In this chapter we will look at two related issues; how the somewhat nebulous duties discussed in the previous chapter operate to protect creditors interests and drawing on theoretical writing on corporate governance analyse the extent to which there is potential for conceptual and actual conflicts of interest. The issues that this dissertation attempts to answer are pertinent to the core of corporate governance and therefore I will initially attempt to outline a conceptual background to the debate within this chapter.
Theories of Corporate Governance
The legal framework within which the Corporation as a social entity operates is informed by a vast and at sometimes incomprehensible corpus of economic theory. An understanding of the role of the corporation will give us an understanding of the objective norm by which we are assessing our current legal rules that regulate the relationships of three of the major corporate constituents: Creditors, Shareholders and Directors. Boatright outlines in his introduction the importance of the modern conception of the corporation to corporate law:
‘The modern theory of the firm, which is central to finance and corporate law, views the corporation as a nexus of contracts between the various corporate constituencies. Upon this foundation finance theory and corporate law postulate shareholder wealth as the objective of the firm’
A problematic issue for Corporate Law is that situations of Insolvency challenge the primacy of shareholder wealth maximisation in favour of creditor protection. It causes many scholars in the legal profession to go back to the roots of why ought corporations be shareholder wealth maximising? And furthermore why does it hold such ideological weight?
Undoubtedly shareholders are one of the most important parties in the contractual nexus of a corporation; they provide ready capital, hold a claim on residual assets and bear the residual risk of corporate failure. However their integral role per se doesn’t justify their primacy in corporate law and theory. Boatright summarises the main argument for shareholder primacy:
- Only those who bear the residual risk are appropriate for making discretionary decisions as to wealth-maximisation.
- If employees, bondholders and perhaps creditors had control they would tend to favour decisions that maximise their fixed-claim, this could mean that less-profitable decisions would be taken.
- Even managers and directors will have separate agendas and avoid profitable ventures if it was likely to increase risk to them or reduce their power.
- Only shareholders that bear flexible and varying costs and benefits are in the position to make purely profit-maximising decisions.
In a legal sense this special interest of the shareholders is protected through the operation of fiduciary duties to shareholders, such theories argue that no other party in the corporate contractual nexus would benefit from the arrangement as much and therefore shareholders are more willing to pay for the privilege of having their interests protected whereas creditors and other parties would rather not have their interests tied as closely to the corporations performance as closely. A good example of the distinctive nature of shareholder and director relations can be viewed when we consider the contract of employment. An employee of a firm does not benefit from a fiduciary duty to maximise profits in various ways as such a duty could prejudice them in many ways such as reducing their pay and lengthening their hours. They would prefer a more fixed contractual relationship. The welfare of society is maximised through this corporate arrangement because it is viewed as the most efficient arrangement but by no means the only arrangement other examples can be employee-owned corporations and most pertinent to this dissertation the role of creditors interests. This work is looking at one aspect of the contractual nexus and whether the balance between shareholder and creditor interests is both ethical and practical. Interrelated into this task are other conceptual questions that we are forced to confront.
The Contractual model discussed above is predominant in the literature surrounding theories on the purpose and nature of the corporation however another angle on the debate which this chapter intends to confront is that of the interface between law and ethics. Many of the legal theories on corporate governance are non-liberal, this is important in the sense that the law isn’t defining the boundaries but is looking to shape the individuals into ethical actors. In other words the law surrounding creditor’s interests is tied up with the operation of the law in trying to maximise ethical business relations rather than merely defining the boundaries of freedom within which a director may act as he likes. Fiduciary Duties are the consequence of pro-active policies but the question must be posed when we are looking at the operation of law is whether the law is achieving its aim of promoting ethical behaviour.
In conclusion to this section then we must be clear to understand that the two conceptual norms by which this work is being guided is ought we to put such emphasis on shareholder primacy as a hegemonic icon? And is the law achieving its aim of moralising the behaviour of corporate actors in the balance between shareholder and creditor interests?
Protection of Creditors Interests
The law in the UK on how it protects creditor’s interests was outlined in the previous chapter and this is by no means a repetition of that section. The aim here is to place UK law on the continuum between ‘inclusive’ theories of corporate governance, as outlined in the previous section that place shareholder’s interests at the forefront, and obvious antithesis which are ‘pluralist’ theories of corporate governance which place a premium on balancing the competing interests of the constituents of the corporate contractual nexus. As with any set of theoretical propositions neither exist in the world in any pure form however they are models against which we can assess our law and analyse how our law protects creditors interests, qualified by normative propositions. In attempting to analyse the extent to which directors should owe duties to the creditors we have to first understand what creditor’s interests are and how implementing director’s duties can operate to protect those interests.
We’ll start at a more abstract level and descend to detail later and look at where directors derive all their duties from, as mentioned in the previous chapter the sources are varied and layered coming both from statute and common law. The previous chapter made it amply clear that director duties were to the company. The fiduciary duty is a flexible tool by which the director can be held accountable for his actions potentially to a variety of people within the corporate nexus. Whilst this is not traditional economic theory as I have outlined above it is a corporate legal reality.
In the UK the position presents one of confusion but from the very nature of the confusion emerges simplicity. Fiduciary duties are the flexible method of deciding cases equitably. The court has made it clear that they are distinctly pluralist hiding behind a veneer of inclusivity. The Law Commission’s paper Company Directors: Regulating Conflicts of Interest and Formulating a Statement of Duties makes it quite clear that the fact the fiduciary duties are owed ‘to the company’ does not mean there is one distinct category of individuals who legally make up the corporation. Obviously as we saw in cases such as Winkworth v. Edward Baron Development Co. Ltd and Facia Footwear Ltd v. Hinchcliffe the court can owe duties to creditors if the situation is right, the courts had authority and theoretical underpinning enough that the case could have been decided against the creditors however it would appear that in both those cases it was the equitable nature of the resolution that guided the court.
However, the list of potential parties to whom directors may owe duties is far from closed and can include employees of the corporation and potentially to subsidiary companies. The list is therefore far from closed and on basic principles anybody who could be construed as part of the corporation and puts the director in a position of trust could derive a fiduciary relationship. However in returning to the issue at hand how does the creditor’s interest work, at the moment it is highly nebulous but a recent case has spread distinct light on the issue and is worthwhile considering in depth to appreciate the nuances in this area of law.
In a very open-ended judgement the case of Yukong Line Ltd v Rendsburg Investments Corporation (No 2) it was stated:
‘Where a director… of a insolvent company acts in breach of his duty to the company by causing assets of the company to be transferred in disregard of the interests of its creditor or creditors, under English law he is answerable through the scheme which Parliament has provided. In my judgment he does not owe a direct fiduciary duty towards an individual creditor’
The judgement of Toulson, J in this case relied heavily on the obiter remarks of Dillon L J in Kinsela v Russell Kinsela Pty Ltd (in liq) to the effect that the status quo of corporate law was to identify the company as the shareholders but that through the process of liquidation the court recognised that creditors interests could replace the shareholders because in the reality of an insolvent to going insolvent company it is the assets of the creditors that the director is dealing with rather than those of the shareholder.
The law is in a somewhat dubious state therefore because the actual protection afforded to creditor’s interests is somewhat in doubt. The director’s duty to creditors only protects their rights in relation to Insolvency and only through certain statutory mechanisms. Parliament made its intentions clear in the House of Commons Trade and Industry Committee’s Sixth Report of 2002 – 2003:
‘We see no need to include a duty to creditors in the statement of directors’ duties. …In the same way that the statement of directors’ duties does not include the detailed obligations they are under which derive from health and safety legislation, environmental legislation or employment legislation, neither need it include obligations under insolvency law’
The clear statement from parliament is that a director’s duty to his creditors is a very minor thing which is confined to a specific set of facts and has absolutely no applicability out with that sphere.
To all the directors of UK Corporations this neat distinction may mean very little, whether the reason they have to pay money back comes from the IA 1986 or Common Law will be very little solace but nevertheless for an academic treatment of the subject it is important and is directly correlative to the importance law attempts to shape the ethical behaviour of directors towards creditors. It underlines the fact that in a solvent company the director has no obligation to take the interests of creditors into consideration. However, this may not be detrimental to our case as Boatright points out the lack of consideration of certain parties within the contractual nexus of a corporation may not necessarily be an issue for concern:
‘The comparative neglect of other constituencies in corporate law is not a matter of concern as long as their interests are adequately protected in some manner’
We established in the previous chapter and highlighted here that without doubt in certain situations directors owe a duty to creditors in respect of their interests. However we have to develop an understanding of whether the law as we have discussed previously is adequate?
Creditors may have many interests in the operation of corporation these can include but are not limited to things such as an ability to control Bankruptcy procedures, particularly their consent over liquidation and re-organisation options, furthermore the kinds of things that securities can be placed over, the publication of reliable lists of such securities and importantly for this essay the ability to take remedial action against management for inappropriate alienations or mismanagement. The different approaches that the law takes to the issues will determine whether provisions are adequate, the reason that this is important is because if the controls are inadequate it will encourage controlling stakes to be taken out by creditors which creates ownership problems in the corporations which adversely affects market liquidity and confidence.
The legal situation as far as the extent of creditors’ interests was discussed in the previous chapter however an analysis of that chapter shows one conclusion; the law is somewhat confused. In the situation outlined in Yukong the availability of a statutory duty meant that a fiduciary duty towards a creditor didn’t exist whereas in the case of Winkworth the court specifically stated:
‘A duty is owed by the directors to the company and to the creditors of the company to ensure that the affairs of the company are properly administered and that its property is not dissipated or exploited for the benefit of the directors themselves to the prejudice of the creditors’
So perhaps on occasions such as here where it isn’t a particular transfer of money to avoid creditor claims as covered by s.212 but some other form of breach then the fiduciary duty can arise at common law. The incidence of this is unarticulated, the only rationale that I can take from the two cases is that perhaps where the director would also be in breach of his fiduciary duty to the company for his actions and incidentally affects the interests of creditors then it gives rise to a fiduciary duty. The complexity of this area is due to the highly unlinked decisions and the sparse use of precedent in the case law. Both the judgement in Winkworth and in Yukong contains phrases such as ‘there is a duty…’ and ‘In my judgement…’ with very little explanation of the rationale behind the decision making process.
The confusion is that the use of the term ‘misfeasance or breach of any fiduciary or other duty in relation to the company’ in s.212 of the IA 1986 would seem to create a fiduciary duty but it is wholly statutory and limited to proceedings in relation to the winding up of a company. The issue therefore boils down to whether outside of bankruptcy and the resultant liquidation or administration there are any interests of the creditors which ought to be protected with reference to a directors actions. In looking at jurisdictions from around the world I have tried to identify situations where our law would not give creditors a right of action against directors which other jurisdictions do however it does appear as though our law creates a somewhat wide right in reference to situations in Bankruptcy and winding up, use of the term ‘misfeasance’ is wide enough to catch a variety of different behaviour that directors might make.
In the United States of America, Kempin Jr notes that there is diversion in the types of actions creditors are allowed to take against directors. He acknowledges that it is universal for creditors to be able to challenge or recoup illegal dividends authorised by directors. We have seen this right is present in the UK and well established as the major use of s.212. However, there is a variety of approaches that the law takes to allowing creditors to sue derivatively on behalf of mismanagement. I would argue here that s.212 gives this right but also the case of Winkworth is illustrative where a director was using funds to buy his wife presents, finance his home and buy shares in his company. That kind of mismanagement was actionable by creditors because it directly led to the situation of insolvency. The overall picture in the US is that, as here, the rights are evolving, unforeseen circumstances haven’t been fully catered for and the law is greatly reactive. However it is unilaterally concerned with insolvency as it is here, there is no example of creditors being able to take action against directors for there actions in a solvent company. Perhaps this is not necessary but the multi-faceted world of business sometimes defies neat distinctions. It is far from clear in the UK when exactly a company becomes ‘insolvent’, use of the balance sheet test and the cash-flow test can create divergent conclusions. Insolvency Law is better characterised as a series of situations in which a company may be considered insolvent and give rise to specific actions. A good example would be to look at the facts of Cornhill Insurance plc v. Improvement Services Ltd where the court held a company as insolvent because it was unwilling, rather than unable, to pay its debts. In this situation it isn’t clear whether Creditors either should or could be able to have an action; clearly their action would be one ‘in the course of winding up a company’ but perhaps creditors might be unhappy with the company as a whole and decide to use the opportunity to challenge decisions of directors in a situation under which the director is operating in the interests of the shareholders. In that situation would it be equitable to enforce some kind of fiduciary duty which in reality the director would be hard pushed to foresee. There is nothing to say that the ‘malfeasance’ in s.212 is limited to those that directly effect insolvency. The situation is hypothetical but the existence of a set of facts outside insolvency that may affect creditors’ interests is not unimaginable and eventually there will be a case to push the boundaries and the adequacy of creditor protection will be measured by the response of the law.
Creditors v. Shareholders
In searching for a more holistic understanding of the issue of creditors’ interest and in attempting to answer the level of protection we ought to assign to them in relation to directors’ decisions we have to understand that there are competing interests in insolvency which can place alternating demands on a director. It is clear from Yukong that the common law fiduciary duty which is most commonly owed to shareholders is distinct form the statutory fiduciary duty towards creditors which only operates in the sphere of insolvency.
The theory behind the conflict of interests is clear but can stand re-iteration. As we discussed earlier the Contract Theory of Corporate Personality as outlined by Boatright saw shareholders as the rightful constituents in which to vest the identity of the corporation. The aim of a solvent corporation is to maximise the wealth of their shareholders however the aim of an insolvent corporation obviously brings into play the rights of creditors. Creditors have only a fixed interest rather than a residual interest in a solvent corporation but in the situation of Insolvency which by its very nature means that the company is unable even on liquidation of its assets to cover the amount of its debts Creditors in effect are vested with a residual interest. The replacement of one group by another places very different demands on a director, this is due to the fact that in the case of shareholders their interest is predominantly maximisation of the value of their shares which are directly correlative to the perceived financial strength of the corporation. In a situation of Insolvency the corporation has to protect its already diminished value so that the return for the creditor isn’t going to be less if the business continues as a going concern. However, the origin of creditor-shareholder conflicts runs deeper than this and is a direct offspring of the notion of limited liability. The notion of limited liability means that both the members (such as the directors) and the Investors (mainly shareholders) are only limited to the liability of the money they put into the corporation. Creditors therefore have claim only to the assets of the corporation rather than the personal finances of any particular actors. Fundamentally speaking this means that modern society, in an effort to encourage enterprise, transfers the risk of business failure primarily onto the shoulders of creditors rather than shareholders. The underlying rationale is that nobody would start a business if they felt they would be personally liable for all the companies’ debts. Shareholders want value from their investment and Creditors want to protect their investment by ensuring the company has enough capital to cover its debts. The conflict is therefore fundamentally over the usage of the company’s capital. This is as between creditors and shareholders but at the crux of these competing interests stands the company director(s) who are under a fiduciary duty at all times to at least one of the two parties. The actions they take ought to be directly correlative to the constituent group that they are serving.
We have to also understand that the respective interests and the setup of limited liability can cause incentives for certain kinds of behaviour that are undesirable, the application of the corporate veil means that in situations of insolvency shareholders may be opportunistic in their behaviour and the risk to the creditors is rarely concerned. Given that in most major corporations the position is that the Directors are the shareholders representatives they will receive pressure from shareholders to make such decisions when in fact their true fiduciary duty may lie with the creditors by that point.
A couple of cases will illustrate how the operation of a fiduciary duty to creditors can interfere in normal management decision-making. In the US Eastern Airlines case and Bank of New England case there where finely balanced financial interests to be considered. In the former case the situation was that due to a recession Eastern Airlines had $500 million debt, their current assets on a balance-sheet test totalled $480 million, it was obviously a case of insolvency but the situation was that there was a 50% chance of market recovery with a correlative 50% chance that it wouldn’t in which case the assets of the company could diminish in value to $200 million. In this situation we can see how finely balanced the interests are, the key factor is that recovery was far from hopeless, in the situation where corporate recovery is a possibility then how does a prospective director balance the interests. Shareholders have an interest because if corporate recovery is achieved then they will receive residual benefits; in the Eastern Airlines case the estimated amount was going to be $100 million; however it appears as though creditors have the primacy in this situation to expect directors not to take excessive risks.
The same occurred in the Bank of New England Situation where recovery was a potentiality but if it failed then the creditors would be left with less than 50% recovery of their debts. In this and the previous situation the US Courts has reasoned that any decisions within the ‘zone of insolvency’ must lie in the favour of the creditors and can place a duty on directors not to take undue risks with the capital value of the corporation.
The primacy of creditor interests in situations of insolvency in most jurisdictions flows from a very sound economic rationale. Shareholders when they enter a contract bear the residual risk of a corporation; creditors for very specific reasons do not wish to enter such a contract. Creditors make a fixed claim on a corporation despite the drawbacks of contracting and the potential for contracts to be re-interpreted; they bear the risk that their interest is limited to what is in the contract as opposed to the flexible fiduciary duties of residual claim holders such as shareholders. The benefit for fixed-claim holders over residual-claim holders is that they are accorded primacy where those fixed-claims are threatened. If this weren’t the case, if directors of distressed companies were to accord primacy to residual-claim holders to the detriment of fixed-claim holders then the concomitant risk to fixed-claim holders would be unsupportable. It would lead to an inevitable hiking in the costs of lending and also encourage market behaviour that is detrimental to western markets such as controlling stakes in a company. The law is as it should be, and most commentators would agree with that assessment. However, this does not lead to unanimous legal regulation across the board, the Continental Systems place a premium on creditor interests and the protection not only in the sense of director’s fiduciary duties but also in other statutory schemes for protection whereas the Anglo-American System is argued to place a premium on the free-market and the starting point is argued to be that the creditor bears the risk of loss when lending.
The balance is not all one sided either; the primacy of shareholder claims in situations of solvency can also be contrary to the interests of creditors. A pertinent example would be where a solvent company has high debt leverage, this fact alone reduces the tradable value of their security over the debt and they would also prefer a solvent company not to make risky decision that put the corporation in financial jeopardy. The shareholders in a solvent company are however concerned with maximising profit and the director who fails to aggressively maximise the equity value of a corporation could be in breach of his fiduciary duties to shareholders, during solvency the only impinging interest of creditors is those contained in the contract and these will usually be satisfied as long as repayments are made in the method and in the time period that is set-out.
The question that this work set itself was to discover the extent to which directors ought to have to take consideration of the interests of creditors as a whole. The purpose in identifying the conflicting interests of shareholders and creditors goes to the very heart of this search. An understanding of how the interests of creditors and shareholders differ gives us an understanding of how a director could be pulled in different directions when a company is nearing insolvency. It also highlights why in insolvency a creditors interest trumps that of a shareholder, given the different nature of the contract that they have.
Chapter 4 – Conclusion
The question that this work set out to answer was the extent to which director’s should have a duty to regard the interests of a corporation’s creditors. In the preceding chapters we have discussed the UK’s approach to creditor’s interest through the legal mechanism of director’s duties. It is clear that there is some form of duty concomitant on Insolvency which requires a director to act as a fiduciary for the creditors however the nature, statutory or common law, extent and application of this duty has not been fully tested. We have discussed the theoretical underpinning of the Contract Theory and the reasons that shareholders have primacy in situations of solvency and the rationale behind the shift in situations of insolvency. We also have concluded that the conflict of interests runs deep between the two parties and it is the role of each individual legal system to set the appropriate level of protection to shareholders and creditors.
It is clear from the foregoing that it is necessary for directors to have duties towards creditors. Management of a corporation has a fundamental place as the fiduciary for many of those in the contractual nexus of the corporation, the identification of the corporation with one subset of that nexus is artificial and as Deakin & Konzelman argue the identification of all the corporations interest with shareholders is an artificial view, in areas of insolvency and employee representation the law is rapidly including non-shareholder constituents in the law’s constant dialogue. Furthermore, it had been argued that one of the normative propositions tied up with this work is why does the law give creditors any interests. It is obvious that the areas they operate within are there to encourage business to behave in an ethical manner and not abuse the privilege of limited liability. Ethical behaviour and an aversion away from opportunistic and risky ventures in a situation of insolvency is what are aimed at in a general manner. The level varies, we saw for example in the US where directors can enter Chapter 7 or 11 without creditor consent, Chapter 7 maybe a hopeless dream and end up costing creditors significant amounts of money.
We now move onto the extent that creditors ought to be the subject of director’s duties and again we have seen in the UK and US that it is wholly demarcated to the area of insolvency. The rationale is that fixed-claim and residual-claim holders have distinct roles in situations of solvency and insolvency. The former will only have precedence in situations where there is not enough capital to cover those claims, in other words Insolvency. I have analysed a number of articles and jurisdictions on the issue and have been unable to discover a situation whereby a creditor would have an equitable interest in the operation of a solvent corporation outside the governing contract. I have to side with Boatright on this issue, the neglect of one group to the advantage of another does not by virtue of the fact alone mean the law is inadequate. I am unable to find a potentially unprotected interest and therefore would agree that until such time as there is more case-law on the issue the confinement of creditor interests to situations of insolvency is legitimate in modern societies.
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