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Global rules on foreign direct investment (FDI)
Cross-border acquisitions and investments increasingly trigger foreign direct investment (FDI) screening requirements.
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Global | Publication | June 2021
This article first appeared on Singapore Management University’s Centre of Commercial Law in Asia’s Global Restructuring Initiative blog on June 14, 2021.
UNCITRAL’s Legislative Guide on Insolvency Law is one of the key international policy frameworks intended to assist lawmakers globally to implement optimal insolvency processes. It contains an outline of the objects and principles that should be reflected in domestic and cross-border insolvency systems to achieve the balance that a best-practice insolvency regime aspires to: efficiency and cost effectiveness on the one hand and fairness to competing creditors on the other hand.
The second edition of Part IV of the Legislative Guide on Insolvency Law, ‘Directors’ Obligations in the Period Approaching Insolvency’ ("Guide"), was published in 2019, and concentrates on the underlying principles that should be adopted to regulate directors’ obligations in the period approaching insolvency, including in an enterprise group context.
At a time where entities routinely conduct their operations on a cross-border basis within complex corporate group structures, and where the risk exposure of businesses and their officers continues to expand in a global context of economic and financial instability – sparked by COVID-19, as well as the growth of cyber, climate and other threats – the need for a consistent framework for the regulation of directors’ duties when a company is approaching insolvency has never been greater.
In this article, we outline the primary recommendations for directors’ obligations in the Guide and explore the extent to which those recommendations are reflected in the relevant corporate and insolvency legislation in Australia. In undertaking this comparative analysis, we will also identify areas for possible future law reform to ensure greater consistency and coherence in existing regulatory and policy settings.
The Guide identifies that ‘it is essential that early action be taken’ – in the form of causing a company to enter a ‘relevant and effective insolvency process’ – by directors when a company is facing an actual or imminent inability to meet its obligations as and when they fall due. That is because of the greater potential for rapid financial decline, and harm to the interests of creditors and other stakeholders, the longer directors continue to cause a company to incur debts and refrain from undergoing a restructure or other insolvency process.
UNCITRAL notes in the Guide that a number of jurisdictions have sought to incentivise directors to take early action by: (i) imposing an obligation on a debtor to apply for commencement of formal insolvency proceedings within a specified period of time after insolvency occurs to avoid trading while insolvent; or (ii) focusing on the obligations of directors in the period before the commencement of insolvency proceedings and imposing liability for the harm caused by continuing to trade when it ought to have been apparent that insolvency could not be avoided.
In doing so, the goal is to stop directors from ‘externalising the costs’ of a company’s adverse financial circumstances by placing all of the risks of continued trade on the company’s creditors. However, according to the Guide, a core disadvantage of this liability-based approach is that directors may become overly risk-averse, seeking to avoid any prospect of personal liability by prematurely closing a viable (but distressed) business that otherwise could have survived, instead of attempting to pursue an informal workout while the company continues to trade. This in turn limits the development of a stronger rescue culture as part of local insolvency processes. Indeed, in the revised edition of its Principles for Effective Insolvency and Creditor/Debtor Regimes released in April 2021, the World Bank identifies that informal workouts are an important part of a best practice insolvency system because they provide a more timely, efficient and cost-effective alternative for viable businesses than formal insolvency options which are often cost-prohibitive and may spell the end of any prospect of an entity trading out of its difficulties.
While many jurisdictions have made progress in ‘refocusing’ insolvency laws with the stated aim of encouraging rescue and reorganisation through informal workouts, the Guide notes that ‘there has been little focus on creating appropriate incentives for directors to use those options’. Particularly where there is no carve-out for insolvent trading liability for directors when an informal workout is being pursued, the imposition of that liability may in fact limit resort to informal restructuring options for viable entities, and therefore the achievement of optimal insolvency outcomes as well as value creation and economic and financial stability on a macroeconomic level.
The Guide also identifies another difficulty for directors when a company is operating in an insolvency context: reconciling the different interests of creditors and shareholders, with the latter tending to favour high-risk strategies to save a company in financial distress to increase shareholder value knowing that there is the protection of limited liability if a high-risk manoeuvre fails.
UNCITRAL takes the view that the core objective in effectively regulating directors’ conduct when a company is nearing insolvency is to seek to balance the often competing goals and interests of different stakeholders: preserving the freedom of directors to discharge their obligations and exercise their judgment appropriately, encouraging responsible behaviour, discouraging wrongful conduct and excessive risk-taking, promoting entrepreneurial activity, and encouraging, at an early stage, the refinancing or reorganisation of enterprises facing financial distress or insolvency.
In implementing this balance, UNCITRAL recommends the following regulatory framework (recommendations 255 to 256): (i) directors ought to have a duty to have due regard to the interests of ‘creditors and other stakeholders’ and to take ‘reasonable steps’ to avoid insolvency and, where insolvency is unavoidable, to minimise the extent of insolvency; and (ii) ‘reasonable steps’ might include matters such as directors evaluating and being independently informed as to the current and ongoing financial situation of the company, seeking professional advice, holding discussions with auditors, protecting the assets of the company to maximise value, considering the structure and functions of the business to examine viability and reduce expenditure, continuing to trade in circumstances where it is appropriate to do so to maximise going concern value, and holding negotiations with creditors or commencing other informal procedures.
According to the Guide, it is also critical for the time when these duties arise to be clearly stated in enabling legislation because, without a clear reference point, directors cannot precisely predict when their personal duties, and potential liability, may crystallise. Again, that may deter responsible risk-taking, including the continuation of trade while an informal workout is pursued. UNCITRAL therefore recommends that the duties owed by directors when the company is facing insolvency ought to arise at a point in time when a director knows, or ought reasonably to have known, that insolvency is imminent or unavoidable (recommendation 257).
In quantifying liability for any breach of these duties, UNCITRAL recommends that local laws should provide that liability is limited to the extent to which the breach caused loss or damage to creditors (recommendations 259 to 260).
It is also recommended that the ‘directors’ owing the duties ought to be specified as not only formally appointed directors but also ‘any other person exercising factual control and performing the functions of a director’ (recommendation 258). This is to reflect the practical reality that persons other than appointed directors may act in the same underlying capacity as appointed directors, exercising real control and influence over the affairs of the company, and those persons ought to be subject to the same duties to incentivise proper and responsible conduct towards creditors.
UNCITRAL’s recommendations are broadly reflected in substance in the Australian regulatory regime, although in a somewhat modified form. Nevertheless, there are both: (i) some legislative improvements that could be made to the Corporations Act 2001 (Cth) (Act) to better reflect the important policy objectives identified in the Guide; and (ii) some cases in which the Act’s expression of directors’ duties in an insolvency context may be seen to more effectively facilitate efficient and fair insolvency outcomes than the recommendations in the Guide.
First, the duty stated in the Guide for directors to have regard to the interests of ‘creditors and other stakeholders’ is inherent in the statutory duty that directors have under section 181(1)(a) of the Act to act in good faith in the best interests of the ‘company’.
Although the interests of creditors are not expressly delineated, Australian courts have held that when a company is operating in an ‘insolvency context’, the identity of the ‘company’ corresponds to the interests of the company’s creditors: Walker v Wimborne (1976) 137 CLR 1 (Walker). However, what is meant by an ‘insolvency context’ is yet to be clearly articulated by the courts – with various formulations put forward such as the need for a ‘real and not remote risk of insolvency’, a matter assessed objectively: see, for example, Kinsela v Russell Kinsela Pty Ltd (in liq) (1986) 4 NSWLR 722. That formulation reflects the UNCITRAL recommendation that duties owed by directors when the company is facing insolvency should be triggered when a director knows or ought reasonably to know that insolvency is imminent or unavoidable.
Nevertheless, leaving these matters to inference from court decisions, rather than being expressly contained in the Act, creates confusion and incoherence in the law. To enhance regulatory certainty and indeed the likelihood that directors, when aware of both the content of the duties and the times when those duties are triggered, will in fact comply with the duties, it would be beneficial for the Act to specify that the section 181(1)(a) duty is owed to the company’s creditors when a person could reasonably form the view that insolvency is imminent or unavoidable.
At the same time, notwithstanding UNCITRAL’s recommendation in the Guide, it may be questioned whether the duty ought to extend to ‘other stakeholders’ in times of doubtful solvency. Indeed, prescribing ‘other stakeholders’ in local enabling legislation is likely to spark more, not less, uncertainty. In that regard, it is a core tenet of insolvency policy globally that shareholders of a company are residual claimants only, whose interests are deferred in the distribution of an insolvency estate. The interests of creditors are the interests that ought to prevail in an insolvency context and which may fairly be correlated with the identity of the company itself. If a particular company is incorporated to achieve other special purposes in the interests of a broader group of stakeholders (other than shareholders or creditors), such as health, education, artistic or other public interest purposes in the case of government-owned or other statutory corporations, then the duty of directors to consider those purposes in their business decisions ought to be expressly stated in the company’s constitution and the role of legislation ought to be confined to recognising the ability of directors to pursue those purposes if so provided for in the company’s constitution.
By way of example, a provision of that kind exists in the United Kingdom under section 172(2) of the Companies Act 2006 (UK), which states that a director’s duty under section 171(1) to act in a manner which promotes the success of the company for the benefit of members (and creditors in an insolvency context, a matter separately recognised in section 172(3)) has effect ‘to the extent that the purposes of the company consist of or include purposes other than the benefit of its members’, as if ‘the reference to promoting the success of the company for the benefit of its members were to achieving those purposes’.
Contrary to the recommendation in the Guide, there is no express duty in the Act for Australian directors to take reasonable steps to avoid insolvency or to otherwise minimise the extent of insolvency, with a liability to compensate creditors for loss or damage caused by any breach. Rather, section 588G of the Act imposes a duty for directors to avoid insolvent trading – specifically, the incursion of a debt by the company when it is either insolvent or otherwise becomes insolvent by incurring the debt and, at that time, there are reasonable grounds for suspecting the company is insolvent or would become insolvent as the case may be.
Nevertheless, the effect of section 588G is substantially the same as the recommendation in the Guide. That is because one of the defences to insolvent trading in section 588H of the Act is proof that a director took ‘all reasonable steps’ to prevent the company from incurring a debt. Those reasonable steps may feasibly include the suggested ‘reasonable steps’ in the expression of the duty in the Guide, matters which would also be relevant in a court’s assessment of whether a director has breached the section 181(1)(a) duty – as well as an additional duty in section 180 of the Act to act with reasonable care, skill and diligence. Further, liability for a contravention of section 588G includes compensation payable to the company’s creditors under section 588J, quantified as the value of the debts incurred. Likewise, the compensation for loss or damage recommended by UNCITRAL to be included in a regulatory scheme for directors’ duties would also in practical terms be quantified as the value of debts incurred when the company was operating while insolvent.
As noted, one of the important objectives identified in the Guide is to create a regulatory regime for directors’ duties which encourages directors to pursue an informal restructuring. In Australia, that objective is reflected in the safe harbour from insolvent trading included in section 588GA of the Act. The provision applies when directors seek to ‘develop a course of action reasonably likely to lead to a better outcome for the company’ than immediate winding up. This is designed to give directors an incentive to appoint a restructuring adviser in pursuit of an informal workout where a company is in financial distress but is viable in the long-term. Indeed, that underlying policy objective is directly reflected in the Explanatory Memorandum to the legislation which introduced section 588GA into the Act in 2017 – the Treasury Laws Amendment (2017 Enterprise Incentives No 2) Act 2017 (Cth). The Explanatory Memorandum states that the safe harbour is intended to drive cultural change amongst company directors by encouraging them to keep control of their company, engage early with possible insolvency and take reasonable risks to facilitate the company’s recovery instead of simply placing the company prematurely into voluntary administration or liquidation.
Arguably, the safe harbour in the Act provides a better balance between the encouragement of risk-taking by directors in the pursuit of value creation and the rescue of viable businesses on the one hand, and fairness for creditors on the other hand. Indeed, in providing immunity from insolvent trading liability, section 588GA provides an incentive for directors of a viable company to refrain from causing the company to immediately enter a formal insolvency process while an informal restructure is investigated. The ‘better outcome’ threshold serves to ensure that the safe harbour is not abused insofar as directors will not be immune from liability unless an informal restructure is reasonably likely to achieve a greater return for creditors than an immediate winding up or another formal insolvency process. As drafted, the recommendations in the Guide do not provide for that minimum protective threshold for creditors.
Finally, the definition of a ‘director’ in section 9 of the Act includes not only appointed directors but also: (i) those who act in the position of a director (commonly known as a ‘de facto’ director); and (ii) those whose instructions or wishes appointed directors of the company are accustomed to act in accordance with (commonly known as a ‘shadow’ director). This reflects the same policy identified in the Guide that it is not merely appointed directors who can influence the company’s affairs, but also other persons who act in the position of a director without being appointed or who otherwise control the actual activities of the company. Because of their control and influence, and the capacity to prejudice the interests of creditors when the company is facing insolvency, those persons ought to also be subject to the same duties as those who are actually appointed as directors.
UNCITRAL issued the second edition of Part IV of the Legislative Guide on Insolvency Law so that it could incorporate recommendations concerning the duties of directors in a group insolvency situation. This coincided with UNCITRAL’s adoption of the Model Law on Enterprise Group Insolvency, also in 2019, which built upon Part III of the Legislative Guide on Insolvency Law, ‘Treatment of Enterprise Groups in Insolvency’, in 2012.
This part of the Guide identifies the core tension that arises for directors in a corporate group context. While each company in the group is a separate legal entity, and directors are expected to ‘promote the success and pursue the interests of the [specific] company they direct’, the reality is that members of a corporate group are typically interdependent and integrated, and ‘addressing the financial difficulties of that company in isolation is likely to be difficult, if not, in some cases, impossible’.
The Guide therefore sets out a regulatory solution which recognises the ‘economic reality of enterprise groups’ while also identifying safeguards to protect the interests of creditors of individual group members by deterring directors from ‘tak[ing] advantage of more vulnerable and dependent enterprise group members for the benefit of other members, such as through transfers of assets, diversion of business opportunities and use of those enterprise group members to conduct more risky transactions or activities or to absorb losses and bad assets’.
The Guide also addresses the further tension that exists when a single person acts as the director of multiple group entities and is required, in an insolvency context, to balance potentially competing economic goals and needs of individual group members compared to the group as a whole. In doing so, the Guide proposes measures for the identification and management of conflicts of interest by directors of multiple group entities.
The specific recommendations in the Guide are that, when two or more companies in a corporate group are facing imminent or unavoidable insolvency (recommendations 267 to 270): (i) directors’ duties should apply in relation to each company, so that directors must, prima facie, act in the interests of the creditors and other stakeholders of, and seek to avoid or minimise the extent of insolvency for, each company to which they are appointed; (ii) nevertheless, where a person is a director of two or more companies, he or she may take reasonable steps to promote a ‘group insolvency solution’ which addresses the insolvency of the group and takes into account the possible benefits of maximising the value of the group as a whole, provided creditors and other stakeholders of each group member ‘are no worse off than if that enterprise group member had not been managed so as to promote such a group insolvency situation’; (iii) where a conflict of interest exists between the obligations owed to different group members, insofar as it is impossible to advance the interests of one group member without causing detriment to the interests of the other group member, a director should take ‘reasonable steps to manage the conflict’; (iv) insolvency laws should specify what these ‘reasonable steps’ are, and they may be stated to include disclosing the nature and extent of the conflict to the board and/or shareholders, requiring the director to refrain from participating in board resolutions on matters giving rise to the conflict, or from attending board meetings altogether where those matters are to be considered, seeking the appointment of additional directors and, as a last resort where there is no other alternative course of action to manage the conflict of interest, resigning from the board of directors.
In Australia, courts have taken a strict approach in regulating the duties owed by directors in a corporate group context, and that approach is consistent with UNCITRAL’s recommendations in the Guide. Thus, in the High Court decision in Walker, Justice Mason emphasised the ‘fundamental principle’ of corporate law doctrine that each company is a ‘separate and independent legal entity’, so that directors must consider the interests of the individual company to which they are appointed in discharging their duty to act in the best interests of that company.
Nevertheless, Australian courts have also held that, in a corporate group ‘with interdependent interests’, directors are entitled, ‘provided the interests of the group remain compatible with the interests of an individual corporation, to also give consideration to the interests of the companies as a group in determining whether the best interests of an individual company would be met by a proposed course of action’: see the landmark decision in the 20 year Bell Group litigation in Westpac Banking Corporation v The Bell Group Ltd (in liq) (No 3) [2012] WASCA 157.
With that proviso, taking into account a ‘group insolvency solution’ within the formulation in the Guide would be permissible according to the case law approach in Australia. However, the inclusion of an express statutory formulation of this aspect of directors’ duties in a group insolvency context would be beneficial to ensure greater clarity and consistency, in particular by adopting the suggestion in the Guide for a ‘no worse off’ safeguard to ensure that the interests of creditors of one group entity cannot be, effectively, traded off to benefit creditors that are greater in number and/or value across the broader group.
The Australian legal position on the management of conflicts of interest could also benefit from statutory clarification in the manner suggested in the Guide. In particular, this issue is currently one that has been left to the courts to resolve and the authorities have diverged in assessing what a director is required to do in the event of a conflict. In some cases, it has been held that a director must at least disclose the relevant conflict to the board and also refrain from board deliberations and voting on a matter giving rise to the conflict: see, for example, Fitzsimmons v R (1997) 23 ACSR 355 and Permanent Building Society (in liq) v Wheeler (1994) 14 ACSR 109.
In other cases, it has been held that a director may have an obligation to take positive action to prevent a transaction giving rise to the conflict from occurring, for example by disclosing special knowledge of facts that may disadvantage the company and that are not known to other directors: Groeneveld Australia Pty Ltd v Nolten (No 3) (2010) 80 ACSR 562.
The inconsistent positions taken in the case law increase the regulatory burden not only on directors, but also on insolvency practitioners required to assess, during the course of an insolvency appointment, whether directors and other officers may have breached their duties and, if so, whether to pursue recovery proceedings. The legal uncertainty in turn leads to inefficient outcomes in insolvency processes.
The Guide provides a useful policy framework for the regulation of directors’ duties in an insolvency context, including in a corporate group setting, which is capable of enhancing regulatory certainty and achieving fairer and more efficient insolvency outcomes in all jurisdictions across the world. Consideration of the extent to which UNCITRAL’s recommendations in the Guide are reflected in Australian law reveals that, while the recommendations broadly accord with the existing approach in Australia in substance, the form of implementation differs in material respects. For example, instead of the recommendation in the Guide for directors to have a duty to take reasonable steps to avoid, or reduce the impact, of insolvency, in Australia directors have a duty not to cause the company to trade while insolvent, subject to a defence of taking reasonable steps to avoid the company continuing to incur debts.
This comparative exercise also indicates that: (i) the existing approach in Australia could be improved in material respects to better reflect UNCITRAL’s recommendations in the Guide in a manner that would aid regulatory certainty and the achievement of optimal insolvency outcomes – for example, expressly identifying in the Act that a director’s duty to act in the best interests of ‘the company’ corresponds to the interests of creditors when there is a reasonable likelihood of insolvency, and also clarifying the scope of directors’ obligations in a group insolvency context, including the steps required to manage conflicts of interest; and (ii) in other respects, the existing law in Australia may promote greater efficiency and safeguards for creditors than the recommendations in the Guide – for example, the safe harbour from insolvent trading in the Act which is designed to promote informal restructuring, subject to the achievement of a ‘better outcome’ for creditors.
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Cross-border acquisitions and investments increasingly trigger foreign direct investment (FDI) screening requirements.
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