Incomplete contracts, contingent fiduciaries and a director's duty to creditors.

• Jurisdiction: Australia
• Author: Keay, Andrew
• Date: 01 April 2008

[This article presents economic arguments for extending a limited form or fiduciary duty to creditors. It clarifies the two components of debtor-firm opportunism against creditors: director-opportunism and shareholder-opportunism. The analysis, carried out within the economic perspective of incomplete contracts, focuses on three elements: incomplete contracts, self-interest seeking individuals and consequential ex post opportunism. The emphasis is on suggesting that the catalyst for a fiduciary duty is the presence of opportunistic behaviour, rather than arguing that it will depend on when a firm is in, near, or in danger of insolvency.]

CONTENTS I Introduction II Case Law and the Obligation Owed to Creditors III Corporate Law and Economic Analysis A Incomplete Contracts B Incomplete Contracts and Under-Investment C Incomplete Contracts and Legal Liability IV Director's Duty to Shareholders A The Origins and Basis of the Duty B Fiduciary Duty to Shareholders: A Closer Examination V Directors' Duty to Creditors in a Debtor-Film A Creditor Protection and Debtor-Firm Opportunism 1 Shareholder-Opportunism 2 Director-Opportunism 3 Reasonable and Legitimate Expectations B The Commercial Law Obligation of Good Faith C Directors' Contingent Fiduciary Duty to Creditors VI Conclusion INTRODUCTION

It is now almost accepted without question, in the courts of a number of common law jurisdictions including Australia (1) and the United Kingdom, (2) that directors of a firm owe a fiduciary duty to their company to consider the interests of creditors ahead of the interests of shareholders when the firm is actually insolvent. (3) But over the years, there has also been a gradual acknowledgement by courts in various jurisdictions that directors owe a fiduciary duty to the company to consider the interests of the company's creditors as well as its shareholders when the firm is short of actual insolvency but near to, or in danger of, it. (4) In the case of Credit Lyonnais Bank Nederland NV v Pathe Communications Corporation ('Credit Lyonnais'), Chancellor Allen of the Delaware Chancery Court ruled that '[a]t least when a corporation is operating in the vicinity of insolvency, a board of directors is not merely the agent of the residue risk bearers [shareholders], but owes its duty to the corporate enterprise [including creditors].' (5)

The Anglo-Australian jurisprudence on this subject can be traced back to the well-known dictum of Mason J of the High Court of Australia in the case of Walker v Wimborne ('Walker') (6) in 1976. His Honour said:

In this respect it should be emphasized that the directors of a company in discharging their duty to the company must take account of the interest of its shareholders and its creditors. Any failure by the directors to take into account the interests of creditors will have adverse consequences for the company as well as for them. (7) Later, in something of a controversial judgment, Lord Templeman in the House of Lords' decision in Winkworth v Edward Baron Development Co Ltd ('Winkworth') said:

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. (8) All three judges recognised that when a company is in financial difficulty, some element of obligation is owed to creditors by directors at some point. Chancellor Allen was somewhat more explicit than the other judges as to where and when this occurs, stating that the duty owed to creditors (who are part of the corporate enterprise) arises in the 'vicinity' of insolvency alongside the duty owed to shareholders. (9) Within this vicinity, the board of directors is not merely the agent of shareholders (who are, by implication, merely part of the principal) but owes its duty to the corporate enterprise as a whole. In other words, directors become the agent for the corporate enterprise, which includes shareholders and creditors. (10)

While Chancellor Allen's concern was clearly directed towards the effects of the vicinity of insolvency on creditors before the firm was in actual insolvency, Mason J held that directors must look after the interests of shareholders as well as those of creditors. By implying that creditors may not be able to look after their own interests exclusively by other means if directors fail to do so, Mason J appears to have suggested an element of creditors' reliance on directors under certain unspecified conditions. The implication, nonetheless, is that the nature of the duty owed to creditors (upon which the creditors rely under certain unspecified conditions) is a fiduciary one arising from an agent--principal relationship.

In contrast to the other two judges, Lord Templeman's emphasis is different. He was clearly concerned with the possibility of directors being in the position to take advantage of creditors for the benefit of directors themselves (as opposed to, or perhaps in addition to, the benefit of shareholders) and that this fact is not sufficiently recognised. Thus, it is of interest to note that all three judges, in three different jurisdictions, suggested that the nature of the obligation to creditors is not fundamentally different from the fiduciary duty owed by an agent to a principal. This fiduciary duty is owed, if not directly, to creditors, indirectly to them through the directors' fiduciary duty to the firm.

The reason given for the shift to consider creditor interests either along with, or in substitution for, shareholder interests (11) is the gradual realisation that if the company is insolvent, in the vicinity of insolvency or embarking on a venture which it cannot sustain without relying totally on creditor funds, 'the interests of the company are in reality the interests of existing creditors alone.' (12) At this time, the shareholders are no longer the owners of the residual value of the firm (13) as they have been usurped by the creditors, whose rights are transformed

into equity-like rights. (14) Thus, the directors are effectively playing with the creditors' money, (15) which means that the creditors may instead be seen as the major stakeholders in the company. (16)

The question that this precipitates is: should the relationship between directors and creditors be construed as one between agent and principal and, therefore, a fiduciary one? Is there a theoretical basis for such a status? If yes, should creditors be accorded the status of a principal to whom directors (as agents) owe a fiduciary duty? At what point does this status arise?

The progressive school of thought has provided provocative community-based arguments in support of a fiduciary duty being owed to creditors by directors in relation to the theory of corporate law. (17) This school bases many of its arguments on fairness.

In contrast, the law and economics school argues that efficiency is a critical or indeed the sole element in determining what approach should be taken. It advocates a contractarian approach that embraces the freedom-to-contract. position--a position which presumes that individuals should be able to make whatever contracts they see fit. (18) The corollary of this latter position when combined with the neoclassical model of economics is that the question of fiduciary duty does not arise between directors and creditors as creditors are adequately protected by contracts which they enter into freely. (19) It is shareholders who should benefit from fiduciary duties; they need such duties to protect themselves because they are less able to safeguard their position through contract. (20) Of course, it is of interest to note that the law and economics school, in general, takes no issue with the directors' fiduciary duty to shareholders (even though shareholders are protected by contracts which have been entered into freely) nor with the implicit assumption that the shareholders' contracts offers insufficient protection.

Like law and economics scholarship, this article adopts an economic approach in order to address the questions posed above. However, the economic approach adopted is one that goes beyond the neoclassical model by shifting the focus of economic analysis of the firm from profit maximisation to resolving conflicts of interests between contracting parties. (21) Specifically, we seek to address the issue of directors' duty to creditors from the economic perspective of incomplete contracts. (22) Our principal aim is, first, to illustrate the fact that mainstream economic arguments can be used to support the recognition of a fiduciary duty owed to creditors by directors of the debtor-firm under certain conditions and, secondly, to propose a case in support of recognising directors' fiduciary duty to creditors on economic grounds. (23) It is worth noting that, generally speaking, those who have argued for a duty to creditors have done so from non-economic, fairness-based perspectives. (24) Thus, our secondary aim is to suggest that there is actually some degree of convergence between fairness and efficiency (or economic) arguments as far as directors' duty to creditors are concerned.

The balance of the article is organised as follows. Part II traces the way corporate law has developed in relation to the kind of obligation that directors are said to owe to creditors. Specifically, we consider whether the positive law provides that directors owe a direct, independent duty to creditors or whether directors owe their duty solely to the company, which includes, under certain circumstances, taking into account the interests of creditors. Part III, after setting out relevant principles relating to an economic analysis of law, sketches out the theoretical framework of incomplete contracting and outlines its economic implications in the context of directors' duty to creditors. A...