Insolvency and the judgment of directors

Insolvency and the judgment of directors

03 March 2012 By Lawyers Weekly

Current insolvency law has uncertainty at its heart, creating instability and engendering inefficient outcomes for both debt and equity stakeholders, writes Tom LennoxDirectors of financially…

Current insolvency law has uncertainty at its heart, creating instability and engendering inefficient outcomes for both debt and equity stakeholders, writes Tom Lennox

Directors of financially distressed companies face difficult questions of judgment. Western Australia's Chief Justice, Wayne Martin, expressed the issue in the following terms: "Australian laws against insolvent trading ... encouraged directors of sick companies to put them into administration, even when there was a real prospect that they might be saved to the benefit of investors and creditors". (Australian Financial Review, page 8, 29 May). The current legal framework of insolvency is arguably a contributor to a destruction of value rather than working to fortify the interests of stakeholders (both equity and debt).

There are difficult questions to weigh up. Divergent interests need to be considered - including the sanctity of contract and recognition of property rights. If a loan is in default, then the agreed consequences of that default should be respected. Other factors include the recognition of fiduciary duties - such as the duty of directors to shareholders - maintaining a spirit of enterprise and an ability to accept risk and ensuring the efficient transmission of information to relevant stakeholders (both debt and equity) so that the optimum business decision can be made quickly.


What would be the test of an effective, efficient and just insolvency framework?

Such a framework should allow a considered reflection on what is in the best interests of all stakeholders (both debt and equity). The framework should embed integrity and allow stakeholders to scrutinise decisions made by fiduciaries and there should be certainty and clarity in the law so that stakeholders can calibrate their position according to the legal framework.

At the heart of such considerations is the essence of a corporation as an agent for shareholders and the fact that directors act as fiduciaries for such equity stakeholders - ie the so-called agency problem. On the one hand, shareholders provide directors with a capacity to bind the corporation (and, by extension, the economic stake of shareholders) while on the other hand - and as a necessary consequence - such directors have a discretion as corporate decision-makers.

How are such decisions to be proscribed and how are directors to be allowed to make business decisions without incurring possible personal liability while protecting all stakeholders, and yet still be encouraged to pursue enterprise?

The current legal framework raises several issues.


First, the uncertainty of when precisely a company is insolvent relative to the personal risk of trading while insolvent creates a tendency for directors to err on the side of caution and place the company into administration.

Second, the grounds upon which a company may be placed into administration support this. Directors may resolve to place a company into administration because the directors are of the view that the company is insolvent or is likely to become insolvent at some time in the future (section 436A). Directors, fearing insolvent trading, will be tempted to take the safe harbour of administration based on "likely to become insolvent".

Third, there is a presumption of insolvency in certain instances (see section 459C - eg failure to comply with a statutory demand, execution of process). There is no presumption of solvency.

Fourth, there is no similar "safe harbour" for directors to continue to trade, even though they may be of the view that administration will cause a loss of value for all stake holders (ie debt and equity) which is proportionately far greater than the risk of continuing to trade while solvent.

Fifth, it is true that there is a defence for directors to a claim that the directors traded while insolvent to the effect that where "it is proved that, at the time when the debt was incurred, the person had reasonable grounds to expect ... that the company was solvent at that time". However, this is a defence having established insolvency. A presumption of solvency allows the directors an initial "safe harbour" without the need for a defence to anestablished breach. Better to have no breach to start with.

It is this balance which the law should be encouraged to strike - the one between directors vigorously pursuing the interests of shareholders and creditors contractual and property rights.

It is interesting to apply the Coase Theorem to insolvency law. Ronald Coase, the 1991 Nobel Prize winner in economics, described how a process of bargaining can lead to efficient outcomes - regardless of the initial allocation of property rights.

The proposition is premised on no transaction costs which would impede the bargaining process to an efficient outcome. The counterintuitive insight which follows from the application of the theorem is that the granting of legal rights is irrelevant to the final outcome which will always be the most efficient.

Government's role is to create structures which minimise transaction costs so that any misallocation of resources can be corrected as quickly as possible with a minimum of cost. Once the legal framework is set and the parties are free to negotiate they will bargain themselves to achieve the efficient outcome. Transaction costs will, however, impede this process by erecting a type of barrier to negotiation.

Uncertainty in the law is a type of transaction cost. If the parties are uncertain as to what the law is, they will consider the various possible outcomes and seek to address each one relative to their interests. This creates a spectrum of possible outcomes (with attendant probabilities) and the need to provide resources for each of these outcomes. However, where the law is certain, the need will be to provide resources for only one outcome. Uncertainty requires more resources than would otherwise be the case and, accordingly, is less efficient than where certainty exists.

Current insolvency law has uncertainty at its heart. The meaning of insolvency is notoriously unclear. An aspect of insolvency law is to assess whether it is in the interests of various stakeholders to continue with a going concern or to terminate the entity and liquidate assets. The efficiency of this determination is at the heart of good insolvency law. The determination of whether to continue or to terminate should be soundly based - not the result of an unstable legal framework.

Arguably, current insolvency law evidences elements of this instability. For example, directors of a financially distressed company are put in the position of accepting the risk of personal liability for insolvent trading or administration, while knowing that great uncertainty surrounds the meaning of insolvent. To apply Coase's analysis, creditors know this and also know that if a company is placed into administration, there is an instant loss of value by reason of the termination of the company as a going concern and the need to value assets on a liquidation basis.

To avoid this outcome, creditors may seek to provide comfort to directors that the company remains solvent. However, the certainty of continuing solvency may not be completely determined by creditors. Other factors may be relevant, such as the capacity of the company to effect asset sales or raise capital. The net effect is a structure which puts directors in a position of great personal risk relative to their obligations to debt and equity holders.

A few thoughts for reform. Consideration should be given to reducing the costs of uncertainty by seeking to clarify when a company is insolvent. For example, allow a presumption of solvency if directors have data supporting both positive equity and capacity to pay debts for, let us say, the next 30 days. Consideration may also be given to a US style of chapter 11 regime. That is, allowing directors to seek court supervised protection against creditors.

This would be, essentially, the current administration process, but with the directors and not the administrator seeking within a finite time period (eg 6 months) to either restructure or liquidate, again with court supervision. Administration becomes a safe harbour and allows an option of restructure to preserve value.

The scale with which value has been destroyed during this continuing financial crisis quite properly invites reasonable questioning of the efficiency of our insolvency laws.

Tom Lennox is a partner at DibbsBarker

Insolvency and the judgment of directors
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