful would prejudice creditors.

3 The purposes and limits of the directors’ duty to protect creditors’ interests

Actions for breach of duty have been and can, continue to be used to enable liquidators to enlarge the assets available to creditors on an insolvent liquidation. They may also be used to thwart directors from proving in the winding up. Further to that, the duty to take into account creditors’ interests circumscribes the power of the shareholders to ratify a breach of duty on the part of the directors since whenever the duty arises the law is clear that shareholders are unable to ratify directors’ actions. Finally, the existence of the duty to consider the interests of creditors means that there is the possibility, because of potential personal liability, that it will act as a deterrent as far as unscrupulous and reckless directors are concerned so that they do not take actions which may well affect creditors’ rights.

Undoubtedly, there are some disadvantages in pursuing a claim for a breach of duty. One of these is that a court is able where the claim is for breach of duty to grant relief to the respondent director under section 727 of the Companies Act 1985. This provision permits a court to, wholly or in part, relieve officers from liability in relation to proceedings for negligence, default, breach of duty, or breach of trust. The court may exercise its jurisdiction under section 727 only if it is satisfied that the person who sought relief had acted honestly, and reasonably, and that, having regard to all the circumstances of the case, he or she ought fairly to be excused. Thus, although the creditor may establish the existence of the duty and its breach by the director, the court may still exonerate him under section 727.

Further to that, even if a liquidator obtains an order from the court based on a breach of duty, the problem facing the liquidator is that the order has to be enforced against the directors who may be impecunious, rendering the proceedings useless. Thus, the existence of the duty may turn out valueless invoked as is usually the case when the company has become insolvent. This point stems from the fact that is that there is no plain statement in the case law on directors’ duties as to when the duty to creditors is triggered.

However, the biggest drawback with pursuing a claim for breach of duty probably is the fact that the fruits of a successful claim will be available to any secured creditor who has a floating charge over all present and future company property.

5 Conclusion

There is a lot of public policy support for maintaining the existence of the directors’ duty to protect creditors’ interests, especially when the company’s financial basis is not secure. The protection provided by this duty should help bolster that afforded by other statutory devices such as wrongful trading (section 214 Insolvency Act 1986), adjustment provisions (Part IV Insolvency Act 1986), fraudulent trading (section 213 Insolvency Act 1986) and misfeasance (section 212 Insolvency Act 1986).

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Bibliography

Statutes

Companies Act 1985

Insolvency Act 1986

Cases

Brady v. Brady (1988) 3 B.C.C. 535.

Kinsela v. Russell Kinsela Pty Ltd (1986) 4 A.C.L.C. 215.

Liquidator of West Mercia Safetywear v. Dodd (1988) 4 B.C.C. 30.

Lonrho Ltd v. Shell Petroleum Co. Ltd [1980] 1 W.L.R. 627.

Percival v. Wright [1902] 2 Ch. 421.

Re Horsley & Weight Ltd [1982] 3 All E.R. 1045.

Walker v. Wimborne (1976) C.L.R. 1.

Winkworth v. Edward Baron Development Ltd [1986] 1 W.L.R. 1512, 1516.

Articles

Prentice, ‘Creditor's Interests and Director's Duties’ (1990) 10 O.J.L.S. 265.

Prentice, ‘Directors, Creditors and Shareholders’ in E. McKendrick (ed.), Commercial Aspects of Trusts and Fiduciary Obligations (Oxford University Press, Oxford, 1992), 79.

Ross, M ‘Directors' Liability on Corporate Restructuring’ in C. Rickett (ed.), Essays on Corporate Restructuring and Insolvency (Brooker's, Wellington, 1996), 177.

Van der Weide, ‘Against Fiduciary Duties to Corporate Stakeholders’ (1996) 21 Delaware Journal of Corporate Law 27.


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