Directors' liabilities in insolvent company

This article examines and reviews Directors' liabilities of an insolvent company under the US and the English law. Insolvency in English law stands defined in section 214(6) of the Insolvency Act 1986. The insolvency in the US law is considered as a combination of the definition given by section 1302 of the Delaware General Corporation Law and section 101(3) of the Bankruptcy Code, that means, proceedings initiated under Chapter 11 for reorganisation or under Chapter 7 for liquidation amount to insolvency.
In a UK company, directors owe two main duties, the duty of care and skill, and a whole series of duties known as fiduciaries duties. Fiduciaries duties under US law are recognised but have a different classification. A director's duties towards his corporation include the fiduciary of care and the fiduciary duty of loyalty. As such the concept of fiduciary in the US law applies both to the duty of care and that of loyalty.
In both these systems, main implications of duty of care are the requirements of attention and attendance on the part of directors. US law recognises the duty of enquiry as akin to duty of care, since there is a loose connection between the duty of care and the business judgement rule, so that a defendant director may invoke the protection of the rule, however, he should be able to show that his business decision, which has been the subject of complaint, was properly intimated to the concerned.
The fiduciary duty of loyalty under US law and the fiduciary duty in English law bear a similar meaning, since both the systems recognise dedication and undivided loyalty to the corporation from its directors, or in other words directors are required to stand on both sides of a transaction, which is subject matter of conflict of interests.
Under the English law, directors' duties are owed to the company and the term "company" has been interpreted to encompass the shareholders as a body but not as individual or creditors. Recent cases on this subject lay down duties on the part of directors extending towards creditors even prior to insolvency. In West Mercia Safetywear v. Dodd, it was, held that the directors did owe a duty to creditors even before winding up, this view was also followed in the case of Winkworth V. Edward Baron Development Co Ltd.
The appropriate standard for directors' duties, however, include independence and lack of favouritism while serving on the board. Most of the US jurisdictions, particularly Delaware, gives precedence to the director' duties to shareholders on the plea that duty owed to creditors is contractual rather than fiduciary, and that the directors do have a duty towards the claims of creditors even in a financially healthy corporation, though the same is not in practice.
"Agency theory" of US law explains this view as exemplified in Clark v. Lawrence, where it was held that creditors could not sue directors for mismanagement. Corporate directors, according to this theory, are the exclusive agents of stockholders, and the creditors' rights are entirely governed by private contracts. A corporate director however, may be held liable where he extends benefits to the creditors at the expense of shareholders.
Whether the company is insolvent, or even doubtfully solvent, the interests of the company are in reality the interests of existing creditors alone. The breach of fiduciary duty towards the company, where the company is insolvent, or its creditors' becomes a relevant1 fact, a fact which is usually ignored. Where these duties come into conflict with wider issues such as the directors' duties to the society at large in the context of insolvency, it is still a burning issue, (the issue was raised in the case of Welfab Engineer Ltd), In that case, the operating company did make profits until 1979 and thereafter began to show financial deterioration, the board reached to the conclusion that if the company was to continue trading, its principal asset, and a freehold property, would have to be sold, accordingly among various offers made to the company, the directors accepted the lowest offer, since the company was prepared to take the whole of Welfab's assets if the offeror to employ all the company's employees. This welfare oriented approach was rejected by the court as being against the interest of liquidator's claim. The court viewed the above narrated fact as a breach of the director's fiduciary duty to the company's creditors, because the higher offer was uncertain, and company's liability for redundancy reduced the value of the higher offer. The view that the directors were not entitled to sell the company to save employee's jobs on such terms which would clearly leave creditors in a worse position than liquidation was rejected on the ground that an honest attempt to save the business should be judged by a strict standard of business judgement rule. The directors were, thus, not held liable for the alleged breach of duty. In insolvency directors are required to extend benefit to the company's creditors, the US courts have accordingly recognised a very wide discretion available to directors to take into account the society's interests such as "unemployment" and "industrial devastation".
According to the strict standard principle, the first priority in taking a decision in such circumstances is creditors' interests' alone. Accordingly directors are not entitled to sell the company to save their own jobs or those of other employees. The decision of the House of Lords in Winkworth V. Edward Baron Development Co Ltd did raise further questions over directors' duties in insolvency, and Lord Temple observed: "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 confined to its creditors2".
The US law has considered corporate directors' duties to its creditors as an exception to the rule that they owe their duties to its shareholders. Directors of an insolvent corporation have a primary duty of care to its creditors, a duty which should apply when the corporation is arguably solvent but financially troubled, and directors' decisions during this time must be assessed from the viewpoint of the creditors whose assets are at risk3.
Directors of a company facing financial trouble no longer represent stockholders' interests, and due to the insolvency they become trustees or quasi-trustees of the corporation's assets for the benefit of its creditors4. In the English law, the enforcement of the liabilities of directors of insolvent companies is, predominantly undertaken under the civil actions, namely, fraudulent trading, wrongful trading and misfeasance or breach of duty. In addition directors whose conduct in the period prior to insolvency has demonstrated that they are unfit to be concerned in the management of a company, may be disqualified by the court under the term of the Company Directors Disqualification Act 1986.
In the two legal systems, Directors' duties in insolvency have many similarities. Even in assessing a director's performance of his duties, the two legal systems have accepted a partly objective standard. However, the standard of due care in English law is both statutory as well as part of common law, whereas the same test in the US law emerges from Judicial considerations.
There is a significant departure by the English law from the position stated in the US law. English law did regulate the conduct of directors in insolvency through the application of statutory requirements. There is no particular statute to regulate directors' liabilities in insolvency in the US law. The courts in their decision-making process have relied on the common law and corporation law rules based on their own interpretation of such principles.
In the absence of any statutory provisions or codified rules in US, the view of the business community and the role of pressure groups play an important part in affecting the courts' decision. Attention is invited to the reaction of legal and business sectors to the Delaware Supreme Court's decision in Smith V. Van Gorkom.
The attitude of English law towards the corporate directors is more onerous, while the US particularly Delaware law, is more protective. On the other hand, a variety of protective devices are provided by US law such as elimination or limitation of directors' liabilities, "charter cap", indemnification or insurance against liability and the unique protection under the business judgement rule. In contrast, the only protection mechanisms available to English corporate directors are embodied in the insurance provisions5.
(The writer is an advocate and is currently working as an associate with Azeem-ud-Din Law Associates Karachi)
1. A fact which is usually ignored by the dependants.
2. This case denied any direct duty owed by directors to an individual creditor.
3. However, the exercise of the exception has been criticised by arguing that the recognition of a fiduciary duty enforceable by creditors against directors of a nearly insolvent company which is still a going concern may allow them to make inappropriate interference in corporate management.
4. Bankruptcy causes fundamental changes in the nature of the corporate relationship... [0] ne of the painful facts of bankruptcy is that the interests of shareholders become subordinated to the interests of creditors.
5. Section 310(1), and the relief provided under section 727 of the Companies Act 1985.