Directors' Duties to Creditors: Contractarian Concerns Relating to Efficiency and Over‐Protection of Creditors
| Author | Andrew Keay |
| Published date | 01 September 2003 |
| Date | 01 September 2003 |
| DOI | http://doi.org/10.1111/1468-2230.6605001 |
THE
MODERN LAW REVIEW
Volume 66 September 2003 No 5
Directors’ Duties to Creditors:
Contractarian Concerns Relating to Efficiency
and Over-Protection of Creditors
Andrew Keay
n
There is case law to the effect that when companies are in financial difficulty directors
owe a duty to take into account the interests of their companies’ creditors. This article
examines the primary reasons why contractarian theory, as applied by the law and
economics school, is opposed to the existence of such a responsibility, namely it
undermines efficiency and creditors can take measures in order to protect themselves
adequately. The article asserts that efficiency cannot alone determine whether a duty
should or should not be imposed on directors. Another critical value, fairness, must
also be considered, and this value justifies the duty on the basis, inter alia, that many
creditors are not able to protect themselves adequately, or at all by contracting, and
are deserving of the limited protection that the duty would bring. In any event, it is
submitted that a duty to creditors would enhance efficiency in some respects and
warrants consideration on that basis.
Introduction
Company shareholders have been protected for many years, to mixed effect, by the
imposition on directors of fiduciary duties to the company. Traditionally, equity did
not provide any protection for the company’s creditors from the actions of its directors;
creditors had to rely solely on their contractual rights (and perhaps proprietary rights if
they had any) against the company. Yet, in England,
1
parts of the Commonwealth
2
n
Professor of Corporate and Commercial Law, Department of Law, University of Leeds. An
earlier version of this article was presented at the SPTL/SLS Annual Conference on 11 September
2002 and held at De Montfort University, Leicester. I acknowledge the helpful comments and
suggestions of the MLR anonymous referee. Of course, any errors that exist are my responsibility.
Ltd [1982] 3 All ER 1045; Winkworth vEdward Baron Development Ltd [1986] 1 WLR 1512;
Dodd (1988) 4 BCC 30; Facia Footwear Ltd (in administration) vHinchliffe [1998] 1 BCLC 218;
Re Pantone 485 Ltd [2002] 1 BCLC 266.
2 Most notably Australia (Ring vSutton (1980) 5 ACLR 546; Hooker Investments Pty Ltd vEmail
Ltd (1986) 10 ACLR 443; Grove vFlavel (1986) 4 ACLC 654; 11 ACLR 161; Kinsela vRussell
Kinsela Pty Ltd (1986) 4 ACLC 215; (1986) 10 ACLR 395; Jeffree vNCSC (1989) 7 ACLC 556;
15 ACLR 217; Galladin Pty Ltd vAimnorth Pty Ltd (in liq) (1993) 11ACSR 23), New Zealand
(Re Avon Chambers Ltd [1978] 2 NZLR 638; Nicholson vPermakraft (NZ)Ltd (1985) 3 ACLC
453; Hilton International Ltd (in liq)vHilton [1989] NZLR 442), and Canada (Peoples
Department Stores Inc vWise [1998] QJ No 3571 (QSC) (Bankruptcy and Insolvency Division)
(Greenberg J); Canbook Distribution Corporation vBorins (1999) 45 OR (3d) 565).
rThe Modern Law Review Limited 2003 (MLR 66:5, September). Published by Blackwell Publishing Ltd.,
9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA. 665
and the United States,
3
courts have held that as part of directors’ duties to their
companies, directors must, in their decision-making, when varying degrees of
financial difficulty exist, take into account the interests of the creditors of their
companies. Commentators are sharply divided over whether or not directors
should or should not be subjected to such responsibility. Some, such as most of
those taking a contractarian approach, are of the opinion that the market and
freedom of contract are adequate factors to protect creditors, while others, some
of whom advocate what is referred to as the communitarian theory of the firm,
4
are of the view that creditors, amongst other stakeholders in the company, remain
in a vulnerable position and should be protected more adequately by mandatory
rules.
The purpose of this article is to examine the primary arguments that have been
articulated by those contractarians who have condemned the imposition of the
additional responsibility on directors to take into account creditor interests.
Predominantly, although not exclusively, these scholars have embraced a law and
economics approach to corporate law, and it is on the law and economics brand of
contractariansim that the article focuses.
5
The reason for considering contractarian
views is that they have been endorsed by a significant body of corporate law
scholars on both sides of the Atlantic, as well as in several Commonwealth
countries, and even considered by law reform bodies in the UK.
6
It has been
asserted, with some justification, by the Australian academic, Dr Michael Whincop,
that the contractarian paradigm, as developed by law and economics scholars,
dominates the theory of corporate law.
7
Certainly analyses undertaken by
contractarian scholars have enlivened the debate as to how we are to view the
company, and they have fostered some interestingdiscussions that go to the heart of
company law.
3 For example, Geyer vIngersoll Publications Co 621 A 2d 784; Credit Lyonnaise Bank
Nederlander, NV vPathe Communications Corp 1991 Del Ch LEXIS 215; and published at (1992)
17 Delaware Journal of Corporate Law 1099; In re Kingston Square Assocs, 1997 Bankr LEXIS
1514 referred to in D. and A. Sibal, ‘Current Developments: Fiduciary Duties of Directors and
Corporate Governance in the Vicinity of Insolvency’ in Twenty-third Annual Current
Developments in Bankruptcy and Reorganization (London: Practising Law Institute, 2001) 660.
4 Advocates of this approach are more ready to contend for the use of legal rules to structure
relations among the various groups who can be regarded as having a stake in the company, on
the basis that company law needs to confront the effects of managers pursuing shareholder
wealth maximisation. See D. Millon, ‘New Directions in Corporate Law: Communitarians,
Contractarians and Crisis in Corporate Law’ (1993) 50 Washington and Lee Law Review 1373,
1378. For a critique of the approach, see Stephen Bainbridge, ‘Community and Statism: A
Conservative Contractarian Critique of Progressive Corporate Law Scholarship’ (1997) 82
Cornell Law Review 856.
5 Paddy Ireland refers to law and economics that focuses on neo-classical micro-economics as the
more extreme version of contractarianism (‘Defending the Rentier: Corporate Theory and the
Reprivatisation of the Public Company’ in J. Parkinson, A. Gamble and
G. Kelly (eds), The Political Economy of the Company (Oxford: Hart Publishing, 2000) 142 n 4).
6 For example, the Law Commission, Company Directors: Regulating Conflicts of Interests and
Formulating a Statement of Duties (Law Commission Consultation Paper No 153, Scottish Law
Commission Consultation Paper No 105, The Stationery Office, London, 1998) Part 3 (and the
subsequent Report (No 261 (Law Commission); No173 (Scottish Law Commission), Part 2) and
the Company Law Review Steering Group (Modern Company Law for a Competitive Economy:
The Strategic Framework (London: DTI, 1999)).
7 ‘Painting the Corporate Cathedral: The Protection of Entitlements in Corporate Law’ (1999) 19
OJLS 19, 27 (the learned commentator asserts that ‘contractarian theory is inevitable because of
the contractual qualities of corporations’ (at 28)). To the same effect, see the comments of
Chancellor W. T. Allen in ‘Contracts and Communities in Corporation Law’ (1993) 50
Washington and Lee Law Review 1395, 1399; R. B. Campbell Jr, ‘Corporate Fiduciary Principles
for the Post-Contractarian Era’ (1996) 23 Florida State University Law Review 561, 561.
According to Professor S. Bainbridge, contractarianism has ‘mounted a largely successful hostile
[in the US] takeover of the corporate legal academy’: n 4 above, 856.
The Modern Law Review [Vol. 66
666 rThe Modern Law Review Limited 2003
The second part of this article examines the kind of duty that is the subject of
this article. The third part provides an introduction to contractarianism and the
developments fostered by the law and economics movement. It also crucially
discusses the value of efficiency as a critical aspect of law and economics thought
and goes on to consider the relevance of another value, namely fairness, that might
be taken into account when assessing the need for a duty to creditors. Additionally
this part identifies some of the challenges formulated by law and economics to a
duty to creditors. The fourth and fifth parts move on to examine the specific
primary contractarian arguments that have been espoused in opposition to
imposing on directors any responsibility to consider the interests of creditors. The
final part offers some concluding remarks.
At the outset I should explain that the article does not, for two reasons, address
the development, and present state, of the law. First, there have been a number of
substantial articles written over the past 15 years by learned commentators that
have done so,
8
and there is no need to traverse the same ground. Secondly, and
more importantly, the article is concerned with theoretical issues rather than
doctrinal ones. Before assessing the contractarian position on the duty under
study we need to examine the nature of the duty that is being considered.
The nature of the duty
Creditors are able to obtain protection, when extending credit to companies,
pursuant to either self-help strategies or legislative enactment. The former
category essentially involves insistence on the inclusion of certain terms in the
credit contract or requiring the provision of security or guarantees. These, and
other self-help strategies, are discussed in detail later. The legislature has provided
some regulatory protection for creditors, primarily found in the Companies Act
1985 and the Insolvency Act 1986. For instance, section 263 of the Companies Act
proscribes the distribution of company assets to shareholders save where the value
of the distribution is less than the profits that are available for distribution. An
example found in the Insolvency Act (although not limited to insolvency
situations) is section 423 which states, in effect, that creditors are entitled to
apply to a court to have certain transactions at an undervalue entered into by a
8 For example, see F. Dawson, ‘Acting in the Best Interests of the Company – For Whom are
Directors ‘‘Trustees?’’ ’ (1984) 11 New Zealand Universities Law Review 68; L. S. Sealy,
‘Director’s Wider Responsibilities – Problems Conceptual Practical and Procedural’ (1987) 13
Mon ULR164; J. Dabner, ‘Directors’ Duties – The Schizoid Company’ (1988) 6 Company and
Securities Law Journal 105; J. H. Farrar, ‘The Responsibility of Directors and Shareholders for a
Company’s Debts’ (1989) 4 Canterbury Law Review 12; C. A. Riley, ‘Directors’ duties and the
interests of creditors’ (1989) 10 Co Law 87; N. Hawke, ‘Creditors’ Interests in Solvent and
Insolvent Companies’ [1989] JBL 54; D. D. Prentice, ‘Creditor’s Interests and Director’s Duties’
(1990) 10 OJLS 265, 275; V. Finch, ‘Directors’ Duties: Insolvency and the Unsecured Creditor’
in A. Clarke (ed), Current Issues in Insolvency Law (London: Stevens, 1991) 87; R. Grantham,
‘The Judicial Extension of Directors’ Duties to Creditors’ [1991] JBL 1; R. Sappideen, ‘Fiduciary
Obligations to Corporate Creditors’ [1991] JBL 365; S. Worthington, ‘Directors’ Duties,
Creditors’ Rights and Shareholder Intervention’ (1991) 18 MULR 121; D. A. Wishart, ‘Models
and Theories of Directors’ Duties to Creditors’ (1991) 14 New Zealand Universities Law Review
323; J. S. Ziegel, ‘Creditors as Corporate Stakeholders: The Quiet Revolution – An Anglo-
Canadian Perspective’ (1993) 43 University of Toronto Law Journal 511; R. Fisher, ‘Preferences
and Other Antecedent Transactions: Do Directors Owe a Duty to Creditors?’ (1995) 8 Corporate
and Business Law Journal 203; D. Prentice, ‘Corporate Personality, Limited Liability and the
Protection of Creditors’ in C. E. F. Rickett and R. B. Grantham, Corporate Personality in the
20
th
Century (Oxford: Hart Publishing, 1998); A. Keay, ‘The Duty of Creditors to Take Account
of Creditors’ Interests: Has it Any Role to Play?’ [2002] JBL 379.
Directors’ Duties to CreditorsSeptember 2003]
667rThe Modern Law Review Limited 2003
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