The director's duty to take into account the interests of company creditors: when is it triggered?

• Jurisdiction: Australia
• Date: 01 August 2001
• Author: Keay, Andrew R.

[Since the comments of Mason J in Walker v Wimborne, a strong line of judicial opinion has developed whereby in certain circumstances it is mandatory for directors, in discharging their duties to their companies, to take into account the interests of their companies' creditors. But there is uncertainty as to what the actual circumstances are that will lead to directors being required to do this. This article, after briefly discussing the rationale for the duty to take into account the interests of creditors, and its development, identifies and examines the circumstances that have been said to trigger the duty. Next, the article assesses the positions taken in the various cases and considers what circumstances should exist before directors are obliged to consider creditors' interests.]

I INTRODUCTION

It is a well-established principle in company law that directors owe duties to their companies as a whole but not to any individual members or other persons, such as creditors; (1) in fact directors would be acting beyond the scope of their powers if they acted for the benefit of creditors. Yet, by way of exception to this principle, and to the principle established in Salomon v Salomon, (2) it has been held in a significant number of cases in Australia as well as in New Zealand, the United Kingdom and the United States that in certain circumstances it is mandatory for directors, in discharging their duties to their companies, to take into account the interests of their companies' creditors. However, this exception is ill-defined for there is a distinct lack of judicial unanimity as to the actual circumstances which will cause directors to have to consider creditors' interests. The lack of precision in delineating the point at which directors are to have regard for creditor interests, and may potentially become liable, is highly unsatisfactory. While acknowledging the fact that establishing guidelines in this area of the law is not easy, it is submitted that directors in undertaking their decision-making need to be guided by consistent and clear principles so that they know the ground rules and at what point in time, if at all, they are subject to this duty. (3) As a matter of legal certainty and fairness, lines have to be drawn (4) so that directors can be confident that when they act they are taking into account the appropriate interests and that their action is safe from attack. If directors are unable to ascertain, with a fair degree of certainty, what they can do and when they are potentially liable, then, from an academic viewpoint, the law is unjust, and, from a practical perspective, directors will nearly always take the safest option in order to prevent any possible lawsuits. In doing this, directors are likely to act defensively and make decisions not on the basis of what is best for the company, but of what will avoid liability. (5)

This article, after briefly discussing the rationale for the duty to take into account the interests of creditors and its development, will identify and examine the circumstances that have been said to trigger the need for directors to take into account creditors' interests. Next, the article will assess the positions taken in the various cases and consider what circumstances should exist before directors are obliged to consider creditors' interests. It is asserted that there is a clear relationship between the extent of the risk of insolvency and the extent of the permissible risk to which directors can expose the assets of the company. Hence, the duty considered here is designed to protect the assets of the company when they are at risk of being lost. The assets may well be at risk because the directors are tempted to embrace a lucrative deal from which the shareholders will gain (and, if they are shareholders, from which the directors themselves will gain), but which will cause loss to the creditors if the deal is not successful.

There are two issues that have excited some consideration in the case law and academic commentaries that are worth mentioning. The first concerns the kind of creditors to whom a duty is owed. The main debate in this regard has been over whether a duty is owed to future creditors. (6) For the purposes of this article only, it is assumed that a duty is not owed to such creditors; it is only owed to present creditors, that is, creditors in existence at the time when the appropriate circumstances triggering the duty come into being. The second issue is whether the duty owed by directors is a direct duty owed to the creditors, (7) or whether it is an indirect duty in that the duty is owed not to creditors, but to the company to consider creditor interests. (8) Undoubtedly the predominance of opinion is that the latter is correct (9) (with the usual enforcer of the duty on behalf of the company being a liquidator), and this article does not seek to challenge that view. However, for ease of exposition, the article will refer, from time to time, to the duty discussed as a duty to creditors. Given the present state of the law, this is not correct technically, but it is a generally accepted shorthand way of referring to the duty, provided that the necessary caveats are mentioned.

II THE RATIONALE FOR THE DUTY

As will be discussed later, the predominant amount of case law in all jurisdictions considered in this article has taken the view that if a company is in various states of financial difficulty the creditors warrant some special consideration. Certainly if the company is insolvent, in the vicinity of solvency 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.' (10) At this time, because the company is effectively trading with the creditors' money, the creditors may be seen as the major stakeholders in the company. (11) The creditors are protected only by contractual rights, but when companies are financially stressed perhaps it is only fair that their position warrants some form of fiduciary protection, (12) whereby the directors become accountable principally to the creditors. Unless this occurs, then the directors have every reason, at this time, to engage in risky ventures (13) that could bring in substantial benefits, but could, if they fail, imperil the company. The shareholders have little or nothing to lose by such a gamble as they have already lost the money that they invested in the company and they cannot be pursued by creditors because of the concept of limited liability. (14) A venture, however risky, could conceivably turn the company around and provide the shareholders with some return, but such action, if it failed, would see the creditors suffer an even greater loss as they would be the ones to lose out if the company collapsed. (15) The fact is that creditors will receive the same sum irrespective of how well the company performs; therefore, they have the most to lose from risky actions being taken by directors. (16) So, while the doctrine of limited liability shifts the risk of failure from the shareholders to the creditors, (17) the duty to take account of creditors' interests seeks to mitigate the shift. Breach of the duty is usually claimed when the company is in liquidation and the duty is a way of compensating unsecured creditors for whom liquidation is frequently perceived as an empty formality. (18) While most jurisprudence sees debtors as the weaker party in the lending situation, the fact of the matter is that when a company is in financial distress it is the creditors who often occupy a position of weakness. (19)

Finally, while there are provisions in legislation (20) that may protect, or, more correctly, provide some compensation for creditors on liquidation occurring, these provisions are often limited in their application. (21) Hence, prescribing a duty to creditors could be the only way of ensuring some protection for creditors where a company is financially distressed. It is not possible, given the focus of this article, to set out all of the instances in which the duty to creditors might protect creditors more adequately than existing legislative provisions, but a couple of examples might assist the following discussion. First, to establish a breach of s 588G of the Corporations Act 2001 (Cth) it must be proved that the company incurred a debt. There is a plethora of commentaries which identify the problems which exist in establishing this element of s 588G. (22) Second, in order to argue successfully that a payment is, for instance, an unfair preference and, hence, a voidable transaction within s 588FF, a liquidator must prove, inter alia, two elements. Firstly, the liquidator must prove that the payment was given in the six months before the relation-back day (23) (usually the date on which a winding-up application was filed or the company resolved to wind up (24)). Secondly, it must be shown that the payment results in the creditor receiving from the company, in respect of an unsecured debt that the company owes to the creditor, more than the creditor would receive from the company in respect of the debt if the payment were set aside and the creditor were to prove for the debt in a winding-up of the company. (25) Claiming that directors owe a duty to creditors means that these foregoing matters are bypassed.

III DEVELOPMENT OF THE DUTY

Whilst it is unnecessary to provide a substantial discussion in relation to how the law has developed, for this has been done admirably by a number of learned commentators, (26) little has been written on the subject for some years and it is appropriate to set out some of the major developments as a precursor to the discussion which is at the heart of this article.

The duty to creditors is seen as having its genesis in the leading judgment delivered by Mason J in Walker v Wimborne. (27) His Honour said:

In this respect it should be...