Creditors' rights of recovery: economic theory, corporate jurisprudence and the role of fairness.

• Jurisdiction: Australia
• Author: Anderson, Helen
• Date: 01 April 2006

[This article investigates' the role played by substantive fairness in the determination of corporate law principles as they relate to particularly vulnerable creditor cohorts'. The meaning and relevance of fairness is discussed, and the article examines economic theory both to show which creditors may not be adequately protected ex ante, as well as to evaluate measures of economic efficiency as a determinant of the law. Established legal doctrines are also considered to assess their impact on these vulnerable creditor groups. Commentary on fairness is examined, before concluding that the law needs to take into account economics, traditional corporate jurisprudence and aspects of fairness relating to creditors' vulnerability and expectations. To ensure fairness to directors, their fault should also be considered before liability is imposed on them.]

CONTENTS I Introduction II The Meaning and Relevance of Fairness III Economic Theory in Corporate Law IV Corporate Law Doctrines 13 V Reconciling Economic Theory, Legal Doctrine and Fairness VI Conclusion I INTRODUCTION

The relationships between corporations and corporate stakeholders are governed in a variety of ways--contractually, by common law and by statute. Each of these is underpinned by established legal doctrines, such as the limited liability of shareholders, the separate legal entity of the company and the organic theory of the company, and these in turn are shaped by practical economics in the form of the shareholder wealth maximisation objective.

However, there is no explicit or implicit recognition in corporate law of the issue of whether the outcome of these rules, as opposed to the process by which they are achieved, is fair. This leads to a series of questions--what does fairness in a corporate context mean; should corporate law be fair; and ought fairness to be relevant along with traditional legal doctrines and considerations of economic theory?

The lack of explicit recognition of fairness may be explained by the difficulties in characterising substantive fairness. Given that academic commentators struggle to identify its requirements, it is hardly surprising that courts and legislatures overlook the matter. Perhaps it is simply assumed that the law is 'just' and 'fair', or is at least attempting justice and fairness--but cases, legislation and its explanatory memoranda rarely allude to substantive fairness as an objective of the law.

It should be noted that both the Corporations and Markets Advisory Committee ('CAMAC') (1) and the Parliamentary Joint Committee on Corporations and Financial Services have recently initiated inquiries into 'corporate social responsibility'. (2) Relevant to both inquiries is the question of whether company directors should be permitted or mandated to consider the interests of parties other than shareholders when making decisions. The basis for such consideration is the power of companies to affect the interests of these non-shareholder constituencies, particularly those that are vulnerable to any abuse of that power. While the economic dimension is one consideration, there is also a question of fairness.

It will be argued here that the law should be fair, and that fairness should be considered by judges and legislators in developing corporate law rules. An examination of the deficiencies of economic theory and legal doctrine supports the search for a further basis for deciding the direction of corporate law. This article suggests that this additional basis should be fairness.

While consideration of economic theories is useful in understanding market mechanisms, and the established legal doctrines are fundamental to incorporation, neither are sufficient to ensure that the outcome of corporate law is fair. This article will concentrate on creditors, a group that is particularly vulnerable to unfair treatment. While a company is a going concern and the creditors are being paid, the question of substantive fairness generally does not arise, but when the company is unable to pay its debts, those cohorts of creditors who lack the capacity to protect themselves contractually from the risk of non-payment--such as employees, small trade creditors and tort claimants--may be treated unfairly.

Allowing liquidators, and in some circumstances creditors, to recover on the basis of, for example, insolvent trading, might be seen as an attempt to 'be fair' to them. But giving a remedy to one party means the imposition of a liability on another party, in this example, on directors. Fairness involves the consideration of the position of all the parties concerned: the creditors who have suffered the loss, the parties who are required to remedy that loss, and others who are indirectly affected by the claim. It will be seen that it is directors who bear the majority of the burden when courts or legislatures do give recovery rights to creditors. The consequences of the imposition of liability on them flow through to their companies and shareholders. Whether this is fair will be considered below.

Part II addresses the meaning and relevance of fairness in the corporate law context. Part III examines briefly current law and economics discourse to determine which parties may be disadvantaged by the terms of their contracts, and to assess the adequacy of economic theory to guide the determination of creditors' rights. Following on from this, Part IV gives an overview of the jurisprudence governing corporations. Finally, Part V examines the theoretical aspects of fairness, and in particular, will address the questions of whether recovery by creditors of their unpaid debts is necessary to achieve fairness, and if directors are the appropriate parties from whom that recovery should be sought.

The aim of this article is to stimulate debate on the deficiencies of economic theories and traditional legal doctrines as determinants of corporate law, as well as to argue for the importance of substantive fairness despite its present lack of recognition by the law. It does not attempt to suggest ways in which fairness in a corporate context can be achieved. If the relevance of fairness can be accepted and its absence from current common law and legislation acknowledged, practical solutions for the benefit of vulnerable cohorts of creditors may follow.

II THE MEANING AND RELEVANCE OF FAIRNESS

In order to substantiate the place of fairness in corporate law, it is first necessary to define it. It then needs to be asked why corporate law ought to be fair, and whether fairness ought to be considered in place of, or alongside, considerations of economic theory and traditional legal doctrines.

Procedural fairness is well accepted and needs no explanation. On the other hand, the principal difficulty with the discussion of substantive fairness is to identify what is meant by the term. It is therefore hardly surprising that its application in positive corporate law is not readily apparent.

Described by Lawrence E Mitchell as 'one of the great unexplained mysteries of corporate law', (3)

[f]airness, as defined by and as used throughout our legal system, is a concept of balance, of proportionality among the parties to a transaction or proceeding. It is a concept that largely has developed in connection with questions of the justice of contractual or procedural arrangements. It is a concept that, in our society, focuses on process, rather than substance. (4) In the context of determining a fairness test for corporate fiduciaries, he notes:

The attempt to identify and articulate the content of the fairness test is, predictably, frustrating. Courts and commentators have long decried [its] ephemeral nature ... One could dismiss the project by resorting to trite comments about equity in general or by rationally placing confidence in the judgment and 'case feel' of courts long ... accustomed to dealing with such matters. That approach, however, would ignore what is most significant about the fairness principle: it is not only a judicial test of the legality of behaviour but also a standard of conduct. As a test of litigation, it may appropriately set forth circumstances in which legal liability will be imposed. (5) For the purpose of this article, Mitchell's notion of balance and proportionality will be adopted. Despite the difficulties with defining the precise meaning of fairness, it is submitted here that it is not fair that the corporate structure and corporate law should be a means of disadvantaging claimants in contract or in tort, especially when companies become insolvent. Unfairness occurs because there is a lack of balance between companies and their directors on the one hand, and those affected by their decisions on the other. The relevance of fairness as a means of determining the content of corporate law lies first in the failure of either economic theory or traditional legal doctrines to reflect the true state of the present environment in which they operate, and second in the emerging consideration and importance of non-shareholder stakeholders in corporate law.

It is not suggested that the concept of fairness should be a determinant of the rights of a claimant against a company or its directors in a particular case. (6) Rather, this article will suggest that it is unfair for the situation of vulnerable creditor cohorts to be ignored, and that any attempt to remedy this lack of fairness needs to be undertaken by courts and legislatures in formulating and applying specific principles and tests of liability. For example, the interpretation of the doctrine of limited liability currently operates in a manner which is unfair to tort claimants as against directors, and this would be an appropriate place for the law to use fairness as a consideration. (7)

Part III of this article will examine neoclassical economic theory, which concentrates on the attainment of economic efficiency and the role of corporate law in that process. This discussion will...