Towards an optimal model of directors’ duties in the zone of insolvency

Introduction

When a company becomes insolvent but it is not yet subject to a formal insolvency proceeding, the shareholders—or the directors acting on their behalf—may engage, even in good faith, in various forms of behaviour that can divert or destroy value at the expense of the creditors. For this reason, most jurisdictions around the world provide a variety of legal strategies to respond to this form of shareholder opportunism. One of these strategies is the imposition of special directors' duties in the "zone of insolvency."  One size does not fit all, however.  Regulators and legislators should consider the country and firm specific factors when modeling the legal structures for the zone of insolvency.

Regulatory models of directors' duties in the zone of insolvency

In a recent article, I analysed the primary regulatory models of directors' duties in the zone of insolvency observed internationally. From a sample of more than 25 jurisdictions from Asia, Australia, Europe, Latin America, Africa, and North America, I distinguish six regulatory models of directors' duties in the zone of insolvency: (i) the imposition of a duty to initiate insolvency proceedings, generally found in Europe and a few other jurisdictions around the world; (ii) the imposition of a duty to recapitalise or liquidate the company, typically existing in Europe and Latin America; (iii) the imposition of duties towards the company's creditors, including the duty to minimise losses for the creditors indirectly imposed by the wrongful trading provisions in the United Kingdom; (iv) the imposition of a duty to prevent the company from incurring new debts, existing in countries like Australia and South Africa; (v) the imposition of a duty to prevent the company from incurring new debts that cannot be paid in full, existing in Singapore and New Zealand; and (vi) the imposition of a duty to keep maximising the value of the firm, found in jurisdictions such as Canada and the United States. Moreover, it should be taking into consideration that, in addition to these special duties generally imposed in the zone of insolvency, corporate directors can be subject to other creditor-related duties. For instance, in the United Kingdom, Australia and Singapore, corporate directors might be required to take into account the interests of the creditors under certain circumstances. In New Zealand, the directors of solvent firms can be liable for 'reckless decision' ultimately harming the creditors.

After analysing the features, advantages and weaknesses of each regulatory model of directors' duties in the zone of insolvency, my paper argues that the 'optimal' approach depends on a variety of country-specific and firm-specific factors, including divergences in corporate ownership structures, firm size, debt structures, level of financial development, efficiency of the insolvency framework, and sophistication of the judiciary.

Factors affecting the desirability of a regulatory model of directors' duties in the zone of insolvency

Corporate ownership structures

In micro and small enterprises (MSEs) as well as large privately owned firms, which are the types of firms found in most countries around the world, there is a greater alignment of incentives between directors and shareholders. Therefore, in the event of insolvency, the directors might be more willing to favour the interests of the shareholders even if it is at the expense of the creditors. As a result, a more interventionist approach to protect creditors, such as the duty to initiate insolvency proceedings, may make more sense. Otherwise, even if the directors do not ultimately harm the creditors once the company becomes insolvent, the existence of this risk may encourage lenders to be more reluctant to extend credit, leading to an undesirable increase in the cost of debt or to most stringent conditions in their debt covenants.

By contrast, in companies with dispersed ownership structures, generally found in the United Kingdom and the United States, a more flexible approach for the regulation of directors' duties in the zone of insolvency may be more justified. Therefore, the duty to maximise value and to keep acting in the best interest of the corporation (US/Canadian approach) or a duty to take steps to minimise potential losses for the creditors (UK approach) can make more sense. In companies with dispersed ownership structures, the directors will be less influenced by the shareholders. Therefore, by being in a better position to preserve their independence, they will have incentives to make value-maximising decisions even if, in the event of insolvency, these decisions do not always please the shareholders. If the shareholders are unhappy with these decisions, the existence of the exacerbated collective action problems existing in companies with dispersed ownership structures will prevent them from quickly removing the directors. Thus, while the separation of management and control is the primary source of agency problems in the context of solvent firms with dispersed ownership structures, it can actually be desirable for the creditors when a company becomes insolvent.

Debt structures

In companies with simple debt structures, as generally occurs in MSEs and large companies in countries with bank-based financial systems, creditors do not face significant coordination costs. Therefore, reaching an out-of-court agreement between debtors and creditors will be more feasible. As a result, since insolvency proceedings might not always be needed, the duty to initiate insolvency proceedings will be less justified. By contrast, in companies with dispersed debt structures, the existence of holdout problems and collective action problems will make certain insolvency provisions – such as a moratorium and the existence of majority rule or even cramdown provisions for the approval of reorganization plans – more needed. Therefore, forcing companies to initiate insolvency proceedings may be more justified in the type of companies with dispersed debt structures generally found in the United States and, to a lesser extent, in other financial centers such as the United Kingdom, Hong Kong and Singapore.

Sophistication of the judiciary

In countries with sophisticated courts, such as the United States, the United Kingdom and Singapore, the involvement of courts in insolvency proceedings is generally justified. Unfortunately, many countries around the world, and particularly emerging economies, might not have an efficient, independent and predictable judiciary comprising experienced, competent and well-equipped judges. In this latter scenario, it would make sense to reduce the involvement of judges in insolvency proceedings. Therefore, those directors' duties in the zone of insolvency requiring a heavy involvement of judges, such as the duty to take steps to minimise losses for the creditors existing under the wrongful trading provisions found in the United Kingdom, should be avoided. In this jurisdiction, the use of relatively clear and bright line rules, rather than broad standards, should be favoured. As a result, a duty to initiate insolvency proceedings may be more desirable in countries without sophisticated courts.

Efficiency of the insolvency system

Many countries, and particularly emerging economies, do not have efficient insolvency proceedings. These inefficiencies can be due to the existence of inefficient laws, inefficient judicial systems, or both. Regardless of the reason, the commencement of insolvency proceedings can be value-destroying for both debtors and creditors. As a result, imposing a duty to initiate insolvency proceedings does not seem a desirable policy in countries with inefficient insolvency frameworks. In countries where insolvency proceedings can serve as an effective and efficient tools that can help debtors and creditors, however, the imposition of a duty to initiate insolvency proceedings can be more justified.

Level of financial development

In countries with developed financial systems, viable companies facing financial trouble may have more chances to obtain new financing. Unfortunately, in many countries around the world, and particularly in emerging economies, companies (and especially MSEs) face significant problems having access to finance even when they do not face a situation of insolvency. Hence, adopting a solution that does not credibly solve the risk of shareholder opportunism in the zone of insolvency can exacerbate the problems associated with the lack of finance often existing in these countries. As a result, in these latter jurisdictions, more interventionist approaches, such as the duty to initiate insolvency proceedings, may make more sense. However, since many companies with underdeveloped financial systems also have inefficient insolvency frameworks, forcing companies to initiate an insolvency proceeding may end up doing more harm than good for the creditors. Therefore, instead of a duty to initiate insolvency proceedings, it would probably make more sense to impose a duty to prevent the company from incurring new debts if the directors know, or ought to have known, that the company will not be able to repay the new debts in full.

Conclusion

Unfortunately for regulators and policymakers, most countries have mixed features. Therefore, designing a desirable model of directors' duties in the zone of insolvency is not that easy. For example, in many countries, and especially in emerging economies, the insolvency system is not very efficient, companies face significant problems having access to finance, the judiciary is not highly sophisticated, and most businesses are MSEs or large privately owned firms.

In those situations, the duty to maximise the value of the firm should be eschewed due to the detrimental effects on the cost of credit that the higher risk of shareholder opportunism associated with this regulatory model may generate, especially in the context of MSEs and privately owned firms. Likewise, if courts are not very sophisticated, judging ex post the particular strategies that the directors adopted to minimise losses for the creditors does not seem a desirable option either. Finally, the imposition of a duty to initiate a value-destroying insolvency proceeding will probably do more harm than good for both debtors and creditors. As a result, in countries with these features, the adoption of other approaches, such as the duty to prevent the company from incurring new debts, can be a more desirable option, especially if it is implemented along with certain safeguards and exceptions, such as those existing in Australia and Singapore.

Regardless of the policy option eventually chosen in a particular jurisdiction or for a particular type of firm, regulators and policymakers need to aware that, when designing a regulatory framework for directors' duties in the zone of insolvency, they cannot just replicate the laws or approaches existing in other countries. In fact, comparing the pros and cons of different regulatory approaches of directors' duties in the zone of insolvency can also be useless, or at least misleading, if this analysis is conducted in a vacuum. Each country has its own features, and the desirability of a particular regulatory model of directors' duties – as well as any other aspect of the insolvency legislation– should be tailored to those features.

For a comprehensive analysis of the insolvency framework and the market and institutional environment existing in emerging economies and how insolvency law should be designed in these jurisdictions, see Aurelio Gurrea-Martinez, Reinventing Insolvency Law in Emerging Economies (Cambridge University Press, Forthcoming, January 2024).

Aurelio Gurrea-Martínez is Associate Professor of Law and Head of the Singapore Global Restructuring Initiative at Singapore Management University.